Structural reform in the BRIC – what needs doing? (2013)

Economic growth in the emerging economies, in general, and in the BRIC, in particular, has slowed down significantly, while for now headline inflation remains quite elevated – China excepted. This points to rising supply constraints and suggests that the growth slowdown is in part structural. Labour markets in Brazil and Russia, for instance, are very tight. While all BRIC economies are in need of productivity-enhancing reform, measures necessary to tackle these constraints vary. 

Hausmann et al. have proposed a framework for the identification of the so-called (most) binding constraint(s) limiting economic growth, called growth diagnostics. Cross-country regression analysis may help identify the factors that constrain economic growth, whether they be low human capital, weak institutions or insufficient capital accumulation. Each country faces a unique set of economic, socio-political etc, conditions, however, and cross-country research singles out the factors that on average support higher economic growth. 

The growth diagnostic strategy, on the other hand, seeks to identify the “the most binding constraints on economic activity, and hence the set of policies that, once targeted on these constraints at any point in time, is likely to provide the biggest bang for the reform buck”. More specifically, Hausmann et al. (2008) propose a decision tree that helps identify the causes of low private investment. The underlying assumption is that it is the level of private investment that in large measure determines future output growth. This framework can be heuristically applied to the BRIC economies. 

Brazil undoubtedly suffers from a high cost of finance. This is, however, not due to bad international finance, for external borrowing costs are very low, but due to a combination of low domestic savings and, arguably, poor financial intermediation. Poor intermediation, in turn, can be attributed to banks’ high reserve requirements and a legal framework that makes it difficult for lenders to recover their losses. Raising domestic (public) savings through a longer-term fiscal adjustment should therefore help address the dearth of domestic savings and lessen the need for high reserve requirements. 

China does not suffer from low private investment and the Hausmannian framework does hence not seem to be applicable here. If anything, it would be desirable to reduce domestic savings through greater fiscal outlays and social expenditure as well as, potentially, by raising the cost capital (aka financial and interest-rate reform) and by forcing SOEs to pay dividends to the government. Financial reform would also help boost household income and potentially reduce the propensity to save. This would help wean the economy off potentially excessive investment and all the risks this entails. China could nonetheless introduce reforms aimed at raising the productivity of investment. This would help it maintain high growth in spite of the anticipated reduction in domestic investment and rise in consumption.

Source: IMF

To the extent that India suffers from low private investment, this can be attributed to low social returns. Interest rates have not historically been very high (in real terms) and governance or market failures would appear to be somewhat less important growth constraints as far as low appropriability is concerned than low social returns and, more specifically, a low level of human capital and a bad infrastructure. Illiteracy is very high and the infrastructure is notoriously poor. Admittedly, market failure is likely the second most important binding constraint in India. India should therefore focus on specific bottlenecks in the energy and infrastructure area as well as reduce market inefficiencies (e.g. accelerated approval of large investment projects, land acquisition law, restrictive labour laws).

Last but not least, the relatively low level of private investment in Russia seems to be primarily due to micro-risks and governance failures and ultimately low appropriability. The cost of finance does not appear to be unduly high and Russia has been running current account surpluses for many years, suggesting excess savings. A poor geography and an at best average-quality infrastructure represent important constraints. But compared to the issues of property risk and corruption, these constraints are arguably less “binding”. Structural reforms aimed at boosting private-sector investment will therefore be key to raise medium-term economic growth. A more efficient state would also help boost the productivity of public investment. But state reform is difficult. WTO accession offers a welcome opportunity to implement structural reforms aimed at making the business environment more predictable, strengthen the rule of law and limit corruption. 

The political economy of structural reform in the BRIC (2013)

The BRIC economies, like most other economies in the world, experienced a slowdown in 2011-12. The bears are worrying that this slowdown might contain a significant structural component. These concerns seem somewhat overdone. Sure, the last decade saw strong global economic growth against a backdrop of low interest rates, increasing global trade flows, rising capital flows to emerging markets and rising commodity prices (the latter benefitting countries like Brazil and Russia). The global growth outlook for the next few years is more modest by comparison.

China is indeed unlikely to return to double-digit annual growth rates, not least because the authorities believe that 7-8% growth is sufficient to maintain political stability. Brazil continues to experience sub-par growth. Indian and Russian economic growth has also decelerated to multi-year-ex-2008/09 lows. The IMF has just revised its 2013 growth forecast to 3.4% and 5.7% for Russia and India, respectively, and 3% for Brazil.

Source: IMF

The growth potential of the BRIC economies nonetheless remains sizeable. All BRIC countries benefit from plenty of catch-up potential and scope to raise productivity via an increase in the physical and human capital stock. The first reason for optimism is that savings have not declined materially, and may even rise over the medium term. The current account positions are strong (China, Russia) or quite manageable (Brazil, India). This means that an acceleration of investment won’t be much constrained by a lack of savings.

Most importantly, the BRIC countries are economically well-positioned to unlock their growth potential through structural reform. Brazil and India, for instance, have taken a number of structural measures recently (e.g. greater FDI in India, infrastructure concession sales in Brazil) Rather than solely relying on anti-cyclical demand-oriented macro policies à la 2008/09, they seem to have been spurred into pursuing structural reform aimed at enhancing productivity and international competitiveness by concerns that the current slowdown might be more structural than cyclical. Admittedly, none of these reforms qualify as big-bang reforms; but they should, at the margin, help support growth over the medium term. Encouragingly, these measures reflect the authorities’ recognition that supply-side reforms are at least as necessary as demand-side policies if high growth is to be sustained over the longer term. Rising inflation in both countries has undoubtedly helped focus policy-makers’ minds.

China has thus far largely refrained from taking strong anti-cyclical policy measures as well as from pushing major structural reforms. This is largely explained by the leadership transition as well as concerns about the longer-term potential negative consequences another large policy stimulus might have for existing economic imbalances. Technocratic-minded groups have put forward a blueprint for further financial sector reform and analysts expect a number of other measures to be forthcoming under the new government (e.g. social housing, infrastructure). The recent publication of a plan to raise household income shows that the authorities are aware of the need to tweak the growth model. Russia is looking at a number of reforms following last year’s presidential elections; though, it remains to be seen how serious the new government is about reform. Importantly, the Russian government seeks to privatise USD 45 bn worth of public sector assets in 2013-15 and to increase infrastructure investment, especially in the Far East.

Recent Brazilian and Indian reforms may appear somewhat surprising. After all, the political-institutional backdrop for reform appears relatively unfavourable – more so in India than in Brazil. PM Singh’s government has been struggling for a long time to persuade its unruly parliamentary coalition to back reforms. The opposition BJP, though in principle more inclined toward reform, has proven less accommodative of reforms than might have been expected. Aggressive reforms carry the risk of destabilising the parliamentary coalition government. This is one of the main reasons why India has not seen more extensive reforms over and above the measures alluded to above.

In Brazil’s presidential political system, unlike in India, the executive does not depend on its congressional base for survival; but the president similarly needs to rally support in a highly fragmented congressional base and multiparty presidential coalitions in order to implement more wide-ranging reforms. The government has had at least one major success (e.g. public sector pension reform). It has also taken a number of other measures aimed at reviving economic growth (e.g. tax cuts, lowering of electricity tariffs). These latter measures did not require the president to spend lots of political capital or build large coalitions in congress, which perhaps explains why they were passed easily.

