Brazil after the elections - what's next? (2010)

Underpinned by a strong political consensus, the main thrust of economic policy will remain unchanged under the new president. A modest and hence manageable erosion of the macroeconomic policy framework, which started under Lula II, looks set to continue. Thanks to much improved fundamentals and the availability of greater “macroeconomic” space, this won’t jeopardise financial stability or undermine economic growth during the next four years. It will however limit Brazil’s upside growth potential and complicate economic policy management in the context of continued strong capital inflows.

The Dilma government will, by and large, bring policy continuity. The incoming government has little incentive to change the basic direction of economic policy. The political consensus in favour of economic stability, especially low inflation (benefitting the poorer social groups) and fair, if not stellar, economic growth (benefitting everybody, including the government, which has more money to spend) is strong. While this will prevent the government from pushing up economic growth at the expense of higher inflation, it will also limit the government’s appetite for big-ticket, growth-enhancing structural reform – especially given the trade-off between the short-term political costs of reform and their medium-term economic benefits.

The new government will not make fundamental changes to the basic economic policy framework that has served Brazil well over the past eight years. However, it will likely take a less purist approach to adhering to the framework, including quantitative targets. First, the government will remain committed to a sufficiently large (recently revised) primary surplus target of 3.1% of GDP. However, repeated accounting changes have reduced fiscal transparency and opened the government to criticism that it seeks to obfuscate the underlying deterioration in fiscal performance. 

Quasi-fiscal spending in the guise of lending by public sector banks and investment by state-owned companies will also continue, albeit at a lesser pace. To be fair, the government remains committed to reducing net public debt to 30% of GDP by 2014 from just over 40% at present and it has re-affirmed the need to restrain expenditure. (It would be desirable to reduce gross debt equally aggressively.) However, no specific proposals have been put forward so far in terms of reining in current expenditure and the significant amounts of investment required in the run-up to the 2014 World Cup and the 2016 Olympics will make it difficult to reduce investment expenditure.

Second, in terms of monetary policy, the authorities seem to have adopted a less hawkish stance. Market expectations are currently for an inflation rate of 5.2% in 2010 and 5.7% in 2011, way above the 4.5% mid-point of the 2.5-6.5% target range. A medium-term inflation rate of, for example, 5.0-5.5% rather than 4.5% would not destroy the central bank’s hard-won credibility but it does carry the risk of undermining it somewhat. While reaffirming the central bank’s independence, the government announced its desire to overhaul the IPCA inflation index. Rightly or wrongly, this has left the market with the impression that the government may be trying to influence monetary policy through the backdoor. Similar to fiscal policy, an erosion of the monetary policy regime at the margin might prevent a faster decline of real interest rates via a reduction of inflation volatility and an anchoring of inflation expectations.

Third, the government continues to adhere to a “dirty float”. But this float has recently become “dirtier”. The central bank’s intervention policy is quite asymmetric: it intervenes when the currency is under appreciation pressure, but it acts much less forcefully when the currency is under depreciation pressure. This is not necessarily unreasonable but does suggest that the authorities seek to limit currency appreciation or, to put it more politely, prevent “excess volatility” and overshooting, especially since the level of precautionary FX reserves is above levels generally considered safe.

Recent changes providing the Treasury with greater flexibility to purchase foreign currency and aiming to make the sovereign wealth fund fully operational in terms of FX intervention point in the same direction. Combined with the re-introduction and subsequent incremental tightening of capital controls, Brazil is moving towards a more controlled and less freely floating exchange rate regime. One may legitimately disagree about the desirability of these moves. The fact remains that the policy regime is being modified, or eroded, if one happen to be critical of these changes.

Taking advantage of a greater monetary and fiscal space, the Dilma government is likely to adhere less strictly to the “letter” or, at least, the “spirit” of the monetary and fiscal targets and take a more “controlling” approach to exchange rate policy. In this sense, the Dilma government represents the continuation of the Lula II government, as opposed to the much more “orthodox” Lula I government. None of this will prevent economic growth from averaging 4-5% over the next few years. However, the more “flexible” fiscal stance and, specifically, the continued expansion in current spending, will be contributing to a sub-optimal policy mix by keeping interest rates at elevated levels. This policy is not only preventing a (faster) rise in domestic savings, investment and growth. By preventing interest rates from declining, it is also decidedly unhelpful in dealing with ample global liquidity, rapidly rising capital inflows and the – from the government’s point of view – economically “nefarious” consequences of currency appreciation.

Concerns about a marginal erosion of the policy regime notwithstanding, Brazil does carry an investment grade rating, enjoys solid external fundamentals and significantly greater room for manouevre (or slippage, if you happen to a critic) than in the past. Greater discipline and a stricter interpretation of economic policy targets would nonetheless help to address rising concerns about a potential drift in Brazilian economic policy.

Emerging markets capital flows – how are the BRIC countries faring and coping? (2010)

The last two “super-cycles” in private capital flows to emerging markets lasted almost exactly seven years. This suggests that the current upswing in capital flows may only be in its early stages. The level of capital flows to the BRICs differs markedly, as do their policy responses in terms of currency appreciation, reserve accumulation and capital controls. Brazil will continue to face a far greater temptation to tighten capital controls – and prevent currency appreciation – than the other BRIC countries.

"Behold, there come seven years of great plenty", according to the book of Genesis. Interestingly, the last two “super-cycles” in private capital flows to emerging markets lasted almost exactly seven years. The first ended with the Asian crisis (1990-1997) and the second with the Lehman collapse (2002-08). In the late 1970s and early 1980s, the EM had experienced a shorter-lived boom (and bust), ending with the Mexican debt moratorium in August 1982. Ominously, economies that suffered a major financial crisis take an average of seven years to complete “deleveraging” during which they tend to suffer from below-average growth (C. Reinhart & V. Reinhart).

All of this seems to suggest that the current upswing in private capital flows to the EM that started in April 2009, following the G20 meeting, may only be in its early stages and may have another five years to run. This sounds plausible considering that high (and rising) EM interest rates, attractive medium-term growth prospects and improved fundamentals will pull capital into EM, while an extended period of unprecedentedly low DM interest rates, sub-par economic growth, exacerbated by an intensifying “demographic drag”, and higher financial risks will push capital out of the DM and into EM.

Capital flows are being underpinned by more than just cyclical and hence reversible factors. The relative “(great) risk shift” in favour of EM would seem to justify a “structurally” higher level of flows. After all, while the DM are being downgraded, EM are being upgraded. Higher EM and lower DM creditworthiness look like they are here to stay. This, in turn, has been behind the greater “strategic” asset allocation to EM by DM institutional investors, which remain heavily under-invested in the EM “space”. The cyclical component is being underpinned by yield differentials and quantitative easing by the Fed, the BoE and, to a far lesser extent, by the BoJ. In practice, it is impossible to disentangle what share of the flows is due to structural versus cyclical factors. For the time being, however, both structural and cyclical factors point to continued strong capital flows. 

Another important distinction concerns “asset price busts” and “financial busts”. The former simply refers to a sharp rise and subsequent fall in asset prices. The latter refers to a sharp downward adjustment in asset prices that triggers a wider “systemic” banking sector or balance-of-payments-cum-sovereign-debt crisis. According to this definition, Russia experienced an “asset price bust” in 2008, but a “financial bust” in 1998. Concerns about a “financial bust” in the EM, and certainly in the BRICs, look very much overdone at this stage. The BRICs benefit from strong external solvency and liquidity.

