Emerging Markets have little choice but to adjust to “excess” global liquidity (2011)

Emerging markets (EM) have generally been seeking to prevent (too rapid an) an exchange rate appreciation since the return of global risk appetite following the April 2009 G20 meeting. Judging by the magnitude of exchange rate changes and FX reserve accumulation, the EM-7 have been experiencing quite different levels of appreciation pressure over the past 24 months. It is noteworthy that five of the EM-7 have weaker nominal effective exchange rates today than before the crisis. Only Brazil and China have stronger or largely unchanged nominal effective exchange rates compared to August 2008. Incidentally, these two countries have also seen a sizeable increase in FX reserves.

Brazil expressed great concern about the monetary and capital flows implications of QE, not least because it faces greater difficulty in dealing with “excess” global liquidity on account of an open capital account and high on-shore interest rates. China, being less concerned about capital inflows than Brazil due extensive capital controls, expressed greater concern about US fiscal deficits given its massive holdings of US government debt.

Policymakers can respond to “excess” inflows in several ways, all of which incur costs – though these costs have to be weighed against the perceived benefits of stemming/slowing currency appreciation. (1) They can allow the exchange rate to appreciate. While this may diminish the attractiveness of local assets in the eyes of foreign investors, it is likely to lead to an “overshooting” of the exchange rate, slowing economic growth and a deteriorating current account position. (2) They can absorb capital inflows into official reserves. If FX intervention is left unsterilised, this will raise domestic inflation. If fully sterilised, this may or may not push up domestic interest rates, but it will typically add to the quasi-fiscal deficit. (3) They can try to limit capital inflows through capital controls and macro-prudential measures. Even if implemented successfully, this may have deleterious effects (e.g. lower secondary market liquidity and higher yields in case foreign fixed-income investors are targeted). (4) They can lower interest rates to reduce the on-shore/off-shore yield differential. Rising inflationary pressure means that this is not an option for EM at the moment. (5) They can tighten fiscal policy. While helpful at the margin, this is unlikely to eliminate “excess” capital inflows altogether. 

All responses dealing with capital-inflow-driven currency appreciation caused by low G3 interest rates and exacerbated by QE carry costs for the EM. While US policy actions have a considerable impact on EM, the reverse does not apply. None of the measures taken by the EM will have a material economic or financial impact on the US economy, let alone on the Fed’s decision to pursue QE or the US government’s decision to run large fiscal deficits. Several factors explain this asymmetry. The dollar exchange rate and, even more so, any bilateral exchange rate is far less important to the US than for its EM trading partners. It is precisely for this reason that the threat by EM to sell US assets in an attempt to influence US economic policy is not credible. Capital controls in other countries do not impose any tangible economic or financial costs on the US – other than perhaps opportunity costs for individual US investors. Protectionist measures targeting US exports are not very credible, for assuming the US responds in kind, these more trade-dependent economies would incur relatively greater economic costs than the US. Not only would the economic and financial, let alone political costs of such measures be far greater for these countries than for the US, the costs would also be greater than the benefits thus derived.

Put differently, the US pursues an economic policy – namely a lax fiscal policy and quantitative easing – it deems to be in its interest and however the EM respond to it is of little consequence to the US. This is a prime example of continued US “structural power”. Structural power is the power of a state to indirectly influence others by controlling the structures within which they must operate – in this instance, the international monetary system. This differs from “relational power”, or the ability of one state to influence another state's behaviour directly in pursuit of specific outcomes. This describes the situation quite accurately, for Washington is not seeking to influence other countries’ policies. It is simply pursuing policies it deems to be in its interest. Meanwhile, the EM have no way of influencing US macro-policy and are therefore left to deal with the QE-driven capital inflows and the implications of rising US government debt.

In short, the US retains maximum policy flexibility, while its choices have a very tangible impact on, and create significant constraints for EM economies. As long as other economies depend more on the US market for their exports than vice versa, they will not only be highly constrained in terms of policy options. They will also wield little in the way of influence that could induce the US to modify its policy. True, the US has thus far failed to get other countries, notably China, to appreciate their currencies. Whether one attributes this to a lack of US relational power vis-à-vis China or simply a reluctance on the part of Washington to wield its power, the fact of US structural monetary power remains the defining characteristic of today’s global monetary and financial system.

