Does the IMF have sufficient resources to bail out the emerging markets (2008)

It is now difficult to imagine that only a year ago the IMF was going through an existential crisis. Almost all major borrowers had repaid their loans and some pundits were suggesting that the high level of precautionary FX reserves in the emerging markets would make the International Monetary Fund unnecessary as a lender of last resort. The global financial crisis has of course once again turned the Fund into an important and, in many cases, pivotal global liquidity provider. The financial shock has exposed financial vulnerabilities in a number of emerging markets. Over the past few months, the IMF has increased its loan commitments by more than USD 40 bn. Further loan agreements are ready for approval by the Fund Board or in negotiation currently being negotiated (Belarus, El Salvador, Latvia and, Serbia, Turkey) and other countries may yet be forced to request IMF financial support over the coming months. This raises the question whether the Fund will have sufficient resources to deal with the global financial crisis.

The massive increase in cross-border financial flows has no doubt made it more challenging for the Fund to counter capital account shocks. In 2002, net private capital flows to emerging markets amounted to USD 170 bn. Last year they reached a staggering USD 1,030 bn. Stripping out more stable FDI flows, net private capital flows exploded from an average of USD 10 bn in 1999-2002 to more than USD 550 bn last year. In gross terms, private cross-border flows also skyrocketed. Gross bank lending to emerging markets soared from USD 117 bn in 2000 to USD 455 bn in 2007, while gross bond issuance doubled from USD 69 bn to USD 142 bn over the same period. Net portfolio equity flows amounted to USD 145 bn in 2007, a ten-fold increase compared to 2000!

But have emerging markets not sharply reduced their financial vulnerabilities over the past few years? This is true for most of the larger, systemically important emerging markets, but is not true for the emerging markets universe as a whole. While emerging markets’ FX reserves have risen dramatically over the past few years, the accumulation has been concentrated in just a handful of countries. FX reserves surged by a staggering USD 1 tr in 2007, but the BRIC countries – and first and foremost China – accounted for over two-thirds of the increase. Emerging markets are also running an aggregate current account surplus, but according to the World Bank one in two registered a deficit in excess of 5% of GDP last year! Not all of these countries depend on private capital flows to finance their current account shortfalls, but many of them do. So the IMF will have its work cut out should the current decline in cross-border financial flows prove more permanent than expected. The longer the global crisis drags on, the greater will be the call on IMF financial resources.

The IMF’s lending capacity has improved in recent years following substantial loan repayments by countries such as Argentina and Brazil. As of September, its one-year forward commitment capacity (FCC) amounted to USD 200 bn, not including an additional USD 50 bn under the New and General Arrangements to Borrow (NAB/GAB). In 2002, the FCC stood at a mere USD 74 bn. Nonetheless, the IMF’s financial resources have seen only very modest growth compared to the staggering upturn in private-sector financial flows (e.g. USD 5.7 bn or 1.8% ad hoc quota increase in 2006). The last significant increment took place during the regular, quinquennial general quota review in 1998 when quotas were boosted by 45% (and the NAB was approved). (A second round of quota increases under the quota and voice reform process will, once approved by IMF members, lift quotas by a further 9.6%.)

The Fund’s new short-term liquidity facility (SLF) provides eligible member countries with access of to up to five times their subscribed quota. This means that in a scenario where four of the world’s six largest emerging markets (e.g. Brazil, India, Korea and Mexico) were to draw on the facility at the same time, the IMF’s lending capacity would decline by USD 100 bn overnight. The fact that loans drawn under the SLF are short-term is somewhat of a mitigating factor. We continue to believe that such a scenario is not very likely. But if the past few months have shown anything it is that almost anything is possible and that financial shocks have become more systemic in nature. If in such a scenario several other countries requested substantial stand-by arrangements (or access to the SLF), IMF resources could quickly become stretched. 

Would such a scenario spell doom for the emerging markets? If our optimism about the larger emerging markets were misplaced and several of these countries ended up requiring large bail-out packages, several lines of defence would be available. Other multilateral and bilateral funding sources could be tapped in order to alleviate the pressure on the Fund’s lending capacity. Japan has already offered USD 100 bn. China may also be persuaded to provide additional financing. Being very dependent on trade and enjoying a solid financial position, China would have an interest in stabilising a badly shaken global financial system and pre-empting potential threats to the world trade system. Offering the Fund USD 100 bn in financing would not make a difference to China’s financial stability and politically it would give Beijing an opportunity to strengthen its role as an important stakeholder in the global financial and economic system. Beijing could probably be persuaded to provide funding in exchange for an increase in IMF voting rights. At the multilateral level, the World Bank and other regional development banks could provide additional funding to emerging markets and so could the EU, the US and Japan (and China) on a bilateral basis, either by way of loans or further central bank swap agreements (e.g. recent agreement on establishing/ augmenting currency swap facility between China, Japan and Korea).

