China – how much ‘catch-up’ growth potential is there left? (2012)

Economies with a low per capita income – reflective of a low capital stock and a low level of technology absorption – find it easier to generate high economic growth rates than high per capita economies operating near the technological frontier. Naturally, low per capita income is only a necessary, not a sufficient condition, hence ‘conditional convergence’. Japan ceased to converge with US income levels in the wake of the 1990 financial crisis. Both Japan and Korea experienced a significant downward shift in their growth rates after their per capita income reached around 50% of US income in the late 1960s and late 1990s, respectively. This is by and large consistent with the Eichengreenian middle-income trap according to which growth slows down by on average 350 bp once the critical level of USD 15,100 (in 2005 dollars) is reached. China will reach this level in 2016. However, China’s per capita income is projected to remain below 40% of US income by 2020 and not reach 50% (much) before 2030. It is therefore not clear that Chinese growth needs to lose significant momentum. This is not to suggest that history will repeat itself. Economic growth and development are extremely complex social phenomena. Economic policies matter. So do other factors such as global economic trends, demographic change and economic size. These and other factors will affect China’s growth trajectory. That said: if technological catch-up and distance from the technological frontier were all there is to economic growth, China would have quite a few years of strong growth to look forward to.

Source: IMF

Brazil – Time to move towards a new growth strategy (2012)

Brazil’s economy has been benefiting from a positive balance-of-payments shock, namely rising commodity prices and strong capital inflows. This has allowed it to pursue a policy of domestic consumption-oriented economic growth. Unless the world economy is being in the midst of a protracted commodity super-cycle, Brazil will not be able to rely on improving terms-of-trade forever. Sooner rather than later, Brazil will need to shift to a more investment-oriented growth strategy – not least because it will need to deal with the adverse consequences of gradually, but inevitably deteriorating demographic trends.

Brazil has had a good run in the past ten years. Economic growth has picked up. Poverty has declined. Foreign investment has been abundant seeking to take advantage of the country’s resource wealth and consumption-oriented emerging middle class. While all these improvements are real, the next ten years will be more challenging in terms of sustaining economic growth at the level of the past ten years.

A stylised history of Brazil’s economic performance over the past decade goes something like this. Following the financial crisis in 2002, Brazil experienced an acceleration of economic growth. Initially, tight monetary and fiscal policies were offset by a massively depreciated exchange rate, providing the impetus for export-driven growth. Later, fiscal and, less so, monetary policy turned supportive of more domestic-demand and especially consumption-driven economic growth. Finally, global commodity prices and Brazil’s terms of trade began to improve on the back of accelerating global growth and, especially, rapidly growing Chinese demand for primary products, allowing further expansion in terms of final consumption. From a supply-side perspective, the consolidation of economic stability under President Lula (2003-2010) enabled the wide-ranging structural reforms introduced under President Cardoso (1995-2002) to finally come to fruition. By granting the central bank operational autonomy and tightening fiscal policy, the Lula government managed to regain confidence. Brazil’s growth rate almost doubled in the 2000s compared with the 1980s and 1990s.

Brazil benefited considerably from a positive shock to its balance of payments, namely rising commodity prices and a surge in capital inflows. In the past few years, the resulting relaxation of the balance-of-payments constraint allowed economic growth to be heavily driven by domestic consumption. In other words, rising export prices allowed Brazil a far more significant increase in domestic consumption than would otherwise have been the case.

Domestic consumption itself was supported by rising social transfers and the greater availability of domestic credit due to various reforms (e.g. credito consignado, bankruptcy code) and the decline in domestic interest rates in the wake of economic stabilisation. On balance, fiscal policy has been more supportive of consumption rather than investment, PAC 1 and 2 (programa de aceleração do crescimento) notwithstanding.

To the extent that Brazil has relied on rising commodity prices and capital inflows to finance its consumption-led growth, it has become more sensitive, if not systemically vulnerable, to future negative shocks. Such a shock would not result in the return of longer-lasting financial instability, for official FX reserves are very large, the public debt position is generally fair and the banking sector (as a whole) is solid. In order for consumption-driven growth to continue, however, the terms of trade would have to continue to improve.

Brazil is running a trade surplus, but its current account is registering a deficit in the order of 2-3% of GDP, due to deficits in the services and income balance. The current account deficit is being financed largely by foreign equity investment (incl. FDI). It is worth keeping in mind, however, that without the improvement in the terms of trade, Brazil would be running a massive trade deficit (all other things being equal). A shock to either the current (commodities) or capital (portfolio) flows would therefore force a precipitous slowdown in domestic consumption on Brazil. Brazil’s sensitivity to a combined current and capital account shock has also increased due its increased reliance on commodity exports and the large stock of relatively liquid foreign portfolio investment – even though the latter is largely denominated in local currency.