Large FX reserves and/or (more or less) flexible exchange-rate arrangements and favourable foreign-currency mismatches provide them with significant buffers in the event of a “sudden stop” in capital inflows. Current accounts exhibit manageable deficits (Brazil and India) or are even in surplus (China and Russia). The risk profile of the inflows is also more favourable than in the past, from the recipient countries’ point of view. The FDI component of inflows remains significant, and portfolio flows are often biased towards local-currency equity and debt, typically of longer duration. Last but not least, the BRICs continue to increase FX reserves, albeit at different speeds.

The level of capital flows to the BRICs differs markedly. Brazil has been experiencing the highest level of inflows during 2009-10 due to its more open capital markets (compared to China and India), perceived improvement in post-crisis growth and/or lower “leverage” (compared to Russia) and very high interest rates. At the same time, Brazil has accumulated far less FX reserves (as a share of GDP) than China and Russia, both of which combine small capital account surpluses (China) or deficits (Russia) and large current account surpluses with a more or less aggressive FX intervention policy. Brazil, by comparison, has “absorbed” parts of its overall surplus via currency appreciation (and a widening current account deficit) due to its more flexible exchange rate and, possibly, the significantly higher costs of sterilised intervention. Brazil’s FX reserves do remain well below those of the other BRICs.

Brazil’s current account deficit, combined with larger foreign capital inflows, also means that it is accumulating both larger net and gross foreign liabilities, however favourable their risk features. Concerns over “excess” currency appreciation and rising sensitivity to a “sudden stop” have contributed to Brazil’s decision to incrementally tighten controls on capital inflows. It is noteworthy, however, that - relative to GDP - the level of gross capital inflows is very similar to pre-crisis levels, while the (real effective) exchange rate is only slightly stronger than before the 2008 crisis.

The bottom line is that the degree to which countries – in this case the BRICs – are struggling with capital inflows (and external surpluses, more generally) differs significantly, as they do with respect to their policy responses in terms of currency appreciation, reserve accumulation and capital controls. Both China and Russia are experiencing much lower levels of gross capital inflows (and, indeed, much higher levels of gross private outflows) than Brazil. But large current-account-related inflows contribute to much larger balance-of-payments surpluses in both countries. Their greater capacity and willingness to prevent nominal currency appreciation have resulted in greater official reserve accumulation. As a result, China and Russia perceive much less of a need to tighten controls on capital inflows than Brazil, whose capital account is very open and whose currency has appreciated tangibly, albeit from weak immediate-post-crisis levels. India falls somewhere in between Brazil, on the one hand, and China and Russia, on the other hand, as regards its capacity and the perceived need to absorb (smaller) external surpluses. No doubt, if we are indeed in for “seven years of plenty”, Brazil will continue to face a far greater temptation to further tighten controls in order to stem foreign capital inflows – and prevent currency appreciation – than the other BRIC countries.

The BRIC countries and the "Beijing consensus” (2010)

After suffering significant political and/or economic crises all four BRIC countries embarked on a course of fundamental reforms during the 1980s and 1990s that transformed their economies and succeeded in boosting growth, largely by fomenting greater private-sector activity. By contrast, the financial crisis has strengthened the influence of the “statists” and increased the allure of what critics have labelled the “Beijing consensus”. The urge to extend the role of the state without a thorough analysis of the potential costs and benefits of doing so should be resisted.

During much of the post-WWII period, the BRIC economies have either been very or relatively closed to trade and they have tended to suffer from heavy state control and intervention. Naturally, the levels of state control and economic restrictions have varied dramatically. After all, China and the (then) Soviet Union used to run state-controlled command economies, while Brazil and India, in spite of significant economic restrictions and the important role played in the economy by the state, had functioning, if restricted, markets.

While Brazil’s and Russia’s development model came unstuck during the 1980s, China’s and India’s had never much “stuck” in the first place – at least judging by the two countries’ level of per capita income. Brazil and Russia experienced their high-growth periods during 1945-1980, before their economies and their respective economic models were engulfed in crisis. The causes for the ultimate failure differ somewhat, but both economies entered periods of stagnation because of “excessive” – if admittedly varying – degrees of state intervention and limited trade openness that ended up undercutting total factor productivity growth. China and India, by contrast, never experienced a comparable (per capita) growth take-off until they started reforming their economies in the 1980s and 1990s, respectively. India’s infamous “Hindu rate of growth” perhaps best captures the relative economic stagnation that characterised the four decades following WWII.

After having suffered significant political and/or economic crises all four countries embarked upon fundamental reforms that transformed their economies and succeeded in boosting growth. Brazil defaulted on its external debt in the early 1980s, after a decade-long external borrowing binge that had helped sustain the import-substitution industrialisation strategy beyond its expiry date. A “lost decade” ensued until the Cardoso administration (1995-2002) started implementing wide-ranging structural reforms, including trade liberalisation and privatisation, and managed to defeat hyperinflation. The Lula administration (2003-2010) finally managed to stabilise the economy for good, and economic growth started to move to a tangibly higher level following the 2002 “transition crisis”.

In Russia, following the break-up of the Soviet Union in 1991, reformist governments transformed the command economy into a market economy by way of a so-called “shock therapy” under Yeltsin (1991-1999). Similar to Brazil, post-reform Russia suffered a major financial crisis in 1998. Economic stabilization and growth take-off were finally achieved during the Putin presidency (1999-2008) – helped, admittedly, by continuously rising oil prices.

In the late seventies, China emerged from the political and economic turmoil of the Cultural Revolution (1966-76) with a pragmatically-minded leadership under Deng. The state-controlled economy was in tatters and the time was ripe for a new approach. Not only did it not matter if the cat was black or white as long as it caught mice. Becoming rich became glorious, too. Various types of liberalising reforms, perhaps most notably the reform of township and village enterprises (TVEs) in the late seventies and the establishment of special economic zones (SEZs) in the eighties, brought about fundamental economic change and set free a stunning economic dynamism lasting to this day.

In India, “liberalization by stealth” (Panagariya) started in the late 1970s and early 1980s and reforms continued under the Rajiv Gandhi government (1984-89), notably the liberalisation of the “Licence Raj”. Economic reforms received further impetus under PM Rao (1991-96) and FM Singh following the 1991 balance-of-payments crisis. The liberalising reforms, conspicuously, helped accelerate per capita growth.

By the late 1970s and early 1980s, the various economic models had either failed after a relative period of success (Brazil, Russia), or the realisation had emerged that the models had never worked in the first place (China, India). Economic and/or political crises acted as a crucial catalyst for reform by allowing political leaders to push through important reforms. One does not have to be of a neo-liberal persuasion to acknowledge that it was a combination of economic reforms aimed at “more market” and “less state” that helped lift growth.

By contrast, the global crisis has politically strengthened the “statists” and has ideologically increased the lure of the, what critics have labeled, the “Beijing consensus” (Halper). The “Beijing” as opposed to the “Washington consensus” rejects the presumption I  favour of (unfettered) “market liberalism” and assigns the state a central role in economic development, mainly through state ownership in sectors that are deemed strategically important, through significant government control over credit, through state support for “national champions” and through state-owned investment funds (aka sovereign wealth funds).

