Rising dragon, falling eagle? (2011)

It is terribly tempting to regard the global crisis as the event that precipitated the decline of the US and the rise of China. The “rise and decline” school has gotten it spectacularly wrong before, however. During the 1970s, especially following the Vietnam War and during the economically difficult Carter years, the “declinists” – as incredibly as this may sound today – were worried that US economic decline would lose Washington the Cold War against an apparently ascendant Soviet Union. It turned out that it was the Soviet Union that was experiencing stagnation and decline, leading to its eventual economic collapse and political break-up a little more than a decade later.

During the 1980s, when the US was running record-high fiscal and current account deficits, Japan was going to emerge as “number one”. Exactly ten years after Ezra Vogel's 1979 book, Japan crashed financially and has ever since suffered an economic malaise. During the 1990s and early 2000s, the US “re-emerged” again as the most powerful economy with no serious challengers on the horizon, despite attempts to construe a German-led Europe and a recovering Japan as potential challengers. Following the 2008 financial crisis, the “declinists” are once more predicting US decline. This time, it is China that is set to rise and challenge US pre-eminence.

China does indeed look set to overtake the US in terms of economic size. Not only does China appear to have weathered the very crisis that pushed the US economy “off-course” pretty much unscathed. But China has been growing at an average annual rate of 10% since the beginning of economic reform in 1979. On current trends and on the basis of conventional PPP estimates, China will replace the US as the world’s largest economy within the next decade or so. Some well-respected China analysts, like Bert Keidel, even forecast the Chinese economy to be twice the size of the US by 2050.

While growth may slow down somewhat from double-digit levels, the medium-term term growth outlook appears solid. A low degree of urbanization and a low capital stock provide conditions conducive to continued strong growth. When Japan slipped into crisis, it had already reached the “technological frontier”. The Soviet economic model, based on “extensive” rather than “intensive” growth, was not sustainable, while geo-political competition forced Moscow to keep defence expenditure at ruinous levels. By contrast, China is generating both intensive and extensive growth. So if China manages to avoid geo-political competition, which the doctrine of “peaceful rise” seeks to achieve, China is likely to enjoy continued solid growth. This is the “China story” seen through the eyes of the bulls.

The China bears, on the other hand, not only expect Chinese growth rates to decline more substantially. But they also see other potentially dangerous speed bumps on China’s way to economic pre-eminence. To stick with this metaphor, a speed bump can slow one down. But if ones hits it at top speed, it may throw one off-course, or even into the ditch. These “bumps” range from increasing natural resource dependence and rising geo-political competition with 'status quo' powers (Friedberg 2005) over 'trapped (economic) transition' (Pei 2006) and a crisis of political legitimacy and political instability (MacFarquhar 2006) to the sustainability (or lack thereof) of China’s investment-focused and supposedly export-oriented growth model in case Beijing fails to shift the economy towards greater domestic demand-led growth (Goldstein & Lardy 2008).

One does not have to be a China bear to recognise that the downside risks outweigh the upside risks. However, China looks unlikely to be thrown off-course in the way the Soviet and Japanese economies were. Structurally speaking, China’s medium-term growth potential is very significant. The spanner that would need to be thrown into the works would have to be very massive. The Soviet and Japanese examples, nonetheless, suggest the need to re-examine periodically the viability of the current growth model to check whether it is appropriate given China’s stage of development. It also suggests that China may face considerable “known unknowns” and, one must assume, a non-negligible number of “unknown unknowns” (rewatch the Rumsfeld classic), though this can, of course, not be known, than the US. History, in any event, appears to counsel caution (and intellectual modesty), when it comes to extrapolating current trends a decade or more out into the future – if for no other reason that “if economists could get themselves be thought of as humble, competent people with dentists, that would be splendid”.

According to the US bears, the US outlook is dire. Huge fiscal deficits, a rapidly rising debt burden and a structurally lower level of economic growth post-crisis weigh on the US economic outlook. Potential growth has probably declined from 3% to potentially as little as 2%, the US manufacturing base has been severely weakened and the US is the world’s largest debtor. This sounds excessively pessimistic. US government debt is unlikely to exceed a 100% of GDP. Low real interest rates and some fiscal effort would make a structurally higher level of debt manageable. US external debt is also less of a problem than the numbers suggest, for US liabilities are denominated in dollars and the dollar benefits from reserve currency status, which is unlikely to be challenged in the near- to medium-term. This means that the US has significant room for maneouvre until the domestic political consensus on growth-enhancing economic reforms can be found.