The point is this: unless we are in the midst of a commodity super-cycle, Brazil will not be able to rely on improving terms of trade (and rising commodity exports) forever. Instead, Brazil needs to shift to more investment-oriented growth. It can do this by changing the mix of consumption/ transfers and investment in total government expenditure. Or it can reduce current expenditure, while maintaining investment, and thus engineer a decline in interest rates, which in turn would stimulate greater private investment. The government is trying to do this, albeit too timidly. It predicts that investment will rise to 20% of GDP in 2012.

Even if this is achieved, this would still be very low by emerging economy standards. A low savings rate remains the most important factor holding back growth and forcing the economy to rely on external savings. The household savings rate amounts to 5% of GDP and the corporate-sector savings rate is 10% of GDP. Importantly, the government savings rate has not changed much in spite of rising revenues over the past few years. This is a concern not least because over the medium term demographic trends will put increasing pressure on public finances by way of rising social-security deficits.

A major cause of Brazil’s low household savings rate is the existence of a pay-as-you-go pension system which provides individuals and families with little incentive to save (cf. China). Large-scale reform will take time given accrued pension rights. However, de-linking social-security (and pension) benefits from the minimum wage and limiting the nominal increase in benefits to below the rate of nominal GDP growth could help raise the savings rate – or should help contain the projected rise in transfers – over the medium term. As long as productivity gains are fully passed on to pensioners it will be difficult to raise the household savings rate. A recent study demonstrates that, contrary to common belief, it was social transfers rather than government consumption that accounted for almost all the increase in government expenditure over the past decade.

Incidentally, a more decisive policy shift would help address, albeit only over the medium term, the high level of interest rates and, possibly, currency overvaluation to the extent that the latter is related to high domestic interest rates. Raising savings, especially government savings, would help lower interest rates, while increased investment should help raise productivity, thus making it easier for industry to live with a strong exchange rate. Whichever way one looks at it, that is, in terms of long-term growth or short-term concerns about currency valuation and de-industrialisation, Brazil needs to consume less and invest more. If it fails to do so, it will struggle to generate real GDP growth of more than 3.5-4.0% over the medium-term.

How large is China’s debt - and does it matter? (2012)

Is Chinese government debt 20% of GDP or 150% of GDP, and does it matter? The short answer is no, not really. Chinese general government debt, which comprises central government debt (including banking sector restructuring related debt) and should comprise local government debt, amounts to 20% of GDP. China does not provide (net) public sector debt statistics, which would consolidate the balance sheets of the general government sector and “public corporations”, including the central bank, state-owned corporations and banks as well as government-owned entities such as the China Investment Corporation (CIC). 

Against the backdrop of China’s bank lending stimulus following the 2008 financial crisis, a lot of attention has been focused on (off-balance sheet) local government debt. Being barred from taking out bank credit, local governments set up funding vehicles to raise bank loans. This is presumably why they do not seem to show up under in the reported general government statistics. The National Audit Office (NOA) recently put local government debt (provinces, cities, countries) at RMB 10.7 tr (USD 1.6 tr or 27% of GDP) at end-2010. This would raise general government to nearly 50% of GDP.

Moody’s believes that this underestimates local government debt by RMB 3.5 tr (USD 520 bn or 9% of GDP), as the NOA only accounts for debt directly guaranteed by local governments. Other analysts (Shih) put the amount of total local government liabilities even higher, at RMB 15-20 tr (37-45% of GDP). But LGFV carried RMB 5 tr and “business units subsidised by the budget” another RMB 5.7 tr in debt. Rmb15,400bn (Rmb9,700bn in LGFV debt plus Rmb5,700bn in non-LGFV debt) and Rmb20,100bn (Rmb14,400bn in LGFV debt plus Rmb5,700bn in non-LGFV debt). If this estimate is correct, combined local and central government debt may be as high as 70% of GDP. 

This does not take into account other public sector debt such as the debt of SOEs and other entities linked to the central government. For instance, the Ministry of Railways (5% of GDP) and policy banks (10-15% of GDP) have incurred substantial debts in recent years. The major “off-balance” item, however, is related to local government borrowing. If, unrealistically, all the debt of all government-owned entities were added up, public debt may add up to 150% of GDP or so. Naturally, failing to net out intra-government holdings, this greatly overstates the public sector’s debt position (e.g. lending by policy banks to local governments).