After all, ad-hoc government intervention and, especially, “state-led” credit policies proved instrumental in limiting the economic and financial fall-out of the 2008 global crisis. In Brazil, the next government will pursue a more active industrial and financial policy and the Brazilian state will no doubt play a more prominent role in selected sectors. In Russia, where parts of the economy are dominated by the state, the government is talking about privatisation, but – like in China – this will at most involve selling minority stakes in “national champions” to foreigners. Neither China nor India will significantly reduce state involvement in the economy in the coming years.

This does not mean that we won’t see any economic reform in the BRICs, but a significant reduction in the role played by the state looks unlikely. All four countries have fared relatively well in terms of growth over the past decade. It is therefore not surprising that the dominant political forces seem to be taking an “if it ain’t broke, don’t fix it” approach. Admittedly, state involvement is not per se a bad thing. In the case of market failure or in areas where the social returns exceed appropriable private returns, for instance, state investment may even be desirable. There are also successful examples of state-led economic development, even if failures have historically been far more common. Amongst other challenges, states face time inconsistency problems and need to avoid capture by factional interests. The more extensive and long-lasting the state involvement, the greater the risk of “capture” by rent-seeking interests, and the greater the negative impact on economic growth.

The role of the state in economic development is too complex to be adequately captured by a label. Nonetheless, there is no denying that the “Beijing consensus” and its cousins in Brasilia, Moscow and New Delhi have thrown down the gauntlet to the, often misunderstood, “Washington consensus”. This political reality notwithstanding, BRIC history suggests the urge to extend the role of the state without carefully evaluating the potential costs and benefits should be resisted. Intellectually, if not politically, the “burden of proof” should remain squarely on the shoulders of the “statists”.

BRIC sovereign wealth funds - the wealth of governments (2010)

BRIC FX reserve accumulation continues apace. As far as the BRICs are concerned, FX reserve accumulation is increasingly difficult to justify in terms of risk insurance: all four BRIC governments are net foreign (currency) creditors. Even if private- sector debt is included, national balance sheets look strong as far as solvency and liquidity are concerned. The performance of the BRICs throughout the crisis has also demonstrated their resilience, if not in terms of growth, at least in terms of financial stability. FX reserve accumulation is therefore characterised by diminishing returns in terms of insurance and increasing financial opportunity costs and (quasi-)fiscal losses. BRIC (and often EM) FX reserve accumulation is being driven by objectives other than risk reduction and financial return, namely: limiting exchange-rate volatility and/or preventing exchange-rate appreciation. By setting up sovereign wealth funds (SWF) with the goal of investing excess reserves more aggressively, the BRIC (and several other EMs) implicitly acknowledge as much.

Unless a government runs a fiscal surplus, it (or the central bank) needs to issue interest-bearing debt equivalent to the amount of FX reserve accumulation if FX purchases are to be fully sterilised. Similarly, unless an economy runs a current account surplus, FX reserve accumulation needs to be financed by an increase in foreign liabilities, whether in the form of debt or equity. For much of the 2000s, Russia ran both a fiscal and a current account surplus. China registered a current account surplus only. Brazil and India, by contrast, were running twin deficits.

From a sovereign perspective, financial returns on FX reserves are determined by the on-shore/off-shore interest rate differential, valuation changes and exchange rate effects. First, to the extent that the BRIC central banks issue sterilisation instruments, they will tend to run a negative carry, that is, they pay a higher interest on their domestic liabilities than they receive on their foreign assets. (China proved to be an exception in this regard during parts of the 2000s.) Second, valuation gains from exchange rate-depreciation vary. However, given relatively low inflation and faster productivity growth in the BRICs, valuations gains will likely be more limited than in the past. (China is even likely to sustain significant losses on the back of seemingly inevitable nominal exchange-rate appreciation.) Third, valuation gains tend to be limited given that a significant share of FX reserve assets is typically invested in short-term, high- grade debt (e.g. Treasury bills). The financial return prospects are not much better from a country perspective1. Depending on the country, valuation losses may remain unrealised, but losses resulting from a negative carry represent an actual cost to the public sector.

While initially the (quasi-)fiscal losses can be justified by declining external risk premia (esp. Brazil and Russia), excess FX reserve accumulation is more difficult to justify. Especially in the case of Brazil and India, countries with high levels of domestic debt and high domestic interest rates, it would be preferable to limit excess FX reserve accumulation financed by domestic debt issuance, as it adds to upward pressure on domestic interest rates. Although generating returns on official assets is not the primary objective and the fiscal costs are not prohibitive, it does make sense to invest excess reserves more aggressively to generate higher returns. This is why three of the four BRIC governments have set up SWFs. They differ in important respects. India has been debating the creation of an USD 10 bn SWF2.

Russia is a textbook example of a resource-dependent economy. Running both current account and fiscal surpluses throughout much of the 2000s, it made a tremendous amount of sense to absorb external surpluses into FX reserves and use the fiscal surpluses to sterilise the purchases by depositing them into an oil stabilisation fund. Russia is highly dependent on the export of volatile, largely non-renewable commodities. So is the government, indirectly. Accumulating FX reserves makes sense from both a stabilisation (volatile revenues, Dutch disease) andsavings―(inter-temporal equity) point of view.

In 2008, the Oil Stabilisation Fund, created in 2004, was split into a Reserve Fund and National Welfare Fund. The former was capped at 10% of GDP and its purpose was to provide the government with funds to finance future fiscal deficits. The latter aims at inter-temporal savings, mainly to support future pension outlays. The Reserve Fund currently has USD 39 bn under management, down from its peak of USD 143 bn just before the global financial crisis in mid-2008. The Reserve Fund only invests in foreign government bonds. The National Welfare Fund is worth USD 86 bn. The Fund can invest in higher-risk assets, including domestic assets, such as loans to domestic banks. The future size of the funds will critically depend on future oil prices and government fiscal performance. However, it currently looks as if the Reserve Fund may be depleted by 2011 owing to persistent fiscal deficits.

Unlike Russia, China has been running large and persistent current account surpluses and, indeed, capital account surpluses, but for the most part small fiscal deficits. In combination with a relatively fixed exchange rate, the central bank had to absorb these surpluses in the form of FX reserves. Until 2007, SAFE was solely responsible for managing PBoC FX reserve holdings. That same year, the China Investment Corporation (CIC), which currently has about USD 300 bn worth of assets under management, was created3. The Chinese government controls a number of other agencies and institutions that manage foreign assets (e.g. African Development Fund, Chinese Development Bank, National Social Security Fund, (partially) state-controlled banks, SOEs). In China, more so than in other countries, it is difficult to draw the line between public-sector- and private-sector-controlled assets. Moreover, SAFE or, more precisely, the SAFE Investment Company is estimated to have invested USD 300-400 bn in the form of ―non-reserve‖ assets4. So the CIC is not the only government vehicle to invest its foreign holdings more aggressively.

The costs of holding very large FX reserves (> 50% of GDP) are relatively manageable given relatively low on-shore rates, partly resulting from domestic financial repression, and a low government debt burden. Furthermore, as the economy continues to grow at double-digit rates in dollar terms, the fiscal costs, as a share of GDP, will be quite manageable. In fact, during parts of the 2000s, the on- shore/off-shore interest rate differential was in China‘s favour. China is, however, quite sensitive to capital losses in case of RMB appreciation. Continued FX reserve (or SWF) accumulation will likely continue apace given prospects of continued very large current account surpluses and, absent further liberalisation of capital outflows, continued capital account surpluses.

