The degree of capital account openness is difficult to measure precisely. Different approaches yield different degrees of openness. Few analysts would disagree, however, that both Brazil and Russia have a more open capital account than China and India. The degree of capital account openness affects the composition and size of external balance sheets. In Russia, the sum of gross external liabilities and assets as a percentage of GDP amounts to 170% of GDP, compared with a 100% or less in the other BRIC. However, if reserve assets are excluded, both Brazil (84%) and Russia (135%) are financially more open than China (54%) and India (51%).
BRIC external holdings are skewed towards high-grade debt (reserve assets), more so in China and India than in Brazil and Russia, and equity liabilities feature prominently on the other side of the balance sheet. From a risk perspective, this is desirable, as equity liabilities represent contingent claims and reserve assets are under the direct control of the authorities. While this asset-liability mix has helped turn the BRIC into international creditors (excluding equity liabilities), it also created a “short equity/ long debt” position. In purely financial terms, this is not an attractive position to hold.
First, the superior prospects for long-term BRIC growth should lead to tangible equity appreciation. Second, a combination of low-ish BRIC inflation and faster productivity growth should tend to lead to currency appreciation, resulting in capital losses on net FCY-denominated assets. Third, even if capital losses are excluded, the BRIC pay more on their net equity liabilities than they earn on their net foreign debt assets. Fourth, the BRIC governments – to the extent that they sterilise FX reserve accumulation related intervention by issuing (relative) high-interest rate domestic debt – will have put up with “negative carry”. Thus, the BRIC run a double “negative carry”.
This explains the desire to invest “excess” FX reserve holdings more aggressively with the help of sovereign wealth funds. The BRIC sit on more than sufficient FX reserves: external financing requirements are lower than FX reserves; the governments are significant net foreign (currency) creditors and total net external debt is close to zero or negative. However, even under the best of circumstances, the governments of Brazil, India, Russia (on account of their high on-shore interest rates) and even China (on account of medium-term nominal currency appreciation) will find it next to impossible to make a profit. It will be similarly difficult to overcome the “negative” carry stemming from the “short equity/ long debt” position.
This is where a greater liberalization of capital outflows might help. First, reducing the share of reserve assets in total foreign assets would limit sterilization costs for the public sector. Second, it would also tend to lead to higher returns, as the private sector is presumably better positioned to generate higher returns than the public sector.
The combination of capital account restrictions and FX reserve accumulation has resulted in a financially unfavourable asset-liability structure. The desire to ensure financial stability, attract growth-enhancing FDI, and, in some cases more than in others, support export-led economic growth and development explains why the BRIC are running – and are willing to run – a financial loss on their foreign position. The financial loss can be considered both an “insurance premium” and a “growth subsidy”.
Effectively, the BRIC governments hold sufficient foreign assets to “collateralise” private sector foreign borrowing. This is not an efficient way to leverage BRIC growth prospects. Obviously, policymakers value economic and financial stability more than generating financial returns. However, the financial opportunity costs of running a “short equity/ long debt” position will continue to increase as BRIC external balance sheets grow, as a share of GDP. Greater (selective) liberalization of capital outflows would help boost the financial returns on foreign assets by allowing the private sector to hold higher return foreign assets. In this context, greater exchange rate flexibility would naturally be desirable. Understandably, governments are somewhat reluctant to liberalise capital outflows, fearing increased volatility. However, in purely economic terms, the BRIC governments’ favourable net foreign position should limit both their “fear of floating” and the “fear of free(er) capital outflows”.
What are the prospects of further liberalization, particularly in China and India? In the case of China, substantial liberalization is unlikely to take place until greater exchange rate flexibility has been achieved. Greater currency flexibility will only happen if the authorities come to believe that the volatility it might cause will not impact economic, financial and political stability. India is somewhat better placed to further open its capital account due to a higher degree of exchange rate flexibility and due to a lower (perceived) dependence on export-led growth. The arguments in favour of liberalization notwithstanding, both countries will maintain a gradual approach to liberalization.
Financial return considerations remain of secondary (or tertiary) importance. However, sooner or later, further capital account liberalisation will take place. The liberalisation of capital flows - both outflows and inflows - would lead to considerable growth in cross-border flows and holdings, especially in the case of China and India. (In advanced economies, combined cross-border assets and liabilities as a percentage of GDP average more than 300%, compared with only 100% and 75% in China and India; and reserve assets typically make up only a small share of total assets.) Capital account liberalisation certainly carries some risks, as the past has shown. But the BRIC economies’ international financial positions are sufficiently solid to allow a greater liberalisation of capital outflows. It would certainly help boost the financial returns on the BRICs’ international financial position and limit the government’s costs of carrying FX reserves.