In institutional terms, the Chinese and Russian governments are better positioned to implement structural reform than Brazil and India, at least as far as the surmounting of legislative obstacles and societal opposition is concerned. In Russia, the presidency has not only extensive powers, but it currently also enjoys a majority in the Duma. In China, the executive rules supreme, even if it often has to contend with different technocratic and regional factions as well as well-connected vested interests, before a sufficiently large consensus on reform policies can be reached. In this respect, it is crucial that Chinese governments (or leadership groups) typically stay in power for a whole decade.

This latter fact is significant because it affects the incentives to pursue structural reform. This is critical, for the economic – and political - benefits stemming from structural reform typically materialise only over time, while the political and electoral (or legitimacy) costs typically materialise instantly. The OECD in a recent study finds that the full pay-off from structural reforms takes on average five years to materialise. This coincides almost exactly with the electoral cycle in democracies. It is easy to see why, unless a country is facing a severe crisis – like India in 1991, Russia in 1997 and Brazil in the early nineties – big-ticket reforms are rather uncommon. If they do take place, they almost inevitably take place early on in a government’s term and, not infrequently, get watered down by vested interests or blocked entirely by so-called ‘veto players’. Given how concentrated the costs of, and how dispersed the benefits from, reforms are (aka higher medium-term growth), vested interest find it relatively easy to mobilise against reform relative to the ‘silent majority’, who would benefit relatively less than vested interests.

A moderate, gradual slowdown in economic growth is harder to instrumentalise in terms of mobilising political support for structural reform – as opposed to an outright economic or financial crisis. This is why the reforms in Brazil and India may look somewhat surprising – then again, the reforms that were passed are not exactly the type of high-impact, growth-accelerating reforms that are needed to raise economic growth dramatically. In purely political-institutional terms, China and, somewhat less so, Russia would appear to be far better positioned to pursue medium-term growth-enhancing reform than Brazil and India – at least once the government makes up its mind.

The long and short of it is this: if the growth decline in the BRIC economies were to prove more pronounced than we currently anticipate and reveal itself to be more structural than we believe, we would expect greater reform efforts to come through, especially in China and Russia. The relative lack of reform in China and Russia was likely due to the perception that economic growth remains broadly satisfactory. (This perception is changing fast in Russia at the moment.) It is encouraging that the Brazilian and Indian governments have taken structural measures – however modest in the eyes of critics – aimed at raising the medium-term growth potential, instead of solely relying on politically less costly demand side measures (though Brazil at least has done this, too). The current sense of pessimism pervading analysts’ views of the BRIC therefore appears overdone. None of this is meant to suggest that structural reforms will be politically easy. The good news is that at least there is a, albeit varying, degree of recognition among the BRIC governments that such reforms are necessary. Once committed to reform, China and Russia will have an easier time implementing them than Brazil and India.

A few observations regarding BRIC economies’ foreign assets & liabilities (2012)

The emerging economies are playing an increasingly important role in the global economy. Their share of global GDP, trade and investment flows is increasing. They have already gained a greater say in multilateral financial institutions in recent years as well as a ‘seat at the table’ with the creation of the G20. The four largest emerging economies, the so-called BRICs, already rank among the world’s eleven largest economies.

In terms of international investment, however, the BRIC countries punch below their weight. Foreign assets amount to 2/3 of GDP in both China and Russia and less than 1/3 of GDP in both Brazil and India. By comparison, US foreign assets amount to 145% of GDP. Foreign liabilities amount to 60% of GDP in Brazil and Russia, and around 40% of GDP in China and India. US liabilities stand at 165% of GDP. In dollar terms, the differences are obviously even more striking. For instance, US foreign assets are five times larger than China’s and a stunning 50 times larger than India’s.

In terms of net international investment position (i.e. the difference between international assets and liabilities), China is the only BRIC country with a sizable net positive position, making it somewhat of an anomaly among emerging economies, generally speaking. Only Argentina and a few newly-industrialised economies (e.g. Hong Kong, Singapore and Taiwan) are net international creditors. China’s net international investment position (IIP) currently stands at 26% of GDP or USD 1.9 tr. (In dollar terms, only Japan has a larger net IIP of USD 3.3 tr.) The US, by contrast, has a net negative position of USD 4 tr.

All BRICs – like most other emerging economies – are ‘long debt’ (mainly in the form of reserve assets) and ‘short equity’ (FDI and portfolio equity). A large share of foreign assets therefore consists of low-yielding foreign government debt securities, and a significant share of liabilities is made up by generally high(er)-yielding equity investments, the combination of which translates into poor financial returns. Even China with its very large creditor position at presentt barely turns a profit. After all, 70% of its foreign assets consist of official reserves. The US, of course, is the mirror image of China, generating net financial returns despite being the world’s largest debtor. This balance sheet structure is largely due to (past or present) controls on private capital outflows and the desire among emerging economies to accumulate official reserve assets – either as a form of insurance against balance-of-payments shocks or as the byproduct of persistent currency intervention in the context of an undervalued exchange rate.

The BRICs are getting a proverbial raw financial deal, at least from an external cash flow point of view. (The benefits that an economy derives from FDI inflows in terms of higher investment and the transfer of technology and know-how may provide a non-financial offset.) Furthermore, in purely financial terms, the public sector as the main holder of low-yielding foreign debt also runs a ‘negative carry’ as a result of (sterilised) FX intervention. (Where FX accumulation is only partially sterilised, or not at all, it translates into opportunity costs all the same.) To the extent that the public sector is net long foreign currency (FCY), which is the case in all four BRICs, it may be able to offset the losses from the negative offshore-onshore interest rate differential by way of currency depreciation. If, on the other hand, the currency tends to appreciate in nominal terms over the medium term, the public sector will suffer valuation losses, on top of carry-related losses.

While the BRIC public sectors are ‘long’ FCY, the economy-wide exchange rate risk is more difficult to quantify. At the risk of over-simplification, assuming that all or most foreign assets are denominated in FCY and all foreign liabilities (except equity liabilities) are also denominated in FCY, all BRICs are ‘longer’ FCY than the net IIP position might imply. Thus, China’s net long dollar position is significantly larger than its positive net IIP implies (USD 3.7 tr versus USD 1.9 tr) and Brazil, India and Russia are also all net FCY creditors, in spite of the first two having a negative net IIP.

The public sector’s long foreign assets and FCY position may be rationalised economically in terms of the need to provide hedge/insurance to the (typically) net short FCY private sector. However, the consolidated private and public-sector balance sheets point to a long aggregate FCY position. From a purely fiscal-financial point of view, leaving aside precautionary motives and trade competitiveness concerns, the public sectors in the BRICs should have an interest in reducing their net long FCY position – or at least in limiting their future growth.

All this may help explain why China seeks to renminbi-ise its foreign assets by way of RMB internationalisation and to gradually allow the private sector to accumulate higher-yielding foreign assets by way of capital account liberalization. If successful, this would help limit FCY mismatches in the public sector, limit the negative carry incurred by the public sector and raise the return on China’s net foreign assets. By the same token, it would not be advisable to reduce public-sector FCY liabilities. On the contrary, from a purely financial point of view, it would seem to make sense for China – and somewhat less so for the other BRICs – to sell more rather than less FCY-denominated debt to foreigners given the government’s and the economy’s large net long FCY positions.

