Why China is getting a raw deal, financially (2012)

The US has been the largest net capital importer in the world for many decades, while China, Germany and Japan have tended to be large net capital exporters, especially during the past decade. In 2012, for instance, Germany and China accounted for a combined 28% of global net capital exports, while the US accounted for 37% of all imports. More strikingly: in 2009, China, Germany and Japan were responsible for nearly 50% of net capital exports and the US for 37% of net imports.

Persistent current account imbalances have translated into changes in net foreign financial positions. In USD terms, Japan, China and Germany are the world’s largest creditors. Net foreign claims today amount to USD 3.4 tr, 1.7 tr and 1.4 tr (or 60%, 20% and 40% of GDP), respectively. By contrast, the US, the world’s largest creditor following WWII, is today the world’s largest net debtor with net foreign liabilities amounting to USD 3.9 tr (or 25 % of GDP).

Interestingly, the US tends to generate positive investment returns in spite of its large net debt. China barely generates positive – and occasionally even generates negative – returns in spite of its large net foreign assets. Even accounting for data quality issues, it is clear that China is generating a dismal financial return. This anomaly can be explained by the structure of the two countries’ external balance sheets. Higher-yielding equity assets make up a significantly larger share of US than Chinese foreign assets, while as a share of total liabilities they are far smaller in the US than in China. The differing asset-liability structure is also reflected in the fact that 25% of total US foreign liabilities consist of low-yielding US treasury securities, while 40-50% of Chinese foreign assets consist of low-yielding US treasury debt. 

The “carry” (i.e. asset-liability yield differential) for Japan, the US and Germany averaged 170 bps, 130 bps and 40 bps, respectively, during 2008-2012. By contrast, China’s carry averaged a negative 250 bps. More specifically, the return on Chinese foreign assets averaged a mere 3.2%, while its foreign liabilities yielded 5.5%. For the US, the equivalent figures were 3.5% and 2.2%. In purely financial terms, China is getting a raw deal and the US a sweet one. This situation is currently being exacerbated, from China’s point of view, by ultra-low US interest rates that both limit US investment income expenditure and depress Chinese investment income receipts.

The currency composition of US and Chinese balance sheets, combined with medium-term exchange rate dynamics, also impacts the two economies’ external position. The US net international investment position has deteriorated far less than the cumulative current account deficits would imply. In addition to favourable price changes due to its long equity/ short debt position, the US financial position also benefitted from exchange-rate (i.e. currency depreciation) related valuation changes over the past decade. Unfortunately, comparable Chinese data are not available, but it is clear that currency appreciation has resulted in financial losses, even after taking into account data quality issues. After all, China’s cumulative current account balance during 2004-12 was USD 2.1 tr, but the net international investment position improved by only USD 1.4 tr.

At risk of over-simplification, Chinese foreign assets are largely denominated in foreign-currency (e.g. PBoC holdings of US treasuries), while its liabilities (mainly FDI and portfolio equity) are largely denominated in RMB. Meanwhile, US liabilities are also, by and large, denominated in domestic currency. Although a larger share of its foreign assets is denominated in dollars, the US is a both a net FCY creditor and long “net equity”. Not only does China benefit less from equity valuation related gains due to its net short equity position, it also stands to suffer losses from RMB appreciation on account of its long FCY position. By contrast, the US stands to benefits from its long equity position as well as, in case of currency depreciation, from its net long FCY position. 

Source: SAFE

In other words, USD depreciation limits the size of the US net debt position and RMB appreciation limits the size of China’s net creditor position. Assuming, not unreasonably, medium-term nominal RMB appreciation, China is bound to suffer exchange-rate-related valuation losses on its foreign-currency assets, while the upside from price-related gains is limited due to the large share of debt on the asset side of its balance sheet. If anything, the rise in US interest rates will negatively impact China’s position given that the bulk of its treasury holdings is concentrated in long-term instruments. By contrast, the relative greater importance of foreign-currency denominated equity assets will tend to put a floor under US net liabilities in case of USD depreciation.