Even if the government were forced to underwrite all outstanding domestic debt liabilities, this would not break the “sovereign” bank. This would hold true even if economic growth declined substantially, real interest rates rose and the primary fiscal balance worsened. Naturally, the actual increase in consolidated public sector debt would be substantially less once intra-government holdings and the collateral transfer associated with the potential takeover of local-government debts are taken into account. As long as China maintains a growth rate of 5%, the government will be in a position to underwrite all outstanding debt liabilities. 

With the financial system as a whole implicitly guaranteed by a very creditworthy central government, the banking sector faces little risk of a systemic destabilization. Significant government ownership, potential regulatory forbearance, a captive depositor base and financial repression further help limit risk. Similar to the bank restructurings of the late 1990s and early 2000s, the government can help out the banks by removing NPLs and recapitalizing the banks. Or it can bail out the local governments (and thus directly the banks) by guaranteeing or taking over local government debts and resolving the issue with the help of strong nominal GDP and cheap financing costs due to low/ zero real interest rates. 

In practice, the resolution will likely be a mix of the central government taking on part of the local government debt and the banks taking limited write-downs in order not to jeopardize their financial stability. (While the government will not allow the write-off to be destablising, it would nonetheless impact the banks’ bottom line.) Another way of looking at this is that a chunk of the investment goes bad and gets absorbed, largely, by the central government – either though recapitalizing the banks or assuming local government debts. The direct financial costs to the central government of the second option will be larger, but the economic costs may be smaller. An economy with a savings and investment rate as high as China’s can afford to do this. The more important question is whether, going forward, government-driven bank lending and government investment is the best way to generate high productivity gains and economic growth and the return on investment to finance the debt. If the marginal productivity of investment were to decline, whether as a result of poor lending decisions or a structural decline in marginal productivity growth, rising debt levels could become a problem. But, in all likelihood, this day is still a decade or so away.

Net international investment position of the BRIC (2012)

Economically, politically and demographically, the BRIC differ dramatically. The same is true with respect to their international financial importance. China is not only by far the BRIC country with the largest foreign assets (and foreign-exchange reserves). Chinese foreign reserve assets alone amount to USD 3.3 tr compared with a combined USD 1.2 tr in Brazil, India and Russia. But it is also the largest net external creditor. China’s foreign investment potential is enormous and dwarfs that of all the other BRIC. For now, China, like the other BRIC, is running a ‘long debt and short equity’. Similar to the other BRIC, most of its assets are denominated in foreign-currency, while its higher-yielding (equity-type) liabilities are predominantly denominated in local currency. From a narrowly financial perspective, China and the other BRIC are getting a proverbial raw deal, not least because they are likely to see their local-currency-denominated liabilities appreciate relative to its largely foreign-currency-assets. After all, real exchange rate appreciation is characteristic of fast-growing emerging economies experiencing productivity growth. Thus, from a narrow financial point of view, the BRIC and China have every reason to diversify their assets out of low-yielding foreign-currency-denominated ‘safe haven’ bonds into higher-yielding, (preferably) local-currency-denominated (from the BRICs’ point of view) assets.

Source: IMF

Defence expenditure in an era of fiscal restraint (2012)

Government debt in many of the advanced G20 economies has increased tangibly since 2008. Japan’s debt is projected to exceed a stunning 250% of GDP by 2016, according to the IMF. (This figure overestimates the effective debt burden somewhat, still…) US and UK government debts are projected to peak at more than 110% and 90% of GDP by the middle of the present decade. By contrast, the emerging G20 will see their gross debt ratios fall from more than 40% of GDP today to less than 30% of GDP by 2015-16. Debt burdens vary considerably across countries, ranging from 65-70% of GDP in both Brazil and India to less than 10% of GDP in Russia. 

Due to significantly faster economic growth, the major emerging economies have been increasing in size relative to the advanced economies. The BRIC share of global GDP, for instance, stood at 15% in the early 90s and is projected to exceed 30% by mid-decade. This will almost inevitably translate into a larger share of global military expenditure. 

Today the top-15 military spenders account for 85% of global defence expenditure. The US alone accounted for more than 40%, down from over 50% during the first GW Bush administration. China, whose economy is the world’s second-largest, is also the second-largest country in terms of military expenditure. Beijing’s defence spending remains 5 x smaller than Washington’s. It may also be noteworthy that eleven of the fifteen largest military spenders are US military allies. Combined with the US, they account for more than 2/3 of global expenditure. 

Last but not least, US expenditure represents 4.8% of GDP, compared with (an officially reported) 2% in China, 3.9% in Russia and less than 3% (and even 2%) in Washington’s major Western European and East Asian alliance partners. (Again, reported expenditure in Japan underestimates effective spending.) By comparison, Soviet military expenditure exceeded an estimated 15% of GDP in the late 80s, while US stood at 6% of GDP at the end of the Cold War.