Unlike China and Russia, but like India, Brazil has been running both fiscal and current account deficits (with the exception of very small surpluses during 2003-07). A capital account surplus and a current account close to balance allowed the central bank to accumulate badly needed FX reserves following the 2002 crisis. Given double-digit on-shore interest rates, however, the ―financing― of FX reserves results in a substantial ―negative carry―. Nominal exchange-rate appreciation over the past few years has not helped, either. While reserve accumulation was instrumental in lowering external risk premia, and possibly domestic risk premia, further FX reserve accumulation will keep domestic interest rates high by adding to the stock of domestic government liabilities.

The Fundo Soberano do Brasil (FSB) was created in 2008. The central bank resisted the transfer of FX reserves to the FSB. In addition to an initial bond issue, the FSB will be financed primarily by fiscal revenues exceeding the targeted primary surplus, though in principle assets can be accumulated via appropriations assigned in the budget. It affords the government a great deal of flexibility; hence initial (and recently confirmed) concerns among some analysts that the government might use the Fund to intervene in the FX market. The FSB is very small and manages USD 9 bn worth of assets. The investment mandate of the Fund is quite flexible.

The Brazilian SWF also differs from the Chinese and Russian funds in that it has so far accumulated LCY assets via excess revenues or domestic debt issuance rather than FCY assets. Unless it uses these revenues to purchase FCY, however, it effectively raises (expensive) domestic debt to finance LCY assets. Given the significant interest rate differential, it makes less sense financially for Brazil to accumulate excess foreign assets than in the other BRICs – even more so, should the Fund remain solely invested in LCY assets. However, should the recent oil discoveries lead to both external and fiscal surpluses, the FSB could turn into a genuine savings fund‖. Both the stabilisation and inter-generational equity argument would then apply.

Without a doubt, China is by far the most important international financial player among the BRICs. In terms of official FX reserves, China currently holds USD 2,500 bn, compared with less than USD 300 bn in both Brazil and India, and USD 450 bn in Russia. It also holds the largest excess reserves, whichever way these are calculated, except in terms of M2. But as long as the government maintains restrictions on capital outflows, the relatively large stock of M2 does not represent a serious contingent claim on FX reserves, even if a relatively inflexible exchange rate regime remains in place.

China will also continue to accumulate more FX reserves than the other BRIC combined for the foreseeable future. The rise in net foreign assets has been staggering. Even in terms of the size of SWF, the CIC and SAFE Investment Company alone control USD 600 bn, compared with the FSB's less than USD 10 bn and Russia‘s (declining) USD 150 bn. The precise domestic-foreign asset split is not precisely known in either case (as far as we can tell). But, undoubtedly, China is the BRIC country with the largest amount of foreign assets held in SWFs, especially if SAFE Investment Company positions are included. Growing, if gradual, financial integration of the BRICs leading to a greater two-way flow of capital will also contribute to BRIC gross foreign asset accumulation. Even where reserve accumulation is financed by running up foreign liabilities (Brazil, India), governments will see their financial influence enhanced.

Central banks, which continue to control the vast bulk of public- sector, and often total, foreign assets, generally do not have the same discretion in their investment decisions, nor the expertise to generate higher risk-adjusted returns on their foreign assets than SWFs. However, even with the establishment of an SWF, it will be difficult for governments to "break even" and currency appreciation will lead to capital losses (in LCY terms). The benefits of continued official asset accumulation are therefore negative from a narrow financial point of view. The economic benefits, less easy to quantify, may be significant (e.g. competitive exchange rate, attract knowledge- and technology-transferring FDI in the export sector), and the fiscal costs, while tangible, will remain manageable. A greater focus on financial returns in the management of BRIC government assets will help limit (quasi-) fiscal losses, but will not eliminate it.

Last but not least, the more excess reserves a government holds, the more flexibility it has in terms of when and where and at what conditions to invest them. This allows the government to deploy hard-currency loans and financing in the pursuit of both commercial and non-commercial (political) interests. For instance, governments can extend FCY loans to domestic companies, whether state- controlled or not, at below-market levels in pursuit of national objectives (e.g. China‘s “going global” policy). The government can also provide loans to governments in pursuit of political objectives (e.g. Moscow‘s loan offers to Belarus) or to foreign suppliers in support of long-term supply contracts, thus ensuring access to strategically important resources (e.g. China‘s oil-loan deals with Brazil, Venezuela etc.). These are all options that none of the BRICs came even close to having a decade ago. In short, the BRIC governments have become financial players to be reckoned with.

See also BRIC sovereign wealth funds (Deutsche Bank Research)

Why it is time for the (BR)ICs to further liberalise capital outflows (2010)

The degree of capital account openness is difficult to measure precisely. Different approaches yield different degrees of openness. Few analysts would disagree, however, that both Brazil and Russia have a more open capital account than China and India. The degree of capital account openness affects the composition and size of external balance sheets. In Russia, the sum of gross external liabilities and assets as a percentage of GDP amounts to 170% of GDP, compared with a 100% or less in the other BRIC. However, if reserve assets are excluded, both Brazil (84%) and Russia (135%) are financially more open than China (54%) and India (51%).

BRIC external holdings are skewed towards high-grade debt (reserve assets), more so in China and India than in Brazil and Russia, and equity liabilities feature prominently on the other side of the balance sheet. From a risk perspective, this is desirable, as equity liabilities represent contingent claims and reserve assets are under the direct control of the authorities. While this asset-liability mix has helped turn the BRIC into international creditors (excluding equity liabilities), it also created a “short equity/ long debt” position. In purely financial terms, this is not an attractive position to hold. 

First, the superior prospects for long-term BRIC growth should lead to tangible equity appreciation. Second, a combination of low-ish BRIC inflation and faster productivity growth should tend to lead to currency appreciation, resulting in capital losses on net FCY-denominated assets. Third, even if capital losses are excluded, the BRIC pay more on their net equity liabilities than they earn on their net foreign debt assets. Fourth, the BRIC governments – to the extent that they sterilise FX reserve accumulation related intervention by issuing (relative) high-interest rate domestic debt – will have put up with “negative carry”. Thus, the BRIC run a double “negative carry”.

This explains the desire to invest “excess” FX reserve holdings more aggressively with the help of sovereign wealth funds. The BRIC sit on more than sufficient FX reserves: external financing requirements are lower than FX reserves; the governments are significant net foreign (currency) creditors and total net external debt is close to zero or negative. However, even under the best of circumstances, the governments of Brazil, India, Russia (on account of their high on-shore interest rates) and even China (on account of medium-term nominal currency appreciation) will find it next to impossible to make a profit. It will be similarly difficult to overcome the “negative” carry stemming from the “short equity/ long debt” position.

This is where a greater liberalization of capital outflows might help. First, reducing the share of reserve assets in total foreign assets would limit sterilization costs for the public sector. Second, it would also tend to lead to higher returns, as the private sector is presumably better positioned to generate higher returns than the public sector.

The combination of capital account restrictions and FX reserve accumulation has resulted in a financially unfavourable asset-liability structure. The desire to ensure financial stability, attract growth-enhancing FDI, and, in some cases more than in others, support export-led economic growth and development explains why the BRIC are running – and are willing to run – a financial loss on their foreign position. The financial loss can be considered both an “insurance premium” and a “growth subsidy”.