Brazil, commodity prices & fiscal policy – Time to upgrade the fiscal policy targets (2011)

The Brazilian economy is booming. Foreign and domestic investor confidence is high. The new government confidently projects real GDP to expand at an average annual rate of 6% over the next four years, underpinned by rising public and private-sector investment. This compares with an actual average growth rate of 2.3% under Cardoso (1995-2002) and 4.1% under Lula (2003-2010).

A widening current account deficit has in the meantime made Brazil more sensitive to a precipitous decline in commodity prices, while the recent surge in capital inflows has made it similarly sensitive to a reflow of foreign capital. If it were not for a further projected rise in commodity prices, Brazil would be registering a trade deficit this year for the first time in a decade on the back of an appreciated exchange rate and burgeoning domestic demand.

The value of non-manufacturing exports as a share of total exports has risen to 60% against 40% a decade ago. Brazil has also absorbed large foreign capital inflows since Q1 2009. Capital inflows doubled from USD 85 bn in 2009 to USD 165 bn in 2010 (or a massive 7% of GDP). The stock of foreign portfolio holdings has tripled over the past two years and now amounts to USD 360 bn (or 15% of GDP). It is hence not difficult to see how Brazil has become more sensitive to a combined current and capital account shock.

Thanks to strong fundamentals such a shock would, similar to 2008, not jeopardise Brazil’s overall economic stability, for its aggregate balance sheet remains strong. In terms of external liquidity and solvency, Brazil’s position is very solid. While some of the recent capital inflows are potentially fickle, any currency depreciation resulting from a balance-of-payments shock would prove self-limiting given that an increasing share of nonresident claims are denominated in local currency. Last but not least, the systemically important bank sector carries a manageable FX exposure, both on-balance-sheet and off-balance-sheet. 

In terms of government finances, Brazil is similarly well-positioned. The public sector is a net foreign-currency creditor to the tune of 10% of GDP. Currency depreciation thus results in a decline in the debt-to-GDP ratio. Public debt has also become less sensitive to a sudden rise in interest rates, while interest rate volatility has declined. Moreover, the government does not directly depend on commodity revenues, other than by way of (limited) dividend payments. Compared to many other commodity-exporting countries, Brazil’s fiscal vulnerability is very low.

That said, the government should raise the primary surplus more aggressively, preferably via a reduction of current expenditure. This would not only be desirable in terms of dealing with capital inflows, currency appreciation, monetary policy and economic over-heating. It would also provide the government with greater fiscal space, should the knock-on effect of a terms-of-trade shock on the government’s fiscal position be larger than expected.

In this regard, the Dilma government has made a decent start by resisting demands for a greater increase in the minimum wage, to which a significant share of primary expenditure is indexed. Last month, the government also announced a reduction in planned current expenditure for 2011. Even if the government succeeds in implementing the cuts, primary expenditure would still rise more than 3% in real terms. However, given the backward-looking adjustment of the minimum wage, current expenditure is set to jump significantly next year. It would therefore be preferable to introduce a fiscal rule aimed at containing or, even better, reducing primary current expenditure over the medium term by, for instance, indexing its increase to be less than the rate of GDP growth. “Discretionary” fiscal cuts should be replaced by a medium-term, rules-based adjustment. As the Brazilian budget is characterised by extensive revenue earmarking and expenditure rigidity, such a rule might require “flanking” reforms.

Such a proposal was put forward by FM Palocci under Lula I. If this is politically not feasible, the government could consider switching from a “primary surplus” to a “structural primary surplus” target (that is, surplus adjusted for the economic cycle and, if necessary, the volatility of commodity-related revenue). Targeting the structural balance would help reduce the pro-cyclicality of Brazil’s fiscal policy. The government might even consider targeting a structural nominal deficit given the continued decline in interest rate volatility. However, given the medium-term trend towards rising primary current expenditure and the need for extensive public investment in the run-up to the 2014 World Cup and 2016 Olympics, it might be preferable to adopt a rule aimed at a reduction of current expenditure rather than a rule that might end up constraining the growth in public investment.

With the help of a credible, rules-based, medium-term fiscal policy adjustment, Brazil would be able to bring about a further structural downward shift in domestic real interest rates and a concomitant rise in domestic investment. This would not only help boost Brazil’s long-term economic growth. It would also help to reduce currency appreciation pressure or make a strong currency valuation more manageable over the medium term thanks to resulting productivity gains. Last but not least, it would provide the government with greater “fiscal space”, should a terms-of-trade shock end up having a greater-than-expected impact on the government’s fiscal position.