Size matters – USD and RMB as a reserve currencies (2015)

The rise of the RMB as a reserve currency has garnered a lot attention lately. The Chinese authorities have taken numerous measures aimed at internationalising the RMB and making it “freely usable”, the latter being a pre-condition for a currency to be included in the IMF’s SDR basket (e.g. opening domestic bond and FX market to foreign central banks; making, or attempting to make, the exchange rate more flexible).

At present, a little more than 1% of global FX reserves are invested in the form of RMB-denominated assets.  Some analysts predict that as much as USD 1 tr of global FX reserves could shift into RMB once it is included in the SDR basket. This estimate is presumably based on the likely weight of the RMB in the SDR basket. The share of RMB assets in global (ex-China) FX reserve holdings would then rise to more than 10%. This may well be the share of reserves central banks will want to hold in RMB, but is there a sufficient supply of RMB assets?

Foreign central banks invest in safe and liquid assets. In practice, this means that the bulk of FX reserves is invested in high-grade, central government debt issued by advanced economies. Central banks are far less keen to invest sizeable amounts in higher-risk and/ or less liquid assets. Not surprisingly, almost 2/3 of global FX reserves are denominated in USD and another 20% in EUR. Foreign official institutions held about USD 4.8 tr worth of US debt securities as of the middle of 2014, of which USD 3.8 tr were US treasuries. 80% of foreign official holdings of US debt securities are concentrated in US treasuries. As the foreign official sector includes sovereign wealth funds, central banks are likely even more heavily invested in treasuries. 

Credit risk matters, as the decline of foreign official holdings of US agency debt illustrates. Today foreign official institutions hold a mere USD 400 m of agency debt, compared to almost USD 1 tr in 2008. The financial distress Fannie and Freddie experienced during the global financial crisis seems to have scared foreign central bank away. Size necessarily matters. Outstanding US treasuries amount to USD 13 tr and marketable treasuries to almost USD 11 tr. Japan comes relatively close second with USD 8.2 worth of government debt securities outstanding. Only six other countries have central government debt exceeding USD 1 tr (UK, Italy, France, Germany, Spain and China). If one looks at the size of the total bond market, the difference is even starker. With global FX reserves amounting to USD 11.5 tr, the bulk of these reserves will necessarily need to be invested in the US treasury market given its superior size and liquidity as well as, generally, creditworthiness.

Leaving aside liquidity, which is an issue in the Chinese government debt market, there may not be enough RMB assets out there for central banks to invest in if USD 1 tr is to be shifted into RMB. Assuming that 90% of RMB-denominated reserve holdings are invested in central government debt, foreign central banks would end up holding 50-60% of the USD 1.7 tr market. While foreign holdings in the US and Germany are roughly at similar levels, it is far from obvious that Chinese policy-makers or foreign central banks for that matter would feel comfortable with this given the potential implications for domestic interest rates and the exchange rate as well as asset prices and liquidity. This is especially salient in a context where the investor base would largely consist of domestic commercial banks, on the one hand, and foreign central banks, on the other.

No doubt, structural factors support the emergence of the RMB as a reserve currency. In the short term, however, a dearth of RMB assets will make a very substantial shift of FX reserves into RMB difficult. China’s bond markets have been growing vigorously over the past decade. And even though economic growth is slowing, there certainly is room for the central government to issue more debt. It will therefore take time before 10% of global FX reserves are invested in Chinese assets. 

