Time for China to become more Brazilian (2013)

What could China possibly learn from Brazil, economically? After all, real GDP growth in Brazil averaged 2.75% annually over the past three decades, compared to 10% in China. Moreover, Brazil’s consumption-oriented growth model is about to exhaust itself, while China’s investment-focussed strategy continues to generate high, if somewhat diminished economic growth. Factor in the social, environmental and political consequences and it becomes clear that China’s growth model needs to change as well. Therefore: Brazil would be well-advised to become more “Chinese” in terms of savings and investment behaviour, while China would benefit from becoming more “Brazilian” in terms of consuming more (saving less).

Brazil’s economic growth has disappointed in the past couple of years. After increasing more than 7% in 2010, real GDP growth decelerated to 2.7% and 0.9% in 2011 and 2012, respectively. Even if real GDP growth recovers to slightly more than 3% this year, it will be below the 4% growth level Brazil got accustomed to over the past decade. While economic growth has disappointed, household consumption has remained resilient due to rising incomes, tight labour markets and the greater availability of household credit. Investment growth, by contrast, has been very weak, especially in the manufacturing sector. This is largely due to rising labour costs, a strong currency and a lack of productivity-enhancing structural reform. Brazil may be showing symptoms of Dutch disease.

The combination of strong consumption and relatively weak investment growth will sooner rather than later force the authorities to choose between higher inflation and lower growth – if this has not already happened. For now, the president continues to benefit from high approval ratings, recent protests notwithstanding, against the backdrop of a strong labour market, rising household incomes and expanding consumption. But the government seems to have realised that greater investment is necessary to keep employment and income growth going over the medium term. The government has been seeking to expand lending by public-sector banks, accelerate public-sector investment, reduce labour and production costs through tax cuts and exemptions and create and/or offer more favourable conditions for/to private investment in infrastructure projects (e.g. sales of infrastructure concessions). Unfortunately, this has thus far failed to trigger a rise in domestic investment.

Chinese GDP growth has slowed down from more than 10% a year to a still high 8% or so. Nonetheless, capital-intensive growth is having an increasingly adverse ecological impact. Investment-led combined with export-oriented growth makes the economy more vulnerable to exogenous shocks and creates incentives to engage in potentially risky quasi-fiscal stimulus policies (2008-09). Last but not least, more service-sector and consumption-oriented growth would be more employment intensive. As such, the political incentives to modify the growth strategy certainly exist, and they are growing larger.

Admittedly, Chinese household consumption is growing rapidly, but so is GDP, while household income remains very small as a share of GDP. Savings remain high across the government, corporate and household sector. Household savings are high in part due to an under-developed social security regime, creating significant incentives to accumulate precautionary savings. Household incomes are weighed down by extra-low returns on household assets due to financial repression. By contrast, corporate savings and investment are high due to a favourable tax and dividend regime as well as an undervalued exchange rate and cheap credit, favouring investment in the export-oriented, capital-intensive manufacturing sector. China has taken measures to raise domestic consumption, mainly by expanding social welfare coverage, providing tax incentives and gradually appreciating the exchange rate. Plans to liberalise interest rates, thus boosting household incomes and raising the cost of capital, and to raise corporate dividend pay-outs are also in the works, amongst others.

Source: IMF

The structural differences between Brazil and China have thus remained very striking. In Brazil, the household sector has limited incentives to generate precautionary savings. An extensive social security and pension regime incentivises households to consume rather than save. In China, the household sector faces the opposite problem: the social welfare regime is not very extensive. In Brazil, the corporate sector is facing very high borrowing costs (in part due to low domestic savings), which limits profitability. In China, the corporate sector has access to very cheap funding due to high savings and financial repression. In Brazil, the exchange rate is overvalued, limiting the incentives to invest in export-oriented industries, while in China the exchange rate - at least until recently - had been undervalued, favouring investment in the export-oriented manufacturing sector. The list goes on.

Policy-makers in both countries have acknowledged the need to adjust their economic strategies; and the political incentives to adapt their respective models do exist, too. Both governments have taken a number of measures in the past few years, but respective consumption/ savings patterns have changed only little in the past few years. Chinese savings have declined a little, but investment is actually higher today than it was before 2008-09. (While the combination of higher investment and somewhat lower savings/ higher consumption has helped narrow the politically-contentious external surplus, it has made the economy even more dependent on investment.) Admittedly, neither Brazil nor China has taken overly aggressive measures to achieve their respective objectives. But savings, consumption and investment patterns perhaps only change slowly.

Perhaps fundamental factors such as demographic trends and cultural or historically-inherited attitudes (e.g. hyper-inflation) are also at work. This does not mean that government policies will not have any effects – only that they need to be pursued more forcefully if Brazil and China are to shift their economic growth models towards greater investment and greater consumption, respectively.