In conclusion, even if a prolonged global crisis were to substantially reduce the Fund’s lending capacity and impair its lender-of-last-resort function, this would not necessarily spell doom and gloom for emerging markets. Our baseline scenario remains one where the larger emerging markets will manage to avoid tapping IMF financial support and in this scenario the Fund’s resources should be sufficient to cope with the financial problems that emerging markets are and will be facing over the next 12-24 months.

It's time to start a balanced debate about Turkish EU membership (2008)

European integration has always been an elite project which, more often than not, has suffered setbacks precisely when it sought public support. The nature of representative democracy is such that elected officials take decisions on behalf of the electorate. Nonetheless, this does not (and should not) absolve the political elites of their responsibility to conduct a reasoned and balanced public debate about the potential costs and benefits of the perhaps most controversial item on the EU agenda: Turkish EU membership. Specifically, it is high time to subject the arguments most commonly deployed against Turkish EU membership to thorough scrutiny.

First, there is the geographic argument: most of Turkey is located in Asia; therefore, Turkey cannot become an EU member. This is by far the weakest of the arguments against Turkish membership. Europe as a geographic reality is an arbitrary construct. Would the anti-membership lobby really object were Turkey populated by Christians of “European” descent rather than Muslims of “non-European” descent? Surely, Europe is and aspires to be much more than a geographic concept. Can a Europe whose aspiration is to foster economic integration and close political co-operation among like-minded liberal democracies really exclude a country with the same aspirations on the grounds that the larger part of its territory is not located in the geographic construct called Europe?

The geographic argument is closely intertwined with a cultural argument: Turkey is a Muslim country lacking the Christian and/or Enlightenment traditions necessary to sustain a liberal democratic polity and a successful economy. This argument not only smacks of a neo-colonial attitude but it also flies in the face of modernization theory. Turkey is the most secular state in Europe (with the possible exception of France) and, since the emergence of the Young Turks a century ago, has been committed to modernisation and, at least since Ataturk, to secularism. Non-European societies have built successful democracies and economies. Turkey for one is in the process of doing exactly that. Would it therefore not seem irresponsible to deny Turkey EU membership on the grounds of religion?

The demographic argument goes something like this: Turkey will be the EU’s most populous country and will upset the EU’s internal political balance. Turkey’s population will exceed that of Germany, currently the EU’s most populous country, as early as 2015, according to the UN. In 2025, the EU-27 will have a population of almost 500 m versus Turkey’s 90 m. In 2050, when Turkish population growth will fall to zero, the respective figures will be 470 m versus 100 m. Turkey’s population share of the EU total would then almost exactly equal Germany’s current 17% share. If a far wealthier Germany is not regarded as dominating the EU today, why should there be reason to be concerned about a demographically equal, but economically far less powerful Turkey in 2050?

Source: UN

Fourth, the political-institutional argument comes in several versions, the most common of which perhaps is: Turkish membership would make EU governance even more unwieldy. Often this is combined with the concern that Turkey, as the quintessential “modern state”, might be less prepared to accept the consensus-oriented EU culture. (The same argument has been used in relation to the recent “joiners”.) It is undoubtedly true that the larger the number of countries, the more difficult it will be to find consensus. But is this really a good enough reason to keep Turkey out of the EU? Will adding one additional member make a big difference? If so, how can the EU afford to admit Croatia but not Turkey? Should the prospect of Turkish EU membership not instead be regarded as an incentive to push forward with much-needed institutional reforms?

The most common economic argument against Turkish membership is the following: Turkey is too poor to join the EU. According to World Bank data, per capita income is higher in Turkey than in Bulgaria and Romania, while Romania’s agricultural sector is even larger than Turkey’s as a share of GDP. On the other hand, Turkey has by far the largest share of its workforce deployed in agriculture (25% versus Poland’s 15%). Add to this the fact that Turkey’s economy is larger in terms of GDP and population and it is clear that an unreformed EU agricultural policy could come under strain following Turkish accession. (The same applies to EU financial policies more generally.) Should this not provide the EU with an incentive to reform what is in obvious need of reform? Will Turkey not have a much more modern and developed economy by the time it joins, making integration much more manageable?

Finally, there is the security argument: Turkish EU membership would directly expose the EU to a geo-politically volatile part of the world. Turkey shares borders with countries such as Georgia, Iraq and Syria. (Some add that membership would also import into the EU a territorial conflict over Cyprus; but this conflict would presumably have to be solved before Turkey becomes a member.) This argument overlooks that Turkey has been a NATO member since 1952. Turkey therefore already benefits from a security guarantee under NATO’s article 5, which most EU members are already a party to by virtue of NATO membership. So what additional security commitments or geo-political risks would Turkish EU membership create for the EU? And in terms of the conflict with the PKK, is this conflict all that different from similar conflicts in some of the current EU member states?

