Emerging markets and FX reserve accumulation (2009)

The risk of an emerging markets (EMs) crisis has been receding, even in Eastern Europe, if market risk indicators are to be believed. Risk appetite has been gradually returning and there are tentative signs that capital flows to Ems may have bottomed out. The provision of large official financing packages, combined with a sense that the risk of a financial sector meltdown in the developed markets has faded, has helped lift demand for riskier assets, including EM assets. We have not yet experienced the full fall-out from the real economy “crash”, but an economic downturn – even one as severe as this – should be more manageable than a global financial sector meltdown. The EM asset price rally has also been fuelled by the expectation that in many (but not all!) EMs the economic downturn will be sharp but short-lived, in contrast to the developed markets, where a sustained rebound will remain elusive.

The Volcker shock of the late 1970s drove many major EMs into default. Although the world economy quickly recovered from the shock, for many EMs the 1980s turned out to be a “lost decade” characterised by economic stagnation and repeated crises. This time, no major EM has defaulted and most major EMs have managed to maintain relatively sound fundamentals, measured in terms of external liquidity, public-sector solvency and banking-sector stability. Many EM economies – especially outside Central and Eastern Europe (CEE) – should therefore recover relatively quickly, even if a return to pre-crisis, US-consumer-fuelled growth rates is unlikely as long as the developed markets continue to de-leverage.

It is remarkable, though not really surprising, how resilient the EMs have proven in the face of the most severe global financial and economic crisis since the Great Depression. Key pre-crisis credit metrics predicted fairly accurately which countries were going to encounter significant difficulties and which countries would manage to “weather the storm” more easily. Countries with large liquid external liabilities relative to liquid external assets, especially if characterised by large non-FDI-financed current account deficits, proved vulnerable and many of them were forced to turn to the IMF. The majority of countries that received official bail-outs are located in CEE. This is not surprising. Many EMs in Asia and Latin America had switched – more or less deliberately and with varying degrees of intensity – to a policy geared towards FX reserve accumulation following severe capital account crises in the 1990s and early 2000s. By contrast, many EMs in CEE failed to build up a comparable external buffer.

The lesson policy-makers are likely to draw from the crisis is that the marginal benefits of reserve accumulation (economic and financial stability) continue to outweigh its potential costs (foregone economic growth, fiscal costs). Even countries with what looked like solid external positions by pre-crisis standards experienced quite disruptive capital account shocks. The shock could have been buffered somewhat more, had governments benefitted from greater policy flexibility on account of larger FX reserve holdings. At the very least, this is the conclusion many EM policy-makers will come to. The narrowing of the US current account deficit will make competition for FX reserves more intense, and this will tempt many EMs to keep their exchange rate undervalued, or at least to keep their currency from appreciating (substantially) once their balance of payments moves into surplus. A large output gap will sharply limit inflationary pressures, further enhancing the attractiveness of such a strategy. Neither the prospect of EMU membership in CEE nor the IMF’s Flexible Credit Line, only readily accessible for “well-managed” countries, will dissuade the majority of EMs from going down this path.

Equally important, many of the countries that had accumulated large FX holdings prior to the crisis will maintain policies geared towards reserve accumulation, whether or not this is desirable from a domestic growth and global adjustment point of view. Politically, it will be difficult to fundamentally change a policy that has “worked” in terms of maintaining stability. Some change at the margin is possible, but a fundamental policy change is unlikely.

Opposition to EM FX accumulation should be limited in the near term; even with respect to China, which will continue to account for the bulk of global reserve accumulation. A combination of narrowing US current account deficit, widening US fiscal deficit and increasing US reliance on Chinese purchases of US government debt seems to have led Washington to adopt a softer stance on China’s exchange rate and FX accumulation policies. The policy debate seems to be shifting from FX intervention policies and global imbalances to fiscal policy and economic growth. This should make it easier for both sides to find common ground. It also means that Beijing – and other EM countries – is likely to encounter much less resistance than pre-crisis to an exchange rate policy that is, intentionally or unintentionally, geared towards reserve accumulation.