Net international investment position of the BRIC (2012)

Economically, politically and demographically, the BRIC differ dramatically. The same is true with respect to their international financial importance. China is not only by far the BRIC country with the largest foreign assets (and foreign-exchange reserves). Chinese foreign reserve assets alone amount to USD 3.3 tr compared with a combined USD 1.2 tr in Brazil, India and Russia. But it is also the largest net external creditor. China’s foreign investment potential is enormous and dwarfs that of all the other BRIC. For now, China, like the other BRIC, is running a ‘long debt and short equity’. Similar to the other BRIC, most of its assets are denominated in foreign-currency, while its higher-yielding (equity-type) liabilities are predominantly denominated in local currency. From a narrowly financial perspective, China and the other BRIC are getting a proverbial raw deal, not least because they are likely to see their local-currency-denominated liabilities appreciate relative to its largely foreign-currency-assets. After all, real exchange rate appreciation is characteristic of fast-growing emerging economies experiencing productivity growth. Thus, from a narrow financial point of view, the BRIC and China have every reason to diversify their assets out of low-yielding foreign-currency-denominated ‘safe haven’ bonds into higher-yielding, (preferably) local-currency-denominated (from the BRICs’ point of view) assets.

Source: IMF

Are the BRIC currencies set to become reserve currencies? (2011)

Global FX reserves are denominated in only a handful of currencies. For a currency to become a major reserve currency, it has to be underpinned by liquid, large and highly-rated bond markets. None of the BRIC can at present aspire to major reserve currency status given global FX reserves worth USD 10 tr. Only the RMB has the potential to become a major, albeit not the dominant, reserve currency by 2030. The USD will continue to benefit from incumbency, and is therefore unlikely to be displaced as the “dominant” reserve currency, assuming the government manages to put debt back on a sustainable path.

A reserve currency is, by definition, a currency in which the foreign assets held by central banks are denominated. Conceptually, this needs to be distinguished from a currency’s private international use (e.g. invoicing of trade), even if in practice the two are closely related. It is also important to distinguish between a major and a dominant reserve currency. A currency is a major and dominant reserve currency if 10% and 50% of global FX reserves are denominated in it, respectively.

Global FX reserves are denominated in only a handful of currencies (roughly: USD 60%, EUR 27%, JPY and GBP 4%, respectively). For a currency to become a major reserve currency, it has to be underpinned by liquid, large and highly-rated (ultimately: sovereign) bond markets. (After all, China dumped agencies and bank deposits in favour of US Treasuries during the 2008 financial crisis). None of the BRIC can at present aspire to major reserve currency status given global FX reserves worth USD 10 tr. Quite simply, none of the BRIC government bond markets has at present the required size and depth to absorb USD 1 tr (or 10% of total) global reserves.

There has been a lot of talk about the RMB replacing the USD as the “dominant” reserve currency. Government debt problems, potential inflation and depreciation are seen as undermining the USD. This fails to distinguish between the “store of value” and the “medium of exchange” function of a currency. Concern about the “store of value” has arisen not only due to rising US government debt and large current account deficits. It also has to do with the shift towards slightly more return-oriented behavior among central banks whose foreign asset holdings exceed pre-cautionary levels.

“Excess reserves” allow central banks to invest in less liquid, higher-risk instruments. A US sovereign default would naturally be a game-changer (but such an event is highly unlikely). It is very debatable whether a higher level of inflation and/or exchange rate volatility would undermine USD reserve status. It is noteworthy that the recent US sovereign downgrade was followed by a “flight” into US Treasuries.

More importantly, medium-term depreciation won’t affect the dollar’s medium of exchange function, only possibly its store of value function. There is simply no high-grade bond market as liquid, deep and creditworthy as the US Treasury market.

The RMB, let alone the other BRIC currencies, will not emerge as a serious near-term contender for “dominant” reserve currency status in the next few years. First, size matters. Global FX reserves are almost USD 10 tr (a full 1/3 is accounted for by China). China’s government bond market is a mere USD 1.6 tr. Though comparable in size to Germany’s, it – leaving aside the issue of capital account convertibility – is not large enough to absorb even 10% of present global FX reserves. Second, even if global FX reserve growth slows from currently 15% to 5% and the Chinese bond market continues to grow 15%, the size of China’s government bond relative to global FX reserves by 2030 will still be smaller than the US government bond market relative to FX reserves today. None of the other BRIC bond markets will be sufficiently large by 2030 to absorb 10% of reserves assuming that foreigners will at most hold 50% of the market.

Third, and related, China’s role in international trade will lead to a greater share of trade being invoiced in RMB. Currently, the US remains the main source of final demand for Asian producers. But this will be changing rapidly, enhancing the incentives of central banks to increasingly manage their currencies against the RMB rather than the US and thus to hold greater RMB reserves. Demand for RMB reserve assets is driven not only by greater use in cross-border trade but, significantly more so, by private financial transactions. Greater private use on the back of RMB convertibility would also enhance the incentives to hold RMB.

Assuming that issues such as secondary market liquidity (China is far from having a deep and liquid bond market) and solvency (China is currently rated A by the major rating agencies) have ceased to present impediments by 2030, this leaves the issue of market access. China has recently taken steps very selectively opening up its on-shore bond market to foreign central banks, allowing them to reinvest their (mainly trade-related) RMB in local bonds. Complete capital-account convertibility would help further the international use of the RMB and increase the incentive for central banks to hold a rising share of their reserves in RMB. It will be interesting to see to what extent the Chinese authorities (perhaps other than the PBoC) are prepared to give up control over large parts of its financial system and its capital account and to potentially undermine the very foundation of its tried and tested economic development strategy!

All said, the RMB has the potential to become a major but not the dominant reserve currency by 2030. First and foremost, China itself will still be holding a significant share of global FX reserves by 2025. But a rising share of non-Chinese FX reserves may be invested in RMB-denominated assets, especially once China moves towards greater RMB convertibility. The off-shore RMB market would be too small to accommodate official demand for RMB. A more dominant position in terms of global trade and greater capital-account convertibility underpinned by a fully-developed domestic financial system will create greater incentives for other countries to manage their currencies vis-à-vis the RMB and thus to raise the share of RMB reserve holdings. Nonetheless, the USD will benefit from incumbency, and is therefore unlikely to be displaced as the “dominant” reserve currency, assuming the US government manages to put debt back on a sustainable path.

BRIC public sector debt is very manageable in spite of rising off-balance sheet risks (2011)

Over the next five years, government debt in the G4 (US, Japan, Germany and the UK), with the exception of Germany, will rise very significantly. The G4 will therefore have to undergo a multi-year fiscal adjustment in order to put debt on a sustainable path. By contrast, the BRIC governments, having weathered the global crisis fiscally unscathed, will see their debt levels largely unchanged and face a very limited or even non-existent need for a fiscal adjustment. Even if BRIC public sectors were forced to take on contingent liabilities (e.g. in case of a banking sector bail-out), they would still be in better shape, financially speaking, than the G4.

Public debt matters – economically and politically. A high and rising level of public sector debt will, sooner or later, push up domestic interest rates, crowd out private-sector investment and eventually threaten government solvency. Rising debt levels also limit fiscal flexibility, ultimately forcing governments into an extended fiscal retrenchment. This can have consequences reaching far beyond the economic realm. A very large debt burden, for instance, forced Great Britain to liquidate its empire following WWII. Similar concerns have informed recent analyses by US foreign policy in the context of an unsustainable US fiscal policy (Bacevich, Johnson, Mandelbaum).