The most commonly deployed prima facie arguments against Turkish EU membership look pretty weak. This is not to say that Turkish EU accession will not bring challenges. But so did the admission of the Eastern European countries. The big difference is that for the European elites, and to a lesser extent the European public, the case for admitting the former Eastern bloc countries was equivalent to a dogma. The Merriam-Webster dictionary defines "dogma” as a “point of view or tenet put forth as authoritative without adequate grounds”. This is not to say of course that there were no very good reasons for eastward enlargement (there were), but the wisdom of enlargement was taken for granted. The debate about Turkish EU membership is often similarly riddled with dogmas, but in this case with dogmas opposing membership. It is high time to rid the debate of dogma and conduct a reasoned debate about the costs and benefits of Turkish EU accession.

BRICs as international investors: China in a class of its own (2008)

The BRIC story is common knowledge by now. The BRIC countries are characterised by high economic growth rates, large populations and expanding middle classes. China and India will re-emerge as major economic and political powers over the next fifty years or so and China is projected to replace the United States as the world’s largest economy by 2040.

According to data compiled by economic historian Angus Maddison, as recently as 1700, Qing China and Mughal India each represented a little less than 25% of world GDP. Their respective share dropped to less than 5% by 1950. The recent revision of World Bank PPP data notwithstanding, China and India are poised to “reclaim” their place as the world’s largest economies over the next half century. This, in a nutshell, is the BRIC story.

The BRIC label visibly lumps together a diverse group of countries. The countries differ enormously in terms of size, population and economic growth potential. An important difference that has received insufficient attention is how the BRICs differ in terms of their economic strategy. China pursues an East Asian development strategy relying on large domestic savings and high investment rates, a competitive exchange rate and a manufacturing-based export-oriented strategy.

The other three BRICs follow very different models. Russia pursues what may be labeled the “Gulf” model, which is based on strategic commodity exports. India and Brazil, by contrast, remain fairly closed economies, forcing them to rely more on the growth of their domestic markets. While India’s growth is heavily concentrated in services (and lagging in manufacturing), Brazil pursues a diversified growth strategy focusing on services, manufacturing and commodities simultaneously.

These differences in economic strategy, especially as pertains to trade openness, stability of export revenues and savings generation capacity, are of relevance to the BRIC countries’ emerging role as international investors. A lot of ink has been spilled on the  rise of sovereign wealth funds (SWF) and increasing outward direct investment (ODI) by emerging market multi-nationals. Although all BRIC countries have seen a substantial increase in external assets, China stands out in terms of size of external asset holdings and asset accumulation.

Only China will be a major net capital exporter over the next decade thanks to its large domestic savings and export-oriented development strategy. China’s current account surplus (net capital exports) has been increasing dramatically. Last year, China was responsible for more than 20% of world net capital exports, ahead of Japan and Germany.

The IMF projects that China will remain a net capital exporter over the coming years, while the other three BRICs are projected to remain (Brazil, India) or to become (Russia) net capital importers. According to the IMF, Chinese cumulative net capital exports will amount to USD 3.4 tr in 2008-2013. By contrast, Brazil and India will register a cumulative current account deficit, while Russia will register a cumulative surplus of a mere USD 35 bn (equivalent to 1% of China’s cumulative current account surplus!). China will accumulate a massive amount of net external assets over the next five years, adding to its already large stock of external assets.

China is already in a class of its own in terms of net international investment position (NIIP). As of 2007, China’s gross (net) external assets totalled USD 2.3 tr (USD 1 tr), more than the gross (net) external assets of the other three BRICs combined. When it comes to the size of gross external asset holdings, China is far ahead of the pack. Nonetheless, the expansion of gross cross-border financial flows combined with continued official asset accumulation will lead to a further increase in government-controlled external assets in all BRIC countries (but much, much less so in Brazil and India than in China and Russia). Even though only two of the four BRICs (China, Russia) will improve their net external position (leaving aside valuation effects), all four BRIC countries will increase their gross external asset holdings. 

Source: IMF

A significant share of the increase in external assets will accrue to the official sector (central bank, SWFs etc.). All BRIC governments (with the exception of India) have set up (China, Russia) or are in the process of setting up (Brazil) sovereign wealth funds with the objective of investing part of their external holdings in higher-return assets rather than keeping them invested in low-return, high-grade debt instruments. This, in addition to increasing external asset holdings, will make the BRIC countries more important international financial players.