Defence expenditure in most of the advanced economies will grow very slowly, at best, and in quite a few countries it will likely fall due to the need for fiscal austerity. By contrast, most of the emerging economies will see continued solid growth in expenditure. In constant 2010 dollar terms, expenditure growth averaged 14% in China over the past decade, 4.8-7.4% in the other BRIC. Among the major advanced economies, only the US and the UK experienced noteworthy rises in expenditure, averaging 6.3% and 2.8%, respectively. It is more than doubtful that this decade will see similar increases given rapidly rising government debt and weak-ish economic growth. That said, even if the emerging economies continue to register solid expenditure growth, it will take a while before any of them will be coming even close to matching US expenditure. 

Brazilian banking sector – a view from 30,000 feet (2012)

The Brazilian economy experienced an acceleration of economic growth over the course of the past decade. Economic growth was underpinned by improving terms of trade, rising exports, broadly supportive macro-policies, solid credit growth and a supportive fiscal policy.

Rising domestic consumption was supported by – amongst other things – increasing government transfers, rising incomes, rising employment and expanding domestic credit. Consumption growth was particularly pronounced among the poorer classes. Increasing domestic credit, especially bank lending to the private sector, was itself a function of reform (e.g. bankruptcy code, crédito consignado or payroll-deducted loans) and the improvement in overall economic conditions (e.g. booming labour market, increasing formalization of the labour market, lower domestic interest rates).

As a result, Brazil experienced a sustained increase in lending to the private sector. Bank lending to the private sector almost doubled between 2003 and today, rising from 24% of GDP to 47%. Although many emerging economies experienced rapid credit growth, Brazil is among only a handful of major emerging economies that saw bank lending double (as a share of GDP).

Total bank credit does not appear to be unsustainably high. Other emerging markets have far higher levels of bank lending. This suggests that credit has room to continue to grow. It is worth mentioning, however, that sooner or later sustained growth will require a larger contribution from mortgage-related lending. Consumer lending is already relatively high in Brazil.

In terms of the composition of bank lending to the private sector, consumer credit has experienced the largest increase. This is to a large extent a direct consequence of the reforms mentioned above. Bankruptcy reform has improved creditor rights, making banks more willing to lend. Payroll-deducted lending, allowing for civil servant social security payments to be used as collateral, has induced banks to boost lending. Lower nominal and real interest rates, although they continue to be very high by international standards, have made borrowing more affordable for consumers (and businesses). Last but not least, solid economic growth and a booming labour market, in turn, have helped improve overall credit conditions. 

As regards the origin of bank credit, both the public and the national private sector banks have roughly doubled their lending as a share of GDP. By contrast, foreign-owned banks not only had a smaller market share initially, their market share has also grown more modestly. It is noteworthy that banks wholly or partially owned by the state (BNDES, Caixa, Banco do Brasil) originate more bank credit than the national private sector banks. This, however, is not unusual in emerging economies.

Brazil has quite a segmented loan market. Loans can be divided into so-called ‘earmarked’ and ‘non-earmarked’ credit. Earmarked credit refers to credit operations with compulsory allocation and/or government resources. Specifically, there exist directed-lending requirements specifying that a fixed share of deposit liabilities needs to be lent to the agricultural and housing sector at below-market interest rates. In addition, BNDES, the state-owned development bank, directly (and indirectly, so-called on-lending) offers credit at below-market interest rates. Non-earmarked credit, by contrast and by definition, is not subject to directed-lending requirements.

Lending rates remain extremely high. Historically, the cost of default (or loss given default) has been the most important contributor to loan spreads (that is, spreads over the risk-free rate), explaining as much as 50% of the total spread.1 By contrast, reserve requirements, which are similarly extremely high by international standards, explain, according to the central bank, only around 5% of the loan spread. Thanks to improving macroeconomic conditions and a fall in nominal and real interest rates, Brazil has experienced a moderate lengthening of loan maturities in recent years. This trend will continue as domestic interest rates continue to decline over the medium term.

In spite of the rapid growth in domestic bank lending, the substantial increase in riskier consumer lending and the lengthening of loan maturities, the Brazilian banking sector (in the aggregate) remains in solid shape. The capital adequacy ratio remains high. As a matter of fact, Brazil has the highest CAR of the major EM-9 countries. — In terms of liabilities, Brazilian banks’ dependence on wholesale funding is high, but manageable overall, not least because banks typically hold large amounts of liquid assets in the form of government debt securities. Brazil’s reliance on foreign funding (as a share of total liabilities) – of special concern given the persisting risk of further rounds of global volatility – is quite low. Due to very high reserve requirements (far higher than in other emerging economies), the authorities have an important crisis-management tool at their disposal (as the 2008 shock demonstrated). Banks’ liabilities and assets are largely denominated in local currency and local foreign-currency lending is prohibited (unlike in Eastern Europe, for instance) and banks face strict limitations in terms of the FX risk they are allowed to run.

