Capital account liberalisation will help improve China’s international financial position (2014)

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).

Source: SAFE

Interestingly, the US tends to generate positive investment returns in spite of its large net debt. China, by contrast, generally generates negative returns in spite of its large net foreign assets. 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 gross 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 an estimated 30-40% 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 bp, 130 bp and 40 bp, respectively, during 2008-2012. By contrast, China’s carry averaged a negative 235 bp. 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 not only limit US investment income expenditure but also 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 considering 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 net foreign-currency creditor as well as 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 in the event of RMB appreciation on account of its long foreign-currency position. By contrast, the US stands to benefit from its long equity position as well as, in case of currency depreciation, from its net long foreign-currency position. 

In other words, USD depreciation limits the size of US net liabilities 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 future 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 further liberalisation of outward FDI and outward portfolio investment should help increase the share of foreign currency-denominated equity assets. Capital account liberalization makes possible a greater “equity-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 foreign-currency 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, these claims will be denominated in foreign currency. 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. Renminbi-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, this is undoubtedly a very long time off. 

The desire to “renminbi-ise” and “equity-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 do 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 (mainly: public sector) would incur on its large net foreign-currency creditor position in the event of RMB appreciation would be tangible. Meanwhile, it makes sense to increase the share of equity claims with a greater price appreciation potential and wait until China’s net creditor position in non-RMB-denominated debt declines further as a share of GDP on the back of continued strong nominal GDP growth, before dismantling all capital controls and floating the RMB.

Sustaining China’s economic ascent will require broad reforms (2014)

Until the onset of the industrial revolution a little more than two centuries ago, China was world’s largest economy. The debate as to why the industrial revolution took place in Western Europe rather than a commercially more advanced China remains a matter of debate (Pomeranz 2000). Domestic and international turmoil during the first half of the 20^th century, followed by disastrous economic policies during the first three decades of the PRC’s existence, led China to fall behind even further. China’s share of global GDP is estimated to have collapsed from historically 1/3 to a mere 4% during the height of the Cultural Revolution in the late 1960s (Maddison). Today it is back at around ¼ (in Geary-Khamis dollar terms). In the late seventies, China finally emerged from the political and economic turmoil caused by the Cultural Revolution (1966-76) under the pragmatically-minded leadership of Deng Xiaoping, who famously stated that it didn’t matter if the cat was black or white as long as it caught mice. Various types of liberalising reforms, notably the reform of township and village enterprises (TVEs) in the late seventies and the establishment of special economic zones (SEZs) in the eighties, brought about fundamental economic change and set free a stunning economic dynamism lasting to this day (Naughton 2007).

The Chinese economy has registered annual economic growth of more than 10% since the late seventies. No other economy has managed to grow that fast for such an extended period of time. Japan and Korea, for instance, experienced real GDP growth 6-8% a year during their respective, shorter-lived high-growth phases. China’s achievement looks somewhat less exceptional if one accounts for the difference in terms of per capita incomes between the most advanced economies and the respective catch-up economy. Chinese per capita income as a share of US income in the late seventies was lower than Japanese of Korean incomes relative to the US in the fifties and seventies. China has therefore been able to sustain higher growth for longer. Chinese per capita income was a little more than USD 9,000 in 2012. US per capita stood at USD 50,000, or more than five times as large as China’s (World Bank 2013). China’s per capita income today is comparable to Albania’s. Due its large population, however, China is today the world’s second largest economy – whether measured at market exchange rates or in power purchasing terms. China’s is also the world’s largest goods exporter, the largest trade, the largest commodity importer as well as the largest producer of industrial goods.

Source: IMF

China has pursued an export-oriented industrialisation strategy relying on high domestic savings and investments characteristic of so-called ‘late developers’ (Gershenkron). Views as to whether the success of the Asian tiger economies was due to essentially liberal policies or the existence of a developmental state continue to diverge (Johnson 1982, Wade 1990, World Bank 1993). Some analysts see China’s economic policies as constituting a set of policies, dubbed the Beijing as opposed to the Washington consensus, instrumental in generating high economic growth (Cooper Ramos 2004; Halper 2010). In this vision, a competitive currency supports rapid export growth; a closed capital account helps keep domestic interest rates low; high savings and investment help build a high-quality infrastructure and finance large investment in export-oriented manufacturing sectors, facilitating export-oriented industrialisation. Meanwhile, an authoritarian regime with a fair degree of policy autonomy and an approach to economic policy characterised by gradualism rather than shock therapy are also essential elements of the so-called Beijing consensus. China’s economic strategy is often compared to that of its East Asian peers, Korea and Japan. Significant differences exist, however (Koerber 2012). Unlike Japan and Korea, China opened up early to allow FDI and as a result its export sector continues to be dominated by foreign firms. Chinese state-owned enterprises continue to represent a significant share of GDP. While the relationship between the developmental state and the corporate sector was close in both Japan and Korea, state ownership was significantly more limited in both cases. 

China, like the other late developers, is perhaps best described as an economy pursuing competitive-conforming strategies (Yifu 2012). This contrasts sharply with countries that pursued comparative-advantage defying strategies such as often occurred in the case of import-substitution policies in Latin America. Even here, the extent to which these policies were failures remains a matter of debate (Rodrik 2008). After all, the larger Latin American economies did succeed in creating an industrial base, while wrong-headed macro-policies eventually led to economic crisis and policy change. It is nonetheless clear that in practice East Asia has been far more successful than countries that pursued an import-substitution industrialisation strategy in terms of generating economic growth, raising per capita incomes and creating economic stability. Competitive-conforming economic development strategies seek to take advantage of cheap, abundant and relatively skilled labour by building up a light manufacturing base while tapping into abundant and stable foreign demand. The resulting acceleration in economic growth allows for a rise in domestic savings and a rise in investment, allowing the economy to upgrade its technological and human capital base over time. Gradually, the manufacturing base is upgraded and economies from exporting light manufacturing to more sophisticated, higher value-added exports. Economically, it is far more difficult to build a high-tech industry from scratch (e.g. Indonesia’s aircraft industry). 

The question today is how much longer China will be able to sustain high real growth rates. The pessimists point towards an unbalanced growth model, signs of over-investment and asset bubbles and the rapidly approaching the co-called middle-income trap (Eichengreen et al 2013) as well as increasing demographic drag. The optimists, by contrast, point to continued urbanization, policy changes aiming to re-balance growth away from investment towards greater consumption, while raising productivity growth, and a still significant catch-up potential relative to the technological leader. Capital controls and a strong external position provide the government with ample policy space to support economic growth over the short- to medium term. The capital stock per capita is quite low, and there is plenty of scope to raise the stock of physical and human capital. If China manages to raise the efficiency of investment, there is plenty of catch-up potential left to tap. It would be a mistake to attribute Chinese growth over the past few decades primarily to extensive as opposed to intensive growth. Intensive growth is reflected in the increase in total factor productivity. Extensive growth is generated due to rising labour or capital inputs. China has undoubtedly witnessed a rapid increase of its capital stock, while labour force growth has contributed relatively. However, China also has generated very significant total factor productivity growth. 