China again has the largest “excess” FX reserves – amounting to USD 1.8 tr, compared with Brazil’s USD 200 bn, India’s USD 310 bn and Russia’s USD 600 bn. (Russia’s FX reserves include assets held by the National Wealth Fund and Reserve Fund.) Government-controlled external assets will increase in all BRICs, but only China (and much less so Russia) will be a net capital exporter. This is why China’s net external asset accumulation will dwarf Russia’s, let alone Brazil’s and India’s. On account of its large current account surpluses and large FDI inflows, China will also dwarf the other BRICs in terms of gross external asset accumulation, especially if the Chinese authorities continue to liberalise inward investment. All four countries will emerge as important international investors. But China, like in so many other respects, will undoubtedly be in a class of its own.

BRIC outlook: Structural growth drivers favour China and India (2008)

The resilience of economic growth in emerging markets has increased due to their much reduced vulnerability of emerging markets to global financial market conditions and due to the greater reliance on demand from domestic and emerging markets rather than developed markets. (Some slowdown in EM growth seems inevitable, but growth figures will remain solid.) If anything, most if not all BRIC countries currently seem to be at risk of overheating. There is of course a cyclical component to strong domestic demand growth, but there are also structural factors at work that bode well for the medium-term growth prospects of the BRICs. These factors can be captured in a simple growth accounting framework. Economic growth can be broken down into several components, namely changes in labour and capital inputs, and total factor productivity which captures technological progress and/ or efficiency gains and is the residual that is not explained by changes in labour and capital inputs. Growth accounting provides an analytical framework to assess medium-term economic growth dynamics. The BRIC economies differ greatly in terms of their growth prospects.

Labour supply dynamics will remain favourable in Brazil and India thanks to demographic trends and/or low urbanisation ratios. In Brazil and India the working age population will continue to expand until the middle of the current century, while in China it will decline after 2015 and in Russia it is at risk of collapsing. (The UN projects Russia’s working age population to decline from 97 m in 2005 to 47 m by 2050!) A low urbanisation ratio of 40% in the case of China may help counteract the projected decline in the working age population by allowing for the transfer of labour from the countryside into the more productive urban economy. In Brazil, not much should be expected from further urbanisation, as the country is already more highly urbanised than many of the developed countries in the world. But thanks to a relatively favourable demographic profile, Brazil will benefit from a 20% increase in the population of working age between 2005 and 2025. This should help support economic growth.

The Russian population of working age is already in decline and little help will come from “surplus rural labour” due to a high urbanisation ratio. From a purely demographic point of view, India faces the most promising prospects, combining solid population growth and a low degree of urbanisation. While this may pose challenges of its own (in terms of urban development and infrastructure), it will be supportive of growth dynamics.

Recent capital accumulation trends favour China and India. Assuming that investment ratios do not change dramatically over the next few years, China and India will face much brighter prospects than Brazil or Russia. Currently domestic investment ratios amount to around 40% and 30% of GDP in China and India, respectively, versus an investment ratio of 20% of GDP (or less) in Brazil and Russia. Although it is difficult to project future investment (and savings) ratios, any changes will probably be gradual. Russia will probably increase its investment ratio thanks to large savings generated by the commodity boom. Brazil, having experienced a more modest increase in domestic savings, will likely see a moderate uptick in investment ratios. In China both investment and savings ratios will decline over the medium term, but are likely to stay at very high levels over the next few years. What seems certain is that Chinese and Indian capital accumulation will proceed at a much faster pace than in Brazil and Russia. If one adds the fact that China and India are growing faster than Russia and Brazil, it becomes clear that investment growth is faster still than suggested by the difference in investment-to-GDP ratios. (We are assuming for simplicity’s sake that the higher gross investment ratio leads to a faster increase in the net capital stock.)

Source: IMF

Total factor productivity (so-called Solow residual or TFP) is difficult to project. This all the more problematic as TFP is generally responsible for the bulk of economic growth in fast-growing emerging markets. If we take the World Bank’s Doing Business assessment as a proxy for the quality of the institutional and micro-economic environment and the efficiency with which labour and capital are used, it becomes clear that all BRIC countries have massive scope to improve TFP levels.

China ranks 83rd and is the only BRIC country in the top-100! If the BRIC governments manage to implement reforms aimed at lifting TFP, all of them will be in a position to ”over-compensate” the negative contribution from adverse labour or capital input trends. The necessary economic and technological “catch-up” depends on the right set of economic policies and these are difficult to predict. But if, again for simplicity’s sake, one takes the level of per-capita income as a proxy for “catch-up” potential (potential TFP growth), then the relatively low GDP per capita incomes in China (USD 4,700) and India (USD 2,500) suggest that their TFP growth potential is greater than Brazil’s (USD 9,000) and Russia’s (USD 13,200).