Rising dragon, falling eagle? (2011)

It is terribly tempting to regard the global crisis as the event that precipitated the decline of the US and the rise of China. The “rise and decline” school has gotten it spectacularly wrong before, however. During the 1970s, especially following the Vietnam War and during the economically difficult Carter years, the “declinists” – as incredibly as this may sound today – were worried that US economic decline would lose Washington the Cold War against an apparently ascendant Soviet Union. It turned out that it was the Soviet Union that was experiencing stagnation and decline, leading to its eventual economic collapse and political break-up a little more than a decade later.

During the 1980s, when the US was running record-high fiscal and current account deficits, Japan was going to emerge as “number one”. Exactly ten years after Ezra Vogel's 1979 book, Japan crashed financially and has ever since suffered an economic malaise. During the 1990s and early 2000s, the US “re-emerged” again as the most powerful economy with no serious challengers on the horizon, despite attempts to construe a German-led Europe and a recovering Japan as potential challengers. Following the 2008 financial crisis, the “declinists” are once more predicting US decline. This time, it is China that is set to rise and challenge US pre-eminence.

China does indeed look set to overtake the US in terms of economic size. Not only does China appear to have weathered the very crisis that pushed the US economy “off-course” pretty much unscathed. But China has been growing at an average annual rate of 10% since the beginning of economic reform in 1979. On current trends and on the basis of conventional PPP estimates, China will replace the US as the world’s largest economy within the next decade or so. Some well-respected China analysts, like Bert Keidel, even forecast the Chinese economy to be twice the size of the US by 2050.

While growth may slow down somewhat from double-digit levels, the medium-term term growth outlook appears solid. A low degree of urbanization and a low capital stock provide conditions conducive to continued strong growth. When Japan slipped into crisis, it had already reached the “technological frontier”. The Soviet economic model, based on “extensive” rather than “intensive” growth, was not sustainable, while geo-political competition forced Moscow to keep defence expenditure at ruinous levels. By contrast, China is generating both intensive and extensive growth. So if China manages to avoid geo-political competition, which the doctrine of “peaceful rise” seeks to achieve, China is likely to enjoy continued solid growth. This is the “China story” seen through the eyes of the bulls.

The China bears, on the other hand, not only expect Chinese growth rates to decline more substantially. But they also see other potentially dangerous speed bumps on China’s way to economic pre-eminence. To stick with this metaphor, a speed bump can slow one down. But if ones hits it at top speed, it may throw one off-course, or even into the ditch. These “bumps” range from increasing natural resource dependence and rising geo-political competition with 'status quo' powers (Friedberg 2005) over 'trapped (economic) transition' (Pei 2006) and a crisis of political legitimacy and political instability (MacFarquhar 2006) to the sustainability (or lack thereof) of China’s investment-focused and supposedly export-oriented growth model in case Beijing fails to shift the economy towards greater domestic demand-led growth (Goldstein & Lardy 2008).

One does not have to be a China bear to recognise that the downside risks outweigh the upside risks. However, China looks unlikely to be thrown off-course in the way the Soviet and Japanese economies were. Structurally speaking, China’s medium-term growth potential is very significant. The spanner that would need to be thrown into the works would have to be very massive. The Soviet and Japanese examples, nonetheless, suggest the need to re-examine periodically the viability of the current growth model to check whether it is appropriate given China’s stage of development. It also suggests that China may face considerable “known unknowns” and, one must assume, a non-negligible number of “unknown unknowns” (rewatch the Rumsfeld classic), though this can, of course, not be known, than the US. History, in any event, appears to counsel caution (and intellectual modesty), when it comes to extrapolating current trends a decade or more out into the future – if for no other reason that “if economists could get themselves be thought of as humble, competent people with dentists, that would be splendid”.

