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".