The Political Economy of Sino-US Relations (2011)

The G-20 summit left the global imbalance issue unresolved. While initially it appeared as if the forceful counter-cyclical Chinese response to the global slowdown and a narrowing US trade deficit might diminish tensions, the renewed rise in Chinese surpluses and widening US deficits have again intensified bilateral frictions. In the US, high unemployment and large fiscal deficits, necessary to support growth while the private sector is de-leveraging, have led to increasing criticism of Chinese exchange rate policies. Meanwhile, the very same fiscal deficits and Fed quantitative easing have led to a lot of disquiet in Beijing. The Chinese government is worried about financial losses on its increasing US asset holdings and the nefarious consequences a super-loose monetary policy will have on its economy. 

With US unemployment forecast to remain high and China’s global and bilateral trade surplus set to widen, tensions over trade imbalances will not go away anytime soon. Neither, therefore, will the risk of trade protectionism or even a trade war. This comment argues that fears about a full-blown Sino-US trade war are over-blown, at least in the short term. It does not focus on technical, legal and procedural obstacles that constrain or facilitate such a conflict. Instead, it analyses the economic-financial vulnerabilities and incentive structure both sides face in terms of escalating the present conflict over imbalances and RMB valuation into a broader trade war. It concludes that while both sides have an interest in avoiding a costly conflict, the US lesser vulnerability relative to China will make a full-blown trade war over the next couple of years very unlikely. However, as a rapidly growing China becomes less dependent on the US market, the risk of a conflict will increase tangibly – unless the bilateral imbalance issue is resolved.

China benefits greatly from its access to the US market. It affords China to pursue an export-led growth strategy, underpinned by sizeable domestic and foreign investment in the tradable sector and supported by an undervalued exchange. It also provides China with access to advanced technology supporting productivity growth. Appreciating its exchange rate would make exports less competitive. All other things being equal, it might reduce economic growth at the margin due to a less favourable contribution from net exports and, possibly, lower investment in the tradable sector. However, it would also shift resources away from the tradable sector and might lead to increasing investment there. The net effect of RMB appreciation on employment would not necessarily be negative, for the non-tradable service sector tends to be more employment-intensive than the relatively more capital-intensive, export-oriented manufacturing sector. The relative strength of the growth and employment effects naturally depend on the magnitude and speed of the appreciation. It is nonetheless worthwhile noting that current account surplus adjustments do not necessarily have a negative impact on growth.

Why then do the Chinese authorities seem so adamantly opposed to RMB appreciation? The uncertainty RMB appreciation would create is something China is concerned about, especially as regards its effects on employment in the coastal areas with its large pool of migrant labour. Thus far China’s economic strategy has been very successful. Not surprisingly, decision-makers prefer a very gradualist approach to economic reform. Rightly or, very likely, wrongly, there is also concern that acquiescing to US demands might get China into trouble similar to Japan after the Plaza and Louvre Accords of the 1980s. Finally, Beijing may be hoping that a more domestically-oriented growth strategy will bring about adjustment without significantly adjusting the RMB, for instance, via moderately higher inflation and concomitant real exchange rate appreciation. Whatever the precise reasons, Beijing is visibly keen to defend the status quo.

The US benefits from large Chinese trade surpluses, allowing it to consume more than it produces, while finding in China a ready and affordable source of financing. Chinese demand and, more specifically, Chinese official demand for high-grade, liquid financial assets has helped keep US government financing costs down. (How many basis points this is worth is subject to intense debate.) On the other hand, a large bilateral deficit has a negative effect on US growth and employment. The Peterson Institute, which has taken a decisive stance on this issue, estimates that a 20-25% appreciation of the yuan would reduce the US current account deficit by USD 50-120 bn, assuming that other Asian currencies are similarly revalued, and create upwards of 500,000 jobs. This would reduce the US unemployment rate by one percentage point. The IMF estimates that US trade with China trade subtracted an annual 0.17 ppt from US growth in terms of negative net exports during 2001-08.

Although the US ability to run up large debts is considerable given its reserve currency status, it is not infinite. If left uncontrolled, debt accumulation could jeopardise US economic and financial stability at some point in the future. It will make the US and the US government increasingly dependent on foreign financing. In short, the US would benefit from a RMB appreciation, but it would certainly not resolve all its economic woes. Nonetheless, Washington is eager to change the status quo.

In this context, it is useful introduce some concepts from strategy and diplomacy as well as game theory. It is useful to distinguish between “coercion” and “deterrence”. An agent A exercises coercive power by getting B to do x by threatening y or promising z. An agent A deters B by persuading B that the costs of a given course of action will outweigh its benefits. In other words, deterrence aims to persuade the opponent not to an initiate action, actively or passively, by threatening to impose or raise the costs of this action, or by rewarding the other party for not doing so. Deterrence comes in two forms: (1) punishment by raising costs of an action and (2) denial of objectives by raising the costs in such a way as to offset to the coveted benefits of an action. Finally, deterrence is associated with maintaining the status quo, while coercion is usually associated with changing it. These concepts can be profitably applied to Sino-US relations.

The Sino-US economic-financial relationship is best described as one of “asymmetric interdependence” (and hence “asymmetric vulnerability”), heavily skewed in Washington’s favour for now. Rising cross-border asset holdings and trade have increased interdependence, raising the absolute costs of economic conflict for both sides – but the costs of a conflict are substantially higher for Beijing than for Washington. This is so because the US market is substantially more important to China in terms of both exports and imports than vice versa. Chinese exports are also relatively more employment intensive than US exports. Last but not least, China is more dependent on US technology imports than the US is on lower- tech Chinese imports. This severly diminishes China’s ability credibly to deter, let alone coerce, Washington with the help of its vast holdings of US debt and its continued financing of US current account and fiscal deficits. China’s relative greater trade vulnerability also accounts for Washington’s coercion potential.

Washington would like to reduce its bilateral current account deficit with China and it would like to see this happen as a result of China adjusting its policies, notably RMB appreciation. Excluding “extraneous” measures (e.g. making threats and promises in non-economic areas), the US can take, or threaten to take, measures aimed at offsetting the benefits China derives from RMB undervaluation (denial) or at raising the costs above the benefits (punishment) in order to coerce China into appreciating its currency (e.g. tariffs, WTO case, meeting currency intervention with currency intervention, intellectually property rights). These measures differ in terms of their legal implications and economic effectiveness. But they all aim to raise the costs of Chinese exports or the costs of maintaining an inflexible exchange rate (in case of counter-veiling currency intervention), thus directly or indirectly leveraging China’s dependence on the US market. China would face significant economic costs in the event of incrementally rising US trade protectionism, much greater than the costs the US would incur even if China responded in a tit-for-tat manner. After all, Washington benefits from “escalation-dominance” as long as game remains confined to economic-financial sphere.

What about Beijing’s deterrence potential? Deterrence seeks to preserve the status quo. China possesses a only limited economic-financial deterrent potential vis-à-vis the US. China’s influence has undoubtedly increased dramatically due to intensifying trade and investment linkages, especially vis-à-vis other countries. Ironically, its vulnerability has also increased due to greater openness and exposure to the international economy, at least vis-à-vis the US. (Just compare 1980 and 2010.) China’s trade integration and ownership of foreign assets have therefore become both a source of influence and vulnerability. In relations with the US, it translates primarily into greater relative vulnerability. Therefore, Beijing has a greater interest in avoiding a trade conflict than Washington.