Over the next five years, government debt is set to decline moderately in the BRICs, while it will rise dramatically in the G4 (US, Japan, Germany and the UK), with the exception of Germany. The G4 will therefore have to undergo a multi-year fiscal adjustment in order to put debt on a sustainable path. By contrast, the BRIC governments, having weathered the global crisis fiscally unscathed, will see their debt levels largely unchanged and face a very limited or even non-existent need for a fiscal adjustment. A combination of significantly lower fiscal deficits, faster economic growth and higher inflation will ensure debt sustainability. According to IMF estimates, the fiscal deficit in the BRIC will average 3.1% of GDP versus 5.6% of GDP in the G4. The real (inflation-adjusted) deficits in the BRIC will be even smaller, of course. 

That said, the level of government debt in the BRIC countries varies substantially. Gross general government debt in Brazil and India amounts to a sizeable 67% and 75% of GDP, respectively, while in China and Russia it stands at a very low 20% and 10% of GDP, respectively. It is also noteworthy that BRIC government debt is almost exclusively held by residents. Only in Brazil do foreigners own a little more than 10% of total government debt. This contrasts sharply with Germany (50%), the UK (30%) and the US (50%), where foreigners hold much larger shares of government debt. If government and central bank balance sheets are consolidated, the public sectors in the BRICs are also all net foreign (currency) creditors. China’s public sector owns net foreign assets worth a stunning – for a country the size of China – 50% of GDP. A very low dependence on foreign financing sharply limits BRIC governments’ financial vulnerability.

Recently, many analysts have expressed concern about the size of (more broadly defined) public sector debt and contingent liabilities in the BRICs (and especially in Brazil and China). Non-financial public sector (NFPS) debt comprises, in addition to the debt of the general government sector, the liabilities of the central bank and nonfinancial public-sector-owned companies. Net NFPS debt, the more relevant indicator from a debt sustainability perspective, amounts to a very manageable 40% of GDP in Brazil, the only BRIC country providing consolidated PS figures. Russia has no doubt the lowest net NFPS debt – the general government is net creditor, after all! For both India and, even more so, China, wide-spread government ownership of non-financial (let alone, financial) companies at both the central and local government levels make it virtually impossible to estimate net public debt with any degree of accuracy.

The Chinese authorities have just released estimates of direct and explicitly-guaranteed local-government debt, a source of concern to analysts following the massive surge in bank lending to local governments in 2008-09, putting it at a manageable 27% of GDP. India has been providing more comprehensive state government debt statistics all along. Neither country provides NFPS estimates. However, unless one assumes that the liabilities owed by public sector companies vastly exceed their assets, net NFPS is bound to be sustainable in all BRICs given the combination of (strong) economic growth, (generally small) government deficits and (low) real interest rates.

What about contingent liabilities? Past experience suggests that banking sector crises are the single most important source of contingent liabilities. All BRIC economies have been experiencing strong real credit growth over the past two years, raising concerns about a future rise in non-performing loans and the potential need for the government to extend financial support to the banking sector. All other things equal: the larger the size of the banking sector and the larger the share of lending by government-owned banks, the greater the potential liabilities. Bank lending to the private sector amounts to 50% of GDP in Brazil, India and Russia and a very considerable 135% of GDP in China. Government-owned banks account for 50% of total banking sector assets in China, 40% in both Brazil and Russia and 70% in India. Ceteris paribus this suggests that China faces the potentially largest contingent liabilities as a share of GDP. Admittedly, in the event of a systemic banking crisis, governments often have little choice but to bail out banks regardless of ownership.

Naturally, credit quality, capital buffers and profitability also affect the level of contingent liabilities. Fitch estimates that the Chinese banking system might require financial support in the order of 10-30% of GDP in a moderate and severe stress scenario, respectively. Bail-out costs in the other BRIC countries would be significantly smaller given the much smaller size of their banking sectors. In short, the contingent liabilities associated with even a severe banking sector crisis would not undermine debt sustainability in any of the BRICs. China, facing potentially the largest contingent liabilities, is best placed to sustain an increase in liabilities given that it enjoys the strongest economic growth outlook, has comparatively little debt and a captive domestic investor (depositor) base. If, unrealistically, all the debt of all non-financial public-sector entities, including central and local governments, were added up and assumed by the central government, Chinese gross public debt may add up to 150% of GDP or so (before intra-public sector netting!). Even in this scenario, this would not break the “sovereign” bank – even if real GDP growth declined substantially (from 10% to 6%), real interest rates rose (by 200bp) and the primary fiscal balance worsened (by 1% of GDP).

In sum, even if BRIC public sectors were forced to take on contingent liabilities, they would still be in better shape, fiscally speaking, than the G4. This does not, however, necessarily translate into higher sovereign risk in the G4, for the latter have a number of things going for them (e.g. large, diverse and “deep” investor base, solid political and economic institutions, a strong debt service track record). Nonetheless, financially and politically, the BRICs will benefit from far greater fiscal flexibility than the advanced economies over the next decade and beyond, off-balance sheet liabilities notwithstanding. Higher underlying growth will increase BRIC governments’ fiscal resources relative to the G4. This will have wide-ranging consequences for the economic and political position of the BRIC relative to the G4.

BRIC banking systems after the crisis (2011)

State-led economic development, if successfully implemented, is appropriate during the early “catch up” phase of economic growth. However, as growth becomes more dependent on indigenous innovation and hence a dynamic private sector, a shift to more market-led rather than state-directed development becomes necessary. This also applies to the banking sector. Subject to proper regulation, banking systems that rely on private-sector banks and market-led credit allocation will eventually tend to generate superior economic outcomes. That said, we are unlikely to see a significant reduction in public-sector bank ownership in the BRIC countries anytime soon, nor, for that matter, a tangible increase in foreign ownership.

Following the global financial crisis, BRIC governments have become (even) less prepared to reduce their presence in the domestic banking system. After all, policymakers’ success in overcoming the credit crunch in 2008-09 in part relied on their ability to provide credit to the economy through public sector-owned banks. In the absence of often substantial public-sector bank lending, the decline in domestic demand in a number of countries (e.g. Brazil, China, India) would have been much more severe. Conventional monetary policy would have been and was insufficient to stimulate bank lending (aka Keynesian “liquidity trap”).

Enter the Beijing consensus, exit the Washington consensus. The Beijing consensus is committed to, among other things, the state playing an activist role in economic sectors deemed “strategic”, invariably including the banking sector. This takes the form of outright government ownership or at least significant government intervention. Instead of near-exclusively relying on private-sector, market-led processes, the state takes an activist approach going far beyond merely regulating private-sector activity. Historically, this type of successful developmentalist, state-led economic policy and development does nonetheless rely on functioning private markets – nowhere is this more evident than in today’s China, where the private sector has been the main engine of economic growth. 

History suggests that this strategy, if successfully implemented, is appropriate during the early “catch up” phase, when per-capita income is low and growth is significantly driven by large-scale investment in physical infrastructure and the introduction of “off-the-shelf” technologies. However, as per-capita income rises, growth becomes more dependent on a dynamic private sector and indigenous innovation. Eichengreen et al. (2011) identify a per-capita income of USD 17,000 (in 2005 constant international dollars) as a critical threshold where economies experience a tangible downward shift in their trend growth. This is where state-directed policies are bound to become less effective in terms of generating growth than a dynamic private sector. This suggests that – following recent PPP revisions – smart state-led policies remain broadly appropriate in low per-capita-income India (USD 3,500) and, less so, in China (USD 7,700) and Brazil (USD 10,000), while they are bound to be less effective in Russia (USD 15,200), all other things being equal. Naturally, should China continue to grow at near-double-digit rates, it would, as Eichengreen et al. (2013) point out, reach the “critical threshold” before the end of the current decade.