Of reversing the Great Divergence and passing the baton (2013)

Economies’ relative weight has been changing rather dramatically over the past few decades – most notably in the case of China. At the beginning of economic reforms in the late seventies, following almost half a century of economic and political instability, China’s share of global GDP was a mere 2.2%, according to the IMF. By 2020, its share is set to exceed 20%. Economic historians estimate that China acounted for 1/3 of global economic output in 1820, just before what has come to be known as the “great divergence” (Pomeranz 2000). In 2017, China will replace the US as the world’s largest economy (in PPP terms). This will be the first time since 1872 – when the US overtook Britain as the world’s largest economy – that a new “number one” will emerge. Between 1870 and 1910, the US nearly doubled its share of world output from less than 9% to almost 16%. Following the devastation of most major economies, the US emerged from WWII accounting for 27% of world GDP. With the recovery of war-devastated economies, the US share began to decline. On current trends, the US share will continue to decline and the Chinese share will continue to increase, but India will be just about the only country with the potential to replace the US as the world’s second-largest economy. But this is unlikely to happen before 2050. Beyond India, there are simply no other potential contenders.

Source: IMF

Which of the emerging economies is afraid of higher interest rates? (2013)

The emerging markets weathered the 2008-09 global financial crisis without sustaining structural damage. True, a small number of EMs received liquidity support from the IMF. But thanks to by and large sound fundamentals, the EMs adjusted to the capital (and current) account shock through a combination of FX depreciation, central bank liquidity support and domestic economic contraction. In the past few years, global financial conditions have been very supportive, as reflected in ultra-loose monetary policies in the major advanced economies and strong capital flows to the (higher-yielding) EMs. So it may be time to ask which EMs are most exposed to a sharp slowdown in capital flows.

A variety of indicators are used to gauge an economy’s sensitivity to capital account shocks. Perhaps the most commonly used one is external financing requirements (EFR). EFR are equivalent to short-term debt, medium- and long-term debt amortisations and the current account in relation to FX reserves. Admittedly, in today’s world where the capital accounts of the major EMs are relatively open and foreign investors hold in some cases significant amounts of LCY-denominated portfolio debt and equity, potential balance-of-payments pressure can far exceed EFR.

However, it is clear that non-resident LCY - and especially equity-claims will weigh far less on the balance-of-payments than short-term FCY-denominated debt claims. This is particularly true in the case of economies with floating exchange rates. Moreover, EFR do not include either non-reserve assets or foreign assets held by the private sector. In spite of these limitations, EFR provide a fair idea as to the potential vulnerability of an EM in the event of an external liquidity shock.

A rule of thumb says that an EFR ratio of less than 100% is “safe” in terms of even a severe balance-of-payments crisis. In fact the Greenspan-Guidotti rule says that FX reserves should at least be equivalent to short-term foreign debt (on a residual maturity basis). Given that EFR include current account related financing needs, EFR of less than 100% are therefore reflective of a pretty solid liquidity risk profile. Moreover, China, Korea and Russia run small current account surpluses, but short-term debt (on a residual basis) in all these countries amounts to less than 50% of FX reserves in 2013. The EFRs are especially favourable given that most of the large EMs have relatively free-floating exchange rates. China and Russia, the EMs with the least flexible currency regime, incidentally have the lowest EFR. Only Turkey is bit of an outlier. Last but not least, it is worth comparing current EFR to those observed just before the massive global shock of 2008. Korea, Poland (not even taking account IMF FCL) and South Africa have much stronger positions, while India and Indonesia have slightly weaker (but still solid) positions (< 100%). Only Turkey’s EFR are today both higher than in 2008 and above the 100% threshold.

In the past, so-called sudden stops or capital flow reversals often translated into higher government debt ratios and worsening sovereign risk. If FCY risk is concentrated in the systemically important sector government or banking sector, a capital flows shock can quickly transmute into a systemic crisis. Today, however, the consolidated public sectors in all major EMs are net FCY creditors. Many EMs have put in place regulations limiting the extent to which banks can run FCY risk, while more flexible exchange rate have removed banks’ incentives to run open FCY positions, thus limiting FCY risk in the systemically important banking sector.

To sum up, the top-10 emerging economies appear well-prepared to withstand a significant tightening of external financing conditions. External liquidity indicators are roughly comparable to those observed just before the massive 2008 global financial shock. Turkey is the EM most sensitive to tightening financial conditions on account of both its large short-term external debt and large current account deficit. Thanks to limited FCY mismatches in the government and banking sectors, an adverse external liquidity shock would translate into currency depreciation and a potentially sharp economic slowdown à la 2008-09. To what extent such a scenario would impact the corporate sector, where virtually all of the FCY risk is concentrated, and to what extent this would impact the banking sector’s financial position by way of their FCY lending to the domestic corporate sector would in part depend on how prolonged currency weakness and the economic slowdown last. Systemic risks appear nonetheless manageable for now, not least because the banking sector is well-capitalised.