Being more dependent on trade than the US, China’s financial deterrence potential is often thought to derive mainly from both its large holdings of US government debt and its continued financing of the US federal government deficit. However, a threat to “boycott” Treasury auctions or dump US debt in the secondary market would not be credible. Similar to the threat to impose counter-veiling trade measures, it would only function as a deterrent if China were, irrationally, willing to incur higher costs than Washington. By triggering a rise in US interest rates, and possibly even financial market dislocation, such actions would push up US interest rates, slow US growth and Chinese imports – the very outcome, Beijing seeks to avoid. Furthermore, China would have to find other dollar assets to invest in, unless it is willing to accept RMB appreciation – and too rapid a RMB appreciation is again the one thing Beijing is keen to avoid.  Second, the US has access to a more diversified investor base, with parts of which it maintains close political relations (e.g. Japan, Middle Eastern oil exporters)  than Beijing has markets to invest in. Last but not least, any politically motivated fire sale of US debt would trigger a very severe political backlash – and not just from the US. The White House would find it very difficult to control a revanchist Congress dead-set on trade sanctions. All considered, China’s deterrent potential is limited – at least as long as it remains unwilling to accept RMB appreciation.

Sino-US economic-financial-diplomatic action can be modelled as a sequential, perfect information, non-zero-sum game, where Washington might well end up making a strategic commitment (in game theory terms) by threatening and subsequently implementing trade sanctions if Beijing does not appreciate its currency. This might appear irrational from a purely economic benefit/ cost point of view. Free trade is a non-zero-sum game, after all. However, if the White House were forced into a brinkmanship strategy by Congress, China would be better off backing down, for both protectionist counter-measures and financial retaliation lack credibility, as both kinds of responses would undermine the very thing China is keen to preserve: unfettered access to US markets and solid US growth. This is so quite independent of the likely retaliatory measures Washington would take in response to Chinese retaliatory action.

Faced with the prospect of US trade sanctions, it would be irrational for Beijing to opt for anything other than a tension-reducing RMB appreciation. This this would allow Beijing to remain in control of its economic policy and stick with gradualism. The costs are also likely to be much smaller than the potential costs incurred in the event of trade conflict escalation. It would seem eminently rational for Beijing to back down and pre-empt US measures by letting its currency appreciate, modestly but gradually. It may, however choose to engage in a temporary tit-for-tat trade strategy to test Washington’s determination to pursue a gradual turning the screw strategy vis-à-vis China, thereby hoping to deter further US measures. However, if Washington calls it bluff, Beijing will be better off backing away from a politically more difficult-to-control trade conflict.

Naturally, this simple, abstract game-theoretical framework may have to be enlarged in order to include Chinese “linkage” strategy. Economic-diplomatic interaction takes place in a much broader bilateral (and multilateral) framework. In game-theoretic terms, Beijign and Washington play multiple games simultaneously. Excluding extreme and extraneous measures such as expropriation or the freezing of financial assets, the broader relationship does give Beijing a greater deterrence potential than a purely economic-financial analysis suggests. If China makes co-operation in areas considered vital by Washington (e.g. Korea, Iran) conditional on Washington not taking more aggressive action on the bilateral imbalances issue, Washington may be deterred. The bottom line is that even if a broader perspective is adopted, a trade war would be avoided, for Washington or at least the White House will work very hard to avoid it in the first place and prevent Congress from forcing it into an aggressive first move.

Turkey and the EU-27 – a medium-term perspective (2011)

In the wake of the “great risk shift”, which saw risk migrate from the emerging to the advanced economies, and given the continued solid medium-term growth outlook in the emerging markets, one finds an understandable degree of enthusiasm in those countries. Turkey is a case in point, having made economic strides over the past decade.

Following the 2000-01 crisis, Turkey implemented far-reaching economic reforms (e.g. floating exchange rate, adoption of an inflation targeting regime and central bank independence, reform of the fiscal policy framework and banking sector reform and recapitalisation). The reforms have significantly improved economic fundamentals and raised economic growth. Average ten-year real GDP growth is running at 4% compared with only 2% in the late eighties and late nineties. Net public debt fell from 70% of GDP (actually higher, pre-GDP revision) to a safe 30% and FX reserve accumulation policy has helped lower net FX liabilities. This has resulted in a decline in interest rates and a sizeable increase in bank lending to the private sector, which doubled from 20% to 40% of GDP over the past decade.

Reasons for accelerated growth include a bounce-back following crises in 2000-01, a “pay-off” from 1980 reforms (e.g. trade opening, domestic economic liberalisation), a proven commitment to economic stability and structural reforms under a one-party government during the 2000s. It is difficult to disentangle the relative importance of these factors. It remains to be seen to what extent policy discipline will last, should a more fractious multi-party coalition government emerge at some point in the future, absent an external anchor (e.g. IMF, EU accession negotiations).

Despite all the impressive progress, significant structural weaknesses persist. First, Turkey has become only moderately more open in terms of trade. Exports of goods and services rose from an average of 19% of GDP in the 1990s to 23% of GDP in the 2000s. Total trade as a percentage of GDP rose from 41% of GDP in the 1990s to 49% of GDP in the 2000s. Second, Turkey’s export mix has not changed dramatically, either. The share of manufacturing products in total exports has remained unchanged at 90%. High-tech exports have stagnated, accounting for less than 2% of manufacturing exports, half the share of the late 1990s and the same level as in 1989 (and considerably smaller than in other major emerging markets). Last but not least, low savings and investment rates severely limit Turkey’s growth potential. Intriguingly, the savings rate actually declined from more than 20% of GDP in the 1990s to less than 17% of GDP in the 2000s, in spite of a major rise in public-sector savings. Not surprisingly, Turkey is running a very large current account deficit, making it highly dependent on external financing to sustain 4-5% annual real GDP growth.

In spite of continued vulnerabilities and weaknesses, Turkey’s relative economic weight will continue to increase. Turkish GDP currently amounts to less than 5% of EU-27 GDP (in PPP terms). Turkish GDP per capita is 50% of the EU average, up from 40% and 30% one and two decades ago, respectively. Under reasonable assumptions, this share could reach 70% by 2030. This would translate into a Turkish GDP that would just about exceed 10% of total EU GDP. This would leave Turkey as the fourth-largest economy in the EU behind Germany, France and the UK, but likely slightly ahead of Italy. Naturally, the risks attached to the outlook for the “catch up” economies are greater than for the slowly growing advanced economies. Even at its peak in 2050-60, Turkish GDP would, under current projections, not exceed 17% - smaller than Germany’s 22% today.

Demographically, Turkey’s population of 73 m is equivalent to 15% of the EU population. While larger than France, Italy and the UK (60-65 m each), it is smaller than Germany (82 m). According to the latest UN projections, Turkey’s population will reach 90 m by 2050 (and gently decline thereafter). At its peak, Turkey’s population share would be equivalent to Germany’s today (17%). The EU is often thought to benefit from a “demographic dividend” in the event of Turkish EU membership. But this is unlikely to be the case. 

Source: Eurostat

Turkey’s population of working age will increase by a mere 5 and 10 million over the next 10 and 20 years, respectively, peaking at 61m in 2040. Effectively, the working-age population will remain unchanged after 2025. Net migration has dropped very dramatically over the past few decades from its peak period in 1960-80 and is projected to fall to zero by 2025. This suggests that even if Turkish EU membership were to grant Turkish citizens complete intra-EU labour mobility, the net flow of workers to the EU-27 would be very limited, perhaps non-existent, and completely inadequate to offset the projected decline in the EU-27 working-age population of 10 m per decade.