Equally important, if the demand for high-grade assets outpaces the ability of the dominant reserve currency country to provide them without jeopardising its financial strength, the system may well be inherently unstable (so-called Triffin dilemma). According to the CBO, US government debt will remain stable as a share of GDP until the end of the decade and then increase under the so-called “current baseline scenario”. (This scenario assumes no policy changes.) True, the US net international investment position has deteriorated sharply in the past few years. Ironically, this has been due to a strengthening economic outlook and rising US asset prices, including the USD. Net fiscal and external requirement will ensure debt sustainability and maintaining confidence in the USD as a reliable reserve currency over the short- to medium-term, but perhaps not the long term. Meanwhile, the demand for safe, liquid assets denominated in a convertible currency is set to outpace the US ability or willingness to provide such assets. Central banks will have an incentive to move into riskier USD assets or move into non-USD assets, including RMB assets. (The slew of sovereign credit downgrades in the eurozone and a declining of German government debt securities will not offer much of an alternative, either.)

In short, the RMB is set to become a more important reserve currency, as China’s sheer economic size and importance in world trade continues to grow, as the demand for reserve assets increases and as China increased the supply of high-grade RMB assets. Like Japan and Korea before, China will gradually remove capital controls and put in place stable, liquid financial markets. This will also facilitate the RMB’s rise. It would be very surprising, however, to see the RMB share in global FX reserves reach even 10% in the near-term given the limited size and liquidity of high-grade RMB assets.

Demography and the global economy – 'continental' drift is well underway (2015)

Continental drift is slow, takes place imperceptibly and inexorably, and typically ends up having dramatic effects in the long run. In this, it is very similar to demographic change. Let’s begin with the facts. The world’s population is set to grow from 7 bn today to more than 9 bn by 2050. By comparison, the world’s population was a mere 2.5 bn in 1950. The regional (continental) demographic balance has been shifting for quite some time. In 1950, four of the ten largest countries were European (Germany, Italy, Russia/ USSR, UK). Today, only Russia, ironically the country with the most adverse demographics, ranks among the top-10. In 1950, the big European four made up 10% of the world’s population. This figure has dropped to 5% today and will continue to decline for the foreseeable future. The populations of Africa and Asia will continue increase dramatically over the next few decades. Admittedly, the aggregate increase hides significant intra-regional differences (e.g. East versus South Asia).

By 2060, three contiguous South Asian countries (India, Pakistan and Bangladesh) will have a combined population of 2.2 bn. This will be equivalent to the combined population of Europe and the Americas. Meanwhile, on current projections, Nigeria’s population is set to reach 460 m and thus to exceed that of the US, whose population is projected to reach 420 m. More intriguingly, two sub-Saharan economies, the DRC and Tanzania, will have populations of 170 m each, according to UN projections. If these projections materialise, they will have a dramatic impact on the international system, economically and politically. Naturally, fifty years is a long time in trend forecasting.

After all, who would have thought in 1970 that fertility rates in many developing countries would collapse as dramatically as they subsequently did. Forty years ago, the average Mexican woman bore seven children, compared to 5.5 in India and Indonesia. Today, fertility ratios have reached fallen to and/ or below replacement levels in all three countries. As a matter of fact, fertility rates in all advanced and the vast majority of the larger emerging economies have fallen to below replacement levels. This means that population size will over time stabilise and eventually begin to decline (absent net immigration). If the experience of the advanced economies is anything to go by, it will be very difficult to engineer a substantial rise in fertility rates. 

Source: OECD

The demographic transition in the EM supports economic growth through its impact on savings and investment, all other things equal. But the demographic window will soon be closing in a number of today’s top-tier emerging economies, if it has not already done so (e.g. China, Russia). It may therefore be time to have a closer look at so-called frontier economies, effectively second- and third-tier emerging economies. This is where the economic growth of the future will be generated provided these economies succeed in creating growth-friendly domestic institutions and political stability. 

Among the fifteen largest countries in the world by population, one finds Pakistan (population: 182 m, per capita income: USD 2,800), Nigeria (167 m, USD 2,500) and Bangladesh (153 m, USD 1,800). By comparison, the per capita income of Germany and the US is USD 38,800 and USD 48,100, respectively. In spite of the former group’s demographic weight, these economies remain tiny. Nigeria, the largest of the three, has a nominal GDP of a mere USD 250 bn – smaller than the GDP of the city-state Singapore, a country of 5 m inhabitants! It will hence take some time before demographically large, but economically small economies will have a tangible impact globally given the low starting level. 