Governments often do play an important role during economic take-off through supporting infrastructure, state-directed investment and financial repression. But these policies need to be tuned to the stage of economic development. As the economy becomes more sophisticated and complex, the state, not matter how efficient, will find it increasing difficult to support growth by way of direct ownership and direct intervention. Funnelling low-interest loans to strategically important sectors or taking advantage of financial repression to offer cheap loans to the economy may work very well for a while. Over time, government bureaucracy will find it difficult to identify so-called winners, while the development of more developed financial system will make it harder to deal with potential negative side effects of financial repression (e.g. off-balance sheet bank lending, housing bubbles). Sooner or later, financial liberalisation and greater efficiency of capital allocation will become necessary (Shih 2008). In order to maintain high growth, more and more credit needs to be extended, which raises the risk of over-indebtedness and risks being unsustainable. The continued availability of cheap capital may limit innovation. More problematically, a less efficient SOE sector receives relatively greater and cheaper funding than the more efficient and innovative private sector given the greater incentives of the state-dominated financial system to lend to quasi-government borrowers. Making way for greater private-sector expansion will almost inevitably require less state and less influence, but a well-though-out and intelligent regulatory and competition framework. Korea, Japan and Taiwan successfully transitioned from state-supported to private-sector led economic growth in their time. Interestingly, preparing for this sort of transition is exactly what the new Chinese leadership is professing it wants aim for.

Received economic opinion is that China should reduce its over-reliance on investment and shift growth towards greater consumption, in part by allowing for more market. On the other hand, the capital stock is still comparatively small. Maintaining high investment does not appear to be a mistaken policy as such, but if, as currently seems to be the case, incremental investment generates less and less growth and increases the debt burden to potentially destabilising levels, policy change is needed. Raising the economic returns on investment will likely require creating more of a level playing field for private companies and state-owned enterprises (SOEs). Initially catch-up economic growth is easy and can largely be directed by the government. Over time, the emergence of rent-seeking interest groups and simply the complexity of an increasingly advanced technological economy make it harder for the government control economic development, while economically the catch-up potential diminishes.

Economically, China will soon be confronting the so-called “middle income trap” that postulates that economic growth experiences a marked downward shift once GDP per capita (in 2005 dollars) reached USD 10-12,000 or so. One may quarrel about the specific level at which the slowdown occurs and the magnitude of the slowdown. But it is clear that as economies gradually approach the technological frontier, it becomes harder to sustain high growth rates. In the case of China, sustaining growth will likely require less state or at the very least a more efficient state, and more private sector.

Source; IMF

Politically, partial economic reform may have led to the emergence of a “mixed” state-centred system that perpetuates the privileges of the ruling elite (Pei 2009). This system allows the elite to reap the gains from limited reforms to sustain the unreconstructed core of the old command economy, thereby ensuring its continued political supremacy. According to the view, China finds itself in a “trapped transition,” where the ruling groups have little incentive to pursue further reform. Absent economic reform, however, economic growth is bound to decline. There certainly is a risk that vested interests to grow too powerful (Olson 1982). Interest-based coalitions emerge that oppose growth-enhancing reforms that would diminish the rents they derive from the present set-up (e.g. SOEs and state-owned banks benefitting from controlled interest rates).

However, other late developers successfully adjusted their approach to economic growth and development policies and thus to sustained relatively high growth (Korea), at least until they started to catch up with the lead economy (Japan). China has thus far also proven its ability to relatively successfully deal with various economic challenges. The key challenge is to pursue the kind of policies that allows China to take advantage of the remaining untouched potential. The new leadership seems to recognise that need for broader economic reform. It has also refrained from opting for the easy way of implementing a large economic stimulus. The government committed itself to a whole range of reforms at last year’s Third Plenum.

In the political-economy terms, the government has an interest in sustaining economic growth in order to maintain popular support. Headline economic is different from rising household income. The reduction in household income, if measured as a share of GDP, may well be the reason for China’s high savings and investment rates, but they nonetheless allowed for a rapid rise in absolute consumption and per capita income levels. In spite of massive investment in capital-intensive industries, China managed to create sufficient jobs to absorb excess rural labour and maintain political stability. Creating employment remains important concern for the government, as unemployment is seen as potentially threatening political stability. In addition to meeting societal expectations of rising incomes, it will be increasingly important to tackle the quality of economic growth (ecological consequences, food safety etc.). In this sense, the leadership’s acceptance of a lower economic growth rate and a commitment to boosting household income and consumption is not only economically realistic, but also politically desirable. The new leadership has also demonstrated its willingness to remove political opponents to necessary reforms (e.g. arrest of several SOE executives).

The Third Plenum reforms, if successfully implemented, will transform China’s economic model fundamentally. Chinese economic reform has long been characterised by gradualism. This gradualism has also been evident in the case of RMB internationalisation. In fact, the government will be even more hesitant to push these reforms aggressively, for rapid liberalisation carries the risk of destabilising economic-financial shocks. Moreover, financial internationalisation will reduce the government’s control over the economy, for RMB internationalisation requires the effective dismantling of the main pillars underpinning China’s economic development strategy: (1) capital controls, (2) domestic financial repression, (3) state-directed credit allocation, a (4) non-market-determined exchange rate and (5) export-led industrialisation. In short, complete RMB internationalisation would spell the demise of the Chinese development model.

The central role government has played hitherto diminish, as the market is allowed to play a “decisive” role. This will be a gradual process. Interest rate deregulation, the opening of the capital account and a more flexible exchange rate will require significant reform in order to make the domestic banking system capable of operating under conditions of more or less deregulated interest rates, the end of financial repression (and loss of captive depositor base) and greater exchange rate variability. This includes directed lending, window guidance, control over capital in- and outflows as well as value of the currency and, indirectly, export competitiveness.  Most importantly, the liberalisation of capital outflows would expose banks and would likely raise the cost of capital. In short, such changes would undermine a system that channels cheap capital to state-owned companies that take advantage of an undervalued exchange rate. In short, such changes would largely dismantle central elements of the Beijing consensus. Equally important, lots of legwork needs to be done before financial and capital account liberalisation can be implemented with acceptable risks to macro-stability. Reform is not going to happen overnight and will necessarily be piecemeal.

China’s medium-term economic ascent is unlikely to be derailed. In the seventies, many analysts predicted that the USSR was going to overtake the US in the eighties, only for it to fall apart, quite literally, at the beginning of the nineties. In the late seventies, Japan was dubbed to become ‘number one’ (Vogel 1979), only for it to experience a major financial crisis and the lost decade of nineties. China is different. It is not a closed command economy, shut off from foreign technology and competition. It is not a country that is even close to catching up with the US in terms of capita. China does face some challenges that resemble problems faces by Japan and even the Soviet such as a weak financial system and adverse demographic prospects and not very productive state sector. But China has sufficient flexibility to deal with these problems in part precisely because of its far greater medium-term growth potential. Unlike the USSR, it does not need to fundamentally transform its economic system, simply gradually reform it. Unlike Japan, China is, and has proven to be, more aggressive in terms of financial sector restructuring. China is very unlikely to return to 10% real GDP growth rates, but at much easier to achieve medium-term 6-7% (the 2013 government target is 7.5%), its growth will prove more sustainable and its ascent steady.

Last but not least, other countries demonstrated that economic development is possible and China can draw on their experience as well the experience of the countries encountered severe economic difficulties. While only very few economies have succeeded in catching up, more or less, with the most advanced economies in terms of per capita income, partial income convergence is achievable and is all China needs to achieve in order to become the world’s largest economy. Its population is about four times as large as the US population. China is set to overtake the US in terms of GDP (measured at PPP exchange rates) as early as 2016, according to IMF projections. Some analysts even project Chinese GDP to reach twice the level of US GDP by 2050 (Keidel 2008). Long-term projections are fraught with problems. Nonetheless, if this scenario were to materialise, it would still leave Chinese per capita income at only a little more than ½ of US income. In spite of the uncertainty, not a completely implausible scenario, if one takes Korea and Taiwan as approximate bases for comparison. The economic rise of China is as pivotal as it appears quasi-inevitable.

