Monthly Archives: July 2014

The BRICS and the Bretton Woods Twins

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The World Cup was not the only event of global significance to take place in Brazil this summer. The leaders of Brazil, Russia, India, China and South Africa met in the city of Fortaleza and announced the formation of two new financial institutions. One is the New Development Bank (NDB), which will finance “sustainable development” projects, with an eventual $100 billion in capital. The second is the Contingent Reserve Arrangement (CRA), which will make $100 billion available to lend to members in financial distress.

If these stated aims seem familiar, they should: they copy the missions of the Bretton Woods “Twins,” the World Bank and the IMF. Why, then, would we need another set of institutions with these mandates? A possible answer could be that these institutions will operate on a smaller scale, and therefore fill a gap between national organizations and international ones.  The principle of subsidiarity states that decisions should be made at the appropriate level, i.e., national policymakers address domestic needs, regional organizations deal with issues of regional relevance, and international institutions address global problems.  In this case, it might be argued that these middle-income nations are better able to make decisions on their level than in a larger forum.

However, economic efficiency is not what is driving this process. The new organizations are a response to the breakdown of quota reform at the IMF and the World Bank. A visitor to Beijing, as I recently was, will hear the complaints that the U.S. government, by not passing the measures needed to implement the reform measures, is frustrating the aspirations of the emerging market nations. Attempts to explain the inaction as the result of domestic politics are dismissed as self-serving justification.

It is difficult not to be sympathetic to these complaints. There is no reason why the long-overdue reallocation of quotas should not proceed. The governments of the emerging market economies have long been promised that an adjustment of their positions would be made, but there was always a procedural hurdle to be cleared. Now, when the world’s governments (including the Obama administration) agree on the particulars, a new reason for inaction appears.

Of course, there are details to be worked out for the new bodies. Who is eligible to borrow from the new development bank? Will it seek to compete with the World Bank by offering more money/fewer conditions? Will there be political “litmus tests” for would-be borrowers?

The new currency arrangement resembles the Chiang Mai Initiative Multilateralization (CMIM), an agreement on currency swaps within Asia, which has been viewed as a complement, and not a substitute, for the IMF. Moreover, as under the CMIM, a country that wants to borrow more than 30% of the maximum access allocated to it would also have to enter an arrangement with —  the IMF! The world, it seems, is not quite ready to cast off the Fund.

But it would be wrong to underestimate the significance of the establishment of these institutions. They are the result of the continuing clash between the G7 countries and the emerging market nations that see themselves as perpetually marginalized within the Bretton Woods institutions. While economic growth in China may be slowing and India continues to strive to accelerate its pace of development, the size of these and other countries in Asia, Africa and Latin America ensure that they will become more dominant over time. If they are frustrated within the traditional bodies of international economic governance, they have the capacity to establish their own forums.

However, economic and financial instability does not respect political camps. Their avoidance are international public goods, requiring cooperation from the full range of nations. A breakdown in global governance only leaves the international economy more vulnerable to volatility that can sweep across borders, as we learned in 2008-09. Perhaps the biggest question about the new organizations is whether they will strengthen the resiliency of the international financial system. It may take another crisis to learn the answer.

On the Road

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Next week I will be in Beijing to teach international macroeconomics at the Hanqing Harris Summer School at Renmin University. I will also be attending a forum on the internationalization of the renminbi organized by the International Monetary Institute of Renmin University. I am looking forward to many interesting conversations with Chinese economists.

I will resume posting after I return.

China’s Outward FDI

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According to the United Nations Conference on Trade and Development’s latest World Investment Report Overview 2014, Foreign Direct Investment inflows to China reached $124 billion last year, while outflows rose to $101 billion. The Report anticipates that outflows will surpass inflows within the next few years, changing China from a net recipient of FDI to a net supplier. This change will affect China’s external balance sheet, and its response to financial crises.

China’s foreign assets have traditionally been overwhelmingly concentrated in foreign exchange reserves. In 2011, for example, reserves accounted for two-thirds of all the country’s foreign assets.  While the central bank’s holdings of foreign currencies (mostly held as U.S. Treasury securities) allowed it to deter any speculative currency attacks, they carried a low rate of return. That return fell even further during and after the global financial crisis as the Federal Reserve drove down interest rates, both short- and long-term. Therefore, China’s assets have not been very profitable. In addition, the foreign exchange reserves have lost value over time as the dollar depreciated. Menzie Chinn has pointed out that the political theater in Washington, DC only heightened Chinese concerns about their holdings of dollars.

A very large proportion of China’s foreign liabilities, on the other hand, has consisted largely of FDI; in 2011, the share of FDI in foreign liabilities was 59%. These investments were very profitable for the foreign firms that held them, producing a substantial stream of income. Consequently, as Yu Yongding, director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences has emphasized, China’s net return on international investments has usually been negative, despite its status as a net international creditor.  China’s net international investment position in 2011 represented +21% of its GDP, but it recorded a negative net primary income flow of about -1% of its GDP.

More assets held in the form of FDI, therefore, will raise the income that China receives from its assets.  Holding FDI in other countries will also give China a chance to diversity the currency composition of its assets. But there is a downside: equity holders share the risks of the ventures they own. In the past, this meant that China’s negative net FDI position acted as a crisis buffer. China’s net primary income turned positive in 2007 and 2008; its foreign exchange assets continued to pay returns, while the return on domestic FDI fell due to the global financial crisis.  Moreover, a decline in the value of FDI as well as portfolio equity lowered China’s liabilities, contributing to an improvement in the net international investment position.

China is not unique in the composition of its foreign assets and liabilities. Philip Lane of Trinity College/Dublin has written about the “long debt, short equity” position of many emerging markets, which helped them ride out the economic turbulence of the global crisis. Many advanced economies, on the other hand, were “long equity, short debt,” which while profitable in normal times, exacerbated the decline in their economies when the crisis hit.

China’s situation will change if there is a shift towards a net positive FDI position. The flow of income from foreign assets will become more pro-cyclical. Moreover, those assets will lose value in the event of a downturn. A depreciation of the renminbi would only increase this valuation effect.

Chinese firms traditionally moved abroad to secure reliable supplies of natural resources. More recently, the surge of outward FDI has also reflected aspirations to venture into foreign markets. The movement outward will eventually raise China’s net investment return and provide it with the ability to hold assets in currencies other than the dollar. But it will also diminish the role of FDI liabilities to act as a crisis buffer. This is one factor that should be added to the list of benefits and costs of a change in China’s net FDI position.