Contrary to the predictions of the dependency theorists of the 60s, developing economies are capable of advancing into the upper middle income brackets, even if breaking into the advanced economy club has proved more elusive. Only Hong Kong, Singapore, Taiwan and Korea have managed to do so. Partial economic catch-up is nonetheless achievable against the backdrop of global technological diffusion and growth-oriented domestic policies. Naturally, rapid population growth and especially a growing youth bulge in various countries risks creating conditions that may well raise political instability (Arab Spring) and undercut growth-oriented reforms and policies, especially in the context of heightened popular expectations, enhanced access to communication/ information and rising educational standards (esp. where these are not matched by improving job prospects).

Today’s top-tier emerging economies have a fair amount of catch-up growth left. The advanced economies will experience increasingly limited economic growth on the back of a declining workforce and age-related pressure on savings and investment. Innovation is also bound to slow down in aging, increasingly risk-adverse societies. While ageing is likely to translate into greater political stability in the near- to medium-term, it may risk translating into inertia to the point of becoming economically and financially destabilising over the longer term (e.g. grey majority and social-security reform). It may be time to start thinking about which of the demographic heavyweights among the least developed economies will become be part of the next generation of top-tier emerging economies over the course of the next two decades.

China’s international investment - what do the data tell us? (2015)

China has emerged as the world’s second-largest international creditor. Only Japan has a stronger net international investment position. China’s net foreign claims amount to USD 2 tr, compared to Japan’s USD 3 tr. Germany is in third place with net foreign claims of USD 1.7 tr. Compared to advanced economies, China’s de facto international financial openness is limited due to continued capital account restrictions. Gross foreign assets amount to 60% of GDP, compared to 150% in Japan and the US - and more than 250% in Germany and Taiwan. As the authorities continue to liberalise two-way capital outflows, Chinese foreign assets will experience substantial growth in the coming years. 

Where do things stand at the moment? First, Chinese foreign holdings have grown rapidly, rising to USD 6.1 tr from USD 3 tr in 2008. This compares to USD 9.5 tr and USD 8.6 tr worth of foreign assets held by Germany and Japan. China is catching up, while it continues to pale next to the United States’’ USD 24 tr of overseas assets. Second and significantly, the PBoC controls the bulk of China’s foreign assets. Reserve assets make up 2/3 of all foreign claims, compared to less than 1/5 in Japan and less than 3% in reserve-currency-issuing countries like Germany and the United States. This is of course largely the legacy of large balance-of-payments surpluses and a FX intervention policy geared towards keeping the exchange rate competitive. Third, the total value of foreign portfolio investment has remained largely unchanged in recent years, fluctuating in the USD 200-280 bn range. This contrasts sharply with FDI, other investment and reserve assets, all of which grew vigorously in 2006-13. Within the portfolio investment category, a shift has occurred away from bonds to equities. The latter grew from practically zero in 2006 to USD 150 bn today. Portfolio equity investment nonetheless amounts to less than 3% of total foreign assets. In Germany and Japan, the share is 10% and in the US it is 27%. But even in a newly-industrialised economy like Korea the figures exceeds 10%. This would point to considerable catch-up potential.

Source; SAFE

This figure is likely to underestimate Chinese holdings of foreign equities, though. The US Treasury estimates mainland Chinese holdings of US equities alone at USD 260 bn, significantly higher than total reported Chinese foreign portfolio equity investment. Reasons for this discrepancy are: holdings in individual companies exceeding 10% are classified as FDI rather than portfolio equity investment; net errors and omissions; to the extent that foreign portfolio equity investment is denominated in a convertible currency, liquid and directly or indirectly controlled by the central bank, it can be booked as a reserve asset. Unfortunately, very little is known about the PBoC/ SAFE investment portfolio. Anecdotal evidence suggests that SAFE started to diversify into equities as early as 2007-08. Nonetheless, the bulk of assets managed by SAFE likely remains invested in highly-rated, liquid sovereign bonds. 