The financial drawbacks of being an emerging economy (2014)

The US today, like Britain under the gold standard, acts as the world’s banker. It is the most important source of international liquidity, thereby leading countries to hold USD-denominated assets. Not only does this allow the US and especially the US Treasury to tap into a large investor base ready to finance current account and fiscal deficits at a lower cost. To the extent that the demand for international liquidity and USD assets exceeds the US balance-of-payments deficit, it allows the US to recycle short-term foreign liabilities into long-term assets. In other words, the US acts like a bank. The US also acts as a venture capitalist (Gourinchas & Rey 2005) to the extent that it borrows from foreigners in the form of debt and, in turn, acquires foreign equity assets. As a result, the US benefits from a so-called “return discount” and a “composition effect”. The return effect is reflected in the fact that the US generates higher returns on its assets than it pays out on its liabilities. The composition effect reflects the fact that the US tends to borrow short and to lend long. 

By contrast, the EM incur financial losses as a result of what might be termed the “return premium”: the rate of return on their liabilities is greater than the rate of return on their assets. While the US benefits from the composition effect, the EM can be said to suffer from an “adverse composition effect”: they borrows long (mainly in the form of FDI) and to the extent that they accumulate foreign claims these are heavily concentrated in short-term, but invariably low-yielding debt (aka FX reserves). 

Put differently, the US is “long equity” and “short debt”. The EM are generally short equity and most of them are also short debt. Only China and Russia are net long debt (that is, they are net creditors). This explains the amazing fact that the US generates positive investment income in spite of being an international debtor, while both China and Russia generate negative investment income on their positive net international investment position (IIP). The composition of EM international balance sheets translates into them paying more on their liabilities than they earn on their assets

Two other countries that stand out in this respect are Korea and Turkey where the rate of return on foreign assets exceeds the rate of return on its liabilities. In the case of Korea, this seems to be in part attributable to the low share of equity claims in total foreign liabilities as well as a relatively low share of FX reserves in total foreign assets. Technically, Korea is not an emerging but a newly-industrialised economy. It is admittedly more of a puzzle why Turkey should generate a higher return on its assets than its liabilities given the composition of its international balance sheet. In part this may be attributable to the relatively low share of FDI in total liabilities.  In other words, the EM are willing to hold low-yielding US (and other advanced economy) assets that offer significant liquidity and low risk, while the US (other advanced economies) investing in the EM tend to hold higher-risk, higher-yielding equity and debt assets. This is why the international financial position of the EM contrasts sharply with that of the major advanced economies (US, Japan, Germany or G-3). 

The G3 are all long equity and – with the exception of the US – they are all long debt. Once more, the US is the exception among the G3 due to its short debt position, while China and Russia are the exception in the EM-10 due to their long debt position. Admittedly, this picture would change somewhat if the UK, France and Italy, all of which are net international debtors, were included in the advanced economy sample.  Moreover, unlike in the EM, a large share of G3 liabilities is denominated in LCY, while their assets contain a significant FCY component on account of their long foreign equity position. (One might hypothesise that with G-3 FDI somewhat concentrated in other advanced economies, the currency valuation and composition effects will be less pronounced than for EM.) The large share of equity claims on the asset side of their balance as well as the generally lower return on its debt liabilities translate into a greater profitability of the G3’s IIP. 

Bottom line: the G-3 tend to earn higher returns on their foreign assets than they pay out on their foreign liabilities, in aggregate. The EM pay out more on their liabilities than they earn on their assets. This is due to both the return and composition effects. Until the EM restructure their international balance sheet significantly, this situation is unlikely to change even once G3 interest rates start to rise.

Economic size & financial might (2014)

For the past decade or so, pundits have been debating, analyzing and discussing the rise of the so-called emerging market economies (EM). Certainly, China’s rise to international prominence has been nothing if not meteoric and was predicted by surprisingly few observers in the beginning. Whether economists doubted the sustainability of real growth rates of 10% or whether the power of compounding confounded them is a moot point by now. 

Recently greater pessimism has begun to spread about the EM growth outlook, and this pessimism focuses at least as much on structural as on cyclical issues. The slowdown in China is widely seen as the result of as necessary to ensure the longer-term sustainability of, admittedly, remains very high growth, north of 7%. The economic reform agenda put forward by the Third Plenum last year was nothing short of impressive, even if it remains to be seen to what extent the Xi-Li leadership will prevail over vested interests that stand to lose from the reforms. 

Source: IMF

By contrast, Brazil and Russia are not only experiencing disappointing growth, but both countries have failed to lay out, let alone pursue a coherent medium-term structural reform strategy. With the election of Modi in India and a very capable central bank leadership under Rajan, the outlook has improved, even if, again, it remains to be seen how aggressively the new government will be pursuing necessary, supply-side reforms. In short, the outlook for the major EM is mixed, but it seems very unlikely that, absent broader reform, the EM will return to the level of growth seen in 2003-11, even if the US sustains solid growth and the euro area returns to a recession-free growth path.

Economic size is one thing, financial size is another. Impressively, four of the ten largest economies are so-called EM. But it is perhaps also noteworthy that the Dutch economy is about the same size as Turkey’s, a country with a population of more than 70 m. Similarly, Norway’s economy with its 5 m people is roughly the same size as Poland, a country of 40 m. What is more noteworthy is the role advanced economies, and especially the large advanced economies, play in global finance. As the EM are typically both smaller and less financially integrated, EM foreign claims do not even begin to compare to those of the advanced economies.

China, as usual, stands out in terms of the sheer size of its foreign claims of around USD 6 tr, not too far behind France or even Germany and Japan, the latter being the world’s largest net creditor. In fact, China has the world’s second-largest net international investment position in dollar terms after Japan. But size is not everything. Nearly USD 4 tr of foreign claims consist of reserve assets in the form of highly-rated sovereign or quasi-sovereign debt securities. This arguably enhances China’s importance even further given that the public sector (mostly the PBoC) controls such a large pot of money, even if it yields China little in terms of influence vis-à-vis its largest debtor, the US treasury. 

The speed with which Chinese assets have increased over the past few years is also pretty impressive. Foreign assets have increased six-fold in dollar terms (even though they have actually declined as a share of GDP!). Chinese foreign assets are twice the size of the combined holdings of Brazil, India and Russia. Excluding Taiwan, China’s foreign assets are larger than those of the ten largest EM combined. Last but not least, the net international investment position (IIP) of Brazil, India and Russia has in dollar terms tended to stagnate or even deteriorate in recent years, while China’s net IIP has improved markedly, rising from USD 1.5 tr in 2008 to almost USD 2 tr today. China is a major net international creditor, while Brazil and India are debtors and Russia’s creditor position is very small.

China will not only remain the most important EM in financial terms, but will also soon be overtaking France and Japan in terms of foreign assets. After all, China’s international financial integration, measured as foreign assets as a share of GDP, is rather limited at the moment. Ongoing reforms aimed at loosening capital account restrictions may lead to greater private-sector cross-border holdings of foreign assets. Private-sector capital outflows would also lead to a greater diversification of Chinese assets holdings, which remain heavily concentrated in public-sector-controlled reserve assets. 