The greater need for a shift to more market-led rather than state-directed development also applies to the banking sector. At a stage of economic development where per-capita income is low and capital productivity is high, it is not difficult to identify profitable and economic growth-generating lending opportunities. This tends to change as economies move into middle-income territory. This is why, subject to proper regulation, banking systems that rely on private-sector banks and market-led credit allocation will eventually tend to generate superior economic outcomes.

This flies in the face of policymakers’ recent successful experience with counter-cyclical state-directed credit policies. After all, the extensive use of government-directed bank lending played an important role in sustaining domestic demand and economic growth (China, India) or may, at least, have prevented an even sharper economic contraction (Brazil, Russia). Interestingly, real bank lending grew significantly faster in the BRIC countries, where governments play an important role in the banking sector. Real credit growth averaged almost 25% in China in 2009-10, while public-sector banks in Brazil, impressively, doubled lending from 10% of GDP in 2008 to 20% of GDP in 2010. 

This contrasts sharply with the contraction in credit experienced by many developed markets and relatively anemic credit growth in those emerging markets where government ownership of banks is very limited (e.g. Mexico, Eastern Europe). Admittedly, other factors such as extensive foreign ownership and significant cross-border lending may also have contributed to differential credit growth. But the role played by public-sector banks was undoubtedly important.

It is perfectly sensible to pursue counter-cyclical state-directed credit policies if the banking system is dysfunctional and is suffering from market failure. However, time inconsistency and politicians’ desire to dish out favours risk turning counter-cyclical policies into pro-cyclical ones. Interestingly, among the BRICs, only Brazil seems to have given in to this temptation, while China, more accustomed to state-directed lending and more concerned about its inflationary consequences, has not. But unless top-notch governance regimes are in place, extensive state-directed credit allocation, especially if sustained over a longer period of time, carries the risk of capture by “rent-seekers”. And rare is the government (or the bureaucracy) that manages to privilege medium-term economic efficiency over short-term political considerations in a consistent manner. An economy that grows at double-digit rates may be able to afford this (China), whereas most economies, especially those constrained by low savings rates (Brazil), cannot. Last but not least, an extensive public-sector presence also undercuts, and if does not undercut then it certainly slows, the development of a more sophisticated banking and financial sector capable of sustaining economic development once an economy moves into middle-income territory.

That said, it is difficult to see why the BRIC governments would be willing to substantially reduce, let alone relinquish their role, in the domestic banking sector over the next few years. Some BRIC governments have sold (China) or are planning to sell minority stakes (Russia) in major state-owned banks. But none of them is seriously considering giving up control. True, Brazil did fully privatise a number of its public-sector banks in the 1990s (and even sold some of them to foreigners), but this occurred against the backdrop of severe financial pressures and an urgent need to resolve a banking crisis. Short of a major crisis, which is unlikely given solid economic fundamentals, we will not see a substantial decline in public-sector ownership and control in the BRICs over the next decade or so.

Similarly, if the history of banking sector opening since the 1990s is anything to go by, none of the BRIC economies will see a significant increase in foreign bank ownership. While opening the banking sector to foreigners has always been a politically unpopular proposition in the BRICs, economically and intellectually it seemed difficult to contest its benefits. The view that greater foreign ownership is unambiguously a good thing, bringing superior regulation, fresh capital, financial innovation and better risk management, has at least been called into question in the wake of the global financial crisis. There are also concerns among BRIC policymakers that a large foreign presence may allow external shocks to be transmitted more easily. This is debatable, however. Extensive foreign ownership may actually have helped avert a larger crisis thanks to co-ordination committing foreign banks to maintain the lending of their domestically incorporated subsidiaries, recapitalise local subsidiaries (if necessary) and, more generally, allow for an “orderly” de-leveraging (e.g. Vienna Initiative). Still, we are not likely to see either a significant reduction in public-sector ownership or a substantial increase in foreign ownership in BRIC banking sectors in the near or even medium-term future.

BRICs & G-3 – changing interaction, emerging complementarities (2011)

Historically, emerging economies characterised by a high degree of trade and/or financial openness were strongly affected by developments in advanced economies. Recent developments suggest that traditional one-way interaction is making way for a more complex and intensifying two-way interaction – or interdependence, if you will. The economic relationship between the G-3 and the BRIC countries (Brazil, Russia, India and China) is, by and large, a complementary one.

Economists – and not just dependistas – tend to look at emerging economies as being economically and financially dependent on advanced economies. Due to their smaller size, greater financial dependence and, not infrequently, greater reliance on commodity exports, the price of which used to be highly correlated with DM growth, the EM used to catch the proverbial cold whenever the DM sneezed. With the exception of extreme events (e.g. the oil shocks of the 1970s), the EM were, generally speaking, very sensitive to the economic and financial developments in the DM, while the reverse was not true. In short, the EM-DM relationship was largely a one-way street.

With the growing weight of the EM in the global economy, this largely one-way interaction has been mutating into greater two-way interaction. The EM are growing significantly faster than their DM peers. The OECD projects that the EM will account for nearly 60% of global output by 2030. The “catching up” has been nothing if not impressive over the past decade and a half. Take the BRICs, for instance. By 2015, they will account for more than 60% of combined G-3 (Germany, Japan, US) GDP, up from less than 10% in 1990. (This of course explains the creation of the G-20.) China is set to become the world’s largest economy before the middle of the next decade.

Recent EM economic performance also suggests that it may be time to re-think DM-EM relations. First, EM growth, perhaps for the first time ever, has been “leading” the global economic recovery. True, the EM failed to “decouple” during 2008/09, but they have, in the aggregate, recovered more quickly and more vigorously than most DM. Second, significant EM growth, combined with their greater economic weight, has been strongly felt in global commodity markets and trade-dependent economies, both emerging and developed, over the past few years. Third, greater financial openness and/or stronger current account positions are turning the EM into international investors in their own right. Fourth, solid fundamentals in most major EM and greater monetary and fiscal space provide the EM with greater flexibility to respond to potential future shocks than most DM. All of this will lead the EM, and especially the BRICs, to play a bigger role – economically, financially and politically.

The BRIC countries are becoming increasingly important to the G-3 countries. China and India, for instance, maintained strong growth rates throughout the crisis, registering average real GDP growth in 2009 of 9.3% and 7.4%, respectively. This has helped underpin, for instance, Germany’s unexpectedly strong recovery. More generally, the BRICs already account for 10-20% of G-3 exports. As a share of GDP, Germany is more exposed to the BRICs than Japan and the US, with exports accounting for 3% of GDP (or USD 100 bn), compared with 2.5% of GDP (USD 115 bn) in Japan and less than 1% of GDP in the US (USD 125 bn). Not surprisingly, China is the most important and fastest-growing export market for all G-3 members. In terms of G-3 outward FDI, the BRICs are less important than with regards to trade – at least as regards stocks.

German and US FDI in the BRICs account for 4-6% of their total OFDI (outward FDI). Only Japan’s FDI exceeds 10% of its total outward FDI, the bulk of which is, not surprisingly, accounted for by China. Once again, as a share of GDP, Germany has the largest OFDI in the BRICs among the G-3. It is not difficult to see the basic complementarity between slowly growing, capital-rich, high-tech G-3 economies and fast-growing, (relatively) low-tech, capital-poor BRIC economies. It is not difficult to see how geography has an impact on the distribution of G-3 trade and investment in the BRICs. For instance, Germany’s resource dependence and specialisation in high-tech capital goods create a good fit with Russia’s natural resource wealth, dependence on manufacturing and especially capital goods imports and the Russian government’s professed desire to modernise the economy.