Growth accounting “accounts” for rather than “explains” economic growth. One major difficulty, shared with many other growth models, is that one crucial variable, namely TFP growth, is very difficult to project. The other problem is that even favourable labour supply and capital accumulation trends do not automatically translate into higher growth (e.g. increasing labour supply remains stuck in the low-productivity rural economy). But favourable changes in labour supply and capital certainly underpin an economy’s growth potential. Low per-capita income favours “catch-up” in low-income countries, even if the realisation of the TFP growth potential depends on the right set of economic policies. (This is why economists like to talk about “conditional catch-up”.) It is interesting that Brazilian and Russian TFP growth has been low over the past decade and half (even though it has started to pick up recently), lagging behind Chinese and Indian TFP growth. Unless Brazil and Russia experience a productivity revolution, their economic growth rates will remain below China’s and India’s. The projected changes in the factors underpinning an economy’s growth potential also suggest that the China and India  will continue to grow much faster than Brazil and Russia over the medium term.

Long overdue investment grade rating affirms Brazil's increasing economic and financial maturity (2008)

Recent research has suggested that global investment banks may overestimate the potential and attractiveness of the BRIC countries. A study by a Swiss research institute showed that the EU and the UK remain much more attractive markets for German mid-cap companies than the BRICs. This finding is not at odds with our enthusiasm for the BRIC (and other emerging) markets. It is of course more difficult to operate in these markets and it is a mistake to equate economic size with market potential. It may be too difficult for mid-cap companies to take advantage of these opportunities in a cost-efficient way. But the fact remains that high economic growth and a rapidly expanding middle class will offer considerable opportunities, and large companies with a global reach cannot afford to miss the business opportunities emerging in four of the largest and fastest-growing economies in the world. The increasing economic and financial maturity of the BRIC countries also continues to boost their attractiveness now that the last of the BRICs has received an investment grade rating.

Brazil used to be what sovereign debt analysts call a serial defaulter. Like many other Latin American countries, Brazil frequently defaulted on its external debt obligations during the 19th and 20th century. In 2002 during the run-up to the presidential elections, Brazil again narrowly avoided yet another default. Since then a disciplined, stability-oriented economic policy combined with a bit of good luck (read: rising commodity prices) has transformed the country from a serial defaulter into a net external creditor and, following the S&P and Fitch upgrades, into an investment grade credit.

The improvement of Brazil’s external position has been nothing but impressive. Brazil, like the other BRIC countries, is a net external creditor. Increasing external assets and declining external liabilities turned the public sector and the economy as a whole into net external creditors in 2006 and 2008, respectively. In combination with the retirement of virtually all the government’s domestic foreign-exchange-linked debt, this has reduced the economy’s vulnerability to sudden stops and eliminated the fear of floating. Strong external fundamentals, a floating exchange rate and an inflation-targeting regime have rendered the economy very resilient to even severe future shocks.

Manageable economic and financial weaknesses persist. This year Brazil will be running its first current account deficit since 2002. But even under pessimistic projections, the current account deficits will likely be fully (or largely) financed through net equity inflows in 2008-09. A widening current account deficit should not be of concern. Inflation has been increasing and is set to overshoot the target for 2008, forcing the central bank to hike rates. Importantly, the central bank, the government and society today accept the need to maintain price stability.

The decline in inflation has greatly benefited the poor and has helped President Lula secure a second term in office. It is difficult to see how Brazil’s commitment to low inflation could be seriously undermined. Public sector debt remains high. Net public sector and even more so gross public sector debt remain high. While we project a decline in debt over the next few years, current primary spending dynamics are not compatible with long-term debt sustainability. But for now, sustainability is not a concern. Brazil’s growth potential is relatively limited. One of the main causes has been insufficient investment. Brazilian gross domestic investment amounted to less than half (!) the level of China and India during 2005-07, so it is no surprise that Brazil grew less than half as fast as China and India over the past decade. But although growth is relatively low (it is actually high by the standards of the 1990s), this won’t undermine the outlook for financial stability.

Brazil’s investment grade rating was long overdue. But it will be critical to raise investment levels if the “growth gap” to the other BRIC countries is to be narrowed and remaining economic weaknesses are to be addressed. The remaining economic weaknesses are very manageable. While a raft of potential structural reforms could help overcome these weaknesses, the government could, we believe, “kill four birds with one stone” by limiting the growth in real primary expenditure. Whether this is politically feasible remains to be seen. It remains indisputable that Brazil has taken advantage of the favourable international environment to clean up its balance sheet. It is now in a position to lay the foundation for sustained higher economic growth.

Some thoughts regarding Turkish EU membership (2008)

Divergent opinions regarding Turkish EU membership are not so much due to disagreement over its likely consequences but rather to the desirability of these consequences. In economic terms, preference hierarchies diverge, whether for ideological or (material) interest reasons. (We would not however that the Turkey debate strikes as incongruously fiercer than the debate over Estonian or Croatian membership.) We recognise that what one would like the EU to be (or become) will drive one’s attitude towards Turkish EU membership.