Generally speaking, this is a trend that we can expect to see across the EM. Historically, large reserve holdings were due to the need of the EM to buy “insurance” against a potential sudden stop in capital inflows, the existence of a managed or pegged exchange in the context of balance-of-payments surpluses and/ or extensive restrictions on resident capital outflows. This is what skews EM foreign asset holdings towards low-risk, low-return reserve assets. The move towards greater currency flexibility, generally solid fundamentals and looser capital flow restrictions will lead the EM, and above all China, to become more significant international financial actors. It will nonetheless take time for the even the larger EM (aka BRIC), China as usual excepted, to rival the major advanced economies in terms of their international financial importance.

Commodity dependence & economic outlook for LatAm-7 (2014)

China’s rise and rising commodity prices undoubtedly contributed to the improvement economic performance and fundamentals over the past decade in the LatAm 7 – with the possible exception of Mexico. (The LatAm-7 economies comprise Argentina, Brazil, Chile, Colombia, Mexico, Peru, Venezuela and account for 90% of regional output.) The rise in commodity prices in the decade following 2003 was very significant: energy prices increased four-fold, metal prices three-fold and food prices doubled, while the prices of agricultural products rose 50%.  Not surprisingly, real GDP growth accelerated from 2.5% to 4%.

Recently, much of the region, and especially Argentina, Brazil and Mexico, has suffered from disappointing growth. The ongoing US recovery, the return to moderate growth in the euro zone and more sustainable, if lower economic growth in China will support the outlook. Then again, analysts forecast a decline in commodity prices of around 10% over the next five years. IMF projections point to a significant decline in prices relative to their 2013 peak: food (-10%), agricultural goods (-20%), metals (-26%) and energy (-14%). prices doubled, while the prices of agricultural products rose 50%.  Not surprisingly, real GDP growth accelerated from 2.5% to 4%.

Source: WTO

Recently, much of the region, and especially Argentina, Brazil and Mexico, has suffered from disappointing growth. The ongoing US recovery, the return to moderate growth in the euro zone and more sustainable, if lower economic growth in China will support the outlook. Then again, analysts forecast a decline in commodity prices of around 10% over the next five years. IMF projections point to a significant decline in prices relative to their 2013 peak: food (-10%), agricultural goods (-20%), metals (-26%) and energy (-14%). 

Generally speaking, commodity dependence can be both a blessing and curse. It can prove a curse because terms-of-trade volatility risks undermining the development of a competitive, export-oriented manufacturing base, while the associated high revenue volatility often leads to over-borrowing during boom times followed by financial crises. The often capital-intensive nature of commodity extraction contributes significantly less to human capital formation (enclave effect) than export-oriented industrialisation and a relative lack of economic diversification often makes it harder to develop linkages to other higher-valued-added sectors. 

Where the government relies on commodity rather than tax revenues, the curse may also help undermine democratic accountability, foster corruption and weaken governance. The resource curse is obviously not the only factor impacting the quality of institutions and economic policies. Other factors (e.g. socio-economic conflict, uneven wealth distribution, Anglo-Saxon vs Iberian colonial legacies) also matter. Importantly, too, the resource curse can be overcome (e.g. Chile). Policy-makers can take advantage of unexpected revenue windfalls to raise investment and savings and support long-term economic growth. Unfortunately, the political economy of economic policy in resource-dependent economies is rarely conducive to such an outcome. Hence: more curse than blessing.

Following the end of the Cold War, democracy spread throughout most of LatAm, even if it did not result in stable, highly-institutionalised regimes everywhere. Especially in countries with weak (or weakening) party systems, (outside) candidates often campaigning on populist platforms came to power. In spite of, in some cases, authoritarian tendencies, these countries have nonetheless not turned into fully-fledged autocracies of old. Political analysts have therefore dubbed them “competitive authoritarian regimes” (Levitsky and Way). Not surprisingly, the quality of economic policies in these countries tends to be lower than in more highly institutionalised regimes (think: Venezuela vs Mexico). Commodity windfalls result in higher revenues (commodity rents) rather than taxing voters directly, which makes it tempting to pursue policies that are politically opportunistic in the short-term and unsustainable in the longer term.

In terms of economic management, policies tend towards pro-cyclicality in commodity economies. Rising commodity revenues lead to expansionary fiscal policies, while real currency appreciation on the back of improved terms-of-trade fuels ultimately unsustainable consumption booms. It is therefore particularly desirable to institutionalise anti-cyclical macro-policies that help save at least part of the temporary revenue windfall in the form of fiscal and FX reserves. This is all the more important because commodity price increases tend to be accompanied by larger capital inflows. 

But I digress. So where does all this leave the LatAm-7 in view of potentially weaker commodity going forward? Overall, the LatAm-7 economies have reduced both their external and gross government debt, again with the exception of Mexico. Gross government debt has declined, even if in some cases only minimally so (Chile, Mexico, Brazil, even if the latter has fared better in terms of net debt). External debt is lower everywhere, except in Mexico. Generally speaking, however, Brazil, Chile, Colombia, Mexico and Peru have improved their fundamentals and/ or policy regimes allowing them to withstand commodity price weakness. Due to its reliance on oil-related government revenues (1/3 of total), Mexico is arguably the country most sensitive to declining energy prices among the LatAm-5. This is somewhat offset in terms of the more limited balance-of-payments impact a sustained decline in commodity prices would have on Mexico given its low level of net commodity exports and its significantly greater export orientation towards what is almost certainly going to be the fastest-growing advanced economy, the United States. Moreover, more than 70% of total exports consist of less price-sensitive manufacturing products, as opposed to commodities. 

Add to this, the rather impressive reform efforts of late and Mexico seems well-positioned to cope with lower commodity prices than most the other LatAm-7, its dependence on oil revenues notwithstanding. By the same token, tangibly higher FX reserves, lower external and public debt as well as relatively flexible exchange rates place the other LatAm-5 in a good position to deal with a commodity downturn, even if in such a scenario lower economic growth appears inevitable following the 2003-13 boom years.

Brazil - The political economy of low economic growth (2014)

Brazilian economic growth has been disappointing of late. At the end of Lula II, the seven-year real GDP growth had crept up to 4%. By 2015, seven-year growth will have declined to its multi-decade average of 2.6%. Put differently, under Lula I and II (2003-10), real GDP growth averaged 4%, significantly higher than the 2.3% registered under Cardoso I and II (1995-2002). (This does not mean that the Lula governments can take all the credit. After all, it was the Cardoso reforms that laid the foundation for subsequent accelerated economic growth, helped by rising commodity prices and moderate-to-low global interest rates.)

If current forecasts are correct, economic growth will average around 2% under Dilma I (2011-14). Admittedly, Brazil is not the only EM to experience a broader decline in trend growth. India, Russia, Turkey, even China, have seen lower growth in recent years, compared to the 2003-10 period. Nonetheless, real GDP growth of 2% is very low even by EM standards. This raises the question why the government has not taken more aggressive measures to lift economic growth. 

Source: IMF

The government did, of course, react to slowing growth. However, the Dilma government has focused more on demand than supply side measures. This has proven to be a mistake, for it resulted in higher inflation and larger (quasi) fiscal deficits, while it failed to prevent a decline in the economic growth rate. It is tempting to argue that, absent these measures, economic growth would have been even weaker still. However, higher inflation points to supply side constraints rather than a lack of demand. Under Dilma I, inflation has been 120bps higher (6% vs 4.8%) and real GDP growth has been 250bps (2.1% vs 4.6%) lower than under Lula II.