Effectively, the BRIC governments hold sufficient foreign assets to “collateralise” private sector foreign borrowing. This is not an efficient way to leverage BRIC growth prospects. Obviously, policymakers value economic and financial stability more than generating financial returns. However, the financial opportunity costs of running a “short equity/ long debt” position will continue to increase as BRIC external balance sheets grow, as a share of GDP. Greater (selective) liberalization of capital outflows would help boost the financial returns on foreign assets by allowing the private sector to hold higher return foreign assets. In this context, greater exchange rate flexibility would naturally be desirable. Understandably, governments are somewhat reluctant to liberalise capital outflows, fearing increased volatility. However, in purely economic terms, the BRIC governments’ favourable net foreign position should limit both their “fear of floating” and the “fear of free(er) capital outflows”.

What are the prospects of further liberalization, particularly in China and India? In the case of China, substantial liberalization is unlikely to take place until greater exchange rate flexibility has been achieved. Greater currency flexibility will only happen if the authorities come to believe that the volatility it might cause will not impact economic, financial and political stability. India is somewhat better placed to further open its capital account due to a higher degree of exchange rate flexibility and due to a lower (perceived) dependence on export-led growth. The arguments in favour of liberalization notwithstanding, both countries will maintain a gradual approach to liberalization.

Financial return considerations remain of secondary (or tertiary) importance. However, sooner or later, further capital account liberalisation will take place. The liberalisation of capital flows - both outflows and inflows - would lead to considerable growth in cross-border flows and holdings, especially in the case of China and India. (In advanced economies, combined cross-border assets and liabilities as a percentage of GDP average more than 300%, compared with only 100% and 75% in China and India; and reserve assets typically make up only a small share of total assets.) Capital account liberalisation certainly carries some risks, as the past has shown. But the BRIC economies’ international financial positions are sufficiently solid to allow a greater liberalisation of capital outflows. It would certainly help boost the financial returns on the BRICs’ international financial position and limit the government’s costs of carrying FX reserves.

EM capital markets growth prospects after the global crisis (2010)

The global crisis has further enhanced the relative growth prospects of emerging markets (EM) capital markets. Advanced economies’ capital markets will continue to make up the bulk of global financial assets, developed markets (DM) deleveraging and EM leveraging notwithstanding. Emerging Asia has not only the largest capital markets, but also the most developed markets in the EM space. From the perspective of global investors and, even more so, financial services providers, some (segments) of the rapidly growing EM financial markets can only be accessed with some difficulty and tapping into their growth requires a well-thought-out, focused strategy. This fact notwithstanding, the “opportunity costs” of not building exposure to – or a platform in – the EM will be increasing over time.

The stock of EM financial assets (bonds, bank assets, equities) grew from USD 15 tr in 2002 to USD 29 tr in 2008, after taking into account exchange rate and valuation effects. As a share of global financial assets, EM assets grew from 10% to 16%, while, as a share of global GDP, they rose from 47% to 57%, according to the IMF. The global crisis has further enhanced the relative growth prospects of EM capital markets. The crisis can arguably be interpreted as a Kooan-type “balance sheet recession”. The term originally described companies seeking to minimise debt rather than maximize profits following Japan’s financial bust. Today’s situation is somewhat different in the sense that it is banks and households that suffer from excess leverage and seek to minimise debt, thereby generating extra-low interest rates, weak consumer demand and weak private sector investment. Private-sector deleveraging in the major advanced economies will lead to a significant rise in public debt over the next few years, similar to what happened in Japan after the bust.

Most advanced economies will experience only modest financial asset growth (ex-government debt). While most EMs are “under-leveraged”, many advanced economies are “over-leveraged”. As of 2008, domestic debt (excluding government liabilities) averaged 400% of GDP in the EU and 250% in the US, but only 100% in the EM. Improved economic and financial stability, continued solid economic growth prospects and rapid per-capita growth will drive solid EM asset growth, not only in dollar terms but also as a share of total global assets and global GDP. Add to this the prospect of higher returns on the back of higher underlying growth and improved EM risk relative to the DMs, and it is not difficult to understand why global investors and financial services providers are allocating a larger share of their capital and investment to EMs.

This optimistic-sounding prediction comes with a few caveats, however. First, advanced economies’ capital markets will continue to make up the bulk of global financial assets for the foreseeable future, DM deleveraging and EM leveraging notwithstanding. At present, the G-3 (EU, Japan, US) make up 80% of global financial assets, while the EMs account for slightly more than 15% of the total. To illustrate the same point: EU financial assets are 2.5 times larger than all EM assets combined. By extension, the bulk of capital markets-related revenues remains highly concentrated in the DMs, even if revenue growth is bound to be greater in the EMs.

Second, the bulk of EM assets is concentrated in Emerging Asia. Not only is EM Asia larger in terms of GDP, but the financial-assets-to-GDP ratio is significantly higher than in the other EM regions. This holds true for total financial assets and it is true in each capital markets segment. Both equity market capitalisation and the stock of private-sector bonds are around twice as large as the other EM regions combined. To a large extent, this reflects differences in regional savings rates and macroeconomic stability.

Third, EM capital markets are relatively bank-centred, while private bond markets are quite under-developed, with some notable exceptions (e.g. Korea, Malaysia). Equity markets are relatively large, Eastern Europe excepted. The size of individual market segments does not generally say much about the sophistication and liquidity, nor about the risk-reward prospects. Generally speaking, however, EM Asia is more advanced than the other EM regions, especially as regards local bond, derivatives and equity markets.

International financial services providers and investors seem to be pushing into the EMs in general and Emerging Asia in particular –pulled by EM economic and financial prospects and much-improved financial stability and pushed by less than buoyant DM prospects. However, it is important to bear in mind that EM financial markets are growing from a low base. Some important markets can only be accessed with great difficulty; or foreign financial institutions face more or less extensive restrictions and – and this will become an increasingly important theme – intensifying competition from increasingly sophisticated local financial institutions. These caveats notwithstanding, the EMs, and particularly Emerging Asia, have a huge development and growth potential. Tapping into this growth will not be easy and will undoubtedly require a very focused and well-thought-out strategy. Nonetheless, the potential “opportunity costs” for financial services providers of not creating a solid, focused business platform, and for global investors of not building substantial exposure to the EMs will certainly be increasing over time.

Rising Brazil may be passing up an opportunity (2010)

Empirical evidence suggests that savings rise after economic growth takes off. Economic reform and stabilization in Brazil seem to have triggered just such a growth take-off. However, in order for the virtuous cycle to be sustained at an ever higher level of 5% (or more), the government would need to allow domestic savings to rise. Officials frequently point to the significant levels of inequality and poverty and Brazil’s democratic political system in an attempt to rationalize why a reduction in government expenditure is neither desirable nor feasible. A look at India’s experience in the 2000s suggests that this view is overly pessimistic.

Comparing Brazil with European countries, the United States and Japan, countries with vastly higher per capita incomes and mature demographic profiles, President Lula in a recent speech suggested that a high tax burden was necessary to finance public policies. This is debatable. By improving the efficiency of public expenditure, the government could almost certainly afford to reduce both expenditure and taxation without compromising its social and economic objectives. This is critical for if the government fails to rein in current expenditure growth, Brazil will be passing up an opportunity to raise its potential growth rate to 5% (or more).

Empirical evidence suggests that savings typically rise after economic growth takes off. In other words, the causality runs from higher growth to higher savings, allowing for a permanently higher level of investment, rather than the other way around. This begs the question of what ignites economic growth in the first place. The answer is likely to vary from case to case: political stabilisation, economic liberalisation, structural reform etc. In the case of Brazil, economic reform and stabilisation under the FHC and Lula governments seem to have triggered such a growth take-off, lifting potential growth to 4% plus, compared to 2.5% previously. However, in order for the virtuous cycle to be sustained, the government needs to allow savings to rise.