China’s demand for technology and Japan’s quest to access new markets given the relative maturity of its own domestic markets create a similarly favourable, but perhaps somewhat lesser fit given the potentially intensifying resource competition and continued political rivalry. Economically, Sino-German relations look like an unambiguous win-win combination. So does the Japanese-Russian combination, which continues to be burdened by a long-standing territorial dispute, however.

Last but not least, it is worth noting that the US has thus far taken relatively little advantage of the “rise of the BRICs”. This is largely, not exclusively, due to its overall lower degree of trade openness and a smaller stock of outward FDI as a share of GDP. Whether measured as a share of GDP or as a share of total exports or outward FDI, however, the US has some “catching up” to do. After all, the weight of the BRICs in the global economy will continue to grow and trade and investment are the most direct ways in which to take advantage of it.

Emerging markets capital flows – how are the BRIC countries faring and coping? (2010)

The last two “super-cycles” in private capital flows to emerging markets lasted almost exactly seven years. This suggests that the current upswing in capital flows may only be in its early stages. The level of capital flows to the BRICs differs markedly, as do their policy responses in terms of currency appreciation, reserve accumulation and capital controls. Brazil will continue to face a far greater temptation to tighten capital controls – and prevent currency appreciation – than the other BRIC countries.

"Behold, there come seven years of great plenty", according to the book of Genesis. Interestingly, the last two “super-cycles” in private capital flows to emerging markets lasted almost exactly seven years. The first ended with the Asian crisis (1990-1997) and the second with the Lehman collapse (2002-08). In the late 1970s and early 1980s, the EM had experienced a shorter-lived boom (and bust), ending with the Mexican debt moratorium in August 1982. Ominously, economies that suffered a major financial crisis take an average of seven years to complete “deleveraging” during which they tend to suffer from below-average growth (C. Reinhart & V. Reinhart).

All of this seems to suggest that the current upswing in private capital flows to the EM that started in April 2009, following the G20 meeting, may only be in its early stages and may have another five years to run. This sounds plausible considering that high (and rising) EM interest rates, attractive medium-term growth prospects and improved fundamentals will pull capital into EM, while an extended period of unprecedentedly low DM interest rates, sub-par economic growth, exacerbated by an intensifying “demographic drag”, and higher financial risks will push capital out of the DM and into EM.

Capital flows are being underpinned by more than just cyclical and hence reversible factors. The relative “(great) risk shift” in favour of EM would seem to justify a “structurally” higher level of flows. After all, while the DM are being downgraded, EM are being upgraded. Higher EM and lower DM creditworthiness look like they are here to stay. This, in turn, has been behind the greater “strategic” asset allocation to EM by DM institutional investors, which remain heavily under-invested in the EM “space”. The cyclical component is being underpinned by yield differentials and quantitative easing by the Fed, the BoE and, to a far lesser extent, by the BoJ. In practice, it is impossible to disentangle what share of the flows is due to structural versus cyclical factors. For the time being, however, both structural and cyclical factors point to continued strong capital flows. 

Another important distinction concerns “asset price busts” and “financial busts”. The former simply refers to a sharp rise and subsequent fall in asset prices. The latter refers to a sharp downward adjustment in asset prices that triggers a wider “systemic” banking sector or balance-of-payments-cum-sovereign-debt crisis. According to this definition, Russia experienced an “asset price bust” in 2008, but a “financial bust” in 1998. Concerns about a “financial bust” in the EM, and certainly in the BRICs, look very much overdone at this stage. The BRICs benefit from strong external solvency and liquidity.

Large FX reserves and/or (more or less) flexible exchange-rate arrangements and favourable foreign-currency mismatches provide them with significant buffers in the event of a “sudden stop” in capital inflows. Current accounts exhibit manageable deficits (Brazil and India) or are even in surplus (China and Russia). The risk profile of the inflows is also more favourable than in the past, from the recipient countries’ point of view. The FDI component of inflows remains significant, and portfolio flows are often biased towards local-currency equity and debt, typically of longer duration. Last but not least, the BRICs continue to increase FX reserves, albeit at different speeds.

The level of capital flows to the BRICs differs markedly. Brazil has been experiencing the highest level of inflows during 2009-10 due to its more open capital markets (compared to China and India), perceived improvement in post-crisis growth and/or lower “leverage” (compared to Russia) and very high interest rates. At the same time, Brazil has accumulated far less FX reserves (as a share of GDP) than China and Russia, both of which combine small capital account surpluses (China) or deficits (Russia) and large current account surpluses with a more or less aggressive FX intervention policy. Brazil, by comparison, has “absorbed” parts of its overall surplus via currency appreciation (and a widening current account deficit) due to its more flexible exchange rate and, possibly, the significantly higher costs of sterilised intervention. Brazil’s FX reserves do remain well below those of the other BRICs.

Brazil’s current account deficit, combined with larger foreign capital inflows, also means that it is accumulating both larger net and gross foreign liabilities, however favourable their risk features. Concerns over “excess” currency appreciation and rising sensitivity to a “sudden stop” have contributed to Brazil’s decision to incrementally tighten controls on capital inflows. It is noteworthy, however, that - relative to GDP - the level of gross capital inflows is very similar to pre-crisis levels, while the (real effective) exchange rate is only slightly stronger than before the 2008 crisis.

The bottom line is that the degree to which countries – in this case the BRICs – are struggling with capital inflows (and external surpluses, more generally) differs significantly, as they do with respect to their policy responses in terms of currency appreciation, reserve accumulation and capital controls. Both China and Russia are experiencing much lower levels of gross capital inflows (and, indeed, much higher levels of gross private outflows) than Brazil. But large current-account-related inflows contribute to much larger balance-of-payments surpluses in both countries. Their greater capacity and willingness to prevent nominal currency appreciation have resulted in greater official reserve accumulation. As a result, China and Russia perceive much less of a need to tighten controls on capital inflows than Brazil, whose capital account is very open and whose currency has appreciated tangibly, albeit from weak immediate-post-crisis levels. India falls somewhere in between Brazil, on the one hand, and China and Russia, on the other hand, as regards its capacity and the perceived need to absorb (smaller) external surpluses. No doubt, if we are indeed in for “seven years of plenty”, Brazil will continue to face a far greater temptation to further tighten controls in order to stem foreign capital inflows – and prevent currency appreciation – than the other BRIC countries.

The BRIC countries and the "Beijing consensus” (2010)

After suffering significant political and/or economic crises all four BRIC countries embarked on a course of fundamental reforms during the 1980s and 1990s that transformed their economies and succeeded in boosting growth, largely by fomenting greater private-sector activity. By contrast, the financial crisis has strengthened the influence of the “statists” and increased the allure of what critics have labelled the “Beijing consensus”. The urge to extend the role of the state without a thorough analysis of the potential costs and benefits of doing so should be resisted.

During much of the post-WWII period, the BRIC economies have either been very or relatively closed to trade and they have tended to suffer from heavy state control and intervention. Naturally, the levels of state control and economic restrictions have varied dramatically. After all, China and the (then) Soviet Union used to run state-controlled command economies, while Brazil and India, in spite of significant economic restrictions and the important role played in the economy by the state, had functioning, if restricted, markets.