While the demand-side-oriented policy response to the global financial crisis in 2008-09 was completely appropriate, the continuation of relatively loose monetary and fiscal policies, including quasi-fiscal expansion through public-sector bank lending, failed to address the real problem: growing supply-side constraints. Basically, Brazil’s output gap closed quickly post-crisis due to a tight labour market and insufficient investment. If anything, the gradual erosion of the macroeconomic policy regime (higher inflation, larger fiscal deficits) may have helped undermine policy credibility in the eyes of the (real economy) private sector. While tax cuts and energy price reductions, for instance, were meant to make the economy more competitive, they were largely interpreted as lacking credibility and as unsustainable over the medium term given their fiscal costs. In this context, the government investment programme (PAC-2) and concession sales, which have been slow to take off mainly due to squabbles over rates of return, has thus far proven too little too late.

So what are the chances that Brazil will see a policy shift over the next year? In the past, severe financial crises spurred reform efforts. Hyper-inflation led to plano real under then FM Cardoso, admittedly after repeated failures to defeat inflation over the previous decade. The banking crisis in the mid-nineties led to large-scale bank restructuring and regulatory reform. The financial crisis of 1998-99 led to the adoption of the Fiscal Responsibility Law. Last but not least, the balance-of-payments crisis of 2002 led the Lula government to convert to fiscal discipline and an orthodox monetary policy. 

Today Brazil is not at risk of an imminent crisis. In the worst-case scenario, it will be stuck with a 2.5% growth rate. Unfortunately, low economic growth appears to be a politically stable equilibrium in the short-term. Unemployment is at record-lows, real incomes continue to rise and a large number of people continue to move into an expanding middle class. This has allowed the president to maintain a dominant lead in the polls and this makes a meaningful shift in policy before the October elections extremely unlikely. 

The relevant question to ask is how sustainable this equilibrium is over the medium term. If real GDP growth continues to trend lower, an uptick in unemployment looks quite possible given continued labour force growth. A sustained slowdown in income growth might also affect government popularity. Equally important, dissatisfaction with public services and an inadequate infrastructure is on the rise. Dilma’s approval ratings hit all-time lows during last year’s protests. This might give the next government sufficient political incentives to more aggressively focus on supply-side-oriented reforms and infrastructure investment (including concessions).

In short- to medium-term, a variety of supply side reforms (e.g. labour market, minimum wage, foreign trade) and an acceleration of public investment and concessions sales would help raise the growth potential and might also help address public discontent. Sooner rather than later, however, the government will have to slow down the growth of current expenditure (mainly transfers) to below the rate of GDP growth in order to increase domestic savings and the economy’s capacity to finance higher domestic investment. Politically, this appears unpalatable, not least becase inter-temporal trade-offs are typically solved in favour of limiting near-term political costs rather than long-term economic benefits. In Brazil, as in most democracies with competitive elections, short-term political expediency tends to outweigh longer-term economic rationality. 

A more orthodox policy might go some way in restoring confidence. (Presidential candidate Eduardo Campos has talked about the need for a more orthodox monetary and fiscal policy.) Broader structural reforms aimed at raising total factor productivity are also highly desirable. But unless the adjustment takes place in the context of slowing down the growth of current expenditure, it is likely to negatively impact public investment. This makes the government understandably reluctant to do what is necessary to live up to its recently re-affirmed commitment to fiscal discipline. Sooner or later, the government will have to accept that it needs to slow down the growth of current expenditure if domestic savings and investment are to rise sustainably. 

One might think that such a policy shift may become less costly in political terms once income growth slows, unemployment rises and public dissatisfaction with a poor infrastructure increases. Unfortunately, the government will likely seek avoid such an adjustment and the concomitant political costs by allowing the fiscal deficit to widen. In other words, there is for now a way for the government to have its cake and eat it. In terms of fostering higher long-term growth, this is a sub-optimal policy and it will likely be insufficient to lift real GDP growth above 3%. A credible, longer-term fiscal adjustment aimed at raising government savings (aka limiting the growth of current expenditure) and flanked by accompanying supply side reforms is necessary to raise domestic investment, increase productivity and lift the growth potential back to where it was during Lula I and II.

A few thoughts on EM government debt (2014)

The global financial crisis has not resulted in a general increase in EM government debt, unlike in the advanced economies. EM government debt is generally lower than in advanced economies. After all, empirical evidence suggests that emerging economies tend to suffer from so-called debt intolerance (Reinhart & Rogoff 2003). Estimates as what is a safe level of government debt typically range from 25-40% of GDP for EM, and much higher for advanced economies. Most major EM are in good shape.

Declining sovereign foreign-currency (FCY) mismatches have helped the top-tier EM avoid systemic financial crises in the past ten years. Typically, local-currency (LCY) as opposed to FCY debt affords governments with greater financing flexibility in terms of relying on the central bank as a lender-of-last resort or in terms of raising LCY liquidity through taxation. Moreover, reduced FCY debt makes government debt levels far less susceptible to sharp upward increases in the event of a balance-of-payments shock and currency depreciation.

EM total (public and private) net external debt varies greatly. Sovereign debt crises are often triggered and/ or exacerbated by the existence of contingent liabilities that governments are forced to assume (e.g. banking sector rescue). Today the EM’s total net external debt position is relatively solid. The 2008 crisis has demonstrated this already. Given restrictions on the size of FCY risks the systemically important banking sector can run, the overall FCY position is quite manageable. Combined manageable overall FCY mismatches, EM have little “fear of floating” these days in part due to the sovereign’s ability to provide FCY liquidity to the private sector and in part because “sudden stops” are self-correcting if exchange rates are allowed to depreciate. Tellingly, China and Russia, the two EM with the least flexible currency regimes, run the largest net FCY position.

External financing requirements are overall manageable and much smaller than a decade ago. More sustainable current account positions combined with larger FX reserves has translated into very manageable external financing requirements (EFR). Both the probability and the impact of a sudden stop are significantly smaller than before. Turkey, no question, is the EM most susceptible to a sudden stop. Luckily, the public sector’s net FCY exposure is close to zero, even though its FCY debt as a share of GDP remains relatively substantial at 20% of GDP. An important risk mitigant is a well-hedged banking sector. Thanks to well-hedged sovereign and banking sector balance sheets, Turkey can withstand even significant currency depreciation without running the risk of experiencing a systemic financial crisis as it used to do in the old days (e.g. 2000-01). Large EFR continue to make it susceptible to a sharp economic slowdown in the event of a sudden stop.

Non-resident holdings of EM domestic LCY government debt have increased dramatically. Low US interest rates and reduced EM sovereign FCY issuance have led foreign investors to pile into domestic LCY bonds. While this effectively transfers FCY risk from the issuer to the investor, a large share of foreign domestic bond holdings may nonetheless represent a vulnerability. Foreign holdings have proven quite stable during the 2013 tapering scare. Foreign holdings of domestic bonds are typically concentrated in longer-term, fixed-rate bonds. While this might raise volatility on this part of the interest rate curve in the event of heavy foreign selling, it also limits government refinancing risks. Short-term debt is largely held by residents and they are arguably far more likely to roll-over their debt than foreigners, even in times of market stress.