According to the US bears, the US outlook is dire. Huge fiscal deficits, a rapidly rising debt burden and a structurally lower level of economic growth post-crisis weigh on the US economic outlook. Potential growth has probably declined from 3% to potentially as little as 2%, the US manufacturing base has been severely weakened and the US is the world’s largest debtor. This sounds excessively pessimistic. US government debt is unlikely to exceed a 100% of GDP. Low real interest rates and some fiscal effort would make a structurally higher level of debt manageable. US external debt is also less of a problem than the numbers suggest, for US liabilities are denominated in dollars and the dollar benefits from reserve currency status, which is unlikely to be challenged in the near- to medium-term. This means that the US has significant room for maneouvre until the domestic political consensus on growth-enhancing economic reforms can be found.

Brazil, commodity prices & fiscal policy – Time to upgrade the fiscal policy targets (2011)

The Brazilian economy is booming. Foreign and domestic investor confidence is high. The new government confidently projects real GDP to expand at an average annual rate of 6% over the next four years, underpinned by rising public and private-sector investment. This compares with an actual average growth rate of 2.3% under Cardoso (1995-2002) and 4.1% under Lula (2003-2010).

A widening current account deficit has in the meantime made Brazil more sensitive to a precipitous decline in commodity prices, while the recent surge in capital inflows has made it similarly sensitive to a reflow of foreign capital. If it were not for a further projected rise in commodity prices, Brazil would be registering a trade deficit this year for the first time in a decade on the back of an appreciated exchange rate and burgeoning domestic demand.

The value of non-manufacturing exports as a share of total exports has risen to 60% against 40% a decade ago. Brazil has also absorbed large foreign capital inflows since Q1 2009. Capital inflows doubled from USD 85 bn in 2009 to USD 165 bn in 2010 (or a massive 7% of GDP). The stock of foreign portfolio holdings has tripled over the past two years and now amounts to USD 360 bn (or 15% of GDP). It is hence not difficult to see how Brazil has become more sensitive to a combined current and capital account shock.

Thanks to strong fundamentals such a shock would, similar to 2008, not jeopardise Brazil’s overall economic stability, for its aggregate balance sheet remains strong. In terms of external liquidity and solvency, Brazil’s position is very solid. While some of the recent capital inflows are potentially fickle, any currency depreciation resulting from a balance-of-payments shock would prove self-limiting given that an increasing share of nonresident claims are denominated in local currency. Last but not least, the systemically important bank sector carries a manageable FX exposure, both on-balance-sheet and off-balance-sheet. 

In terms of government finances, Brazil is similarly well-positioned. The public sector is a net foreign-currency creditor to the tune of 10% of GDP. Currency depreciation thus results in a decline in the debt-to-GDP ratio. Public debt has also become less sensitive to a sudden rise in interest rates, while interest rate volatility has declined. Moreover, the government does not directly depend on commodity revenues, other than by way of (limited) dividend payments. Compared to many other commodity-exporting countries, Brazil’s fiscal vulnerability is very low.

That said, the government should raise the primary surplus more aggressively, preferably via a reduction of current expenditure. This would not only be desirable in terms of dealing with capital inflows, currency appreciation, monetary policy and economic over-heating. It would also provide the government with greater fiscal space, should the knock-on effect of a terms-of-trade shock on the government’s fiscal position be larger than expected.

In this regard, the Dilma government has made a decent start by resisting demands for a greater increase in the minimum wage, to which a significant share of primary expenditure is indexed. Last month, the government also announced a reduction in planned current expenditure for 2011. Even if the government succeeds in implementing the cuts, primary expenditure would still rise more than 3% in real terms. However, given the backward-looking adjustment of the minimum wage, current expenditure is set to jump significantly next year. It would therefore be preferable to introduce a fiscal rule aimed at containing or, even better, reducing primary current expenditure over the medium term by, for instance, indexing its increase to be less than the rate of GDP growth. “Discretionary” fiscal cuts should be replaced by a medium-term, rules-based adjustment. As the Brazilian budget is characterised by extensive revenue earmarking and expenditure rigidity, such a rule might require “flanking” reforms.

Such a proposal was put forward by FM Palocci under Lula I. If this is politically not feasible, the government could consider switching from a “primary surplus” to a “structural primary surplus” target (that is, surplus adjusted for the economic cycle and, if necessary, the volatility of commodity-related revenue). Targeting the structural balance would help reduce the pro-cyclicality of Brazil’s fiscal policy. The government might even consider targeting a structural nominal deficit given the continued decline in interest rate volatility. However, given the medium-term trend towards rising primary current expenditure and the need for extensive public investment in the run-up to the 2014 World Cup and 2016 Olympics, it might be preferable to adopt a rule aimed at a reduction of current expenditure rather than a rule that might end up constraining the growth in public investment.