While Brazil’s and Russia’s development model came unstuck during the 1980s, China’s and India’s had never much “stuck” in the first place – at least judging by the two countries’ level of per capita income. Brazil and Russia experienced their high-growth periods during 1945-1980, before their economies and their respective economic models were engulfed in crisis. The causes for the ultimate failure differ somewhat, but both economies entered periods of stagnation because of “excessive” – if admittedly varying – degrees of state intervention and limited trade openness that ended up undercutting total factor productivity growth. China and India, by contrast, never experienced a comparable (per capita) growth take-off until they started reforming their economies in the 1980s and 1990s, respectively. India’s infamous “Hindu rate of growth” perhaps best captures the relative economic stagnation that characterised the four decades following WWII.

After having suffered significant political and/or economic crises all four countries embarked upon fundamental reforms that transformed their economies and succeeded in boosting growth. Brazil defaulted on its external debt in the early 1980s, after a decade-long external borrowing binge that had helped sustain the import-substitution industrialisation strategy beyond its expiry date. A “lost decade” ensued until the Cardoso administration (1995-2002) started implementing wide-ranging structural reforms, including trade liberalisation and privatisation, and managed to defeat hyperinflation. The Lula administration (2003-2010) finally managed to stabilise the economy for good, and economic growth started to move to a tangibly higher level following the 2002 “transition crisis”.

In Russia, following the break-up of the Soviet Union in 1991, reformist governments transformed the command economy into a market economy by way of a so-called “shock therapy” under Yeltsin (1991-1999). Similar to Brazil, post-reform Russia suffered a major financial crisis in 1998. Economic stabilization and growth take-off were finally achieved during the Putin presidency (1999-2008) – helped, admittedly, by continuously rising oil prices.

In the late seventies, China emerged from the political and economic turmoil of the Cultural Revolution (1966-76) with a pragmatically-minded leadership under Deng. The state-controlled economy was in tatters and the time was ripe for a new approach. Not only did it not matter if the cat was black or white as long as it caught mice. Becoming rich became glorious, too. Various types of liberalising reforms, perhaps most 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.

In India, “liberalization by stealth” (Panagariya) started in the late 1970s and early 1980s and reforms continued under the Rajiv Gandhi government (1984-89), notably the liberalisation of the “Licence Raj”. Economic reforms received further impetus under PM Rao (1991-96) and FM Singh following the 1991 balance-of-payments crisis. The liberalising reforms, conspicuously, helped accelerate per capita growth.

By the late 1970s and early 1980s, the various economic models had either failed after a relative period of success (Brazil, Russia), or the realisation had emerged that the models had never worked in the first place (China, India). Economic and/or political crises acted as a crucial catalyst for reform by allowing political leaders to push through important reforms. One does not have to be of a neo-liberal persuasion to acknowledge that it was a combination of economic reforms aimed at “more market” and “less state” that helped lift growth.

By contrast, the global crisis has politically strengthened the “statists” and has ideologically increased the lure of the, what critics have labeled, the “Beijing consensus” (Halper). The “Beijing” as opposed to the “Washington consensus” rejects the presumption I  favour of (unfettered) “market liberalism” and assigns the state a central role in economic development, mainly through state ownership in sectors that are deemed strategically important, through significant government control over credit, through state support for “national champions” and through state-owned investment funds (aka sovereign wealth funds).

After all, ad-hoc government intervention and, especially, “state-led” credit policies proved instrumental in limiting the economic and financial fall-out of the 2008 global crisis. In Brazil, the next government will pursue a more active industrial and financial policy and the Brazilian state will no doubt play a more prominent role in selected sectors. In Russia, where parts of the economy are dominated by the state, the government is talking about privatisation, but – like in China – this will at most involve selling minority stakes in “national champions” to foreigners. Neither China nor India will significantly reduce state involvement in the economy in the coming years.

This does not mean that we won’t see any economic reform in the BRICs, but a significant reduction in the role played by the state looks unlikely. All four countries have fared relatively well in terms of growth over the past decade. It is therefore not surprising that the dominant political forces seem to be taking an “if it ain’t broke, don’t fix it” approach. Admittedly, state involvement is not per se a bad thing. In the case of market failure or in areas where the social returns exceed appropriable private returns, for instance, state investment may even be desirable. There are also successful examples of state-led economic development, even if failures have historically been far more common. Amongst other challenges, states face time inconsistency problems and need to avoid capture by factional interests. The more extensive and long-lasting the state involvement, the greater the risk of “capture” by rent-seeking interests, and the greater the negative impact on economic growth.

The role of the state in economic development is too complex to be adequately captured by a label. Nonetheless, there is no denying that the “Beijing consensus” and its cousins in Brasilia, Moscow and New Delhi have thrown down the gauntlet to the, often misunderstood, “Washington consensus”. This political reality notwithstanding, BRIC history suggests the urge to extend the role of the state without carefully evaluating the potential costs and benefits should be resisted. Intellectually, if not politically, the “burden of proof” should remain squarely on the shoulders of the “statists”.

BRIC sovereign wealth funds - the wealth of governments (2010)

BRIC FX reserve accumulation continues apace. As far as the BRICs are concerned, FX reserve accumulation is increasingly difficult to justify in terms of risk insurance: all four BRIC governments are net foreign (currency) creditors. Even if private- sector debt is included, national balance sheets look strong as far as solvency and liquidity are concerned. The performance of the BRICs throughout the crisis has also demonstrated their resilience, if not in terms of growth, at least in terms of financial stability. FX reserve accumulation is therefore characterised by diminishing returns in terms of insurance and increasing financial opportunity costs and (quasi-)fiscal losses. BRIC (and often EM) FX reserve accumulation is being driven by objectives other than risk reduction and financial return, namely: limiting exchange-rate volatility and/or preventing exchange-rate appreciation. By setting up sovereign wealth funds (SWF) with the goal of investing excess reserves more aggressively, the BRIC (and several other EMs) implicitly acknowledge as much.

Unless a government runs a fiscal surplus, it (or the central bank) needs to issue interest-bearing debt equivalent to the amount of FX reserve accumulation if FX purchases are to be fully sterilised. Similarly, unless an economy runs a current account surplus, FX reserve accumulation needs to be financed by an increase in foreign liabilities, whether in the form of debt or equity. For much of the 2000s, Russia ran both a fiscal and a current account surplus. China registered a current account surplus only. Brazil and India, by contrast, were running twin deficits.

From a sovereign perspective, financial returns on FX reserves are determined by the on-shore/off-shore interest rate differential, valuation changes and exchange rate effects. First, to the extent that the BRIC central banks issue sterilisation instruments, they will tend to run a negative carry, that is, they pay a higher interest on their domestic liabilities than they receive on their foreign assets. (China proved to be an exception in this regard during parts of the 2000s.) Second, valuation gains from exchange rate-depreciation vary. However, given relatively low inflation and faster productivity growth in the BRICs, valuations gains will likely be more limited than in the past. (China is even likely to sustain significant losses on the back of seemingly inevitable nominal exchange-rate appreciation.) Third, valuation gains tend to be limited given that a significant share of FX reserve assets is typically invested in short-term, high- grade debt (e.g. Treasury bills). The financial return prospects are not much better from a country perspective1. Depending on the country, valuation losses may remain unrealised, but losses resulting from a negative carry represent an actual cost to the public sector.

While initially the (quasi-)fiscal losses can be justified by declining external risk premia (esp. Brazil and Russia), excess FX reserve accumulation is more difficult to justify. Especially in the case of Brazil and India, countries with high levels of domestic debt and high domestic interest rates, it would be preferable to limit excess FX reserve accumulation financed by domestic debt issuance, as it adds to upward pressure on domestic interest rates. Although generating returns on official assets is not the primary objective and the fiscal costs are not prohibitive, it does make sense to invest excess reserves more aggressively to generate higher returns. This is why three of the four BRIC governments have set up SWFs. They differ in important respects. India has been debating the creation of an USD 10 bn SWF2.