Government re-financing risks are very manageable. Given solid total external financing requirements and, even more so, the very small share of short-term FCY government debt, FCY refinancing risks have ceased to be an issue for EM. What about overall (basically: LCY) government refinancing risks? It is naturally unfair to compare the financing requirements of advanced economies to those of emerging economies. The former typically benefit from a deep and diverse investor base, often including foreign official investors in addition to a large number of non-bank investors. As far as the EM are concerned, Brazil and India, the two emerging economies with the highest government debt, have the largest gross financing requirements. India benefits from a captive investor base, while Brazil has not experienced liquidity problem with the exception of the 2002 crisis, when the prospect of Lula winning the elections and repudiating debt spooked even domestic investors. Since then, the structure of Brazilian government debt has improved dramatically. A relatively low share of foreign holdings might also be regarded as a mitigating factor in the case of Brazil. Less than 20% of domestic debt securities are in the hand of non-residents investors. In short, liquidity and foreign-currency risks attaching to government debt look quite manageable, even in Brazil and India.

Source: IMF

Cyclically-adjusted primary balances have moved from surplus into deficit over the past few years. Commentary is often focused on this fact. The intuition seems to be that a primary deficit is equivalent to a Ponzi scheme. While in absolute terms debt does increase ad infinitum, the financially relevant metric is the debt-to-GDP ratio. As long as this ratio does not increase indefinitely, government debt is sustainable. What matters therefore is the so-called the interest-rate/ growth differential. 

A favourable interest rate/ growth differential affords most EM to run a primary deficit. The IMF provides estimates of the interest-rate/ growth differentials for the EM. Brazil is the only country with a positive differential due to a combination of high domestic interest rates and low trend growth. Assuming the IMF forecasts are correct, all EM can afford to run (varying degrees!) of primary deficits without seeing their debt-to-GDP ratio indefinitely. In some cases the forecast primary deficit exceeds the interest rate/ growth differential, but the difference is small. 

In the baseline scenario, the adjustment in the CAPB required to stabilise government debt falls within the margin of error (0.1-0.2% of GDP). In the case of Russia, the uncertainty attaching to the CABP forecast is especially significant given the dependence on energy-related revenues. What but if the IMF is too sanguine about the interest rate/ growth differential? This could be the case of if the IMF growth projections are too optimistic and/ or the IMF is too bearish on interest rates. The IMF growth projections appear reasonable. Only Indonesia and Mexico are projected to experience faster growth in 2014-19 than during the boom years of 2002-07. The Brazil projection may appear optimistic. But Brazil should manage to grow 2% a year over the medium-term.

In a downside scenario, government debt dynamics do not appear overwhelmingly unsustainable. If differential moves by 100 bps against the EM, most of them would need to improve their CABP. Brazil, Russia and South Africa would need to make the largest fiscal adjustment in the order of 0.5% of GDP (and sustain it) in order to stabilise debt at current levels. All said, the deterioration of the CAPB should not be too much of a concern assuming (moderate) growth projections and interest-rate projections are more or less correct. Naturally, it would be desirable for the EM to improve their CABPs in order to increase their policy flexibility and widen their fiscal space, including the capacity to react to adverse shocks.

EM government debt would be manageable, even if government were to assume significant banking sector related contingent liabilities. Two words of caution are in order, though. Calculating the CABP is as at least much an art as a science. Moreover, discretionary policy measures can quickly lead to changes in the CABP, while contingent liabilities often materialise rapidly and unexpectedly. Especially the latter can quickly add to the government burden, raise interest rates and interest payments and thereby undermine medium-term solvency, absent a broader fiscal adjustment. In addition to wars, banking sector bail-outs have historically proven a major source of contingent liabilities. Assuming, heroically, that EM governments are forced to recapitalise their banking sectors with funds equivalent to 15% of total bank lending, government debt ratios would increase, but not to an extent where it would irredeemably undermine government solvency. Luckily, EM with large banking sectors tend to have low to medium debt levels and vice versa.

All things considered, government liquidity and solvency risks, including contingent liabilities, appear very manageable in the top-tier EM. The risk arising from contingent liabilities is also manageable. Last but not least, even if EM growth were to underperform and/ or EM interest rates were to rise more than currently expected, the fiscal adjustment required to stabilise the debt-to-GDP ratio looks politically and economically feasible. High nominal/ real GDP growth and limited FCY mismatches, which allow EM to devalue their currencies in order to boost economic growth, would make such an adjustment easier to implement than in economies with a lower growth potential where currency depreciation is not a policy option (e.g. euro area).

China’s rise - trade expectations & naval expansion (2014)

China’s export-oriented industrialisation strategy has proven highly successful in terms of economic growth and development. Economic openness is a critical ingredient of late development. The division of labour allows economies to specialise and take advantage of their respective comparative advantage. Economic openness offers late developers access to advanced technology, even if in the case of China high-technology sales are restricted. From a national and economic security standpoint, however, China’s growing integration and especially a sharply increased dependence on strategic commodity imports have created sensitivities and vulnerabilities. China is the world’s largest exporter of goods. Economically, gross exports overestimate the importance of foreign trade for economic growth, or at least value-added. The value-added may well be less significant that what gross exports to GDP imply. 

Chinese foreign trade as a share of GDP has been declining. Moreover, Chinese foreign trade as a share of GDP is not extremely high, but China’s dependence on commodity imports and its reliance on trade-processing-related job creation over the past few decades alerts makes foreign trade, access to foreign markets and control of sea lines of communication a very important issue. Processing trade is by its very nature very employment intensive. Local value-added has been increased over the past few years and over time, China will become a major source of final demand in its own right. While this will make China more important to other countries and makes political support for a trade embargo less compelling, it will not impact China’s perceived vulnerability significantly. Strategically, the dependence on foreign trade combined with concerns about future access to necessary markets creates considerable incentives to build a navy powerful enough to secure sea lines of communication.

China’s vulnerability to a disruption of international trade is nonetheless significant. Seaborne trade is critical to China’s continued economic development. China is a net commodity importers, 90% of its trade is seaborne as well as 80% of its energy imports, most of which need to pass through the Strait of Malacca. China’s desire to gain control or at the very least be in a position to deter threats to sea lines of communication is eminently understandable. This helps explain significant Chinese efforts to diversify the sources of its commodity and energy exports, including sources that do not depend on seaborne transportation such as Central Asia and Russia. China is becoming increasingly dependent on the imports of natural resources and food stuffs. China is a net manufacturing exporter and a net commodity importer. The dependence is on food and commodity imports is economically and politically more important than a dependence on overseas markets for manufacturing exports. China’s dependence on commodity imports renders it potentially vulnerable, politically and militarily, to outside pressure. It also represents a potential threat to domestic political and economic stability.