Turkey’s economic and, much less so, demographic weight relative to the EU will be growing over the coming decades. While there are many reasons – political, economic and strategic – that make Turkish EU membership desirable for both the EU and Turkey, it would do little to alter the fundamental economic and demographic dynamics of the EU – the “great risk shift” and Turkey’s buoyant medium-term growth prospects notwithstanding.

Are the BRIC currencies set to become reserve currencies? (2011)

Global FX reserves are denominated in only a handful of currencies. For a currency to become a major reserve currency, it has to be underpinned by liquid, large and highly-rated bond markets. None of the BRIC can at present aspire to major reserve currency status given global FX reserves worth USD 10 tr. Only the RMB has the potential to become a major, albeit not the dominant, reserve currency by 2030. The USD will continue to benefit from incumbency, and is therefore unlikely to be displaced as the “dominant” reserve currency, assuming the government manages to put debt back on a sustainable path.

A reserve currency is, by definition, a currency in which the foreign assets held by central banks are denominated. Conceptually, this needs to be distinguished from a currency’s private international use (e.g. invoicing of trade), even if in practice the two are closely related. It is also important to distinguish between a major and a dominant reserve currency. A currency is a major and dominant reserve currency if 10% and 50% of global FX reserves are denominated in it, respectively.

Global FX reserves are denominated in only a handful of currencies (roughly: USD 60%, EUR 27%, JPY and GBP 4%, respectively). For a currency to become a major reserve currency, it has to be underpinned by liquid, large and highly-rated (ultimately: sovereign) bond markets. (After all, China dumped agencies and bank deposits in favour of US Treasuries during the 2008 financial crisis). None of the BRIC can at present aspire to major reserve currency status given global FX reserves worth USD 10 tr. Quite simply, none of the BRIC government bond markets has at present the required size and depth to absorb USD 1 tr (or 10% of total) global reserves.

There has been a lot of talk about the RMB replacing the USD as the “dominant” reserve currency. Government debt problems, potential inflation and depreciation are seen as undermining the USD. This fails to distinguish between the “store of value” and the “medium of exchange” function of a currency. Concern about the “store of value” has arisen not only due to rising US government debt and large current account deficits. It also has to do with the shift towards slightly more return-oriented behavior among central banks whose foreign asset holdings exceed pre-cautionary levels.

“Excess reserves” allow central banks to invest in less liquid, higher-risk instruments. A US sovereign default would naturally be a game-changer (but such an event is highly unlikely). It is very debatable whether a higher level of inflation and/or exchange rate volatility would undermine USD reserve status. It is noteworthy that the recent US sovereign downgrade was followed by a “flight” into US Treasuries.

More importantly, medium-term depreciation won’t affect the dollar’s medium of exchange function, only possibly its store of value function. There is simply no high-grade bond market as liquid, deep and creditworthy as the US Treasury market.

The RMB, let alone the other BRIC currencies, will not emerge as a serious near-term contender for “dominant” reserve currency status in the next few years. First, size matters. Global FX reserves are almost USD 10 tr (a full 1/3 is accounted for by China). China’s government bond market is a mere USD 1.6 tr. Though comparable in size to Germany’s, it – leaving aside the issue of capital account convertibility – is not large enough to absorb even 10% of present global FX reserves. Second, even if global FX reserve growth slows from currently 15% to 5% and the Chinese bond market continues to grow 15%, the size of China’s government bond relative to global FX reserves by 2030 will still be smaller than the US government bond market relative to FX reserves today. None of the other BRIC bond markets will be sufficiently large by 2030 to absorb 10% of reserves assuming that foreigners will at most hold 50% of the market.

Third, and related, China’s role in international trade will lead to a greater share of trade being invoiced in RMB. Currently, the US remains the main source of final demand for Asian producers. But this will be changing rapidly, enhancing the incentives of central banks to increasingly manage their currencies against the RMB rather than the US and thus to hold greater RMB reserves. Demand for RMB reserve assets is driven not only by greater use in cross-border trade but, significantly more so, by private financial transactions. Greater private use on the back of RMB convertibility would also enhance the incentives to hold RMB.

Assuming that issues such as secondary market liquidity (China is far from having a deep and liquid bond market) and solvency (China is currently rated A by the major rating agencies) have ceased to present impediments by 2030, this leaves the issue of market access. China has recently taken steps very selectively opening up its on-shore bond market to foreign central banks, allowing them to reinvest their (mainly trade-related) RMB in local bonds. Complete capital-account convertibility would help further the international use of the RMB and increase the incentive for central banks to hold a rising share of their reserves in RMB. It will be interesting to see to what extent the Chinese authorities (perhaps other than the PBoC) are prepared to give up control over large parts of its financial system and its capital account and to potentially undermine the very foundation of its tried and tested economic development strategy!

All said, the RMB has the potential to become a major but not the dominant reserve currency by 2030. First and foremost, China itself will still be holding a significant share of global FX reserves by 2025. But a rising share of non-Chinese FX reserves may be invested in RMB-denominated assets, especially once China moves towards greater RMB convertibility. The off-shore RMB market would be too small to accommodate official demand for RMB. A more dominant position in terms of global trade and greater capital-account convertibility underpinned by a fully-developed domestic financial system will create greater incentives for other countries to manage their currencies vis-à-vis the RMB and thus to raise the share of RMB reserve holdings. Nonetheless, the USD will benefit from incumbency, and is therefore unlikely to be displaced as the “dominant” reserve currency, assuming the US government manages to put debt back on a sustainable path.

Brazil as a commodity exporter – opportunities & risks (2011)

Rapid commodity-intensive industrialization, population growth and rising per capita incomes in the emerging markets should continue benefit the Brazilian economy over the medium term. An over-reliance on commodity exports, if not skillfully managed, tends to have a number of detrimental effects, however. Creating a solid framework for dealing with the expected pre-salt-related revenue windfall, reforms targeting productivity growth and a strong fiscal adjustment are necessary if a potentially risky shift towards an economic model that relies too much on domestic consumption and improving terms-of-trade is to be avoided.

Brazil has benefitted from a very significant rise in world commodity prices and an improvement of its terms-of-trade, recent volatility notwithstanding. Brazil’s export mix has also become more commodity-intensive and China has become Brazil’s largest single export market (not counting the EU-27 as a single entity) absorbing 15% of exports (and rising). The export structure remains relatively diversified and Brazil is far from being a pure “commodity play”. That said, high-tech goods make up less than 14% of manufacturing exports, which themselves represent less than 40% of total exports. That said, total exports as a share of GDP remain very low, meaning that a negative terms-of-trade shock would necessitate significant nominal exchange rate depreciation in order to preserve the external equilibrium. Brazil’s export structure may be diversified, product-wise and geographically – and Chinese growth has historically exhibited a low correlation with the US – but Brazil’s terms-of-trade remain susceptible to significant swings.

Source: World Bank

Commodity booms frequently led to over-borrowing and are often followed by busts and sometimes default. According to Reinhart and Rogoff, Brazil defaulted (or “restructured”) its debt seven times during 1824-2010 (Brazil became independent in 1822) and was in default for almost a quarter of this period. Is this time different? Yes. The current account deficit as a share of GDP is manageable and fully financed by non-debt-creating FDI. Gross external debt is small and net debt remains around zero. The systemically important public sector is a net foreign-currency creditor, enabling it to provide FCY liquidity to other sectors of the economy, if necessary.