Brazilian household and government consumption has been virtually flat (as a share of GDP) during the past few years, although the acceleration in economic growth should have lowered the consumption share in GDP. In countries like China and India, both government and household consumption declined following the growth acceleration over the course of this decade. In Brazil, both households and the government seem to have a much higher propensity to consume. This propensity has been underpinned by strong growth in government consumption and transfers.

Raising private sector savings through public policies is not straightforward, neither politically nor economically, and certainly not in the short term (e.g. pension reform). The government has far greater control over its own consumption and savings behavior. It should therefore rein in the growth of government consumption (and transfers), that is, raise government savings. Whether higher savings are then best utilized to boost public investment, reduce the fiscal deficit (and crowd in private-sector investment) or finance tax cuts, thus raising the appropriable returns on private-sector investment, is a separate debate. If the government fails to rein in expenditure growth, the virtuous cycle of higher growth, investment and savings may be undermined.

Officials frequently point to the significant levels of inequality and poverty and Brazil’s democratic political system in order to rationalize why a reduction in government expenditure is either not desirable or feasible, or both. It is no doubt a fascinating debate to what extent, for example, the ability of the East Asian economies and more recently China to “extract” savings and limit current expenditure growth was conditional on the authoritarian nature of their political systems. The example of India, on the other hand, is more difficult to dismiss. India managed to lift its savings and investment ratio substantially during the course of the last decade, even though India suffers from much higher levels of absolute poverty than Brazil. India is also a democracy that, due to the fragmented nature of its parliamentary system, should find it at least as difficult, if not more difficult, to resist political pressure for higher government spending.

Indian investment and savings ratios increased on the back of both declining household and government consumption. While the contribution to domestic savings from declining household consumption was more marked, government consumption also declined. By contrast, government consumption in Brazil remained conspicuously high (as did current expenditure, including transfers). It may be easier to raise savings on the back of very high economic growth: Indian real GDP growth averaged nearly 8% compared to 5% in Brazil. But Brazilian real GDP growth also almost doubled in recent years, yet government consumption and current spending remained stubbornly high.

The snag is that even if politicians accept the need to raise public-sector savings, it is not in their short-term political interest to rein in electorally rewarding current expenditure growth. With the economy humming along nicely, social security reform is not a viable political option, even if stubbornly high household consumption strongly points to the necessity of encouraging greater household savings. However, a multi-year commitment to slowing current expenditure growth to below the rate of nominal GDP growth should be possible, expenditure rigidity and revenue-earmarking notwithstanding, politically and economically.

Such a reform would probably have to take place at the very beginning of a presidential term (Brazil will hold a presidential election in October 2010) and against the backdrop of significant growth, allowing for a continued solid increase in real expenditure; and it would probably have to go hand in hand with increased public sector investment, allowing the government to reap electoral rewards by way of “pork barrel”-type spending. All said and done: 2011 may be remembered as the year Brazil managed to lift economic growth onto a 5-6% growth path. Or it may simply be remembered as the year when Brazil passed up a tremendous opportunity.

Yuan as a reserve currency (2010)

See also: Yuan as a reserve currency (Deutsche Bank Research)

Following the creation of EMU, some observers predicted that the euro would emerge as the world’s major reserve currency. More recently, eurozone travails and rapidly rising US indebtedness have re-ignited the debate about alternative reserve currencies (incl. SDRs). Among the possible medium-term contenders for ―top currency‖ status are the yuan and the euro. Neither the UK nor Switzerland, nor Japan, have or will have the necessary economic and financial size for their currencies to become the world’s dominant reserve currency. The eurozone-16 is about the size of the US economy, and China, on current trends, is set to replace the US as the world’s largest economy sometime during the 2020s. China is already the world’s largest exporter and will soon also be the largest trading nation. Contrary to the US, the world’s largest debtor, China is also a large net external creditor, only trailing Japan.

Many observers have therefore drawn parallels between today’s situation and the dollar replacing sterling during the inter-war period and post-WWII. British sterling, burdened by the financial legacy of WWI and WWII, was replaced as the world’s reserve currency by an economically and financially ascendant dollar. This raises a number of interesting questions. How likely are we to witness another such transition in the coming decades? What are the prospects that the yuan will replace the dollar as the dominant reserve currency? What would be its economic, financial and political implications?

Following Papaiouannou & Portes (2008), several conditions underpin a reserve currency (and its international use): the size of the economy, low inflation and exchange rate stability, deep and efficient capital markets, and political stability and geo-political strength.

First, in terms of economic size, China is likely to overtake the US sometime around 2025 and outstrip it thereafter. Second, as regards low inflation and exchange rate stability, the Chinese yuan at first sight seems to fit the bill already. However, China maintains capital controls and a quasi-pegged exchange rate. So it cannot be said to have passed the test yet. However, there is little reason to believe that China will not be able to maintain low inflation and relative exchange rate stability if it moves towards convertibility in a gradual manner accompanied by the necessary domestic institutional reforms (e.g. central bank independence, inflation targeting). Admittedly, this will require a move towards a market-based banking system and this implies that the government will not only have to implement a host of secondary reforms aimed at ensuring financial sector stability post-convertibility but also have to accept a significant diminution of direct control over the financial system. (It will be interesting to see how this plays out.) Like most other maturing emerging markets, China is likely to move from what might be called a ―developmental‖ approach to managing its exchange rate and capital flows to a floating exchange rate and an open capital account. As China’s economy grows in size, it will become less dependent on export-led growth and the US market, making a switch towards a flexible exchange rate regime increasingly attractive in terms of policy flexibility.

Third, deep and efficient capital markets and full currency convertibility are even more important than exchange rate stability. This is where China lags the most. The yuan is not convertible and the authorities maintain tight capital controls. The domestic bond market is relatively small and illiquid and foreigners’ access is, of course, highly restricted. A reserve currency also requires sophisticated foreign exchange and derivatives markets. Beijing has on several occasions affirmed its commitment to gradually move towards yuan convertibility and is seeking to develop domestic bond, derivatives and foreign exchange markets. Last but not least, while China enjoys political stability, it continues to lag as regards the ―rule of law―. As long as it continues to compare poorly with the US and the eurozone, foreigners may remain reluctant to invest in on-shore yuan assets. It is noteworthy that, according to the World Bank, China has made next to no progress on this score over the past decade or so.

In all these areas, China has a long way to go. How quickly Beijing will manage to put in place the necessary conditions for the yuan to emerge as a major reserve currency depends mainly on political decisions taken in Beijing. A gradualist approach is no doubt going to prevail, especially as regards convertibility. It will probably take around 15-20 years for Beijing to put in place the conditions necessary for the yuan to emerge as a reserve currency. Not surprisingly, the yuan’s private and official use is currently very limited. The yuan plays next to no role as an international store of value (e.g. FX reserves), nor as unit of account (e.g. neither HK nor Macao peg their currencies to the yuan). Only recently have the authorities started to allow yuan assets such as deposits to be held off-shore (e.g. HK) and for the yuan to be used in trade settlement, albeit in a pilot project.