Arguably, China’s position is not all that different from Germany’s in the early 1900s and Japan’s in the 1930s. The breakdown of a relatively open world trading system and the emergence of economic blocs was one reason. In an environment where managed trade and political power and domination, the emergence of trade blocs (Ottawa), it is not surprising that aggressive states like Germany and Japan enjoyed significant support among industry. Once again, none of this is to deny that there existed very important qualitative differences between British Commonwealth, Germany’s Lebensraum and Japan’s Greater Asia Co-Prosperity Sphere. In fundamental economic terms, the differences were far less pronounced, if they existed at all. The causes behind Japan’s imperial drive are no doubt complex. Once again, strategic imperative featured nonetheless prominently. Gaining control of resource-rich Manchuria or, under increasing pressure, ensuring access to vitally important natural resource of South-East Asia underpinned Japan’s politico-military expansion, whatever other motives and causes might have played a role. German leaders had good reason to worry about the dependability of outside suppliers. In the decade and a half before the war, dependence on trade for vital goods increased dramatically, driven by phenomenal growth in both population and industrial size. Domestic oil production, for example, had gone up 140 percent from 1900 to 1913, but still accounted for only ten percent of total German oil needs. The state went from being a net exporter of iron ore as late as 1897 to relying on outsiders for close to 30 percent of its needs by 1913, despite domestic production increases of 120 percent. By 1913, over 57 percent of Germany's imports were in the form of raw materials, versus 44 percent in 1903 and 41 percent in 1893. All this was occurring at a time when Germany's ratio of trade to GNP was rising to new heights: from 32 percent in 1900, to 36 percent in 1910, to almost 40 percent in 1913 (Copeland 1996).

Naturally, the factors behind German and Japanese expansionism in the thirties and forties are complex – as are the reasons behind China’s naval modernisation programme. At some level, increasing naval capabilities are simply a reflection of economic growth and bureaucratic interests vying for financial resources. Strategically, however, it shows that rising powers are concerned about their dependence on strategic commodity imports. The breakdown of the international economic and financial system during the inter-war period led Japan to aggressively expand its sphere of economic influence. Its move into South-East Asia was in part driven by concerns about maintaining access to raw material. Similarly, the US oil embargo strengthened the case of the faction supporting the strike against Pearl Harbor.

Strategically, Germany was afraid of encirclement. This is today often derided as a phoney justification for German expansionism. But this is too facile. No doubt, German diplomacy made major mistakes and German Flottenpolitik was one such egregious strategic mistake in that it antagonised Britain and yielded zero military-political return given its inability to effectively challenge the British navy (Kennedy 1976). Imperial Germany had good reason to fear a naval blockade, as wide-spread starvation during the 1917-18 on the back of naval blockade demonstrated. Seeking to improve its imposition by forcing Britain into a naval race was politically and strategically disastrous. But this does not remove the underlying concern. The fact that Japan’s and Germany’s strategies failed disastrously should give Chinese policy-maker reason for pause. After their complete defeat in WWII, the two countries simply had no other option but to rely on the US for foreign market access and the protection of sea lines. The existence of a common enemy and a military alliance provided both countries with reassurance. Last but not least, neither country was in a position to challenge the US. China, by comparison, does have the potential to challenge the US over the longer term as well as locally in the shorter term. China and the US do not face common security threat. It is no surprise that China (Chinese planners and strategists) would be concerned about China’s maritime vulnerabilities.

Source: WTO     *excl. Hong Kong

Washington is strongly committed to the freedom of navigation and interested in maintaining a strong economic foothold in the region, and hence political stability. However, in a conflict situation, all bets might be off. Britain’s naval blockade helped bring Germany to its knees. Geo-politics and geo-economic logic leads China to build a navy. (Germany) Moreover, as China becomes economically more powerful, it will quite naturally seek to strengthen its ability to secure its trade routes. China has a strong interest in staying economically integrated. It also has an interest in mitigating its dependence on strategic commodity imports by diversification or protection. It will therefore be very interesting to see how the shale gas revolution will impact China’s reliance on energy imports. A growing economy and rising per capita incomes will nonetheless translate into significant commodity dependence, at a time when, interestingly, the US may be moving towards greater self-sufficiency. It therefore has a strong interest in mitigating or managing this dependence. Domestic political stability depends on it. China’s economic prosperity depends on it. So do ultimately its international influence and power. Political and military is built on economic prosperity and China’s economic prosperity is heavily dependent on trade and, more specifically, natural resource imports. 

Not surprisingly, China is pursuing a two-pronged strategy of protecting its sea lines of communication and of diversifying its sources of imports geographically, including seaborne and land-based (Central Asia, Russia, Africa). It is equally logical for China’s naval build-up to run head-on into the security interests of many of its neighbours and by extension the US. Military competition, unlike economic competition, if it cannot be avoided is a zero-sum game. From Beijing’s point of view, it makes perfect sense to pursue a strategy aimed at achieving economic security. Following MacMahon, sea power is meant to preserve commercial, political and military aces (in that order). China appears to fit this logic perfectly. China is not building its naval power in order to exert diplomatic and political influence in far-flung corners of the world, but in order to protect its commercial interests. The building of ports Sri Lanka and Pakistan is not as such a naval military strategy, though ports are dual-use, but part and parcel of securing trade routes, commercial access and diversification.

Source: CFR

Paradoxically, China’s naval expansion and territorial-maritime claims is bound to weaken China’s strategic position. Even though China may well succeed in pushing the US navy out of the East and South China Seas, beyond the so-called first island chain, strategically, this would not alter China’s position substantially as far as protecting its sea lines of communication is concerned. If anything, a more assertive Chinese stance will lead most countries in the region to move closer to the US. This is what Edward Luttwak (2012) calls the “logic of strategy”. Virtually all the countries making up the first island chain have an interesting in opposing China’s claims and in countering its strengthening naval capabilities, whether or not they join a formal alliance. As these countries control choke points that China would find it possible break through, China’s naval modernisation will have little to show for in strategic terms. It may help China gain control over its “near maritime abroad” and perhaps the natural resources that fall within the so-called nine-dash line. But this is a heavy price to pay for what no doubt will be perceived by Beijing as a strategic-maritime encirclement. The ghost of Tirpitz may end up haunting China. Germany’s imperial fleet proved pretty much useless in military terms and was extremely costly in diplomatic terms.

Beijing’s geo-political position is not great in the first place. The Philippines, Vietnam, Brunei, Malaysia have competing maritime claims in the South China Sea. Japan and China have competing claims in the East China Sea. Importantly, Myanmar’s decision to open to the outside world seems to be at least in part driven by concerns about becoming overly reliant on China, economically. Moreover, the US has close allies in Japan and Korea, Singapore, Australia and New Zealand, Thailand. India is also pulling closer to the US and naval competition is accelerating with both countries pursuing aircraft carrier programmes. Sino-Russian relations have historically been difficult and the two countries even went to war with each other in the sixties. While Moscow is keen, it is concerned about rising Chinese influence in Russia’s demographically Far East. In spite of energy co-operation, Russia regards China as more of a potential competitor than ally. In short, China has no major ally in the region. Laos and Cambodia are relatively insignificant countries. North Korea is more of a liability than an asset whose main use is to prevent the emergence of a unified Korea allied with the US.

China should therefore strenuously seek to avoid conflict with its neighbours and settle outstanding disagreements through negotiations in order to avoid countervailing alliances. It is far from obvious that the benefit of successfully asserting maritime claims outweighs the costs of antagonising its already suspicious neighbours and driving them into an anti-China alliance out. Beijing’s more assertive behaviour does bring about exactly the opposite. Instead of “speaking softly and carrying a big stick” (Teddy Roosevelt), it does almost the opposite. After all, what looks like aggressive posturing to its neighbours looks like a rational and logical step to reduce its vulnerability or at least raise the costs of imposing a naval blockade on China. This is the nature of a “security dilemma”. 

