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.