Gross government debt vs government net worth (2013)

Gross general government is the most frequently used indicator in terms of cross-country comparisons. The concepts covers the financial liabilities of the central and sub-national governments. While it takes into account social security funds, it does not include the liabilities of financial or non-financial government-owned enterprises. It also fails to account for government assets. Net general government debt, for instance, nets out the general government’s financial liabilities and assets (with the exception of shares, equity and derivatives). Consolidating the assets and liabilities of both the general government sector and the central bank, one arrives at ”net financial worth of the consolidated government and central bank sector”. One could go further and take into account non-financial assets owned by the government (e.g. buildings, land) to arrive at “net worth.” Last but not least, one could add the assets and liabilities of government-owned companies as well as government equity holdings of partly privatised enterprises into the mix to arrive the broader public sector’s net worth. If nothing else, the broader concepts suggest that in terms of stock (if not necessarily, flows), the financial position of many advanced economy governments are not as bad as the general government debt concept might suggest – especially in the case of Japan.

Monetary power & European monetary integration (2012)

Germany’s economic power allowed it to extend its economic model on the rest of Europe. It is not just Germany, of course. Other countries share German policy preferences, largely creditor nations. Germany’s economic power has been increasing over the past few decades. Today Germany is economically and financially the dominant economy in Europe. As such, its ability to influence the economic policies of other countries and its ability to influence the future evolution of the European macroeconomic policy regime is considerable. 

What are the sources of German economic power? First, Germany is the largest economy. Second, Germany has very strong public finances. Third, the capacity to raise debt is significant. Fourth, Germany runs external surpluses and is a large net foreign creditor. Without German’s financial strength, any bail-out regime will be inadequate. This effectively means that German non-participation dooms any bail-out regime. If, for example, Finland decided not to contribute to a financial rescue, it would not significant diminish the regime. That said, rising trade and financial integration has also made Germany both more sensitive and vulnerable. Economic-financial interdependence often is asymmetric and this asymmetry provides Germany with a great deal of influence in European economic and financial affairs. 

The (West) German economy has been characterized by a specific combination of institutions, ideology and interests, creating a German model of macroeconomic management. The combination of these institutions somewhat inadvertently led to the rise of Germany structural power (Strange). In a way, Germany obtained economic power as inadvertently as some people say Britain acquired its empire: in a fit of absent-mindedness.

What institutions underpin the German model? First, the West German government established an independent central bank tasked with maintaining low inflation. (This was largely the result of the experience with hyperinflation in the 1920s.) By contrast, central banks in other major West European countries were not as independent or not independent at all. Germany was able to establish a track record of monetary stability and maintain inflation rates at levels consistently below those of the other major European economies, such as France, Italy and the UK. 

Second, the government made far more modest use of an activist fiscal policy to support economic growth. Keynesianism experienced only a very short-lived popularity in the late 60s and early 70s. Ultimately, it was the priority accorded to price stability rather than growth and an independent central bank unwilling to accommodate expansionary fiscal policies that put paid to activist fiscal policies. A relatively high degree of economic openness also limited the effectiveness of fiscal stimulus measures. Last but not least, German ordo-liberal thinking dominated economic policy. More speculatively, Germany, aware of its precarious position as a frontline state, was also more concerned about high public debt than other European countries.

Third, the structure of the German wage bargaining system, dominated by unions in the export sector, typically resulted in wage moderation. Thus export openness contributed to relatively lower wage inflation (adjusted for productivity) than in other countries where wage bargaining was dominated by unions operating in sheltered sectors, including public services, or more militant unions, period. An independent central bank whose actions would have helped increase unemployment rather than accommodate inflationary wage settlements was important. The wage bargaining ha undergone important changes since the nineties, but it remains geared to preserving German economic competitiveness.

These institutional features created a macroeconomic policy regime that prioritized low inflation over economic growth and ended up relying on exports for economic growth rather than activist and potentially debt-increasing fiscal policies. Not only did this allow Germany to establish a track record of monetary and fiscal probity. It also contributed to structural trade and current account surpluses throughout much of the post-war period. The commitment to financial stability and external surpluses increased German power as Europe became economically and financially more integrated. This became increasingly evident following the break-up of the Bretton Woods system and the creation of (various) European exchange rate regimes.

In the context of balance-of-payments imbalances, power derives from the “capacity to avoid the burden of adjustment required by payments imbalance” (Cohen 2006: chapter 2). This provides the surplus country with autonomy and constrains the policy space of the deficit country. While the surplus country is autonomous, the deficit country will sooner or later be forced to either devalue (so-called expenditure-switching policies) or adjust monetary and fiscal policies (expenditure-changing policies) to address the external disequilibrium. The external equilibrium needs to be restored via decreased domestic absorption and increased exports. 