According to US Treasury data, China’s holdings of US government securities has remained more less unchanged at USD 1.1.-1.3 tr since 2011, while FX reserves have increased from USD 3 tr to USD 4 tr over the same period. This does not mean that the entire USD 1 tr increase in reserve assets has gone into higher-risk assets, but concerns about the value of the dollar and the financial outlook in the US more generally will have induced SAFE to move some of the recently accumulated reserve assets into equities. Competition with its rival, China’s sovereign wealth fund (or CIC) will have provided the necessary political-bureaucratic incentive to do so. Unfortunately, there is just no way of knowing to what extent SAFE has acquired, for instance, foreign equities. What is known is that CIC increased its global equity holdings from 2.3% (or USD 2 bn) in 2008 (CIC was created in 2007) to 40.5% (or an estimated USD 80 bn) in 2013. SAFE is unlikely to hold 40% of its assets in the form equities. But given that Chinese holdings of US treasuries (or agencies) have barely increased since 2011, some of the additional reserve assets will likely have been invested in higher-risk foreign assets, including equities. 

The broader point is this: China holds more FX reserves than it needs for balance-of-payments financing purposes. There are different metrics to estimate adequate FX reserve levels. China’s IMF-defined reserve adequacy ratio is about 200%, while a ratio of 100-150% is considered adequate. Given still extensive controls on resident outflows, China would therefore be more than fine even with a ratio less than 100%, for the time being. In other words, out of USD 4 tr worth central bank foreign assets, the Chinese government could afford to invest at least USD 2 tr in higher-risk international assets. 

How significant would this be? By comparison, global equity markets are worth USD 65 tr (or slightly more than USD 60 tr, ex-China). The US accounts for USD 24 tr. US bond markets are valued at USD 38 tr, including USD 12 tr worth of treasuries. Euro area bond markets are worth USD 20.6 bn out of which USD 8.5 bn consist of central government securities. In short, USD 2 tr is sizeable, but not overwhelming from a global market perspective. Nonetheless, changes to China’s (or SAFE’s) asset allocation strategy could have more important effects at the individual country level. After all, USD 2 tr is equivalent to Germany’s and France’s market cap and it is about twice the size of the Korean or Taiwanese market.

G3 & geo-political competition (2015)

It was the rise of Athens and the fear that this inspired in Sparta that made war inevitable, writes the Greek historian Thucydides in his famous History of the Peloponnesian War. War between a rising China and a fearful United States may not be inevitable, not least due to nuclear weapons. Security competition will be impossible to avoid. 

While settling a significant number of land border claims, China has been pursuing a more assertive foreign policy with regards to maritime claims in the East and South China Sea. In response, the Obama administration decided to “pivot” to Asia. Militarily, Washington seeks to deploy 60% of all naval assets to Asia by 2020. Diplomatically, it is seeking to build closer with countries that are odds with Beijing. Economically, it is pursuing the Trans-Pacific Partnership (TPP) in order to strengthen its foothold in, and demonstrate its commitment to, its actual and potential allies. Japan, meanwhile, has begun to raise defence expenditure and decided to join TPP negotiations. Tokyo is similarly also pursuing a more activist regional diplomacy in an attempt to counter China’s growing weight.

Competing territorial claims are at the proximate cause of recent regional tensions. Nationalism, historical grievances, arcane legal arguments and natural resources all play a role. Ultimately, however, the quest for security is the structural cause that drives growing competition. Beijing seeks to create greater strategic depth. By claiming the area within the so-called nine-dash line, virtually the entire South China Sea, China seeks to turn the seas into territorial waters, thereby excluding foreign navies as well as creating a forward base from which to project naval power beyond the so-called First Island Chain (Japan, Taiwan, the Philippines). China does not want the US navy freely roaming its “near seas”. Ultimately time, China wants to project naval power beyond the Second Island chain (Japan, Marianas, Guam) in order to be able to protect its sea lines of communication instead of continuing to depend exclusively on the US navy for protection. If successful, this would greatly strengthen Beijing’s position vis-à-vis its neighbours, including Taiwan.