With the help of a credible, rules-based, medium-term fiscal policy adjustment, Brazil would be able to bring about a further structural downward shift in domestic real interest rates and a concomitant rise in domestic investment. This would not only help boost Brazil’s long-term economic growth. It would also help to reduce currency appreciation pressure or make a strong currency valuation more manageable over the medium term thanks to resulting productivity gains. Last but not least, it would provide the government with greater “fiscal space”, should a terms-of-trade shock end up having a greater-than-expected impact on the government’s fiscal position.

EM capital flows – portfolio equity flows up, bank lending down (2011)

Capital flows to EM-30 are forecast to remain at record levels, the recent Middle East related jitters notwithstanding. The stock of potentially fickle non-resident claims has increased tangibly in a number of EM since 2009. While this may increase the magnitude of a potential capital account shock, manageable foreign-currency mismatches will ensure that any sudden reflow of capital will eventually prove largely self-correcting.

Capital flows to EM-30 are forecast to remain at record levels over the next two years. Capital flows comprise foreign direct, portfolio (equity and debt securities) and other investment (trade, credits, loans and currency). By contrast, flows into dedicated EM funds, often used as a benchmark for gauging investor appetite, consist of portfolio investment, as defined above, only. As far as fund flows are concerned, there has recently been a pull-back due to the events in Egypt. The outlook for capital flows to the EM-30, on the other hand, will nonetheless remain solid and is forecast to average USD 900 bn in 2009-12 or 4.4% of aggregate EM-30 GDP. This compares to USD 800 bn in annual flows, or just shy of 7% of GDP, during the pre-crisis 2004-07 boom.

As a share of total flows, FDI and “other” debt flows will remain remarkably stable. Portfolio equity flows will jump from 10% to 20%, while bank lending will decline. This is not surprising given the capital constraints some, especially, developed market banks continue to face. It is in fact remarkable that after net inflows of 30 bn in 2008 and a small net negative flow of USD 15 bn, bank lending to EM should amount to a significant USD 125 bn annually.

Comparing 2004-07 with 2009-12, the most remarkable aspect that emerges is that a sharp increase in portfolio equity flows will almost entirely offset the decline in bank-related inflows. It is not difficult to see what is underpinning these flows. First, mega-low developed markets interest rates make it very attractive, for the moment, for developed market investors to “search for yield” in the EM space. Historically low offshore borrowing rates on account of low G3 interest rates and tight spreads also support inflows. This drives flows into both foreign- and local-currency denominated EM debt instruments. Local EM interest rates fell across the board in the aftermath of the 2008 crisis, but they have remained substantially higher than in the G3 throughout. Moreover, the short-term outlook is for rising EM rates due to growing inflationary pressures.

Second, many EM currencies looked fundamentally undervalued following the crisis and the “flight to safety”. Many EM have sought to slow down or even limit currency appreciation in an attempt to sustain export growth against the backdrop of low capacity utilization rates. Not surprisingly, EM with flexible currencies, high interest rates and open capital accounts have seen the greatest appreciation (e.g. Brazil, Turkey). Some of these currencies now look on the strong side, especially where the financing of their current account deficits is increasingly dependent on non-FDI inflows. Generally speaking, however, EM currencies do not (yet) look overvalued.

Third, improved EM creditworthiness on the back of a solid external position and sustainable public-sector debt have reduced the risk component of the risk-reward equation. This is particularly true relative to DMs, where many sovereigns have in some cases suffered multiple credit rating downgrades. EM sovereign credit ratings have resumed their improvement since the 2008 crisis. And a case can be made that the rating agencies are behind the curve with regards to both emerging and developed economies’ creditworthiness. CDS spreads signal as much. Most major EM sovereigns trade at 150 bp or below – inside of, or close to, many of the EU sovereigns.