The autonomy of the surplus country is reflected in its greater power to delay and deflect economic adjustment. If the deficit country does not adjust, it will eventually run out of reserves, as the markets will become unwilling to finance the deficit. The surplus country, by contrast, is able to hold out much longer by absorbing balance-of-payments surpluses in to FX reserves. This may or may not have economic consequences somewhere down the line (e.g. inflation). But it is clear that, unlike the deficit country, the surplus country can choose to resist nominal exchange rate appreciation more easily and is less readily forced to adjust its macroeconomic policy mix. In general, the surplus country finding it easier to both delay and deflect adjustment is able to stick to its macroeconomic preferences, while the deficit country is not. 

It is useful to distinguish between the permanent costs of adjustment and the transitional costs. The transitional costs associated with a change in economic policy typically falls on the deficit country. The permanent economic costs in terms of output and domestic consumption are always shared, even though they are typically felt much more strongly in the deficit country. After all, the deficit country needs to reduce domestic absorption and export more, while the surplus country (in a two-country model, at least) will need to increase domestic absorption and reduce exports, if balance is to be restored. Put differently, a devaluation of the deficit currency will lead to the revaluation of the surplus currency. The question hence is which country will adjust its economic policies and sacrifice or compromise its macroeconomic policy preferences. For instance, will the deficit country forego growth in the interest of monetary and fiscal discipline, or will the surplus compromise its monetary and fiscal discipline in order to help restore the external equilibrium.

This analysis becomes especially relevant in the context of fixed (but adjustable) exchange rate and particularly in the presence of an open capital account. There the so-called ‘unholy trinity’ emerges. In this context, the ability of the deficit countries to pursue an independent monetary and, to some extent, fiscal policy is heavily constrained. The country that benefits from the largest current account surpluses, the largest government debt market and the greatest financial credibility will tend to be the only country capable of pursuing an independent monetary and fiscal policy. Even the lesser surplus countries often find their policies constrained the so-called anchor country. If the capital account is closed, countries enjoy (short-term) policy flexibility, even if expansionary policies will ultimately result in devaluation. If the capital account is completely open, even short-term policy flexibility does not exist if the exchange rate peg is to be maintained. 

Source: Economist

Again, this does not mean that the stronger country is an invulnerable position in terms of the permanent adjustment costs. It simply puts it into a relatively less vulnerable position. For instance, a massive currency devaluation of a deficit country will lead to greater economic turmoil there in the surplus country that will see its currency appreciate, not least because the economy of the devaluing currency is only one among many trading partners of the surplus economy.

The emergence of a fixed exchange rate regime in the 1970s and an increasingly open capital account regime in the 1980s in Europe led to the emergence of the deutschmark as the anchor currency in Europe. It increased the constraints on economic policies other countries were able to pursue. This provided Germany with structural power vis-à-vis other European countries. Structural power is the power of a state to indirectly influence others by controlling the structures within which they must operate (Strange 1996). 

This type of power is not relational, however, in the sense that while it constrains it does not lend itself as a tool to exercise direct influence on another actor’s behaviour. Structural power  (Susan Strange) confers broad policy autonomy, but it does provide the anchor county with direct leverage of other countries’ economic policies. Ultimately, countries not willing to be constrained in this way could always opt to float their currencies, typically at manageable economic - but not necessarily political - costs. Last but not least, structural power does not translate into readily quantifiable, tangibly economic gains, either. It simply means that the structurally dominant country can pursue its preferred economic policy, while indirectly and inadvertently forcing others to adjust their policies.

Famously, this type of power was put into relief during the early 1990s. Reunification had led to a rising demand and price pressures in the German economy, leading the Bundesbank to raise interest rates. However, other ERM countries were cyclically in a very different position. In the face of ‘speculative’ attacks, a number of countries were forced to devalue. This demonstrates neatly the structural nature of German power. German policy-makers, unlike others, enjoyed policy autonomy. By taking advantage of this autonomy, they set the constraints under which other policy-makers had to operate. By contrast, the other countries saw their own policy space heavily constrained.

The advent of EMU and actually one of the reasons why EMU came into existence was because the deficit countries were eager to remove the balance-of-payments constrained and thus diminish German power by supra-nationalising monetary policy. In the context of a monetary union (read: irrevocably fixed exchange rates), balance-of-payments deficits will always be financed by the private- or, failing this, by the official sector. On the flipside, the fiscal constraint becomes tighter for financially/ fiscally weaker countries. Fiscal problems cannot easily be addressed by way of a growth-boosting devaluation. The lack of control over monetary policy removes a further tool to address fiscal imbalances, at least in the short term. Put differently, monetary union removes expenditure-switching (read: devaluation) as a policy option and leaves weaker countries only with expenditure-changing policies (read: fiscal austerity).