Fiscal policy is consistent with a continuous reduction in net debt. Rising government revenues (as a share of GDP) are in part attributable to a broadening of the tax base, improved tax administration, declining labour market informality and greater economic stability. Commodity-related revenues are not a very significant source of direct government revenue. That said, during boom times, economists often provide overly optimistic assessments of a country’s underlying (structural) fiscal position. Buoyant financial markets and higher commodity prices will have benefitted government revenues from capital gains and profit taxes. True, tax revenues largely fluctuated in line with nominal GDP growth during the 2008-09 downturn. But this still leaves open the question how revenues would evolve if Brazil were confronted with a permanent rather than temporary drop in commodity prices.

Economists (like investors) frequently underestimate the tendency of systems to “mean-revert”. We may find ourselves in the midst of a (super) commodity cycle underpinned by high-speed, resource-intensive growth in China. This may have caused a permanent upward shift in Brazil’s terms-of-trade, a permanent increase in income and wealth, and, indirectly, a tangible rise in government revenues. But high commodity prices may also turn out to be an aberration, which will end as soon as China shifts away from very resource-intensive growth and/ or as world interest rates start to rise (or risk aversion increases). A permanent decline in commodity prices would lead to currency depreciation and trigger negative wealth and income effects, which would, in turn, adversely affect economic growth.

For the time being, and recent market volatility notwithstanding, rapid commodity-intensive industrialisation and population growth and rising per capita incomes in the emerging markets should continue to benefit Brazilian exports over the medium term. Brazil is a “diversified commodity exporter”. Food and agricultural raw materials make up 2/5 of its goods exports. Brazil is the world’s leading exporter of soybeans, poultry, beef, orange juice, coffee and sugar. The top five export products in terms of value are iron ore, oils & fuels, transport equipment (aircraft), soy and sugar & ethanol. Moreover, Brazil’s agricultural potential is huge. Its potential arable land is estimated at over 400m hectares (FAO), but only 50m are currently being used, and Brazil has more spare farmland than the next two largest countries combined. 

Similarly, the recent discovery of so-called “pre-salt (oil) deposits” has the potential to propel Brazil from 15th to 5th place in terms of proven reserves. It will, if successfully exploited, transform the country into an important oil exporter – and provide the government and the economy with a significant revenue windfall. This offers a huge opportunity to accelerate economic development, provided the windfall is spent wisely by investing in education and infrastructure and provided the country can avoid “Dutch disease” related problems. In short, Brazil is very well positioned to benefit from what may be a longer-lasting shift in the global economy: the economic rise of populous and relatively resource-scarce countries such as China and India.

Nevertheless, an over-reliance on commodity exports, if not skillfully managed, tends to have a number of detrimental effects. Economically, it tends to result in revenue volatility (due to occasional large swings in export prices), over-borrowing, lack of economic diversification and “Dutch disease”/ de-industrialisation problems. As regards Brazil, there are as of yet no signs of systemic over-borrowing, the economy and exports remain relatively diversified and the government does not over-rely on direct commodity revenues.

Revenue volatility and “Dutch disease” problems will be manageable if they are dealt with by way of a structurally tighter fiscal policy and the creation of an intelligently managed off-shore wealth fund. Industrial policy is another tool to address industrial competitiveness problems. But, at a minimum, its success will depend on both the design of intelligent policies and an autonomous state capable of implementing these policies efficiently and impartially. A dual strategy of raising domestic savings (and investment) and lifting productivity through targeted microeconomic reform is called for.

In short, creating a solid framework for dealing with the potential commodity-related revenue windfall and reforms targeting productivity growth are necessary if a potentially risky shift towards an economic model that relies too much on domestic consumption and improving terms-of-trade and too little on productivity growth is to be avoided. A strong short and long-term fiscal adjustment would go quite some way towards addressing related potential risks. It should ensure that rising revenues are invested (or at least saved) rather than spent on consumption and transfers, thus preparing the economy for a potential future deterioration in its terms-of-trade.

Hyperbolic talk of currency war masks reality of persistent US structural power (2011)

The world economy is on the brink of a “currency war”. Some policymakers have threatened “retaliation”. This is hyperbole, for not only is war is an odd term to refer to a situation where somebody sells you something at a discount, which is effectively what you do when you keep your exchange rate at “competitive” levels. But a good, old-fashioned term like “beggar-thy-neighbour” policies would do just fine to describe what is going on. International monetary relations are fraught with tensions, which the G20 summit in Seoul, unsurprisingly, left unresolved. In times of low growth, economic uncertainty and/ or high unemployment, tapping external demand through a “competitive” exchange rate becomes both an attractive policy option and a bone of contention. 

In this context, the US Federal Reserve has been pursuing a policy of quantitative easing aimed at pushing down bond yields, raise US asset prices and weaken the exchange rate. In doing so, the Fed is seeking to both fend off deflation risks and support economic activity. Other countries fear that lower interest rates and a weaker dollar will put appreciation pressure on their currencies and increase capital inflows – especially countries with flexible exchange rates, an open capital account and high interest rates. 

A country can respond to capital inflows in several ways. (1) It can absorb the capital inflows into official reserves via FX purchases. If left unsterilised, this will raise domestic inflation. If fully sterilised, this may or may not push up interest rates, but it will typically addition to the fiscal costs of carrying reserves. (2) It can let the exchange rate appreciate. While this may diminish the attractiveness of local assets in the eyes of foreign investors, it is likely to lead to an “overshooting” of the exchange rate, slowing economic growth and a deterioration of the current account. (3) It can try to limit capital inflows through capital controls or macro-prudential measures. If implemented successfully, this will reduce secondary market liquidity and push up domestic yields. All these responses carry economic, financial and/ or, in the case of controls, implementation risks. Policymakers facing surging capital inflows and an appreciating currency find themselves between the proverbial rock and a hard place. 

While Fed quantitative easing has a very significant impact on other, especially smaller economies, any “retaliatory” measures these may take have virtually no economic or financial impact on US. Several factors explain this asymmetry. (1) The dollar exchange rate and, even more so, any bilateral exchange rate is far less important to the US than for its trading partners, with the possible exception of the EU given the importance of bilateral trade. (2) Capital controls in other countries do not impose any tangible economic or financial costs on the US – other than perhaps opportunity costs for individual US investors. (3) Sanctions by other countries targeting US exports are neither credible, for, assuming the US responds in kind, these typically more trade-dependent economies would incur relatively greater economic costs than the US. 

“Currency war” therefore seems a misnomer. It may feel like war to smaller countries, as they feel compelled to take “defensive” action to fend off capital inflows. But if this is a war, the US has not noticed. The US pursues an economic policy it deems to be in its interest and however these countries respond to it is of little consequence to the US. This is a prime example of continued US “structural power”. Structural power is the power of a state to indirectly influence others by controlling the structures within which they must operate. This differs from “relational power”, or the ability of one state to influence another state's behavior directly. This describes the situation quite accurately, for Washington is not seeking to influence other countries’ behaviour. If one prefers to stick to martial metaphors, US policy may be said to cause “collateral damage”. 

US structural power is attributable to the dollar’s status as a reserve currency, the US government’s ability to issue debt in its own currency and the large size of the US economy on which other countries are – or perceive themselves to be – depend in terms of generating economic growth. Keen to maintain a competitive exchange rate, the other economies have little choice but to absorb US capital outflows into FX reserves. This is not to say that some of these countries could not inflict meaningful costs on the US by, for example, dumping US assets or imposing protectionist measures on US exports. However, both the economic and financial costs of such measures would be far greater for these countries than for the US. 