If one believes that Europe should be an exclusively European-Christian project (Giscard), then Turkey does indeed have no place in the EU. If one believes that the EU should emerge as a fairly coherent, perhaps centralised entity under the leadership of “core” European states (Paris), then Turkish EU membership may appear “unhelpful”. If one opposes the emergence of a “strong”, centralised EU and instead favours a loosely organized free trade zone with limited economic co-ordination (London), then Turkish EU membership is welcome indeed (as it might would further add to the diversity and size of EU membership). If one wants to unambiguously integrate Turkey in the Euro-Atlantic economic and political alliance system (Washington), then one will tend to support Turkish EU membership is welcome. In many cases, this one overriding normative commitment determines the position towards EU membership. I am aware that Turkish EU membership will have a bunch of consequences, but let me say a few words about the most important macro-consequences.

Demographically Turkish EU membership would seem to benefit the EU economically. The EU will be stagnating demographically, if not decline over the coming decades. The EU projects the total EU population to rise from 457m in 2005 to 469m by 2030 and then decline to 450m by 2050. While the share of the working age population will decline from 54 to 47%, old-age dependency will shoot up massively from 25% today to 53% by 2050. Turkey’s demographic situation is far better. The population aged 15-64 will see net increase of 15 m until 2050, much of which will sooner or later be absorbed by the domestic economy. Given that the total working age population will be > 200 m, Turkish demographic development will not help reversing the EU’s demographic fortunes. The EU independently will have to reform in social security, health and labour markets to cope with the demographic challenge. Sooner or later the Turkish economy will absorb the surplus labour itself. Nonetheless, at the margin adding Turkey will go some way towards stabilizing the absolute size of the working age population. By fully integrating Turkey. economically, a more efficient allocation of capital and labour will be possible, benefiting economic well-being in Turkey and the EU.

Geo-strategically, Turkish EU membership would enhance the EU’s position. (Again, whether this is deemed relevant or desirable will depend on what the EU is supposed to be.) Turkey has been a key strategic and military partner at least since it joined NATO in 1952. Turkish EU membership would arguably provide the EU with a greater influence, economically and politically, in the regions bordering Turkey. The EU has been keen to diversify its sources of energy imports and Turkey’s location is key whether it concerns accessing energy supplies in Central Asia or the Gulf region. Turkey borders on Iraq and Iran, countries with third- and fourth-largest oil reserves. (Iran also has the world’s second-largest gas reserves after Russia.) An important petroleum pipeline already runs from the Caspian to the Mediterranean. If the EU wants to reduce its dependence on Russian gas supplies (as seems to be the case), then Turkish EU membership would certainly enhance its bargaining position.  This is not to say that Turkish EU membership is pre-requisite if the EU is to tap Central Asia’s and the Gulf region’s energy supplies. But it would certainly deal the EU a stronger hand and Turkey’s relative position vis-à-vis Central Asia and the Gulf region would also be enhanced.

Economically, the case for membership is clear-cut. In 2007, Turkey was the EU’s 7^th largest trading partner (ahead of India and Brazil), although Turkey’s share of the EU-25 outward FDI stock amounts to only 1-2% of the total (ahead of India, but not Brazil). The Turkish economy would add about 4% of the current EU-25 GDP. Although given “catch-up” economic growth, this share will increase over time, it will not have a transformative effect on the EU economy (although increasing FDI outflows would certainly benefit Turkey). From the EU perspective, benefits will be more visible at the micro- and sector level. Labour markets in the new member-states will tighten over the coming decades and EU companies will want to diversify its outsourcing location where labour is relatively abundant and where political and institutional stability is a long-term prospect.  In addition, EU companies would benefit from making Turkey a regional centre to serve the fast-growing Middle Eastern region. It would seem that the economic benefits would not be overwhelming magnitude-wise from the EU perspective (it would be from a Turkish perspective in terms of investment inflows and development), but again at the margin it would benefit the EU. It is obvious that in relative terms economically Turkey will benefit more from full E(M)U membership than the EU. But benefit it will both sides.

I won’t be touching upon the institutional consequences, as these are intimately linked to precisely what the EU is meant to be (or become). Few people that greater general economic well-being, more influence and a more gradual demographic transition are not desirable. Perhaps the most normative, but perhaps also the most powerful argument in favour of Turkish EU membership is that if the EU aspires to be a political and economic project, it should not exclude countries that aspire to submit themselves to the rule. The EU as a post-modern, quasi-structure spreading, democracy, liberalism, the rule of law and domestic political stability is something to be celebrated (whatever the current and future shortcomings of the EU). Denying a country who aspires to the same values membership would strike my sense of fairness. But then again, this happens to reflect my personal hierarchy of preferences.