Source: DoD

Having evolved from an autarkic to a highly integrated economy since the late seventies, China’s economic prosperity and political stability today depend on external trade and, in particular, access to commodity supplies. China is the world’s largest consumer and importer of many commodities and largely relies on seaborne trade. Sixty per cent of Chinese crude oil imports, for instance, pass through the Strait of Malacca, a figure that is bound to rise further in coming years. It is therefore no surprise that Beijing seeks to use its growing economic power and military capabilities to manage this potential vulnerability. One of way to achieve this is expand its zone of influence and control.

What China is doing is what rising powers do. Wilhelmine Germany, unsuccessfully, sought to build a navy to challenge the Royal Navy. A rising United States, not being in a position to expel the European powers from the Americas, sought to prevent their further expansion in the Americas (Monroe Doctrine), before being able to take a more assertive stance (Spanish-American War). Similarly, Beijing is claiming much of the East and South China Sea and it is complaining about the US military presence in the region. Its growing military capabilities are perceived as a potential threat by the US and, especially, other countries in the region that have competing territorial claims.

Security competition in the region is very unlikely to go away. For a start, Japan is even more dependent on energy imports than China. So any Chinese gain is a Japanese loss in terms of security. The second- and third-largest economies in the world are locked into a zero-sum game. Leaving aside historically conflictual relations, it is difficult to see how there will be co-operation rather than competition or even conflict. Moreover, great powers typically seek to face down challengers. They do not simply pack in and abandon the field. Washington is therefore not going to withdraw from the world’s most dynamic economic region without putting up resistance. The pivot is proves as much.

Security competition has the potential to be destabilising. However, geo-political competition can coexist with prosperity, economic growth, international trade and investment. Economic interdependence may or may not act as a check on outright conflict. It certainly does not prevent competition and, if push comes to shove, not even armed conflict. (Ask Norman Angell.) Barring a major accident, a broader and full-blown military conflict in East Asia is unlikely. The economic costs would be tremendous and, more importantly, nuclear powers, for good reason, tend to be more circumspect about going to war with one another. 

Continued competition will drive solid growth in defence expenditure throughout the region. Japan will regard economic revitalisation as crucial if it is to keep up with the competition. Japan’s arms industry will benefit from increasing government expenditure and greater sales, supported by the government, to Japan’s partners in the region. Japan will also direct a greater amount of investment and offer more financing to actual and potential allies in the region in order to mitigate potential China-related supply chain risks and to build stronger relations with actual and potential allies. For similar strategic reasons, Japan is also going to join TPP, in spite of domestic opposition.

China will continue to diversify its commodity imports, seeking to mitigate its dependence on maritime trade (Silk Road, Central Asia, Russia), while strengthening its naval capabilities. Beijing will also seek to raise energy efficiency. Beijing will seek to build closer diplomatic, economic and financial relations within the region and beyond (e.g. string of pearls countries, Pacific Islands, Africa), offering investment and financing. 

Source: NPR

Last but not least, Washington will remain strongly engaged, diplomatically, economically and politically, current diversions in the Middle East notwithstanding. TPP is just one example of how the US tries to counter growing Chinese influence. US engagement will also translate into more investment, more trade and greater economic benefits for some of the smaller countries (e.g. Philippines, Vietnam). The US will also sell more arms to the regions, benefitting the US defence industry. 

The point is this. Many future economic, financial and political trends in the region will be, if not determined, heavily influenced by the continued security competition between a rising China and a status quo defending United States and its regional allies.