In other words, the US retains maximum policy flexibility, while its own choices have a very tangible impact on, and create significant constraints for, other countries. As long as other economies depend more on the US market for their exports than vice versa, they will not only be highly constrained in terms of policy options, but they will also wield little in the way of bargaining, let alone retaliatory power vis-à-vis the US. Even holding large amounts of US debt will provide them with very little leverage as long as they are reluctant to let their currency appreciate. True, the US has thus far failed to get other countries, notably China, to appreciate their currencies. Whether one attributes this to a lack of US relational power or a reluctance on the part of Washington to yield its power, US structural power remains the defining characteristic of today’s global monetary and financial system. 

BRIC public sector debt is very manageable in spite of rising off-balance sheet risks (2011)

Over the next five years, government debt in the G4 (US, Japan, Germany and the UK), with the exception of Germany, will rise very significantly. The G4 will therefore have to undergo a multi-year fiscal adjustment in order to put debt on a sustainable path. By contrast, the BRIC governments, having weathered the global crisis fiscally unscathed, will see their debt levels largely unchanged and face a very limited or even non-existent need for a fiscal adjustment. Even if BRIC public sectors were forced to take on contingent liabilities (e.g. in case of a banking sector bail-out), they would still be in better shape, financially speaking, than the G4.

Public debt matters – economically and politically. A high and rising level of public sector debt will, sooner or later, push up domestic interest rates, crowd out private-sector investment and eventually threaten government solvency. Rising debt levels also limit fiscal flexibility, ultimately forcing governments into an extended fiscal retrenchment. This can have consequences reaching far beyond the economic realm. A very large debt burden, for instance, forced Great Britain to liquidate its empire following WWII. Similar concerns have informed recent analyses by US foreign policy in the context of an unsustainable US fiscal policy (Bacevich, Johnson, Mandelbaum).

Over the next five years, government debt is set to decline moderately in the BRICs, while it will rise dramatically in the G4 (US, Japan, Germany and the UK), with the exception of Germany. The G4 will therefore have to undergo a multi-year fiscal adjustment in order to put debt on a sustainable path. By contrast, the BRIC governments, having weathered the global crisis fiscally unscathed, will see their debt levels largely unchanged and face a very limited or even non-existent need for a fiscal adjustment. A combination of significantly lower fiscal deficits, faster economic growth and higher inflation will ensure debt sustainability. According to IMF estimates, the fiscal deficit in the BRIC will average 3.1% of GDP versus 5.6% of GDP in the G4. The real (inflation-adjusted) deficits in the BRIC will be even smaller, of course. 

That said, the level of government debt in the BRIC countries varies substantially. Gross general government debt in Brazil and India amounts to a sizeable 67% and 75% of GDP, respectively, while in China and Russia it stands at a very low 20% and 10% of GDP, respectively. It is also noteworthy that BRIC government debt is almost exclusively held by residents. Only in Brazil do foreigners own a little more than 10% of total government debt. This contrasts sharply with Germany (50%), the UK (30%) and the US (50%), where foreigners hold much larger shares of government debt. If government and central bank balance sheets are consolidated, the public sectors in the BRICs are also all net foreign (currency) creditors. China’s public sector owns net foreign assets worth a stunning – for a country the size of China – 50% of GDP. A very low dependence on foreign financing sharply limits BRIC governments’ financial vulnerability.

Recently, many analysts have expressed concern about the size of (more broadly defined) public sector debt and contingent liabilities in the BRICs (and especially in Brazil and China). Non-financial public sector (NFPS) debt comprises, in addition to the debt of the general government sector, the liabilities of the central bank and nonfinancial public-sector-owned companies. Net NFPS debt, the more relevant indicator from a debt sustainability perspective, amounts to a very manageable 40% of GDP in Brazil, the only BRIC country providing consolidated PS figures. Russia has no doubt the lowest net NFPS debt – the general government is net creditor, after all! For both India and, even more so, China, wide-spread government ownership of non-financial (let alone, financial) companies at both the central and local government levels make it virtually impossible to estimate net public debt with any degree of accuracy.

The Chinese authorities have just released estimates of direct and explicitly-guaranteed local-government debt, a source of concern to analysts following the massive surge in bank lending to local governments in 2008-09, putting it at a manageable 27% of GDP. India has been providing more comprehensive state government debt statistics all along. Neither country provides NFPS estimates. However, unless one assumes that the liabilities owed by public sector companies vastly exceed their assets, net NFPS is bound to be sustainable in all BRICs given the combination of (strong) economic growth, (generally small) government deficits and (low) real interest rates.

What about contingent liabilities? Past experience suggests that banking sector crises are the single most important source of contingent liabilities. All BRIC economies have been experiencing strong real credit growth over the past two years, raising concerns about a future rise in non-performing loans and the potential need for the government to extend financial support to the banking sector. All other things equal: the larger the size of the banking sector and the larger the share of lending by government-owned banks, the greater the potential liabilities. Bank lending to the private sector amounts to 50% of GDP in Brazil, India and Russia and a very considerable 135% of GDP in China. Government-owned banks account for 50% of total banking sector assets in China, 40% in both Brazil and Russia and 70% in India. Ceteris paribus this suggests that China faces the potentially largest contingent liabilities as a share of GDP. Admittedly, in the event of a systemic banking crisis, governments often have little choice but to bail out banks regardless of ownership.

Naturally, credit quality, capital buffers and profitability also affect the level of contingent liabilities. Fitch estimates that the Chinese banking system might require financial support in the order of 10-30% of GDP in a moderate and severe stress scenario, respectively. Bail-out costs in the other BRIC countries would be significantly smaller given the much smaller size of their banking sectors. In short, the contingent liabilities associated with even a severe banking sector crisis would not undermine debt sustainability in any of the BRICs. China, facing potentially the largest contingent liabilities, is best placed to sustain an increase in liabilities given that it enjoys the strongest economic growth outlook, has comparatively little debt and a captive domestic investor (depositor) base. If, unrealistically, all the debt of all non-financial public-sector entities, including central and local governments, were added up and assumed by the central government, Chinese gross public debt may add up to 150% of GDP or so (before intra-public sector netting!). Even in this scenario, this would not break the “sovereign” bank – even if real GDP growth declined substantially (from 10% to 6%), real interest rates rose (by 200bp) and the primary fiscal balance worsened (by 1% of GDP).

In sum, even if BRIC public sectors were forced to take on contingent liabilities, they would still be in better shape, fiscally speaking, than the G4. This does not, however, necessarily translate into higher sovereign risk in the G4, for the latter have a number of things going for them (e.g. large, diverse and “deep” investor base, solid political and economic institutions, a strong debt service track record). Nonetheless, financially and politically, the BRICs will benefit from far greater fiscal flexibility than the advanced economies over the next decade and beyond, off-balance sheet liabilities notwithstanding. Higher underlying growth will increase BRIC governments’ fiscal resources relative to the G4. This will have wide-ranging consequences for the economic and political position of the BRIC relative to the G4.

Demographic trends in advanced and emerging economies and their potential consequences (2011)

Population growth is projected to turn negative in China (2025) and Brazil (2040). Russia’s population has been declining for over a decade. This is worth keeping in mind when analysing the “rise of the BRICs”. The BRICs (with the exception of India) will sooner rather than later be confronting significant demography-related challenges, including a shrinking labour supply, a potentially declining pace of innovation, declining domestic savings, rising pension and healthcare expenditure and, more arguably, a structural decline in inflation. Moreover, both developed and emerging economies must not discount the non-linear effects population decline is bound to trigger.