Fourth, investors have adjusted upward their short- and medium-term growth projections for the EM, while they have downgraded their assessment of medium-term DM growth given concerns about debt sustainability and adverse demographic changes, especially in Europe and Japan. It appears reasonable for DM investors to increase exposure to EM economies, which are set to increasingly drive global economic growth for the foreseeable future.

Fifth, unlike in the 1990s, capital inflows, by and large, are not financing “excessive” current account deficits. Most major EMs are running current account surpluses, or if they do run deficits, these tend to be small and largely financed by FDI, a few EM excepted. This means that, unlike in the past, large capital inflows do not coincide with deteriorating EM fundamentals and rising net external debt. This should help lower the risk of, at least, credit-driven contagion.

The outlook is for continued, solid capital flows to the EM – short-term Middle East related jitters notwithstanding. A sudden, unexpected re-assessment of the inflation and interest rate outlook for the US and EU is perhaps the most significant near-term risk to the EM capital flow outlook. What if capital flows did stop or even reverse? After all, short-term non-resident claims have increased sharply, especially in countries with open capital accounts (e.g. Brazil, Turkey). In a scenario where foreign investors try to squeeze through a narrow doorframe on the way out, exchange rates and asset prices would decline sharply, in a way similar – though to a lesser extent – to late 2008. In the 1990s, massive capital account shocks drove emerging markets into, or to the brink of, insolvency (e.g. Mexico 1995, Asia 1997, Russia 1998, Brazil 1998/89 and 2002). Today’s more flexible exchange rates, overall improved external positions, the tendency of non-residents to accumulate short-term local- rather than foreign currency claims as well as the greater importance of intra-bank as opposed to inter-bank cross-border lending translate into generally manageable sovereign and country FCY mismatches. This will ensure that any shock will prove largely self-correcting – or, at least, it will be neither systemically destabilising nor will it risk triggering a sovereign credit event, as it would have done in the old days.

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.

Sino-US relations - coercion & deterrence (2012)

Following the mid-term elections in 2010, the Republicans were widely expected to shift US policy from a narrow focus on RMB appreciation to broader bilateral economic issues (incl. IPRs, procurement policies, state support for Chinese SOEs). While the Republican leadership in the House did end up preventing the anti-Chinese currency legislation from reaching the White House, parts of Congress remain highly critical of the executive’s handling of bilateral trade and currency issues, showing how high unemployment and large bilateral trade deficits continue to carry the potential of triggering a rise in bilateral tensions. 

Nonetheless, tensions should remain manageable for the foreseeable future. Beiing has resumed a gradual, controlled nominal appreciation of the RMB against the USD. A shift towards greater domestic-consumption-led growth in China, as laid out in the 12^th five-year plan, and a rising real exchange rate should help limit bilateral imbalances. Even if bilateral imbalances remain sizeable, this should allow the Treasury to manage political pressure emanating from Congress. Pro-business House Republicans are also likely to resist protectionist pressures on Capital Hill, holding the line against the more labour-oriented, less free-trade Democrats. 

It is nonetheless worth asking what would happen if the US administration were to take a more aggressive stance towards China regarding the RMB. Here it is useful to distinguish between “coercion” and “deterrence”. An agent A coerces agent B by getting B to do x by threatening y or promising z. An agent A deters by persuading B that the costs of a given course of action will outweigh its benefits. Deterrence aims to persuade the opponent not to initiate action by threatening to impose (or raise) the costs of this action, or by rewarding the other party for not doing so. Deterrence comes in two forms: (1) punishment by raising the costs of an action and (2) denial of objectives by raising the costs in such a way as to offset tthe coveted benefits of an action. Finally, deterrence is associated with maintaining the status quo, while coercion is usually associated with changing it. These concepts can be profitably applied to Sino-US economic relations. 

China seeks to maintain the status quo (export-oriented growth & undervalued exchange RMB), while the US would like to change the status quo (reduction in bilateral trade deficit & appreciation of the RMB). Rising cross-border asset holdings and trade have increased interdependence, raising the absolute costs of economic conflict for both sides – but the costs of a trade conflict are relatively higher for Beijing than for Washington. This is so because the US market is substantially more important to China in terms of both exports and imports than vice versa. Chinese exports are also relatively more employment-intensive than US exports. 