The move from fixed (but adjustable) exchange rates to monetary union helped enhance the power of the economically stronger country in similar way the move from a closed to a an open capital account in the context of a fixed exchange rate regime strengthened the power of the surplus country. Similar to balance-of-payments imbalances, large fiscal deficits and/ or rapidly rising debt weaken the policy autonomy of the financially weak country. The fiscally stronger country, enjoying superior access to market funding at cheaper rates, enjoys far greater policy autonomy. Similarly, the ability of the fiscally weaker country to defer or deflect adjustment compared with the country with sound public finances is much weaker. The strong country can choose to maintain fiscal discipline or it can decide to pursue expansionary policies, thus supporting the short-term adjustment of the fiscally weaker countries via higher growth. However, not facing immediate market pressure to adjust policies, it is in a position to delay and deflect adjustment. The financial weak country is not. 

Again, adjustment is always mutual, complementary and shared in the sense of the eventual economic costs. They are also typically much larger in the case of the weaker country. The question is once more who will bear the transitional costs in terms of adjusting fiscal policies. Will the fiscally stronger country boost domestic demand and, especially in the context of fixed rather than flexible exchange rate, help boost economic growth in fiscal weaker country, thus supporting adjustment there. Or the will the fiscally weaker country be forced into fiscal retrenchment, potentially leading to a decline in economic growth and a further deterioration of the fiscal position. To a significant degree, this is a question of whose policy preferences will prevail and which country will absorb the ‘transitional costs of the adjustment’. 

The fiscally and financially stronger country is not invulnerable. Fiscal austerity will reduce export growth and, more extreme, a sovereign default would typically lead to financial losses in the fiscally stronger country to the extent that it holds claims. Potential financial contagion could further raise the economic and financial costs. However, the costs to the defaulting country will almost always by far exceed the costs incurred by the financially stronger country. The stronger country may not be invulnerable, but its relative stronger position confers its significant leverage vis-à-vis financially weaker governments by way of the provision of conditional financing. This leverage does lend itself more easily to the exercise of relational power, that is, the power get another state to take actions it would otherwise not have taken.

The sources of German financial and ultimately relational power are similar to the sources of structural power in the case of balance-of-payments imbalances. In addition to running external surpluses and having established a solid monetary and financial track record, other factors matter.

First, Germany is among the larger European economies the one with greatest borrowing and lending capacity. This is currently reflected in lower debt ratios, a lower fiscal deficit, an AAA credit rating and, most revealingly, in low yields on government debt. The combination of economic size and borrowing capacity makes Germany the most powerful country in terms of its ability to extend credit to other countries in financial need.

Second, Germany is constitutionally obliged to run a structural surplus (so-called ‘debt brake’). This provides investors with some assurance that government finances will remain on a sustainable path. Moreover, from a more short-term perspective, Germany’s short- and medium-term fiscal outlook will not force it to implement growth-diminishing fiscal austerity. It also has a greater capacity to generate economic growth through extra-EMU exports, offsetting weaker intra-EMU exports, than most other European economies. 

Third, German debt is a ‘safe haven’ asset for EUR investors in the context of monetary union. Due to its track record of monetary and financial stability as well as its large current account surpluses, investors are willing to lend to Germany in times of market stress, typically at very favourable conditions. This has thus far led to an easing of Germany financing conditions, further underlining its continued ‘anchor’ economy function in the context of EMU.

In short, the Germany benefits from the largest borrowing capacity and the most favourable interest rates. The resulting ability to offer financial support to other governments, bilaterally or multilaterally, provides it with political leverage. Due to its ability to offer conditional financial support in exchange for a change in policy, Germany is the most powerful country in Europe as far as economic policy is concerned. EMU has enhanced not only enhanced German power by narrowing the policy and especially fiscal policy space of the other European countries relative to Germany. Naturally, this is not necessarily a permanent feature of EMU. Germany’s strength is to some extent the function of lack of fiscal discipline and/ or prudence in other countries. EMU has also led to a qualitative change. Power is (much more) relational today, as opposed to (primarily) structural pre-EMU. Germany certainly is not in a position to single-handedly bail out the rest of the Eurozone governments, but its participation in any rescue effort is indispensable if it is to be credible.