The outlook for the Brazilian banking system is also helped by Brazil’s solid economic fundamentals, its sensitivity to commodity price developments and the recent decline in economic growth notwithstanding.

First, external vulnerability (as opposed to sensitivity) is low. Brazil has been experiencing significant capital inflows over the past few years. However, a large equity component has helped limit potential risks related to the now sizeable stock of portfolio liabilities owed to non-residents, as has the very significant increase in FX reserves. FX reserves have increased from USD 200 bn in early 2009 to USD 365 bn today. Brazil’s external solvency and liquidity position remains strong. In net terms, both the sovereign and the economy as a whole are net foreign (currency) creditors. While the currency itself is vulnerable to a sharp depreciation in the event of a balance-of-payments shock, such a shock, unlike in the past, would not have systemically destabilising consequences, including for the banking sector.

Second, the creditworthiness of the government is solid. For what it is worth, it carries an investment grade rating. The fiscal stance is sufficiently conservative to ensure the continued decline in the net debt-to-GDP ratio. On current trends, it might fall to as low as 30% of GDP by 2015-16 from 36-38% of GDP at the moment. Gross debt remains relatively high, but to a significant degree this reflects public sector asset accumulation (e.g. lending to official financial institutions and FX reserve accumulation). The government’s capacity to support the financial sector in the unlikely event of a crisis is considerable and will continue to grow as government debt continues to decline.

The government has ample scope to recapitalise the banking sector. A back-of-the-envelope calculation demonstrates this. Gross general government debt at present amounts to 55% of GDP or so. Assuming – very conservatively – a real ‘equilibrium interest rate’ of 7%, real GDP growth of 3% and a primary surplus of 2.4% (below the present 3.1% of GDP target), the government could afford an increase in debt of 10-20% of GDP (equivalent to 20-40% of total bank lending) without undermining debt sustainability. Given that the general government has claims on official financial institutions (mostly BNDES) amounting to 7-8% of GDP, with the latter accounting for 10% of GDP of bank lending, it is clear that the government’s ability to support the banking sector is actually far greater, potentially amounting to 2/3 of all domestic bank lending – and this assumes that the government would not impose any losses on banks’ equity and debt holders. In short, the government is in a position to provide a very substantial backstop in the unlikely event of a banking sector crisis. 

Given large capital buffers at the systemic level actual losses will obviously be far smaller. Brazil and Brazilian banks are currently benefiting from strong labour markets, rising real incomes, ample capital inflows and historically low real interest rates – and the economy is expected to pick up steam in the second half of this year. Historically, however, periods of rapid credit growth usually lead to an increase in credit risk. Brazil is unlikely to be an exception. The good news is that – at the systemic level – capital buffers look adequate to cope with rising default rates. 

In short, the outlook for the banking sector is fair. True, Brazil has experienced bank failures over the past ten years, but they never represented a serious risk to systemic banking sector stability. The same is likely to hold true in the foreseeable future. That said, a sustained economic downturn, including a weakening of the labour market, would negatively impact on banks’ consumer loan portfolios, not least because this segment has experienced the highest growth in recent years. A moderation in consumer lending is desirable. Consumer lending (excluding mortgage lending) is already quite high. For consumer lending to continue to expand at a solid but sustainable rate, mortgage lending would have to take off. Declining nominal and real interest rates, if sustained, might yet make this a possibility.

Political economy of Sino-US relations (2012)

US 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. 

Fears of 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 concomittant 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 fianncial 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. Moreover, 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 an 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 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. 

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. Nonetheless, a limited escalation is possible, if Congress succeeds in making a first move and China temporarily chooses a tit-for-tat strategy to verify US commitment. An outright “war” is unlikely. Several safety valves exist that make this so. 

First of all, Beijing may simply resume a gradual, controlled nominal appreciation of the RMB against the USD. Even if bilateral imbalances remain sizeable, this should allow the Treasury to manage political pressure from Congress more easily. From China’s point of view, less risk attaches to this course of action than allowing the US to take the initiative. In the context of shifting towards greater domestic-consumption-led growth, which given the rapidly increasing size of the economy, will sooner or later become inevitable, this will be a desirable “exit strategy” – and may yet be embraced by Beijing. 