Russia is a textbook example of a resource-dependent economy. Running both current account and fiscal surpluses throughout much of the 2000s, it made a tremendous amount of sense to absorb external surpluses into FX reserves and use the fiscal surpluses to sterilise the purchases by depositing them into an oil stabilisation fund. Russia is highly dependent on the export of volatile, largely non-renewable commodities. So is the government, indirectly. Accumulating FX reserves makes sense from both a stabilisation (volatile revenues, Dutch disease) andsavings―(inter-temporal equity) point of view.

In 2008, the Oil Stabilisation Fund, created in 2004, was split into a Reserve Fund and National Welfare Fund. The former was capped at 10% of GDP and its purpose was to provide the government with funds to finance future fiscal deficits. The latter aims at inter-temporal savings, mainly to support future pension outlays. The Reserve Fund currently has USD 39 bn under management, down from its peak of USD 143 bn just before the global financial crisis in mid-2008. The Reserve Fund only invests in foreign government bonds. The National Welfare Fund is worth USD 86 bn. The Fund can invest in higher-risk assets, including domestic assets, such as loans to domestic banks. The future size of the funds will critically depend on future oil prices and government fiscal performance. However, it currently looks as if the Reserve Fund may be depleted by 2011 owing to persistent fiscal deficits.

Unlike Russia, China has been running large and persistent current account surpluses and, indeed, capital account surpluses, but for the most part small fiscal deficits. In combination with a relatively fixed exchange rate, the central bank had to absorb these surpluses in the form of FX reserves. Until 2007, SAFE was solely responsible for managing PBoC FX reserve holdings. That same year, the China Investment Corporation (CIC), which currently has about USD 300 bn worth of assets under management, was created3. The Chinese government controls a number of other agencies and institutions that manage foreign assets (e.g. African Development Fund, Chinese Development Bank, National Social Security Fund, (partially) state-controlled banks, SOEs). In China, more so than in other countries, it is difficult to draw the line between public-sector- and private-sector-controlled assets. Moreover, SAFE or, more precisely, the SAFE Investment Company is estimated to have invested USD 300-400 bn in the form of ―non-reserve‖ assets4. So the CIC is not the only government vehicle to invest its foreign holdings more aggressively.

The costs of holding very large FX reserves (> 50% of GDP) are relatively manageable given relatively low on-shore rates, partly resulting from domestic financial repression, and a low government debt burden. Furthermore, as the economy continues to grow at double-digit rates in dollar terms, the fiscal costs, as a share of GDP, will be quite manageable. In fact, during parts of the 2000s, the on- shore/off-shore interest rate differential was in China‘s favour. China is, however, quite sensitive to capital losses in case of RMB appreciation. Continued FX reserve (or SWF) accumulation will likely continue apace given prospects of continued very large current account surpluses and, absent further liberalisation of capital outflows, continued capital account surpluses.

Unlike China and Russia, but like India, Brazil has been running both fiscal and current account deficits (with the exception of very small surpluses during 2003-07). A capital account surplus and a current account close to balance allowed the central bank to accumulate badly needed FX reserves following the 2002 crisis. Given double-digit on-shore interest rates, however, the ―financing― of FX reserves results in a substantial ―negative carry―. Nominal exchange-rate appreciation over the past few years has not helped, either. While reserve accumulation was instrumental in lowering external risk premia, and possibly domestic risk premia, further FX reserve accumulation will keep domestic interest rates high by adding to the stock of domestic government liabilities.

The Fundo Soberano do Brasil (FSB) was created in 2008. The central bank resisted the transfer of FX reserves to the FSB. In addition to an initial bond issue, the FSB will be financed primarily by fiscal revenues exceeding the targeted primary surplus, though in principle assets can be accumulated via appropriations assigned in the budget. It affords the government a great deal of flexibility; hence initial (and recently confirmed) concerns among some analysts that the government might use the Fund to intervene in the FX market. The FSB is very small and manages USD 9 bn worth of assets. The investment mandate of the Fund is quite flexible.

The Brazilian SWF also differs from the Chinese and Russian funds in that it has so far accumulated LCY assets via excess revenues or domestic debt issuance rather than FCY assets. Unless it uses these revenues to purchase FCY, however, it effectively raises (expensive) domestic debt to finance LCY assets. Given the significant interest rate differential, it makes less sense financially for Brazil to accumulate excess foreign assets than in the other BRICs – even more so, should the Fund remain solely invested in LCY assets. However, should the recent oil discoveries lead to both external and fiscal surpluses, the FSB could turn into a genuine savings fund‖. Both the stabilisation and inter-generational equity argument would then apply.

Without a doubt, China is by far the most important international financial player among the BRICs. In terms of official FX reserves, China currently holds USD 2,500 bn, compared with less than USD 300 bn in both Brazil and India, and USD 450 bn in Russia. It also holds the largest excess reserves, whichever way these are calculated, except in terms of M2. But as long as the government maintains restrictions on capital outflows, the relatively large stock of M2 does not represent a serious contingent claim on FX reserves, even if a relatively inflexible exchange rate regime remains in place.

China will also continue to accumulate more FX reserves than the other BRIC combined for the foreseeable future. The rise in net foreign assets has been staggering. Even in terms of the size of SWF, the CIC and SAFE Investment Company alone control USD 600 bn, compared with the FSB's less than USD 10 bn and Russia‘s (declining) USD 150 bn. The precise domestic-foreign asset split is not precisely known in either case (as far as we can tell). But, undoubtedly, China is the BRIC country with the largest amount of foreign assets held in SWFs, especially if SAFE Investment Company positions are included. Growing, if gradual, financial integration of the BRICs leading to a greater two-way flow of capital will also contribute to BRIC gross foreign asset accumulation. Even where reserve accumulation is financed by running up foreign liabilities (Brazil, India), governments will see their financial influence enhanced.

Central banks, which continue to control the vast bulk of public- sector, and often total, foreign assets, generally do not have the same discretion in their investment decisions, nor the expertise to generate higher risk-adjusted returns on their foreign assets than SWFs. However, even with the establishment of an SWF, it will be difficult for governments to "break even" and currency appreciation will lead to capital losses (in LCY terms). The benefits of continued official asset accumulation are therefore negative from a narrow financial point of view. The economic benefits, less easy to quantify, may be significant (e.g. competitive exchange rate, attract knowledge- and technology-transferring FDI in the export sector), and the fiscal costs, while tangible, will remain manageable. A greater focus on financial returns in the management of BRIC government assets will help limit (quasi-) fiscal losses, but will not eliminate it.

Last but not least, the more excess reserves a government holds, the more flexibility it has in terms of when and where and at what conditions to invest them. This allows the government to deploy hard-currency loans and financing in the pursuit of both commercial and non-commercial (political) interests. For instance, governments can extend FCY loans to domestic companies, whether state- controlled or not, at below-market levels in pursuit of national objectives (e.g. China‘s “going global” policy). The government can also provide loans to governments in pursuit of political objectives (e.g. Moscow‘s loan offers to Belarus) or to foreign suppliers in support of long-term supply contracts, thus ensuring access to strategically important resources (e.g. China‘s oil-loan deals with Brazil, Venezuela etc.). These are all options that none of the BRICs came even close to having a decade ago. In short, the BRIC governments have become financial players to be reckoned with.

See also BRIC sovereign wealth funds (Deutsche Bank Research)