There are many good reasons why China should move towards greater capital account convertibility and promote the greater use of the RMB as an international reserve currency, one of them being the structure of China’s external balance sheet. The liberalization of outward FDI (largely accomplished) and outward portfolio investment should help increase the share of foreign-currency-denominated equity assets. Capital account liberalization makes possible a greater “equity-isation” and “renminbi-isation” of China’s foreign assets as well as, potentially, the renminbi-isation of its debt assets. Together this should over time help reduce its long FCY position and raise both the profitability and price appreciation potential of Chinese-owned foreign assets. 

Nonetheless, as long as China runs a current account surplus vis-à-vis the US, it will have to accumulate net foreign claims on the US. And as long as US residents do not issue RMB-denominated liabilities, the claims will be denominated in FCY. For all practical purposes, US residents issuing RMB-denominated debt on a large scale would require complete Chinese capital account liberalisation. For now, increasing the share of equity assets by way of – private-sector or CIC-managed – capital outflows is therefore the easiest way to raise the profitability of the asset side of China’s balance sheet. Renimbi-ising its foreign assets in a meaningful way in the near- to medium-term would require China’s largest debtor (US government) to issue RMB-denominated debt. If this ever happens, it is undoubtedly a very, very long time off. 

The desire to renminbi-ise the asset side of China’s balance sheet may help explain why China is moving towards capital account liberalisation and why it, incidentally, seems to be becoming keener to sign a bilateral investment treaty with the US. The relative inability to recycle the balance-of-payments surplus into RMB assets and the present lack of asset renminbi-sation not only make China an “immature creditor” (McKinnon 2010). It also helps explain why China is afraid to float its currency. The financial losses it (read: public sector) would incur on its large net foreign-currency position in the event of RMB appreciation would be tangible. Meanwhile, it makes sense to increase the share of equity claims with a greater appreciation potential and wait until China’s net foreign-currency position is less long and less long (FCY) debt (esp. as a share of GDP).

Competitive disinflation and economic adjustment in the euro area: core vs peripherals (2012)

Germany has historically pursued a policy of – what French economists have termed – “competitive disinflation”. This policy combines a commitment to low inflation and wage restraint with a reliance on export -led economic growth, limiting both the scope and the (perceived) need for (Keynesian) expansionary fiscal policies. With the creation of EMU, this economic model was extended from the “core” or German-led “deutschmark area” (DEM area) (Austria, Switzerland, Benelux) to the “peripherals” (Greece, Ireland, Portugal, Spain). 

Upon entering EMU, the peripherals experienced a tangible drop in interest rates, contributing to a credit-fuelled economic expansion, while the DEM area economies, many of whom had entered EMU at overvalued exchange rates, faced relatively high interest rates and experienced an extended period of low growth. Combined with the constraints of the “Stability and Growth Pact”, this, not surprisingly, led the DEM economies to pursue a policy of competitive disinflation via wage restraint and export sector restructuring. Strong growth in the periphery and disinflation in the core led to widening current account deficits and debt accumulation in the periphery. This helped get us to where we are today.

Reassuring investors with regard to public sector solvency in the context of low growth, large fiscal deficits and a low level of international competitiveness is at present the peripherals’ most pressing challenge. With neither monetary nor exchange rate policy at their disposal, the peripherals will mainly have to rely on a fiscally-supported “internal devaluation” to generate higher economic growth in the short term. (Productivity-boosting structural reforms will help lift medium-term growth.) Such a policy will help address public sector solvency concerns. Greater demand from the surplus countries, whose public finances are on a much more solid footing, would at least somewhat help offset the effects of market-imposed fiscal tightening on growth in the deficit countries, for the greater the required disinflation, the greater the required fiscal adjustment. At some point, such a policy may obviously become self-defeating unless it is supported by long-term, low-cost official financing.