By contrast, the US has the advantage of being an off-shore balancer. China has territorial and maritime claims. The US has established a track record of relatively free trade and freedom of navigation. China has not. China’s more assertive diplomatic stance risks antagonising its neighbours, while its growing naval capabilities raises concerns. It is not easy being a rising power. This will make it attractive to many countries in the region. As an off-shore balancer and no territorial claims and committed to upholding the freedom of navigation, the US is perceived as less threatening than a rapidly rising, more assertive China. China has relatively few friends and zero allies. North Korea is useful in so far as it helps maintain a buffer between the China and future potentially US-allied, unified Korea. By contrast, China has a volatile friendly in North Korea and has garnered goodwill in Cambodia and Laos.

The risk of outright military conflict may be somewhat mitigated by confidence-building measures and strategic re-assurance, but it is far from obvious that it will suffice to overcome the logic of strategic competition itself. Some analysts have argued that a policy mix of reassurance and resolve may help manage rising security competition (O'Hanlon & Steinberg 2014). More likely than not, such policies may help mitigate competition and help manage some risks associated with (e.g. accidents), but it is unlikely to overcome the underlying logic represented by the security dilemma. China wants project power outwards, leading many of its neighbours to feel threatened. Moreover, the US is also very unlikely to concede East and South-East Asia to China’s sphere of influence. The need to reassure allies has led the Obama administration to pivot to Asia. This is of course not the way Beijing sees it.

China was for a long time focussed on Taiwan. Recently Chinese claims have become more extensive and have been asserted in a more forceful manner. China seems to claim most of the South and East China Sea and its expanding military capabilities are increasingly representing a threat to US naval assets operating in the Taiwan Strait and within the so-called First Island Chain (Japan, Taiwan). Ballistic anti-ship missiles even have the capability of striking US assets beyond the First and potentially second island china (Guam). This threat remains manageable from the US perspective, as China seems to lack the ability to locate and zoom in on a moving target thousands of miles at sea. Moreover, the US navy will have available tactical counter-measures. Nonetheless, China’s naval modernisation has begun to present a threat to the US navy. This contrasts sharply with the unchallenged control of the sea the US navy enjoyed until very recently. The other dimension of China’s naval build-up is to do with Taiwan and China’s long-standing claims to sovereignty there. Using nationalist rhetoric disguises the longer-term strategic objectives China is, consciously or unconsciously, pursuing.

In recent years, China is increasingly making its presence felt in the East and South China Sea. China is actively pursuing a policy of what military strategists call anti-access/ area denial. The US responds by adopting the Air Sea Battle concept that seeks to strike deep on land-based threats. The US seeks to maintain escalation dominance. Military planners are prone to see military relations as a zero-sum game. Strategists have to take into account the political purpose that military might is meant to achieve. It is important to distinguish between military competition and nuclear. A strong case can be made that nuclear weapons are deterrent instruments, much less so, if at all, coercive tool. This is all the more true in the case of two countries possess a nuclear deterrent. The existence of a nuclear deterrent may reduce the risk of an all-out war. This does not mean that military competition or an arms race cannot or is not taking place. The best China can hope to achieve in the short- to medium-term is turn the seas within the first island chain into an area of “mutually assured denial” (Holmes) for itself and its neighbours, including the US.

The risk is that China inadvertently enters into a naval race with the US and thereby antagonises its neighbours fearful of China’s territorial claims and concerned about China’s broader ambitions. A comparison with Imperial Germany seems to suggest itself. Wilhelmine Flottenpolitik did a great deal of damage to British-German relations and ultimately led London to reinforce its presence and meet the challenge head-on. The situation is however somewhat different in the sense that the German navy potentially threatened Britain directly rather than its overseas possessions or allies. Nonetheless, the outcome was relatively predictable. Diplomatically, it was a catastrophe. Militarily, it was a disaster. Famously, the German navy saw very short-lived naval action before retreating to its home port. A military strategy without a political-diplomatic strategy is not helpful and in many cases decidedly harmful. China may run the same risk. Rising naval power is one thing. Rising naval power combined with intensifying territorial and maritime disputes with its neighbours is likely to provoke a strong reaction from its neighbours, who will feel much less threatened by an off-shore balancer like the US than the rising hegemonic power in Asia. It is no coincidence that India is accelerating its naval build-up, including indigenous aircraft carriers. Japan’s launching is to be seen in the same light.

China, inadvertently or not, aims to shift the balance of military power in the surrounding seas in its favour, or at least acquire the ability to turn the seas into a no-go zone for the US and other countries. Its rather extensive maritime claims strongly suggest this. Moreover, the string of pearls strategy aimed at securing trade routes linking China to the region sitting on large, cheap energy, the Middle East, will bring China directly in competition with India. In addition to having unresolved border conflicts, China’s construction of port facilities around India littoral will lead India to respond. The fielding of an indigenous aircraft carrier and naval expansion show how seriously India takes China’s growing presence in the India Ocean and Arab Sea.

Meanwhile, Washington is responding to the perceived rise in Chinese power and capabilities in the political and military sphere by strengthening relations with its regional partners and allies (e.g. Australia, India, Japan) and increasing its military posture in the region, while treading cautiously in areas of more direct concern to Beijing (e.g. Taiwan). The TPP is squarely intended to exclude China by integrating the economies of Washington’s major allies and partner on both sides of the Pacific. No wonder, China feels this is another initiative directed against it.

Henry Kissinger (2011) dedicates the last chapter of this book to a brief comparison of the rise Imperial Germany after 1871 and that of China today. An important question is whether it is China’s intentions or its capabilities matter. It is clear that military planners are predominantly occupied with capabilities rather than intentions. In other words, military planners will tend to be offensive realists. Political leaders may or may not be defensive realists, but they have greater flexibility in terms of their world view. (It is therefore imperative that politician remain firmly in charge and ensure that military strategy remains subservient to a country’s overarching political strategy. After all, war is the continuation of politics by other means, not vice versa. Capabilities matter far more than intentions, at least as long as states have failed to build security communities (Deutsch 1957, Schroeder 2004, Wendt 1992). Socialisation may change things, but socialisation requires a context conducive to creating trust. A common threat or enemy may help alter perceptions more permanently (e.g. France-Germany after 1945) and it may have facilitated agreement or softened competition between Britain and the US post-WWI.

Barring a major accident, Chinese economic power and military capabilities will continue to increase and geopolitical competition in East and South-East Asia is bound to intensify. China’s increasing economic interdependence increases China’s interest in securing its seaborne lines of communication. Its economic rise affords it to expand its naval capabilities. While China remains many years away before it is in a position to reach naval parity, its expanding capabilities, combined with greater assertiveness in terms of maritime claims, have already begun to raise concerns among many of its neighbours as well as the US. China, as the rising power, is a less favourable position than the US as the off-shore balancer with no territorial claims and proven commitment to freedom of navigation. In military terms, China’s increasing capabilities and threat asymmetry will lead to intensifying military and naval competition in East Asia. The existence of nuclear weapons will limit the risk of war, but it does not prevent conventional military competition. Economic and financial interdependence will raise the costs of military conflict, but it will not render it impossible. After all, interdependence did not prevent the outbreak of WWI. It is crucial that political considerations outweigh purely military considerations. This is what distinguishes the responsibilities of the political and military leaderships. Sound strategy makes it absolutely imperative that politics prevails over military necessity. After all, to extend Clausewitz: war (and military competition) is simply the continuation of politics by other means. It was the rise of Athens and the fear that this inspired in Sparta that made war inevitable. The rise of China certainly inspires fear in a number of countries and will lead to military, political and diplomatic competition and instability. War is not inevitable, whatever the rise and decline school may argue (Organiski 1980, Gilpin 1981, Kennedy 1987).