Rise of the BRICs revisited (2009)

The “rise of the BRICs” thesis has received much criticism – some of it deserved, some of it undeserved. There is little doubt that major change is afoot, but the thesis is somewhat misleading, even deceiving, as it discounts what will be the most momentous development of the first half of the 21st century: the rise of China. Naturally, the growing economic importance of India, Brazil and Russia will have important consequences, but these simply don’t compare to the implications of China’s rise. Economically, financially and politically, China overshadows and will continue to overshadow the other BRICs. China’s economy is larger than that of the three other BRICs combined. Both China’s exports and its official FX reserve holdings are more than twice as large as those of the other BRICs combined.

China is the real story here! In Washington DC, for example, there is much talk these days about Chinese exchange rate policy and China’s rapidly increasing financial prowess, about increasing Chinese military and especially naval capabilities, even about Chinese soft power. Prominent analysts and former government officials, like Bergsten and Brzezinski, are calling for the establishment of a G-2 consisting of the United States and China. While the proposal has thus far received at best a cautious response in both Beijing and Washington and a generally skeptical response from analysts, it is a reflection of the importance Washington insiders attach to China’s growing stature. One may legitimately disagree with the G-2 proposal, but China’s increasing economic and political weight in world affairs is a reality.

China’s relative and absolute economic importance will continue to rise for the foreseeable future. In terms of economic growth, China has been outperforming the other BRICs by a wide margin over the past thirty years. Over the past decade, real GDP growth averaged 10% in China, 7% in both India and Russia and 3.3% in Brazil; and China will continue to grow faster than its peers. A high savings rate, a low level of urbanisation, low per capita income (considerable “catch-up” potential) and, importantly, a successful export-oriented, manufacturing-based development strategy underpinned by strong investment in infrastructure and education will combine to sustain China’s superior economic performance. China will also soon become the world’s largest economy (by 2025-30).

Albert Keidel (until recently at the Carnegie Endowment for International Peace) even projects the Chinese economy to be twice the size of the US economy by the middle of this century! China will be facing challenges, ranging from gradually deteriorating demographics and questions about environmental sustainability up to potential international trade frictions. Sooner or later economic growth is set to slow down from current levels. But the short and medium-term outlook remains favourable relative to the other BRICs and, of course, even more so relative to the advanced economies. Investment ratios in Brazil remain very low. Russia is overly dependent on hydrocarbons and is facing very adverse demographic developments. India will have to overcome domestic opposition to growth-enhancing and growth-sustaining economic reforms and it is not clear yet that the leap-frogging “services revolution” will turn out to be an economically and politically viable development model. For all these reasons, China will continue to outperform the other BRICs over the next couple of decades.

Economic and increasing financial openness will create stronger incentives for Beijing to make its voice heard in global economic and financial affairs, while its rapidly increasing economic and financial weight will ensure that its voice will be heard. In terms of trade openness, China is the most highly integrated economy among the BRICs. Chinese merchandise trade (export and imports of merchandise) amounts to 2/3 of its GDP compared with 1/2 in Russia, 1/3 in India and a mere 1/5 in Brazil. Moreover, Chinese growth has also become more dependent on exports (though the degree of this dependence is being hotly debated) and it is becoming ever more dependent on commodity imports, ranging from energy and metals to foodstuffs.

China may seem financially less integrated than Brazil or Russia on account of existing capital account restrictions. China remains relatively closed as far as foreign portfolio investment is concerned (even if gradual liberalisation has been taking place). However, China has been receiving large FDI inflows over the past decade (by far the largest among the emerging markets) and China’s external assets amounted to a substantial USD 2.3 tr in 2007 (and have grown rapidly since). The Chinese government has become the single largest holder of official FX reserves and of US government debt securities. With every year that goes by, China’s economic, political and financial weight will increase – and incentives to make its voice heard in global economic and financial affairs will become concomitantly and inexorably stronger. Recent official Chinese comments on US financial policy and the reserve status of the dollar already point to greater assertiveness than in the past.

None of this is meant to suggest that the “rise of the BRICs” is not a significant development. It is, but it pales by comparison with the rise of China. China is the 800-pound “panda” in the room. China will become the world’s largest economy, and a high degree of economic integration will force Beijing to become more involved in managing global economic and financial affairs. The G-2 proposal overestimates Beijing’s and Washington’s ability to jointly manage world affairs by discounting the growing importance of the other BRICs and the continued relevance of the EU and Japan. However, at the very least, the proposal is an implicit, even explicit recognition that China’s rise is significantly more important than the rise of the other BRICs and that the world must try to find a way to accommodate China’s growing importance by offering it “co-equal stakeholdership”.