Second, the imbalances may resolve themselves, via the real appreciation of the RMB, making a nominal appreciation unnecessary. Greater focus on domestic growth in the context of the next five-year economic plan (2011-15) may help limit the overall current account deficit to levels similar to what the Chinese authorities forecast. The IMF forecasts the Chinese current account to move back to 8% of GDP by 2015 (or USD 800 bn) from last year’s 300 bn deficit. The Chinese authorities, by contrast, see it settling down at 4% of GDP. This may not be enough to eliminate frictions altogether, but 4% of GDP, incidentally, would be close to the quantitative targets that the Treasury floated a few months ago. However, a lot will depend on what happens to US unemployment and growth. Most likely, the bilateral trade balance will remain a cause of friction. 

Third, even if the bilateral trade imbalance remains significant and Beijing does not revalue the RMB, the US administration may continue to hold the line in order gain support for policies whose success depend on Chinese co-operation (e.g. Iran, North Korea). 

Fourth, if the trade deficit remains large and if Congress succeeds in pushing the administration to take more forceful action and if the president decides not to veto legislation, then forceful US coercive action will take place. While this may lead initially to a tit-for-tat game, an escalation to the point of a full-blown trade war remains unlikely, for Beijing will have a huge incentive to avoid a broader confrontation. From China’s perspective, it would preferable to accept RMB appreciation rather than ultimately risk a trade conflict that would end up imposing higher costs on China than a largely, self-managed RMB appreciation. 

Naturally, the wild card remains Congress and its ability to override presidential vetoes and force the White House to take action against China.If Congress is the wild card on the US side, Chinese public opinion and “saving face” may be the wild card on the Chinese side – both of which might throw a spanner into rational, diplomatic game. If raison d’etat, rationality and pragmatism prevail in both Beijing and Washington, recurring tensions will remain manageable. This is based on the assumption that both parties seek to maximise employment and growth rather than purchasing power. Because Washington would incur substantially lower costs in the event of a bilateral trade conflict, it is in a position to coerce a rationally acting China in to making concession on RMB valuation. Naturally, Washington may refrain from taking action, lest Beijing refuses co-operation in other games Washington and Beijing are engaged. In reality, however, domestic forces may lead a state to pursue “irrational” policies. 

What are the domestic forces influencing government policy? In China, the PBoC is primarily concerned about monetary and financial stability. Cognisant of the need to sooner or later re-balance the economy towards greater domestic consumption driven growth, the PBoC is relatively sympathetic towards gradual nominal exchange rate appreciation, especially if domestic inflation and asset prices surge further. The MoF, linked to the export sector, on  the other hand strongly opposed to currency appreciation. The ultimate arbiter is the prime minister, responsible for economic affairs, and the president, who needs to take into account the broader Sino-US relationship. The prime minister and president have sent ambiguous signals, occasionally decisively rejecting foreign pressure. The political leadership appears to be concerned about the RMB issue in as far as employment and economic and domestic political stability are concerned, but they will also be influenced by the desire to maintain good relations with the US. 

While bureaucratic politics no doubt influences economic decision-making, China’s top leadership does not face the cross-pressures as the White House. This should make easier for the Chinese government to act “rationally” which the US government that is more open to domestic pressure, especially from Congress and, arguably, from public opinion. In the US, Congress is in a position to push, even force, the executive to take a tougher stance vis-à-vis China. This is also more likely happen than in China due to the more democratic nature of the political system where members of congress have to run for re- election frequently. It is no coincidence that high unemployment has forced the RMB issue back on the domestic political agenda. The government in the guise of the Treasury may seek to “hold the line”. The White House’s reluctance to take a more forceful, coercive stance vis-à-vis the RMB issue reflects the acknowledgment that Washington needs Beijing’s support on a number of top priority foreign policy issues rather than the belief that behind-the-scenes diplomacy will yield better results than coercive measures. But the White House may at some point find it opportune for domestic political reasons to give in to domestic pressure. After all, “all politics is local.” Ironically, US-based companies with extensive export capacity in China and exporting to the US benefit from an undervalued RMB and therefore oppose RMB appreciation. In other words, the US government is more open to influence and pressure from domestic political forces than the Chinese government. 

This makes it more likely for Washington to become more aggressive vis-à-vis China, while China, with a government more insulated from domestic political pressures, is more likely to act “rationally”. It also makes it easier for the US to credibly adopt a brinkmanship strategy. If this analysis is correct, it has two very major implication: in the very short term, a trade war is very unlikely; but over the medium term, the risk of a trade conflict will increase – unless, of course, imbalances narrow substantially. Here is why. Offering the largest market to other countries and issuing the reserve currency provides the US with immense (structural) power. Any country highly dependent on trade with the US, even if holding US assets will be in a relatively weak position to deter aggressive US action, let alone exert economic-financial pressure on the US. This is why China, for now, would find it in its interest to acquiesce into RMB appreciation in order to avoid a trade war. However, China’s relative trade dependence will be declining as the size of its economy approaches and outstrips the US. Relatively speaking, US trade and financial dependence on China will be increasing. Similarly, the increasing international use of RMB may help gradually make China less dependent on US dollar assets (relative to the size of its economy). 

