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.
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| 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).