Is Germany a regional hegemon? According to Keohane (1986), the hegemon “must have access to crucial raw materials, control major source of capital, maintain a large market for imports, and hold comparative advantages in good with high value added, yielding relatively high wages and profits”. This definition is somewhat expansive. A weaker version requires the hegemonic state to be “powerful enough to maintain the essential rules governing interstate relations, and willing to do so” rather than “structural domination”. Germany does have access to raw materials, even though this access is taking place on a commercial rather than a political or jurisdictional basis. Depending on how narrowly one defines this characteristic, Germany may or may not meet it. It does however meet all the other criteria. Germany is undoubtedly the largest provider of capital in Europe. Its current account surplus (equivalent to net capital flows) is running at around 4-5% of GDP (or EUR 200 bn). It is also the largest producer of capital goods. Not only is Germany the largest economy in EMU, it is also the largest market of intra-EMU imports, accounting. Last but not least, it does hold a comparative advantage in terms of high value added goods and both wages are high and corporate sector is very profitable.

This definition of hegemony may be a somewhat arbitrary definition. Ultimately, it may be more interesting to analyse how, where and to what effect German economic power historically manifested itself. In economic terms, the breakdown of the Bretton Woods system left Germany’s macroeconomic preferences unchanged, while its own macroeconomic policies in the context of fixed exchange rate and increasing cross-border capital flows created increasing constraints for others. Germany’s power was largely structural in nature. While Germany had a strong preference for stabilizing intra-European exchange rate in order to maintain financial stability and export competitiveness, its ability to change other countries economic policy mix was very limited. Indirectly, however, structural power contributed to the decision of other countries to agree to so-called convergence policies and a German-style monetary union. 

European monetary integration has increased German power, but has also increased its vulnerability. EMU may or may not have been a quid pro quo for German reunification. But EMU almost completely reflected German policy preferences and effectively led to the extension of Germany’s monetary regime to the rest of Europe. EMU ended up increasing Germany’s relative power (as well as its absolute economic-financial vulnerability). Rising market pressures punished fiscally weaker countries, while enhancing the political power of the fiscally stronger countries, namely Germany. Germany’s ability to successfully operate under the constraints imposed by EMU (low inflation, no competitive devaluation, generation of growth via exports) combined with a domestically institutionalised preference for fiscal discipline allowed Germany to out-compete most other countries and maintain sound public finances. This ended up conferring relational power, defined as getting somebody to do something s/he would not otherwise have done. Not only does the newly emerging Eurozone governance structure, including the initial rescue efforts, reflect German preferences. 

Government debt in the advanced economies with special reference to Japan (2013)

Japan is the country with the highest level of government debt among the advanced economies. Continued large fiscal deficits will push the debt-to-GDP ratio to more than 250% of GDP by the middle of the present decade. Japan’s position is nonetheless not as dramatic as it looks. (1) In net terms (net of government financial assets), debt stands at 135% of GDP. This is still high, but not unprecedentedly so. (2) Government debt in Japan, unlike in the other advanced economies, is not consolidated on an intra-government basis. Intra-government consolidation would reduce the net debt ratio by another 20 percentage points or so. (3) If non-financial assets are taken into account (e.g. fixed assets, land), the government’s net worth is roughly zero. (4) Furthermore, if the government balance sheet is consolidated with the central bank and the broader public-sector, public sector net worth looks even more favourable. (5) Japanese government debt is predominantly owned by residents, predominantly banks. Government moral suasion makes it unlikely that they will refuse to finance the government. (6) Contingent liabilities in terms of future pension- health-related spending are comparatively low in Japan, in spite of relatively adverse demographic trends. (7) Last but not least, Japan is the world’s largest international creditor. Admittedly, if the government fails to significantly reduce the fiscal deficit of 9% of GDP (on a cyclically adjusted basis), government debt will become unsustainable over the medium- to long-term. Nonetheless: the Japanese government’s present financial stock position is not as dire as the headline figures might suggest.

Source: IMF

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.

China’s international financial position – strength or vulnerability? (2013)

China’s increasing economic size makes it an increasingly important international actor. Over the past decade, China emerged, next to Germany and Japan, as a major net capital exporter. Large current account surpluses have translated into a major improvement of China s international financial position. In USD terms, China is today the world’s second-largest creditor. Net foreign claims today amount to USD 1.7 tr (or 20% of GDP) compared to USD 3.4 tr (or 60% of GDP) in Japan. By contrast, the US, the world’s largest creditor in the immediate aftermath of WWII, is today the world’s largest net debtor with net foreign liabilities amounting to USD 3.9 tr (or 25 % of GDP).

Financial power has many dimensions and can be exercised in a variety of way. A country can extend aid and offer investment. It can offer preferential access to its markets (Hirschman 1945/ 1980). It can be a source of foreign direct investment and technology transfers. China’s growing international financial resources, rising outward investment and its prominent position as an importer and exporter have materially increased its influence (and interests) over the past few decades. A large net foreign creditor position can help limit financial vulnerabilities. In extreme scenarios such a war, countries and countries can draw down their foreign assets in order to finance vital imports, as Britain did during the early days of WWII, provided these assets do not get frozen. Ay, there’s the rub.