Rapidly rising GDP combined with a greater focus on domestic growth will help tilt the balance-of-economic-and-financial power in Beijing’s favour. Once the tipping point is reached, the balance could change very dramatically given large Chinese holdings of US government debt. A declining Chinese dependence on the US market will make Beijing more confident on account of lower costs of an economic conflict. A declining and over-confident US relative to its actual position and a rising China might end up engaging in an economic-financial conflict. When China’s economy approaches the position of the US and its trade dependence on the US dimnishes but its financial leverage remains large due to large US debt, its leverage will increase increase rapidly. Beijing will then not only be more likely to stand its ground in the event of US pressure; it may also become more aggressive vis-à-vis Washington. This would also be a time when an escalation would not be easily contained by either side’s recognition that it is in a substantially weaker, more vulnerable position. Near economic parity, when it is not obvious who is more vulnerable, the risk of misperception and miscalculation will also rise. Then, the risk of a wider trade conflict will be much higher than it is today. In short, if this analysis is correct, Sino-US trade conflict and protectionism will be increasing over time, unless the issue of bilateral imbalances is resolved to both side’s satisfaction. Policy-makers in Beijing and Washington take note.

Emerging economies – who's afraid of the next ‘sudden stop’? (2012)

In the event of another global shock, the emerging markets (EM) remain well-positioned to cope with its economic and financial consequences. Inevitably, a sharp slowdown in global economic growth, let alone a recession, will negatively impact EM growth. Most EM weathered the 2008 financial shock without succumbing to systemic financial instability (aka sovereign and/ or banking sector crisis). Some of the larger EM received IMF support with no conditionality attached (Colombia, Poland and Mexico). The bulk of EM was nonetheless able to absorb the shock without suffering lasting structural damage. True, bank lending increased substantially in the wake of the crisis in some countries, raising risks. But fair medium-term growth prospects provide sufficient room to work off potentially rising credit risks over time. Last but not least, EM governments benefitting favourable debt dynamics would be in a position to support local banking systems should this become necessary.

The external liquidity position of the major EM remains solid, generally speaking. Under conditions of a pure float (and manageable FX mismatches in the public and banking sectors), the level of required FX reserves is close to zero. The more rigid the exchange rate arrangement (excluding currency unions), the more FX reserves will need to be held. The experience of the past two decades has shown that more often than not the breaking of a currency peg under market pressure triggers severe government debt and banking crises. Hence the required level of pre-cautionary is substantially higher under more rigid regimes (more prevalent in the past) than under more flexible arrangements. It is no surprise therefore that EM with more rigid regimes have larger FX reserves (e.g. China, Saudi Arabia). Similarly, EM with more (e.g. Brazil, Indonesia, Poland, South Africa and Turkey) or less flexible regimes (e.g. Russia) tend to have relatively lower FX reserves. 

There are various ways to measure liquidity risk. Under conditions of an open capital account, the so- called liquidity ratio is useful. (In case of a currency board M2, or another monetary aggregate, to FX reserve ratio and in the case of a closed capital account import cover may be better ways of capturing liquidity risk.) It captures the sensitivity/ vulnerability of an economy to a capital account shock. It is the ratio of short-term liquid assets (FX reserves and commercial banks’ liquid foreign assets) to short-term liquid liabilities (short-term debt on a residual basis and non-resident holdings of local-currency (LCY) debt of all maturities). The intuition is that if liquid assets exceed liquid liabilities, the economy is, generally speaking, in okay shape.

The liquidity ratio however overstates actual vulnerabilities, as it adds all marketable LCY debt securities held by non-residents to the denominator. Since the bulk of non-resident holdings is typically invested in maturities of more than one year, non-residents seeking to exit their holdings and exchanging the proceeds into FCY would suffer severe valuation losses such that the actual drain on FX reserves would be far less than what is implied by the liquidity ratio. This is of course more relevant under very flexible exchange rate regimes. 

The liquidity ratio does not take account of current account financing needs. External financing requirements do. It captures an economy’s external debt service obligations (short-term debt on a residual basis) and current account financing requirements relative to FX reserves. Interestingly, the two liquidity risk measures tell a similar story in terms of EM external liquidity risks: Poland and Turkey appear to be the economies most vulnerable to a capital account shock among the major EM. 