While China’s substantial creditor position does not provide it with coervice power at present, it has arguably increased its deterrent potential, thanks to its vast holdings of US debt and its continued financing of US current account and fiscal deficits. Nonetheless, if push came to shove, Beijing’s deterrent would not be powerful enough to deter US pressure completely, but it is likely to make the US administration think twice before lending its support to a more aggressive stance vis-à-vis Beijing.  

True, China’s export dependence on the US diminishes its ability to take advantage of its creditor position and credibly coerce the US to adjust its economic policies by selling (or threatening to sell) its US debt holdings or withholding financing. China does, however, possess a growing economic-financial deterrent potential vis-à-vis the US in terms of raising the absolute costs to the US in the event of exploiting its bilateral creditor status. Incidentally, this may help explain why the US has thus far abstained from naming China a currency manipulator. After all, the US Treasury did name South Korea, Taiwan, and (then, less powerful) China currency manipulators in the late 1980s and early 1990s. 

China is benefiting from its deterrent potential in terms of preserving, or at least minimising, changes to the status quo. Beijing does stand to lose more in relative terms in case of a conflict. This is certainly a plausible interpretation of the BPoC’s greater tolerance of RMB appreciation whenever US pressure rises. From Beijing’s point of view, a controlled appreciation of the RMB is a small(er) price to pay to stave off protectionist measures. Meanwhile, the rising absolute costs of a Chinese financial response will make the US administration think twice before taking a more aggressive stance vis-à-vis Beijing.

The US will continue to run current account and fiscal deficits and it will rely on Chinese financing. From a US perspective, rising indebtedness will translate into a rising transfer of fiscal resources to China. If Chinese holdings of US treasuries were to amount to 20% of GDP in 2015 (as it would under quite plausible scenarios), this would roughly translate into a fiscal transfer from the US to the Chinese government of around 0.6% of US GDP annually, assuming a nominal average interest rate of 3%. A doubling of nominal interest rates (or the debt ratio) would, all other things being equal, double US interest payments to China as a share of GDP. Rising interest payments would also add to the current account deficit. But this wouldn’t break the bank.

That said, unless the US manages to implement a very significant reduction in its fiscal and current account deficits, the financial balance of power will shift in China’s favour. Such a shift is far from inevitable, however. Given that its liabilities are denominated in dollars, the US government is in a position to maintain a balanced relationship even after Sino-US trade relations become more symmetrical. If the US manages to put its fiscal house in order, its vulnerability vis-à-vis China will remain quite manageable. By ensuring debt sustainability, the Treasury will always be able to find a marginal buyer for its debt at a reasonable price, even if a major investor (like China) were to lose appetite for US debt. If, on the other hand, the US fails to put its fiscal house in order, the economic-financial balance of power will shift decisively in China’s favour and may provide China with gradually growing coercive financial power by 2030 or so. 

With China lacking coercive power in the – from Washington’s point of view – benign scenario, Washington will continue to run its fiscal and monetary policies as it sees fit without facing the risk of being coerced by China into changing its policies. The ability to do so is underpinned by the United States’ “exorbitant privilege” (Giscard), that is, its ability to finance large and persistent current account deficits in its own currency. Sheer market size and developed financial markets and, ultimately, the dollar’s reserve currency status account for so-called structural power and weaken the financial-political power of the surplus countries (incl. China), as long as they are– or perceive themselves to be – dependent on the US market in terms of economic growth. This certainly was the case in the past when Germany and Japan were running large surpluses. China’s inevitably diminishing bilateral trade dependence and increasing creditor status will therefore not necessarily tip the bilateral balance in China’s favour.

Brazil after the elections - what's next? (2010)

Underpinned by a strong political consensus, the main thrust of economic policy will remain unchanged under the new president. A modest and hence manageable erosion of the macroeconomic policy framework, which started under Lula II, looks set to continue. Thanks to much improved fundamentals and the availability of greater “macroeconomic” space, this won’t jeopardise financial stability or undermine economic growth during the next four years. It will however limit Brazil’s upside growth potential and complicate economic policy management in the context of continued strong capital inflows.