Demographic trends will diverge sharply over the coming decades. Germany and Japan, the world’s third- and fourth-largest economies, are already experiencing population decline. Less often-mentioned is the fact that most top-tier emerging markets, including the BRICs, are also rapidly approaching an inflection point. Population growth will soon turn negative in China (2025) and Brazil (2040). Russia has been experiencing population decline since 1995. Only India’s population, projected to overtake China’s by 2020 or so, will continue to grow past the middle of the century. By contrast, the UN projects the populations of France, the UK and the US to expand, albeit gradually, until the end of the century. 

Population aging, even more so population decline, is bound to have important political, economic and social consequences. First, labour supply, defined as the population aged 15-64, will shrink. Increasing labour market participation, let alone raising working hours, will only go so far. Sooner or later, man hours worked will decline. Only in Brazil, India, the UK and the US will the potential labour force be tangibly larger in 2030 than today.

Meanwhile, the dependency ratio (population aged younger than 15 and older than 65 relative to the rest) will be rising in both the BRICs and the G5. This will likely reduce savings. If investment remains unchanged, interest rates will have to rise. If investment declines, too, as is likely, a rise in interest rates will be avoided, but economic growth will diminish. Either scenario is negative for government debt sustainability.

Second, there is some evidence that innovation and technological progress is furthered by large, expanding populations (Kremer 1993), all other things being equal. The older populations become, the more reluctant they will be to adopt new technologies (demand) and the less able they will be to innovate (supply). This may, however, be offset by the greater economic incentives to innovate in the context of a declining labour supply and the resulting upward pressure on wages. A declining ability to innovate is arguably less relevant for the less advanced economies – not least because they can simply import (and adapt) existing technology. By contrast, advanced economies operating at the “technological frontier” and facing declining capital and labour supply will have to rely, even more than before, on total factor productivity growth. Just when innovation is becoming more important, the capacity to innovate may be declining!

Third, an increase in the old-age dependency ratio will typically raise pension and healthcare expenditure. Not only will this weigh on the domestic savings rate but it will also raise government outlays, putting pressure on the fiscal accounts. Entitlements are significant in all advanced economies and, if left unreformed, will put major pressure on fiscal positions at a time when household savings are declining. More likely than not, this will put downward pressure on public (and private) investment and thus negatively affect the economy’s growth potential. It may also raise interest rates.

Fourth, and admittedly more speculatively, a declining population and a rising old-age dependency ratio may drag down inflation due to decreasing demand (Ezer 2011). Empirical support for such a view is mixed. In the context of a zero (nominal) interest rate, Japan has been suffering from deflation over the past two decades. While this can be largely attributed to the “debt overhang” following the financial crisis two decades ago, it is possible that demographic factors have also contributed to deflationary pressures. If there is some truth to this, population aging may lead to low inflation. A very low level of inflation, let alone deflation, would negatively affect debt sustainability by setting a floor for real interest rates or even raising the real value of debt.

As such, this is bad news, especially for the initially more rapidly aging G5. As regards Japan and the US at least, potential growth may already have declined due to on-going post-crisis deleveraging. The structural fiscal position has deteriorated sharply and public debt has moved onto an unsustainable path. Over the medium term, the situation will become even more challenging due to a declining labour supply, declining savings and investment, diminished growth, rising age-related (government) expenditure and a more limited ability to diminish the real debt burden due to lower inflation. By contrast, a (generally) more favourable demographic outlook, a much more sustainable initial fiscal and public debt position and a significant (and undiminished) post-crisis growth potential puts the BRIC in a very different position – at least in the short- to medium-term.

It would be a mistake to underestimate the possible lateral (or non-linear) effects of population aging/ decline by disregarding economic, political and financial feedback loops. Mathematically, population growth tends to turn exponential, as does population decline – speaking of non-linearities! Negative population dynamics tend to intensify in the context of positive feedback loops and negative externalities. For instance, a rising fiscal burden, diminished growth prospects and less innovative society may drive young entrepreneurial types into emigration, while fiscal pressures and declining public investment may lead to a general deterioration of economic, financial and social conditions, which might further accelerate population decline (positive feedback). On other hand, rising labour incomes amid a declining workforce may attract greater immigration, softening the demographic downward trend (negative feedback). Last but not least, it may raise fertility against the backdrop of rising labour compensation.

Politically, the emerging “grey majority” might make reforms aimed at lifting economic growth or reforming public finances by limiting pension and health care expenditure well-nigh impossible. Domestically, this may result in political stalemate and intensify economic stagnation/ decline. In foreign affairs, the “grey majority” may diminish the tendency to pursue aggressive policies, while fiscal weakness may diminish the inclination to engage in financially costly armed conflicts. Incidentally, fewer children may make parents less inclined to lend support to armed conflict, while a smaller share of young people may make it more difficult for governments to garner domestic support for a high-stakes foreign policies, as the risk-averse, older majority prevails.

To sum up, demographic change will have important, if somewhat underdetermined economic, financial and political consequences. While virtually all top-tier emerging markets and advanced economies are aging, different countries will be confronting demography-related challenges with greater or lesser urgency. Interestingly, the dividing line is not as clear-cut as might be expected. China and Russia will be characterised by a rapidly aging demographic, while among the advanced economies the Anglo-Saxon countries will be confronted with less dramatic change – relatively speaking. This should be borne in mind when analysing the “rise of the BRICs” and the “decline of the ‘West".

Sino-US financial imbalances bound to grow further (2011)

China’s official FX reserves hit a stunning USD 3.2 tr in July. In order to prevent too rapid a nominal appreciation against the USD, the People’s Bank of China (PBoC) is forced to recycle a large share of the balance-of-payments surplus into dollar-denominated assets. Official FX reserves are typically invested in liquid, high-grade debt instruments. About half of China’s FX reserves are invested in US treasuries and agencies, making the Chinese government the single largest creditor of the US government.

Beijing will have no choice but to pile into US government debt for the foreseeable future. If the Chinese current account surplus gradually moves back to 7.5% of GDP by 2015, as the IMF – assuming an unchanged real effective exchange rate – projects, and assuming China will be running a capital account surplus of 2% of GDP a year (below its historical average!), it could see its FX holdings increase by USD 3.5 tr by 2015. Even under much less aggressive assumptions, FX reserves are bound to increase by a massive USD 2.0-2.7 tr over the next five years. Assuming China keeps the share of dollar-denominated assets constant (at an estimated 2/3), continues to invest the bulk of its dollar-denominated holdings in US treasuries and reduces its exposure to agencies, holdings of US treasuries could rise from currently USD 1.2 tr to nearly 4 tr under the admittedly aggressive IMF baseline scenario.

If, on the other hand, the Chinese authorities, who project a current account surplus of 4% of GDP, are correct, China will accumulate only USD 2.25 tr in additional FX reserves by 2015 (assuming a relatively small capital account surplus of 1.5% of GDP). This would nonetheless sufficient to push total Chinese holdings of US government debt to nearly USD 3 tr. If only 1/2 of the cumulative increase in FX reserves were invested in US government debt, Chinese holdings would turn out lower, but would still exceed USD 2.5 tr by 2015. In short, even under such a “best-best-case” scenario, Beijing’s exposure to Washington and Washington’s reliance on Chinese financing will continue to grow tangibly.