Dragon or giant panda? What China means for Brazil (2008)

At first sight Brazil and China look strikingly complementary in terms of trade and investment.  China needs commodities to fuel its rapid economic growth. Brazil has abundant natural resources, ranging from iron ore over soy to oil. (Recent oil finds could turn Brazil into a major exporter in the coming years.) Brazil suffers from low savings and investment rates. China generates “excess” savings. The savings ratio is a paltry 17% of GDP in Brazil and a massive 45% of GDP in China, and China exports its “excess” savings as reflected in its huge current account surplus. The Brazil-China pairing looks like a compelling story, except maybe for the fact that China will become an increasingly important commercial competitor in manufacturing. This has some sectors of Brazilian industry wondering about how beneficial Brazil’s economic relationship with China really is (or will be).

Brazilian exports to China have been booming, but Brazil registered a bilateral trade deficit for the first time in many years. Structural factors drive resource-intensive economic growth in China, mainly urbanisation, demographic transition and industrialisation. This is good news for Brazil’s commodity-intensive export industry. Not surprisingly, bilateral trade has been booming, growing very rapidly from a low base. Last year Brazilian exports to China accounted for only 7% of total exports. But this made China Brazil’s third-largest trading partner (or second-largest if one does not count the EU as a single partner) and the country with which trade grew fastest. But last year Brazil also registered a trade deficit with China despite record-high commodity prices, and Brazilian manufacturing exports to China have basically stagnated in recent years.

Chinese overseas direct investment (ODI) in Brazil has thus far disappointed. China has largely “recycled” its huge capital and current account surpluses in the form of official FX reserve accumulation, the recent establishment of a sovereign wealth fund notwithstanding. Given the huge domestic demand for commodity imports, political, strategic and even economic logic would seem to make it attractive for China to invest directly in overseas (Brazilian) commodities sectors. Indeed, during his 2004 trip to Latin America, President Hu allegedly promised USD 100 bn in Chinese foreign direct investment until 2010. So far, Chinese ODI in Latin America, let alone in Brazil, has been disappointing. Chinese ODI data record average annual ODI in Brazil of USD 10 m! Even under the assumption that some of the Chinese FDI flows to Brazil are routed through off-shore centres, Chinese ODI in Brazil remains disappointing.

The key question is whether Brazil can afford to rely on an essentially commodity-based export model. Will China not become a threat to Brazil’s manufacturing sector and future economic development? No doubt, Brazil’s labour-intensive, low-tech manufacturing sector will increasingly come under pressure and even some of the tech-heavier parts of the economy may face increasing competition from China over time. China registered a staggering increase in high-tech exports in the past few years. Already in 2005, 31% of Chinese manufacturing exports consisted of high-technology products compared with 13% of Brazilian exports. Brazil will find it difficult to pursue a development strategy based on a rapidly expanding, broad-based, export-oriented manufacturing sector. First, China combines rapid productivity growth, low-cost labour and the fact that it has already built up a competitive export-oriented manufacturing sector with the help of foreign direct investment. Occupying a favourable position in the Hausmannian “product space”, China will find it much easier than Brazil to move into the higher value-added, tech-intensive segments of the manufacturing space. Finally, China found and will continue to find it easier to maintain a competitive exchange rate than Brazil whose exchange rate is much more volatile.

Brazil is unlikely to become a manufacturing powerhouse like China or an internationally competitive “service centre” like India(although it will have internationally competitive manufacturing and service companies). Building on its comparative advantage, Brazil will have to move to more high-value-added, adjacent parts of the “product space”. Brazil is well-placed to offer the whole range of commodities ranging from energy over metals to soft commodities. The key challenge will be to increase the “value-added” in these sectors. But Brazil is in a unique position to draw on its resource wealth, to further develop its technological edge in agriculture, alternative energies etc. and move downstream (e.g. distribution, marketing) in order to capture the more profitable stages of the value chain. Brazil is one of the few countries with a sufficiently large resource base and a relatively sophisticated research infrastructure in promising economic sectors (e.g. ethanol, agricultural research) placing it in a fairly unique position among resource-rich emerging markets. 

It is a mistake to believe that the only path to sustained economic growth leads via export-oriented, manufacturing-based development. Granted, pursuing an export-oriented economic development has historically proven a relatively successful strategy. It provides economies with important benefits like stable demand and a clear technological upgrading trajectory. But in the end, Paul Krugman is right. What matters is productivity growth, not trade or international competitiveness. It may be that an internationally integrated manufacturing sector makes it easier to overcome domestic opposition to economic reform. But in the end it is increasing productivity that propels an economy forward, not trade or a large manufacturing sector. Focusing efforts exclusively on building a competitive export sector is a dubious strategy (as the 1970s demonstrated), especially if amongst other things the economy is relatively closed and services already represent 2/3 of the gross national product. The key to economic growth is domestic economic reform, nomatter whether the economy is closed or open, or whether its export industry is dominated by manufacturing or commodities. Again an internationally integrated manufacturing sector may spur productivity-enhancing reforms, but it is by no means the only way to achieve sustained economic growth. This is particularly true for continental-sized economies with large domestic markets like Brazil. China will therefore appear to some economic experts as a giant panda, to others as a fire-spitting dragon. But for Brazil as a whole the panda/ dragon question is a moot one. China’s meaning for Brazil will be whatever Brazil wants it to be and this in turn will depend on whether Brazil gets on with economic reforms.