A few additional observations are in order, though. All major EM look well-positioned to weather an external shock and FX depreciation, as all EM governments are either net FX creditors or run basically a neutral FX position. Even a sharp currency depreciation would therefore fail to undermine government debt dynamics due to resulting balance sheet effects stemming from foreign-currency mismatches. Moreover, the economies with weaker external liquidity (e.g. Poland, Turkey) are also characterised by quite flexible currency regimes, allowing them to absorb a shock largely via the exchange rate. 

Last but not least, other idiosyncratic factors, not captured by the above indicators, act as risk mitigants – leaving aside potential issues relating to data quality. External financing requirements do not take into account often tangible and almost always quite stable FDI inflow into account. A share of Polish short-term debt consists of lending from foreign parent banks to their local subsidiaries. These lines are likely to be rolled over even during a crisis and even if it is necessary to overcome some co-ordination problems on the part of the banks (e.g. Vienna initiative). In the case of Turkey, the banking system faces significant restrictions in terms of the FX exposure it is allowed to run, while its scope to extend on-shore FCY lending, a potential source of significant credit risk in the event of currency deprecation, is also limited. The capacity of both the government and the banking system to sustain a sharp depreciation allows both Poland and Turkey to survive even a severe liquidity shock. 

In short, the EM are well-positioned to withstand an external shock in terms of maintaining systemic financial stability. Poland and Turkey, EM with weaker liquidity ratios, also seem reasonably well-prepared given solid government net FX debt positions, manageable FX mismatches in the banking sector and a floating currency. This is what the 2008 crisis demonstrated and this is also what external liquidity risk measures are telling us with respect to future shocks.

Sino-US relations & South China Sea (2012)

Will China’s economic and political rise prove destabilising? Scholarly, let alone political opinion is divided. Some believe that with a bit of diplomatic skill China can be integrated into the existing international system without causing destabilization (Ikenberry, Shambaugh). Others are far less sanguine (Friedberg). The pessimists often compare China’s rise with that of Wilhelmine Germany. More specifically, the Anglo-German naval race is sometimes seen as foreshadowing Sino-US naval rivalry. In this analogy, today’s South China Sea, characterised by competing maritime claims, is the strategic equivalent of the North Sea at the beginning of the last century. 

Taking advantage of its economic rise, China is understandably eager to expand its bluewater navy in order to be able to secure sea lanes given its rising dependence on trade and especially commodity imports. After all, eighty percent of China's crude oil imports pass through the South China Sea, as does the bulk of its merchandise trade. It is not difficult to see why China’s neighbours are similarly interested in the South China Sea. For instance, two-thirds of South Korea's energy supplies and nearly 60 percent of Japan's and Taiwan's energy supplies also pass through the South China Sea. 

The US is a close ally of many countries bordering the South China Sea and its navy has been dominating the world’s oceans since the end of WWII. China’s increasing naval capabilities are perceived as a potential threat not just by US allies in the region, but also by the US navy. In an attempt to re-assure US regional allies and ensure US naval dominance, the Obama administration announced a so-called pivot into Asia with the goal of moving 60 percent of US naval assets into the Pacific by 2020, up from 50% today. Diplomatically, the US administration even went as far as declaring that the resolution of maritime disputes in the South China Sea was in the ‘US national interest’, while Beijing opposes the internationalisation of the issue and refers to South China Sea as a ‘core interest’ (alongside Taiwan and Tibet). 

Intensified naval competition is not inevitable, but it won’t be easy to avoid it, either. The US (and its allies) perceives the Chinese naval build-up as a potential threat (or challenge, at least). China’s claim to the entire South China Sea, whatever its historical-legal merit, does nothing to alleviate concerns. By responding with its pivot, Washington feeds Beijing’s perception in terms of US attempts to ‘box it in’ and thus prevent the rise of Chinese naval power. This will almost inevitably encourage Beijing to increase its naval capabilities. And so on. 

The opposing logics that affect, if not determine, Chinese and US policies are perhaps best illustrated by the following quote by a US analyst: “It is in the South China Sea that the components of Asia’s changing power dynamics are most concentrated and on display: China’s growing strategic heft and paranoid sense of entitlement (…) and the United States’ compulsion to meet China’s strategic challenge.” Interchange ‘China’ with ‘United States’ (and drop the word ‘growing’) and you might just get a sense of what the situation may look like when viewed from Beijing rather than Washington.

The situation is more complex that suggested here. Domestic political dynamics, the existence of oil and gas reserves and historical animosities further complicate the situation. Ultimately, however, the South China Sea issue is of massive geo-strategic significance to both China and the US and its allies. Developments in the South China Sea will provide a bellwether not just in terms of the intra-regional security dynamics, but also in terms of shifts in the broader Sino-US balance-of-power. 

Source: DoD