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.