Germany does not face any immediate pressure to tighten fiscal policy - if the markets are to be believed. Putting off fiscal tightening would be unlikely to undermine German creditworthiness, which remains critical to backstopping EMU sovereign debt wobbles. However, Germany has committed itself to a, albeit modest, multi-year fiscal tightening. By institutional (constitutional) design, habit and, perhaps, cultural inclination, it will stick with a policy of competitive disinflation. In doing so, it will increase the adjustment burden of the peripherals.

Germany is visibly willing to act as a 'financial stabiliser', for good, self-interested reasons, ranging from the financial exposure of its banking sector over to a potential EMU sovereign default to preserving EMU for a variety of economic and political reasons. Germany’s policy DNA does not seem to allow it to act as a significant (discretionary) 'economic stabiliser' in terms of generating intra-EU demand, but it is willing to act – and, significantly, thus far allow the ECB to act – as a “financial stabiliser”.

Does this mean that a currency union based on “competitive disinflation” is inherently flawed? No. After all, the pre-1914 gold standard worked just fine – at least, as far as the major economies were concerned. It might, of course, be argued that the inter-war experience (incl. the Great Depression) offers a more relevant comparison. Two important lessons can be drawn from the experience of the 1920s and 30s (and/ or the post-WWII period): it is systemically destabilising for all major economies to pursue de-/dis-inflationary policies simultaneously; and domestic institutions differ in terms of their conduciveness to both sustaining “disinflation” and facilitating adjustment (e.g. fiscal rules, labour market institutions favouring wage moderation). 

The implications for today’s situation are clear. First, an EMU that tilts towards a policy of “competitive disinflation” is viable as long as it can tap external sources of demand via, for instance, exchange rate depreciation. Second, the EMU as a whole is going to rely to a large extent on extra-EMU demand as an important source of growth. This is where the DEM area, accounting for more than 40% of eurozone GDP, with its greater openness, which incidentally is more geared towards extra-EU markets than in the peripherals, will have to act as a conduit for global demand to feed into higher EMU growth. Third, the peripherals will need to implement wide-ranging domestic reforms geared towards maintaining both fiscal sustainability and external competitiveness if the EMU’s internal economic, financial and political viability is to be assured. Whether this is both economically and politically feasible remains to be seen.

Recent proposals for how to avoid the next crisis have focused on the need for institutional reform at the EU level (e.g. EMF, fiscal union). However, even if some of these reforms do turn out to be politically achievable, it would be desirable to implement domestic reforms that allow the peripherals to sustain a policy of competitive disinflation over the medium term. Merely establishing a sanction mechanism at the EU level will prove insufficient as long as domestic institutions underpinning “competitive disinflation” have not been put in place.

EMU largely reflects German preferences – it is the German economic model writ-large. It is hence not surprising that the DEM area ended up outcompeting the peripherals inside EMU. With Germany unwilling to act as a significant economic stabilizer and only as a 'limited-liability' financial stabiliser , the peripheral countries will have no choice but to adjust (or to default). In the short term, emergency measures may do the trick; but if these policies are to be sustained over the medium term, they will need to be accompanied by domestic institutional reforms.

Brazil – Government debt is declining, or is it? (2012)

The outlook for debt sustainability in Brazil is favourable. Net public-sector debt has fallen tangibly. Brazil’s gross debt remains relatively high compared with most of its emerging markets peers, however. Interestingly, gross government debt has remained substantially unchanged in the past five years – in spite of solid real GDP growth and a reasonably tight fiscal stance reflected in large primary surpluses. This can be attributed to public-sector asset accumulation financed by domestic debt issuance. Had the government refrained from accumulating assets, gross (domestic) government debt would be 10-15 percentage points lower than it is today. A fundamental change in policy appears unlikely, as it would conflict with the government’s revealed policy preferences.