The Dilma government will, by and large, bring policy continuity. The incoming government has little incentive to change the basic direction of economic policy. The political consensus in favour of economic stability, especially low inflation (benefitting the poorer social groups) and fair, if not stellar, economic growth (benefitting everybody, including the government, which has more money to spend) is strong. While this will prevent the government from pushing up economic growth at the expense of higher inflation, it will also limit the government’s appetite for big-ticket, growth-enhancing structural reform – especially given the trade-off between the short-term political costs of reform and their medium-term economic benefits.

The new government will not make fundamental changes to the basic economic policy framework that has served Brazil well over the past eight years. However, it will likely take a less purist approach to adhering to the framework, including quantitative targets. First, the government will remain committed to a sufficiently large (recently revised) primary surplus target of 3.1% of GDP. However, repeated accounting changes have reduced fiscal transparency and opened the government to criticism that it seeks to obfuscate the underlying deterioration in fiscal performance. 

Quasi-fiscal spending in the guise of lending by public sector banks and investment by state-owned companies will also continue, albeit at a lesser pace. To be fair, the government remains committed to reducing net public debt to 30% of GDP by 2014 from just over 40% at present and it has re-affirmed the need to restrain expenditure. (It would be desirable to reduce gross debt equally aggressively.) However, no specific proposals have been put forward so far in terms of reining in current expenditure and the significant amounts of investment required in the run-up to the 2014 World Cup and the 2016 Olympics will make it difficult to reduce investment expenditure.

Second, in terms of monetary policy, the authorities seem to have adopted a less hawkish stance. Market expectations are currently for an inflation rate of 5.2% in 2010 and 5.7% in 2011, way above the 4.5% mid-point of the 2.5-6.5% target range. A medium-term inflation rate of, for example, 5.0-5.5% rather than 4.5% would not destroy the central bank’s hard-won credibility but it does carry the risk of undermining it somewhat. While reaffirming the central bank’s independence, the government announced its desire to overhaul the IPCA inflation index. Rightly or wrongly, this has left the market with the impression that the government may be trying to influence monetary policy through the backdoor. Similar to fiscal policy, an erosion of the monetary policy regime at the margin might prevent a faster decline of real interest rates via a reduction of inflation volatility and an anchoring of inflation expectations.

Third, the government continues to adhere to a “dirty float”. But this float has recently become “dirtier”. The central bank’s intervention policy is quite asymmetric: it intervenes when the currency is under appreciation pressure, but it acts much less forcefully when the currency is under depreciation pressure. This is not necessarily unreasonable but does suggest that the authorities seek to limit currency appreciation or, to put it more politely, prevent “excess volatility” and overshooting, especially since the level of precautionary FX reserves is above levels generally considered safe.

Recent changes providing the Treasury with greater flexibility to purchase foreign currency and aiming to make the sovereign wealth fund fully operational in terms of FX intervention point in the same direction. Combined with the re-introduction and subsequent incremental tightening of capital controls, Brazil is moving towards a more controlled and less freely floating exchange rate regime. One may legitimately disagree about the desirability of these moves. The fact remains that the policy regime is being modified, or eroded, if one happen to be critical of these changes.

Taking advantage of a greater monetary and fiscal space, the Dilma government is likely to adhere less strictly to the “letter” or, at least, the “spirit” of the monetary and fiscal targets and take a more “controlling” approach to exchange rate policy. In this sense, the Dilma government represents the continuation of the Lula II government, as opposed to the much more “orthodox” Lula I government. None of this will prevent economic growth from averaging 4-5% over the next few years. However, the more “flexible” fiscal stance and, specifically, the continued expansion in current spending, will be contributing to a sub-optimal policy mix by keeping interest rates at elevated levels. This policy is not only preventing a (faster) rise in domestic savings, investment and growth. By preventing interest rates from declining, it is also decidedly unhelpful in dealing with ample global liquidity, rapidly rising capital inflows and the – from the government’s point of view – economically “nefarious” consequences of currency appreciation.

Concerns about a marginal erosion of the policy regime notwithstanding, Brazil does carry an investment grade rating, enjoys solid external fundamentals and significantly greater room for manouevre (or slippage, if you happen to a critic) than in the past. Greater discipline and a stricter interpretation of economic policy targets would nonetheless help to address rising concerns about a potential drift in Brazilian economic policy.

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)