Assuming furthermore (as per Congressional Budget Office) that US treasuries (held by the public) climb to USD 12.6 tr (or 70% of US GDP) by 2015, China could end up holding close to 1/3 of the total – or 2 ½ times today’s share – under the IMF baseline scenario. Or to put it differently, Beijing would hold 37% of Chinese GDP worth of US treasuries (up from 20% of GDP today), while Washington would owe 20% of US GDP worth of treasuries to the Chinese government (up from 7.5% of GDP today). Under the other scenarios, these ratios would be somewhat lower, but not dramatically so.

A number of caveats are in order. First, the current account projections might be way off the mark. The IMF estimates appear to be at the high end. China’s real effective exchange rate will almost certainly appreciate. And if it does not, would the deficit countries be prepared to absorb the rising trade surpluses such a projection implies? That said, it is difficult to see why the surplus should fall much below 3-4% of GDP, short of Beijing allowing the RMB to rise very significantly in nominal terms. And this looks similarly unlikely.

Second, China might ease restrictions on private-sector capital outflows (while maintaining controls on inflows). This might help lower the cumulative balance-of-payments surplus, FX reserve accumulation and thus the pace of treasury accumulation. While the Chinese authorities profess a desire to move towards greater capital account openness, this will invariably be a very gradual process and will not be anywhere near completion by 2015. Besides, the capital account would have to shift into deficit to make a tangible dent in the overall balance-of-payments surplus. This does not look like a very probable scenario at the moment. Even if FDI outflows, which face the least restrictions, rise to USD 100 bn a year, this would be insufficient to push the capital account into deficit, given continued strong FDI and “other” capital inflows. Moreover, a sharp rise in outward FDI might trigger rising political resistance among recipient countries. It already has. (No wonder that Beijing put a bilateral investment treaty near the top of its agenda during last May’s SED.)

Third, China might decide to accumulate dollar-denominated assets other than US government debt and/or divest a share of its existing holdings of US government debt. The China Investment Corporation (CIC) is reportedly to receive another USD 200 bn, in addition to its initial USD 110 bn allotment, of PBoC foreign reserves. However, the new allocation would amount to less than 6% of official reserve holdings. Moreover, the traumatic 2008 experience when the CIC’s equity investments lost significant value will ensure that any larger shift out of US treasuries into higher-risk assets will be a very gradual process. The speed of diversification will inevitably lag the increase in FX reserves over the next few years. Even a deteriorating US fiscal outlook would not do much to change this given that virtually all other USD assets would presumably be similarly negatively affected by rising US sovereign risk. Purchasing non-treasury USD assets would not allow China to diversify the risk associated with its USD assets. If it did shift out of treasuries, Beijing might end up fuelling the very crisis it seeks to avoid. Chinese holdings of US treasuries are bound to grow further.

In short, even determined efforts by the Chinese authorities will be insufficient to prevent a further, significant accumulation of US treasuries. It will not be possible to shift additional reserve holdings into higher-risk instruments sufficiently quickly to avoid a further accumulation of US treasuries. Only the US treasury market offers sufficient depth to absorb Chinese USD investments. Long story short: Beijing will continue to accumulate claims on the US government, while Washington will see its liabilities vis-a-vis China continue to rise. The financial stakes in Sino-US relations will be rising inexorably for the foreseeable future – relentlessly raising the bilateral economic and political stakes.

BRIC banking systems after the crisis (2011)

State-led economic development, if successfully implemented, is appropriate during the early “catch up” phase of economic growth. However, as growth becomes more dependent on indigenous innovation and hence a dynamic private sector, a shift to more market-led rather than state-directed development becomes necessary. This also applies to the banking sector. Subject to proper regulation, banking systems that rely on private-sector banks and market-led credit allocation will eventually tend to generate superior economic outcomes. That said, we are unlikely to see a significant reduction in public-sector bank ownership in the BRIC countries anytime soon, nor, for that matter, a tangible increase in foreign ownership.

Following the global financial crisis, BRIC governments have become (even) less prepared to reduce their presence in the domestic banking system. After all, policymakers’ success in overcoming the credit crunch in 2008-09 in part relied on their ability to provide credit to the economy through public sector-owned banks. In the absence of often substantial public-sector bank lending, the decline in domestic demand in a number of countries (e.g. Brazil, China, India) would have been much more severe. Conventional monetary policy would have been and was insufficient to stimulate bank lending (aka Keynesian “liquidity trap”).

Enter the Beijing consensus, exit the Washington consensus. The Beijing consensus is committed to, among other things, the state playing an activist role in economic sectors deemed “strategic”, invariably including the banking sector. This takes the form of outright government ownership or at least significant government intervention. Instead of near-exclusively relying on private-sector, market-led processes, the state takes an activist approach going far beyond merely regulating private-sector activity. Historically, this type of successful developmentalist, state-led economic policy and development does nonetheless rely on functioning private markets – nowhere is this more evident than in today’s China, where the private sector has been the main engine of economic growth. 

History suggests that this strategy, if successfully implemented, is appropriate during the early “catch up” phase, when per-capita income is low and growth is significantly driven by large-scale investment in physical infrastructure and the introduction of “off-the-shelf” technologies. However, as per-capita income rises, growth becomes more dependent on a dynamic private sector and indigenous innovation. Eichengreen et al. (2011) identify a per-capita income of USD 17,000 (in 2005 constant international dollars) as a critical threshold where economies experience a tangible downward shift in their trend growth. This is where state-directed policies are bound to become less effective in terms of generating growth than a dynamic private sector. This suggests that – following recent PPP revisions – smart state-led policies remain broadly appropriate in low per-capita-income India (USD 3,500) and, less so, in China (USD 7,700) and Brazil (USD 10,000), while they are bound to be less effective in Russia (USD 15,200), all other things being equal. Naturally, should China continue to grow at near-double-digit rates, it would, as Eichengreen et al. (2013) point out, reach the “critical threshold” before the end of the current decade.

The greater need for a shift to more market-led rather than state-directed development also applies to the banking sector. At a stage of economic development where per-capita income is low and capital productivity is high, it is not difficult to identify profitable and economic growth-generating lending opportunities. This tends to change as economies move into middle-income territory. This is why, subject to proper regulation, banking systems that rely on private-sector banks and market-led credit allocation will eventually tend to generate superior economic outcomes.

This flies in the face of policymakers’ recent successful experience with counter-cyclical state-directed credit policies. After all, the extensive use of government-directed bank lending played an important role in sustaining domestic demand and economic growth (China, India) or may, at least, have prevented an even sharper economic contraction (Brazil, Russia). Interestingly, real bank lending grew significantly faster in the BRIC countries, where governments play an important role in the banking sector. Real credit growth averaged almost 25% in China in 2009-10, while public-sector banks in Brazil, impressively, doubled lending from 10% of GDP in 2008 to 20% of GDP in 2010. 

This contrasts sharply with the contraction in credit experienced by many developed markets and relatively anemic credit growth in those emerging markets where government ownership of banks is very limited (e.g. Mexico, Eastern Europe). Admittedly, other factors such as extensive foreign ownership and significant cross-border lending may also have contributed to differential credit growth. But the role played by public-sector banks was undoubtedly important.