Why emerging markets will weather the storm (2008)

Volatility in world financial markets has increased substantially in recent months. The US economy is experiencing a sharp slowdown, maybe even a recession. In this context, the question is often asked whether emerging markets will slip into crisis. In our view, the answer is no, and here is why.

First, external solvency has improved substantially. Several years of current account surpluses and robust equity inflows have allowed emerging markets to clean up their balance sheets. Governments have been pre-paying external debt and accumulating substantial external assets at an unprecedented speed, leading to a noticeable improvement in creditworthiness. External solvency indicators are far superior to what they were during the 1990s and early 2000s. We estimate that emerging markets in the aggregate (defined as the 25 largest emerging economies) became a net external creditor in 2007 – and this has not been simply due to massive Chinese asset accumulation.

Second, external liquidity remains abundant. Emerging markets continue to run an aggregate current account surplus and net capital inflows will remain near record levels this year. Uncertainty about the outlook for the US economy and financial markets and continued strong growth in emerging markets will continue to attract foreign investor interest. A strong external liquidity position provides emerging markets with a considerable buffer against external shocks, whether in the form of declining exports or a drop in portfolio inflows.

Third, the global environment remains supportive. The US economy may be heading south, but commodity prices remain high by historical standards, especially energy and metals. Continued strong demand for commodities from emerging markets and especially China is likely to support commodity prices. Increasing energy prices have had a knock-on effect on soft commodities like corn and sugar used in biofuels. Similarly, the recent sharp decline in US interest rates will help support emerging market asset prices. Increased risk aversion in US financial markets has spilled over into emerging markets and pushed up spreads. But the sharp decline in US interest rates means that in many cases emerging market asset prices have increased and financing costs have declined. Finally, the global growth outlook remains respectable, even though the US economy may slow down considerably. With growth in emerging markets in many cases fuelled by domestic demand, these economies are today far less vulnerable to a decline in US growth than in the past. The fact that economic growth takes place in the context of much more balanced domestic and external positions provides emerging markets with flexibility to counteract the slowdown in external demand through domestic policy measures.

Fourth, improved macroeconomic policy regimes have made many emerging markets less sensitive to external demand conditions. Improved external solvency and liquidity mean that emerging markets are less dependent on capital inflows. This has also allowed them to overcome their “fear of floating” and to introduce more flexible exchange rate regimes. Sure, some countries have maintained somewhat inflexible exchange rate regimes (e.g. China, Russia, less so India), but their net external creditor position, often combined with capital account restrictions, sharply mitigates the risk of balance-of-payments or other financial crises. In the past, fixed exchange rate regimes combined with a substantial dependence on capital inflows, typically to finance current account deficits, led to currency crises when investors lost confidence in the country, forcing the authorities to respond with monetary tightening and slowdowns in domestic demand and economic growth. Today many emerging markets can respond to such a situation with a combination of exchange rate depreciation and interest rate cuts. Also, generally improved fiscal and government debt positions allow emerging markets to pursue counter-cyclical policies, or at least do not force them to run pro-cyclical (contractionary) policies in an environment of slowing growth. We are therefore quite optimistic about the EM growth outlook, even if the global environment were to deteriorate more than we currently expect.

Last but not least, many countries have put in place credible and sustainable macroeconomic policies. Sure, supportive international economic conditions have made it easier to pursue stability-oriented policies. But in the key emerging markets a consensus seems to have emerged in favour of sustainable policies aimed at lower inflation, external solvency and sustainable public debt dynamics. The desirability of low inflation, fiscal adjustment and external asset accumulation are now widely accepted. The Asian economies decided to buy “insurance” following the 1997 crisis. Mexico became more cautious after 1994-95 and Brazil after 2002. Some countries in Latin America continue to pursue policy mixes incompatible with long-run macroeconomic stability. But in the wider emerging markets universe economic populism is limited.

The major emerging markets are capable of withstanding even a severe external shock. Of course, not all emerging markets are in an equally solid position to confront an external shock. Some Eastern European countries are experiencing large current account deficits, strong domestic credit growth, equity and housing market appreciations and an overvalued exchange rate. This combination has often proven a dangerous mix. But the systemically important emerging markets like China, Brazil, Russia, India, Korea and Mexico are in a strong position to face down even a sharp deterioration in global economic conditions. Of course, the United States is still the 800-pound gorilla, but emerging market economies are stronger and more agile today when it comes to coping with a sneezing gorilla.