If Beijing manages to meet the prerequisites, the yuan will become a reserve currency. China’s economic size and its share in international trade will grow, increasing the incentives of its trading partners, especially of small open economies, to ―manage― their currencies vis-à-vis the currency of their dominant trading partner (as they do in other parts of the world). As trade with China becomes more important relative to other countries (read: US, EU), countries will have an incentive to hold at least parts of their reserves in yuan-denominated assets – provided the yuan meets the above conditions. From there, it will only be a small step towards the yuan’s greater private use as a store of value, transaction vehicle and unit of account.

This does not mean, however, that the yuan will necessarily become the world’s dominant currency. Prerequisites are, by definition, necessary but not sufficient conditions, for even if China makes the yuan fully convertible, creates deep and liquid domestic bond markets, maintains a strong financial position etc., it will still need to overcome ―network externalities― (that is, an economic agent is more likely to use a currency if everybody else uses it), ―politics‖ and the existence of ―peer competitors‖ (dollar, euro).

Politics will matter greatly. States do not typically finance (accumulate claims on) countries that are, or may be, their geo- political competitors – if they can help it, that is, or if there is any credible alternative. Countries that do not have close political relations with Beijing are therefore less likely to keep the bulk of their foreign assets in yuan (e.g. India, Japan). Naturally, the more dependent a country is on trade with China, the more constrained its choice will be.

What economic, financial and political consequences would a rising yuan and a declining dollar have? First, a reserve currency country (RCCs) derives seigniorage. To the extent that foreigners hold a reserve currency, the reserve currency country acquires foreign goods or financial assets by ―printing‖ money. In the 1960s, economists used to call this exorbitant privilege. By holding currency, foreigners effectively extend an interest-free loan to the RCC. Second, RCCs benefit from a liquidity discount. To the extent that foreigners are more likely to hold RCC liabilities, interest rates are lower than would otherwise be the case. Estimates as to the seigniorage and liquidity discount― benefits vary, but they are frequently estimated to be worth around USD 500 bn and an annual 100 bp in the case of the US.

Furthermore, the RCC enjoys an exorbitant privilege not just because it can finance its deficit by issuing its own currency or debt denominated in its own currency. As the world’s banker, it can also borrow short at low rates and lend long at higher yields, earning the spread, while as the world’s venture capitalist (Gourinchas & Rey 2007), it can sell liquid, domestic-currency-denominated high-grade domestic debt to finance (foreign-currency-denominated) illiquid, high-return assets.6 This may help make a net foreign debtor position sustainable in the long term.

Third, by increasing the number of investors, RCC financial markets may also be deeper and more efficient than they would otherwise be, thus potentially benefitting the international competitiveness of the financial industry. Fourth, to the extent that a reserve currency is in greater use, an RCC may also benefit from improved terms-of- trade. Increasing use of the reserve currency in international trade tends to raise the value in terms of the quantity of goods that can be purchased for every unit of the currency. Last but not least, domestic companies may benefit from lower transaction costs and lower exchange rate uncertainty (though this is empirically contested).

Reserve currency countries incur not just benefits, but also costs. First, the reserve currency will tend to be overvalued, hurting competitiveness and potentially economic growth, due to larger demand than otherwise for its financial assets. Second, RCC economic and especially monetary and exchange rate policies matter greatly to other countries, potentially opening the RCC to international scrutiny and pressure. In this context, some have argued that the country is then compelled to take greater account of international public opinion and other countries’ views. This is somewhat debatable, at least in the sense that whenever push came to shove in the past Washington seemed in the end to have privileged its own interests over those of others (e.g. Nixon shock, Reaganomics, John Connally’s ―dollar is our currency, but your problem). While the US certainly managed to delay and deflect pressure for international adjustment and even get other countries to adjust (e.g. Plaza, Louvre accords), this was only in part due to its reserve currency status, and principally due to the size of the US economy and its importance as an export market for other countries – which arguably were more concerned about their competitiveness, growth and domestic monetary stability than about the potential financial losses on their dollar holdings – and the existence of close security ties in the case of Germany and Japan post-WWII.

Perhaps more of a concern is a possible ―fall from grace―, that is, the potentially painful economic and financial adjustment that takes place when a reserve currency declines. Under fixed exchange rates, economic policy will be heavily constrained, as the country has to absorb the ―monetary overhang―. The risk of a run on the currency may also become considerable (e.g. post-war sterling devaluations). Under flexible exchange rates, however, this is likely to be somewhat less of a problem. Similarly, an RCC runs the risk of greater instability of demand for money. This perceived risk made the German and Japanese authorities reluctant to push for a greater international role for their currencies in the 1980s.

What are the implications for Sino-US relations? The rise of the yuan as a reserve currency would confer benefits on China. It would boost seigniorage revenue, and might enable China to finance its debt more cheaply (though, compared with the present situation, a lot would depend on how the opening of the capital account affects Chinese interest rates). It might have only a limited effect on Beijing’s ability to resist international pressure for economic adjustment, which is already quite considerable. Beijing’s ability to deflect international pressure will be largely a function of economic size and financial prowess. The larger its economy and the less dependent it becomes on foreign trade, the less vulnerable it becomes to protectionist threats. On the other hand, increased foreign yuan reserve holdings may constrain the policy flexibility of other countries – similar to the way in which China’s dollar holdings and dependence on the US market are constraining it today. Moreover, China would benefit from more efficient financial markets, even though efficient capital markets are also a pre-condition for reserve currency status, and Chinese corporates and banks are likely to become internationally more competitive for the reasons discussed above. Admittedly, the benefits are somewhat difficult to quantify, even if they are real.

What does it mean for the US? In addition to foregoing, or at least benefitting less from, the privileges that come with issuing the dominant reserve currency on account of peer competition, the US might have to ―mop up‖ excess dollar liquidity in the (unlikely) event that official reserve holders actively sell down dollar reserves as compared to refraining from increasing their dollar holdings. Even under floating exchange rate regimes, this may lead to sustained monetary weakness and/or constrain macroeconomic policy flexibility. More importantly, the US may increasingly have to resort to issuing non-dollar-denominated debt in order to finance its deficits (e.g. Carter bonds) and a more binding balance-of-payments constraint would limit the US capacity to run large external deficits. The US would then have to raise taxes or curtail expenditure instead of relying on free and/or low-cost foreign funding. US economic policy flexibility would diminish tangibly.

If the yuan emerges as a reserve currency potentially rivalling the dollar, China will become more powerful and the US less powerful in international economic and financial affairs, especially given divergent net international financial positions and China’s greater economic size. However, the factor that will do most to alter the balance-of-power will be China’s declining dependence on the US market, or conversely the United States’ relatively increasing dependence on the Chinese market.

The emergence of the yuan as a major reserve currency will reflect the underlying shift in economic and financial power, even if it does, independently, provide tangible benefits to China. China’s diminished dependence on the US as an export market coupled with exchange rate flexibility will enhance China’s position vis-à-vis the US. Simultaneously and significantly, the US will face greater constraints in terms of financing its balance-of-payments deficit. This will be compounded by China’s declining relative dependence on the US market, allowing for greater exchange rate flexibility and greater flexibility as to whether and under what conditions to continue to extend credit to the US. Beijing may thus gain a degree of control over how hard or how soft the US balance-of-payments constraint will be, potentially influencing US economic and financial flexibility. This is likely to have ramifications for Washington’s political position in the world – something which the Obama administration’s National Security Strategy in fact acknowledges.