It is perfectly sensible to pursue counter-cyclical state-directed credit policies if the banking system is dysfunctional and is suffering from market failure. However, time inconsistency and politicians’ desire to dish out favours risk turning counter-cyclical policies into pro-cyclical ones. Interestingly, among the BRICs, only Brazil seems to have given in to this temptation, while China, more accustomed to state-directed lending and more concerned about its inflationary consequences, has not. But unless top-notch governance regimes are in place, extensive state-directed credit allocation, especially if sustained over a longer period of time, carries the risk of capture by “rent-seekers”. And rare is the government (or the bureaucracy) that manages to privilege medium-term economic efficiency over short-term political considerations in a consistent manner. An economy that grows at double-digit rates may be able to afford this (China), whereas most economies, especially those constrained by low savings rates (Brazil), cannot. Last but not least, an extensive public-sector presence also undercuts, and if does not undercut then it certainly slows, the development of a more sophisticated banking and financial sector capable of sustaining economic development once an economy moves into middle-income territory.

That said, it is difficult to see why the BRIC governments would be willing to substantially reduce, let alone relinquish their role, in the domestic banking sector over the next few years. Some BRIC governments have sold (China) or are planning to sell minority stakes (Russia) in major state-owned banks. But none of them is seriously considering giving up control. True, Brazil did fully privatise a number of its public-sector banks in the 1990s (and even sold some of them to foreigners), but this occurred against the backdrop of severe financial pressures and an urgent need to resolve a banking crisis. Short of a major crisis, which is unlikely given solid economic fundamentals, we will not see a substantial decline in public-sector ownership and control in the BRICs over the next decade or so.

Similarly, if the history of banking sector opening since the 1990s is anything to go by, none of the BRIC economies will see a significant increase in foreign bank ownership. While opening the banking sector to foreigners has always been a politically unpopular proposition in the BRICs, economically and intellectually it seemed difficult to contest its benefits. The view that greater foreign ownership is unambiguously a good thing, bringing superior regulation, fresh capital, financial innovation and better risk management, has at least been called into question in the wake of the global financial crisis. There are also concerns among BRIC policymakers that a large foreign presence may allow external shocks to be transmitted more easily. This is debatable, however. Extensive foreign ownership may actually have helped avert a larger crisis thanks to co-ordination committing foreign banks to maintain the lending of their domestically incorporated subsidiaries, recapitalise local subsidiaries (if necessary) and, more generally, allow for an “orderly” de-leveraging (e.g. Vienna Initiative). Still, we are not likely to see either a significant reduction in public-sector ownership or a substantial increase in foreign ownership in BRIC banking sectors in the near or even medium-term future.

Why Brazil is both catching up and falling behind (2011)

Brazil’s medium-term economic prospects underpinned by solid fundamentals, favourable demographics and strategic natural resource exports are bright. Nonetheless, while per-capita income growth has picked up tangibly over the past few years, it remains way below that of Brazil’s East Asian “peers”. Per capita GDP in China and Korea, as a share of Brazil’s, increased from 7% and 62% in 1980 to 60% and 270% in 2010, respectively. Even if Chinese growth declines a couple of percentage points from current levels, its per-capita income will exceed Brazil’s by 2020.

Brazil is doing well. It weathered the 2008-09 global crisis largely unscathed (except for a significant growth slowdown in 2009). It is once more attracting record levels of capital inflows, including very significant FDI. Record-high terms-of-trade and a strong exchange rate are supporting a consumption boom. Unemployment is at all-time lows. Major oil discoveries carry the promise of turning Brazil into an important energy exporter over the next decade and generate windfall revenues for the government. Large FX reserves, a flexible macro-framework (however, imperfectly adhered to in practice), a stable political system, a favourable demographic outlook and an expanding middle class, underpinned by a solid banking system and an increasing number of internationally competitive companies, bode well for medium-term economic growth.

Brazil thus has legitimate grounds for optimism. But everything is relative. Per-capita GDP growth accelerated from less than 1% in the 1980s and 1990s to 2.4% during 2001-10 (or 3.5% since 2004). While this represents a significant improvement, it falls way short of star performers like China and Korea, both of which experienced dramatically higher per-capita growth for any given level of income. As a result, per-capita GDP in China and Korea, as a share of Brazil’s, increased from 7% and 62% in 1980 to 60% and 270% in 2010, respectively. Even if Chinese growth declines a couple of percentage points from current levels, its per-capita income will exceed Brazil’s by 2020.

East Asia’s rapid economic development can be attributed to a number of (causally) difficult-to-disentangle factors, including high investment and large domestic savings, favourable demographic developments (falling dependency ratio) and an outward-oriented, export-led industrialisation strategy, resulting in a high degree of trade openness, which, in turn, offers access to advanced technology and fuels productivity gains. Brazil shares next to none of these characteristics. It has remained a relatively closed economy with merchandise trade accounting for a mere 20% of GDP (compared with 3-4 times that share in China and Korea). The share of commodities in total exports is high (and has actually been increasing). National savings and domestic investment remain relatively low.

Investment is a major driver of economic growth, and investment is largely financed by domestic savings. This means that unless an economy runs a significant current account deficit (imports foreign savings), its investment capacity is limited by its domestic savings. Worryingly, economic stabilisation, an improved outlook and extremely favourable international conditions have not yet had a tangible impact on domestic savings. Especially the terms-of-trade shock should have had a positive, if typically only transitory, impact on savings. Brazil’s domestic savings rate averaged 16.9% of GDP in 2001-10 and a mere 17.8% during the second half of the decade, compared with 17.5% of GDP during the “lost decade” of the 1990s.

This is a problem, for not only has the savings rate barely budged (so far) but it remains a stunning 30 percentage points below China and more than 10 percentage points below Korea’s. High savings rates in EM Asia and low savings rates in Latin America are generally attributed to a varying combination of historical (hyper-inflation), economic (growth), demographic (change), (fiscal) policy and even cultural factors. The difference in investment rates is slightly less pronounced given Brazil’s greater reliance on foreign savings to finance domestic investment. It is likely that marginal capital productivity, especially in infrastructure, is higher in Brazil than in its Asian peers, given the very limited investment in Brazil in this sector over the past three decades. Brazil should therefore get more “bang for its buck”, but an investment rate of 20% of GDP will be insufficient to sustain a growth rate of more than 5% annually. Micro-economic evidence suggests much the same. Brazil’s infrastructure has come under heavy pressure.

Similarly, a number of industries are struggling to find qualified staff. In short, a relative lack of investment in physical infrastructure (e.g. getting commodities to ports, for example) and human capital (e.g. engineers capable of implementing large-scale infrastructure projects) is creating bottlenecks that are driving up prices. In short, if Brazil wants to raise its sustainable rate of economic growth, it needs to raise its investment in a sustainable manner, that is, without running too large a current account and fiscal deficit. The IMF projects the investment to rise from just below 20% of GDP today to an average of 21% of GDP during 2016, assuming an almost unchanged savings rate of around 17.5% of GDP. This compares poorly to China and Korea, which will invest more than 45% and 30% of their respective GDP during 2011-16.

The most likely scenario is one where Brazil settles onto a medium-term growth trajectory of 4.5% per year. This will be politically and economically sustainable. The government faces very limited incentives to pursue major, growth-enhancing structural reform: from an electoral point of view, the short-term political costs of reform would outweigh the political benefit of higher medium-term growth. Smaller, incremental reform less prone to encounter political opposition is much more likely. This is not a catastrophe, but it won't allow Brazil to grow anywhere near Asian levels. Hence Brasilia should not be surprised if China overtakes Brazil in terms of per-capita income soon.