China’s increasing financial prowess, and especially its very significant creditor position vis-à-vis the US, provides it with little bilateral influence. As a consequence of China’s mercantilist policies, reflected in a controlled, competitive exchange rate and large external trade surpluses, China has accumulated large net foreign assets. Importantly, foreign claims are largely held by the Chinese public sector forced to absorb large balance-of-payments surpluses in order to prevent exchange rate appreciation in the context of controls on private-sector capital outflows. A significant share of these surpluses has been recycled, as central bank foreign assets typically are, into liquid, high-grade, but low-yielding US and European government debt. China s outsized international creditor position is a by-product of its policy of export-oriented industrialisation rather than an objective as such. In fact, China’s large claims on the US government has made if, if anything, more vulnerable in the past few years. Naturally, financial integration does always create financial sensitivities, but being a captive investor raises financial and economic risks in a way that an equally large, but more diversified asset portfolio would not create.

Being a large international creditor provides China with greater policy flexibility (in normal times) as well as with the capacity to lend to other countries in convertible currency. This is especially the case with regards to smaller countries or countries in financial dire straits. In relation to the US, however, China’s creditor position yields little influence. It may have made Washington more reluctant to pursue economically confrontational policies towards Beijing, but it does not provide Beijing with a lever of direct influence vis-a-vis Washington, mainly because of the US’s reserve-currency country status and China’s dependence on the US as an export market. China remains too dependent on the US in terms of trade and the US is not sufficiently dependent on China financially as to be open to Chinese financial pressure. The flipside from Beijing s point of view is that the Chinese economy does not only depend on the US export market, but that financially it is heavily exposed to the US government.

Two thirds of China’s foreign assets are reserve assets, largely held in the form of liquid, high-grade sovereign debt, mostly in US treasuries and agencies. According to the US Treasury, China holds an estimated USD 1,100 bn worth of US treasury securities – and another USD 450 bn worth of agency debt. This likely underestimates the actual size of Chinese holdings, but it shows how exposed China is to the US. Nonetheless, it affords China little influence. The threat to stop buying or even selling US treasuries would be neither credible and even if it were made, let alone realised would cause greater damage to China than for the US. 

First, economically and financially, China would shoot itself in the proverbial foot if it were to sell large amounts of US treasuries. The value of its holdings would decline and higher US interest rates would weigh on the US growth outlook, hurting Chinese exports. Furthermore, China would have to find other dollar assets to invest in, unless it is willing to accept RMB appreciation – and too rapid a RMB appreciation is hardly in China’s interest in terms of exports and dollar-denominated US debt holdings. If it does re-invest in dollar-denominated assets, this would presumably help ease financing conditions in other parts of the US economy, potentially offsetting the negative effect of higher rates in the treasury market. But these assets would be less liquid and carry higher credit risk. A Chinese threat to divest US debt may therefore not be considered very credible by Washington. From a financial perspective, the diversification benefits are doubtful, while credit risk would increase from China’s perspective.

Secondly, even if Beijing were to sell large holdings of US debt, it is unclear how sizeable an impact this would have on US yields. In the very short run, it might disrupt financial markets, but the medium-term impact would likely be manageable, as other foreign (official) buyers would step in, albeit at higher interest rates (e.g. Japan, Gulf countries). In the current environment, the situation might act in order to prevent excess market volatility. Last but not least, any politically motivated fire sale of US debt would trigger a very severe political backlash – and not just from the US. A fire sale (as opposed to a gradual unwinding of holdings) would also undermine China’s standing as a reliable financial investor and economic partner in the eyes of many other countries. 

Financially, economically and politically, Beijing would pay a high price for pushing up US borrowing costs and, in all likelihood, a much higher price than Washington would end up paying. First, the US has access to a more diversified investor base (with parts of which it maintains close political relations) than Beijing has markets to invest in – at least as long as Beijing seeks to maintain a stable USD-RMB exchange rate. Second, in the short run, the US market is also substantially more important to China in terms of both exports and imports than vice versa – and the Chinese export sector is relatively more employment intensive! Last but not least, Beijing’s concern about maintaining near-double-digit growth rates would diminish the credibility of any action that risks triggering an outright economic conflict with the US, or a severe US economic slowdown on the back of financial instability. 