The world will be moving towards a multiple reserve currency system over the medium- to long-term. It will take China 15-20 years to put in place the conditions necessary for the yuan to emerge as an international reserve currency and longer to become a potential rival of the dollar (and the euro). This is naturally an educated guess only, based on the projection of China’s future economic size, foreign trade and financial market size. Ultimately, the rise of the yuan is a question of how quickly Beijing is willing to push forward with financial markets reform and yuan convertibility. Prerequisites are, by definition, necessary but not sufficient conditions, for even if China makes the yuan fully convertible, creates deep and liquid domestic bond markets, maintains a strong financial position and gains foreign investor confidence through legal-institutional reform, it will still need to overcome ―network externalities‖ currently favouring the dollar and the euro, the relative attractiveness of its ―peer competitors and ―politics‖. A lot will depend on the global political situation twenty years from now.

The following appears to be the most probable scenario: the yuan is set to become a major reserve currency, but it is not a foregone conclusion that it will emerge as the dominant reserve currency 20, 30 or even 40 years from now. For, despite heated theoretical debate, it is possible for two or maybe three major reserve currencies to co-exist. How stable such a system is would depend – as it always does – on the underlying economic, financial and political dynamics. The reserve currency structure (and the extent of a currency’s public and private international use, more generally) is likely to reflect the wider economic bi- or tripolar structure of the international economic system. 

Scholars & the rise of China (2010)

The Chinese economy has been growing at 10 percent annually since the beginning of economic reform in the late 1970s. If current trends hold, China will overtake the US in terms of economic size by 2025. In PPP terms, China will be world’s largest economy by 2020.

Economic analysts are divided about China’s road to economic preeminence. Some foresee dangerous speed bumps while others argue that interdependence can only smooth the ride. Despite China’s dramatic economic rise and increasing financial weight, the Sino-US economic-financial relationship can be best described as one of “asymmetric interdependence” – where Beijing finds itself in a position of “asymmetric vulnerability” – heavily skewed in Washington’s favor.

Several factors and developments could undercut China’s trajectory. Some analysts anticipate rising geo-strategic competition between China and the US. Historically, rising powers make use of their increasing influence, argues Aaron Friedberg, and increasing dependence on imported commodities could lead China to mitigate supply risks by seeking “regional preponderance,” thus increasing strategic competition between Beijing and Washington. From there, it’s a small step to construct a scenario where geostrategic competition leads to economic conflict weighing on Chinese economic development, as predicted by international relations realists such as John Mearsheimer. Other scholars are more optimistic about the possibility of a peaceful “power shift.” David Shambaugh, Robert Sutter and Bates Gill interpret much of Beijing’s international behavior as evidence that China is becoming a “responsible stakeholder” in an international system that, by and large, offers it benefits through an open trading system.

Some analysts anticipate political instability. The lack of post-Mao charismatic leadership and the declining strength of ideology have weakened the foundations of China’s political system, according to Harvard’s Roderick MacFarquhar. Increasing social activism could undermine Communist Party rule and regime stability. Again, from this analysis, it’s only a small step to come up with a scenario where political volatility and uncertainty weigh on economic growth. Andrew Nathan is more optimistic, arguing that the Chinese government has repeatedly proven its ability to respond to newly-emerging social and economic demands. Localized social unrest does occur, but given the combination of regime responsiveness and political control, he maintains that “a spark isn’t going to start a prairie fire in China.” Demographics ensure that demands for political reform will remain manageable as “the middle class won’t demand democracy when it is afraid of an even more numerous class of peasants and migrant workers, and therefore sees the authoritarian regime as a bastion of order against chaos.”

Lack of further reforms might undercut future growth. Pei Minxin, senior associate at Carnegie Endowment, suggests that partial economic reform has led to the emergence of a “mixed” state-centered system that perpetuates the privileges of the ruling elite. This system allows the elite to “tap efficiency gains from limited reforms to sustain the unreconstructed core of the old command economy – the economic foundation of its political supremacy.” He calls this a “trapped transition,” where the ruling groups have little incentive to pursue further reform. Absent economic reform, however, economic growth is bound to decline. A variation of this argument has been put forward by Woo Wing Thye, professor of economics at UC Davis, who suggests the challenge lies in sustaining economic growth while at the same addressing rising social inequality and accommodating increasing middle-class demands for political reform. Optimists, like Barry Naughton, point out that the government has repeatedly proven its ability to successfully deal with various economic challenges and that growth remains largely driven by large-scale economic and demographic forces that are relatively independent of government policy.

Naturally, other concerns range from environmental sustainability and viability of the current investment-heavy, export-led growth strategy to political event risk. According to the “bears,” all of these might create potentially non-negligible risks capable of undermining, or at least significantly slowing down, China’s rise. Nonetheless, short of a complete – and very unlikely – breakdown, a reasonable downside scenario is likely to mean 5 to 7 percent annual growth, rather than full-blown economic stagnation. China is unlikely to be thrown off-course in the way the Soviet and Japanese economies were. Structurally, China’s medium-term growth potential is, after all, significant. Unlike Japan in the 1980s, China is located far from the technological frontier, and its development model is based on a relatively high degree of economic openness, and unlike the Soviet Union, China is better suited to generate total factor productivity by importing foreign technology. Therefore, China will more likely than not continue to register at least 8 percent annual growth over the next decade.

China’s increasing economic size will provide Beijing with growing political, economic and financial influence. While China’s rise has greatly increased its power, this has thus far translated into limited bilateral influence vis-à-vis the US. China’s most important economic-financial lever of influence regarding the US is the threat to sell off its estimated $1.4 trillion in US treasury and agency debt.

Such a move would be costly for Beijing, however, economically and financially, China would shoot itself in the proverbial foot. First, the value of its holdings would decline, and higher US interest rates would weigh on the US growth outlook, hurting Chinese exports. Furthermore, unless it’s willing to accept renminbi appreciation, China would have to find other dollar assets to invest in, as rapid renminbi appreciation is hardly in China’s interest in terms of exports and dollar-denominated US debt holdings. However, if China does re-invest in dollar-denominated assets, this would presumably help ease financing conditions in other segments of the US financial system, potentially offsetting negative effect of higher rates in the treasury market on the economy. Second, if Beijing were to dump large chunks of US debt, it might disrupt financial markets in the short run. The medium-term impact would likely be manageable, as other official foreign buyers with close security ties to the US, including Japan and Gulf nations, would step in, albeit at higher interest rates. Last but not least, any politically motivated fire sale of US debt would trigger a severe political backlash – and not just from the US – as well as undermine China’s standing as a reliable financial investor and economic partner.

Financially, economically and politically, Beijing would pay a high price for significantly raising US borrowing costs and it would end up paying a higher price than Washington – simply reflecting the fact that China is much more dependent on the US than vice verssa. The US has access to a more diversified investor base, with which it maintains close political relations. The US market is substantially more important to China in terms of both exports and imports than vice versa – and the Chinese export sector is relatively more employment intensive.

China’s holdings of US debt do not lend themselves as a coercive instrument and are perhaps better regarded as a limited deterrent. Rising cross-border asset holdings and trade have increased interdependence, raising the costs of economic conflict for both China and the US. Nonetheless, the potential costs of a conflict due to China’s trade dependence are substantially higher for Beijing than for Washington.

However, if and when China reduces its export dependence on the US market relative to US dependence on the Chinese market, and if and when it adopts a substantially more flexible exchange rate regime, the balance of economic and financial power will shift dramatically in Beijing’s favor. Until then, Beijing has a far greater interest in preventing a wider economic-financial Sino-US conflict than Washington does.