Many advanced economies are facing debt sustainability challenges. The emerging economies, by and large, are not. The average gross government debt-to-GDP ratio in the EM G-20 is 37% of GDP, as opposed to 110% of GDP in the advanced G-20 economies. This ratio is projected to decline to less than 30% by 2016, while in the advanced economies it will climb by five percentage points

Brazil is a case in point. The outlook for debt sustainability is favourable. Net public-sector debt has fallen from a peak of nearly 60% of GDP in 2002 to less than 40% now. If Brazil maintains a primary surplus of 3% of GDP, registers an average real interest rate of 6% and generates real GDP growth of 4% in 2012-15, net debt will fall to less than 30% of GDP by 2015. It remains to be seen if the Brazilian government will be able to resist the temptation to switch to a less disciplined fiscal policy once debt approaches the 30% mark.

The government understandably focuses on the (lower) net debt ratio rather than the higher gross debt ratio. Not only has gross general government debt fallen by less, declining from a peak 82% of GDP in 2002 to 65% of GDP. It would be highly desirable to reduce the government debt burden more aggressively. Brazil faces relatively large contingent liabilities in the guise of rising age-related expenditures. While Brazil’s demographic profile is relatively favourable, its old-age dependency ratio will double by 2030 and then (almost) double again by 2050, reaching nearly 40%. The IMF estimates the net present value of age-related pension and health expenditure at 70% and 40% of GDP, respectively. Only Russia and Ukraine, two countries with incomparably worse demographic dynamics, face larger pension and health-related liabilities. Other emerging economies will be confronted with rapid increases in age-related expenditure, but they will generally start from a better debt position and/or benefit from higher underlying economic growth (e.g. Russia, China, Saudi Arabia and Turkey).

Brazil’s gross debt also remains relatively high by emerging economies standards compared with most of its emerging markets peers. It is about 20 percentage points higher than the EM G-20 average. Net debt remains around 10 percentage points above the EM average. Among the major emerging markets, only Hungary (80%) and India (69%) have higher gross debt ratios. Brazil’s gross government debt, including gross domestic government debt, has remained substantially unchanged in the past five years – in spite of real GDP growth of 4.2% per year and a reasonably tight fiscal stance reflected in a primary surplus of 3% of GDP. Net debt, by contrast, has fallen by a full 10 percentage points since 2006.

This apparent discrepancy is largely explained by below-the-line transactions related to public-sector asset accumulation. More specifically, domestic debt issuance tied to sterilised FX intervention and loans to official financial institutions have helped prevent a decline in domestic debt, while the related asset accumulation has not (materially) affected the decline in net debt. Not only has this kept gross (domestic) debt high. It also has resulted in higher-than-otherwise net interest payments. After all, the negative carry on FX reserves has averaged around 1,000 bp in the past few years. The negative carry on lending to official institutions is roughly Selic minus the TJLP (or government-determined long-term interest rate) and has thus averaged around 500 bp. This has helped keep net interest payments high, thus preventing a more rapid decline in debt levels. Admittedly, there are difficult-to-quantify benefits related to FX reserve accumulation (up to a point) and there may be broader economic benefits (which are more difficult to prove) related to subsidised lending. Undeniably, however, public-sector asset accumulation has been costly in strictly fiscal-financial terms.

After all, had the government refrained from accumulating FX reserves and extending loans to official financial institutions after the 2008 financial crisis, gross (domestic) government debt would be 10-15 percentage points lower than it is today. If the resulting lower interest payments and resulting lower interest rates are factored in, gross government debt could today be as low as 35-37% of GDP rather than 52% of GDP. A lower level of domestic debt would almost certainly translate into lower interest rates, leading to a further acceleration in debt reduction. If the government is serious about reducing interest rates, it should not only run a tighter policy but also reduce the speed of asset accumulation and related below-the-line debt issuance. The related slowdown in government-subsidised credit and a stronger nominal exchange rate would similarly help lower interest rates, albeit at the risk of conflicting with the government’s revealed policy preferences.

Source: Banco Central do Brasil