An unwillingness to let the RMB appreciate, potentially significantly, and a reluctance to incur large financial losses on its foreign asset holdings (in that order) presently limits Chinese flexibility as regards the holdings and purchases of treasuries. China, after all, benefits greatly from its access to the US market. It affords China to pursue an export-led growth strategy, underpinned by sizeable domestic and foreign investment in the tradable sector and supported by an undervalued exchange. It also provides China with access to advanced technology supporting productivity growth. Appreciating its exchange rate would make exports less competitive. All other things being equal, it might reduce economic growth at the margin due to a less favourable contribution from net exports and, possibly, lower investment in the tradable sector. However, it would also shift resources away from the tradable sector and might lead to increasing investment there. The net effect of RMB appreciation on employment would not necessarily be negative, for the non-tradable service sector tends to be more employment-intensive than the relatively more capital-intensive, export-oriented manufacturing sector. The relative strength of the growth and employment effects naturally depend on the magnitude and speed of the appreciation.

In short, China’s holdings of US debt do not lend themselves as a coercive instrument. They may act as a sort of limited deterrent. Naturally, rising cross-border asset holdings and trade have increased interdependence, raising the costs of economic conflict for both sides – but the potential costs of a conflict due to China’s trade dependence are substantially higher for Beijing than for Washington. The Sino-US economic-financial relationship is therefore best described as one of ―asymmetric interdependence‖ (or asymmetric vulnerability), skewed in Washington’s favour for now. 

Global income convergence – myth and reality (2013)

Conditional convergence posits that poorer economies benefit from a so-called catch-up growth potential. As a result of faster per capita growth, GDP per capita will over time converge to the level of the most advanced economies. As per capita income converges, per capita growth will slow down to the so-called steady state rate that economies experience when operating at the technological frontier. This convergence is conditional because whether or not it comes about is a function of supportive conditions and growth-oriented policies. This theory differs sharply from the so-called dependency theory, which posits, by contrast, that poor, peripheral economies find it impossible to catch up with the advanced economies. Germany’s and Japan’s rapid economic rise in the late 19th century and post-WW-II, respectively, demonstrate that catch-up is possible, even though dependency theorists would not regard either country as belonging to the periphery. While German per capita income reached ¾ of UK per capita GDP just before WWI, Japan (and Germany) reached a comparable level relative to the US only in the late 70s/early 80s. What is nonetheless remarkable is that the relative economic position of many emerging economies today, defined as their per capita income as a share of the lead country, has changed relatively little. Real per capita income levels have, of course, risen in most economies over the past few decades. Surprisingly, few of the so-called emerging economies have, however, been able to replicate Germany’s and Japan’s success. Excluding city-states (Hong Kong, Singapore, Macau) as well as demographically small, but very resource-rich economies (Kuwait, UAE, Brunei, Qatar), only two economies have succeeded in catching up with the major advanced economies, if not with the US itself: Korea and Taiwan. It is similarly remarkable that with the exception of Russia the per capita incomes of the world’s five largest emerging economies (BRIC, Mexico) amount to only about 30% of US per capita GDP or less. If one is a pessimist, one will interpret this as evidence that catch-up will be difficult to achieve. If one is an optimist, one will interpret this as meaning that the major emerging economies will continue to benefit from a tremendous growth potential, even if it will require structural reforms to exploit it.

Source: IMF

Caribbean and Central America face challenging prospects (2013)

Many Central American and the Caribbean countries have similar characteristics. (1) They have small economies that are very open to international trade and they are heavily exposed to exogenous economic-financial shocks and natural disasters (e.g. hurricanes, earthquakes). (2) In the smaller Caribbean countries, financial sectors are typically quite large, translating into potentially huge contingent government liabilities. (3) Economic growth has stagnated over the past decade, at least in many non-commodity-exporting economies. (4) Many economies are facing high and rising public debt. Not surprisingly, 9 out of the 15 sovereign bond defaults/ restructurings that occurRed globally since 2003 affected countries in/ bordering on the Caribbean. Two countries have even gained the doubtful distinction of double-defaulters (Belize and Jamaica).

Source: Moody's

Economies relying on tourism and financial services have fared poorly due to deteriorating terms-of-trade, compared to commodity exporters (Guyana, Suriname, T&T, only Belize excepted). This is a concern, not least because the financial situation in many energy-importing economies in the region would be far worse if Petrocaribe did not exist. The Petrocaribe programme sponsored by Venezuela sells many Caribbean economies oil at a very significant discount. Members include: Antigua and Barbuda, the Bahamas, Belize, Cuba, Dominica, Dominican Republic, Grenada, Guyana, Haiti, Guatemala, Honduras, Jamaica, Nicaragua, St. Lucia, St. Kitts and Nevis, Sant Vincent and Grenadines, Suriname and Venezuela. 

Political change in Venezuela (aka the end of Petrocaribe) would risk causing a severe regional financial crisis. Combined with governance challenges (The Economist talks of “failed states” in Central America) and limited political and financial support for the region (neither Mexico nor the US are particularly interested), Central America and the Caribbean will remain the region to watch in terms of future sovereign debt crises.