Why is so much capital flowing uphill, from the poor countries to the rich ones, instead of from the rich to the poor? The question is of great practical importance.
<<Like Elmat keeps saying: Capital must spread more evenly>>
Capital flow must change course
By Martin Wolf
Published: June 26 2005 20:09 | Last updated: June 26 2005 20:09
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Why is so much capital flowing uphill, from the poor countries to the rich ones, instead of from the rich to the poor? The question is of great practical importance. The answer should suggest both how long the present pattern of global capital flows or current account “imbalances” is likely to last and how it may end.
What, then, is happening to capital flows to and from the emerging market economies? What drives these trends? What role does policy play? Do the trends matter? How should these trends be dealt with?
To start with the trends themselves, figures from the International Monetary Fund’s latest World Economic Outlook show the scale of the flows. The foreign currency reserves of emerging markets rose by $1,556bn in 1997-2004, of which $519bn came last year and another $523bn is forecast for this year.
Those countries ran an aggregate current account surplus of $336bn last year. It is a dramatically different picture from that in 1996, when emerging market economies ran an aggregate deficit of $93bn (see chart). Last year’s current account surplus was equivalent to 3.5 per cent of their aggregate gross domestic product, at market prices. Strikingly, that is close to Japan’s ratio.
In addition, those countries received $186bn in net foreign direct investment last year and a total net private inflow of $196bn. The sum of the current account surplus and net private capital inflows was equal to 5.4 per cent of their aggregate GDP.
Asian emerging economies ran a current account surplus of $193bn last year, which accounted for more than half the total. The Middle East represented another third of the current account surplus of emerging market countries and the Commonwealth of Independent States (principally Russia) close to a further fifth. The one region of the developing world to run a large current account deficit – of $51bn – was central and eastern Europe. It was also the only one of these regions to have shifted further into deficit since 1996, by $33bn.
The swing in the aggregate current account balances of Asian emerging market economies (which include Hong Kong, Singapore, South Korea and Taiwan) was $233bn – again, just over half the total. Of the surplus regions, the Asian region is the only one to be, in addition, a large net recipient of private capital. Asian emerging market economies received an aggregate net inflow of private capital $130bn in 2004, which was two-thirds of the total flow to emerging market economies.
If one looks at foreign direct investment alone, Asian emerging market economies received $87bn out of a total flow to emerging market economies of $186bn in 2004. Those in the western hemisphere received $45bn, central and eastern Europe $22bn and the CIS just $8bn.
Three broad patterns emerge.
First, the $430bn swing in the emerging market economies’ aggregate current account deficit was the principal counterpart to the $549bn increase in the US deficit between 1996 and 2004.
Second, two big forces have driven the swing from deficit into surplus: the rise in the price of oil, which has pushed the Middle East and the CIS into large surpluses; and the financial crises of 1996-99, which drove the emerging market economies of Asia and the western hemisphere out of their deficits.
Third, the most important emerging market region for the global capital flows is Asia. In addition to running a large aggregate current account surplus, emerging Asia is also remarkable for its massive recycling of private capital inflows.
The countries that matter within the Asian region (excluding Japan) fall into three groups: the newly industrialised economies of Hong Kong, Singapore, South Korea and Taiwan (of which Korea was badly affected by the Asian crisis of 1997-98); members of the Association of South-East Asian Nations other than Singapore (of which four were also significantly affected by the Asian financial crisis – Indonesia, Malaysia, the Philippines and Thailand); and, much the most important, the rising Chinese colossus.
In 2004, the first group had an aggregate current account surplus of $90bn, the Asean four had one of $34bn and China $70bn. China also received $56bn in inward net FDI and overall net private capital inflows of $93bn. All this financed a staggering $207bn increase in China’s overall currency reserves. China accounted for 36 per cent of the Asian emerging economies’ current account surplus, 60 per cent of their reserve accumulations, 64 per cent of their net inflow of FDI and 71 per cent of their net private capital inflow.
Why is this apparently perverse pattern of capital flows happening? The normal assumption, after all, is that poorer countries would be recipients of capital from rich countries with surplus savings.
One possible explanation might be that, in practice, bad policies and institutions reduce investment opportunities in poor countries, while good policies and institutions raised them in rich ones. This seems a plausible reason for relatively low investment rates in the western hemisphere, Africa, the CIS and the Middle East – which were all in the range of 20-23 per cent of GDP in 2004. But it has no applicability to Asia (see charts). Moreover, the advanced countries’ aggregate investment rate was itself only 21 per cent.
The principal determinant of the pattern of capital flows is, it turns out, divergent savings rates. In 2004, gross savings rates (at market prices) were a mere 14 per cent in the US, 15 per cent in the UK, 21 per cent in the eurozone and 28 per cent in Japan. They were also 19 per cent in central and eastern Europe, 21 per cent in both Africa and the western hemisphere, 30 per cent in the CIS, 32 per cent in the newly industrialised Asian economies, 35 per cent in the Middle East, 38 per cent in developing Asia as a whole and a staggering 44 per cent in China (all measured at market prices).
In short, because investment rates were closer together than savings rates, the world’s capital exporters were countries with high savings rates and the importers were ones with low savings rates. Surprisingly perhaps, many of the highest saving economies were poor, while some of the lowest saving countries were rich. The US is far and away the most important of the latter, just as China is the most significant of the former.
High savings rates in oil-rich countries are not surprising. Nor are they foolish. Recipients of a windfall do well to spread the spending out over time. But Russia’s current account surplus of 10 per cent of GDP last year must also reflect the dreadful investment climate in that country.
Yet Asia is, once again, the big story. China’s investment rate is 15 percentage points higher than the pre-crisis average, while its savings rate is 12 percentage points higher (see chart). The Asean four invested only 21 per cent of GDP in 2004, which is 4 percentage points lower than the pre-crisis average, while their savings rates are 3 points higher. Finally, the Asian newly industrialised countries have also lowered their investment rates by 4 percentage points since before the crisis, while their savings rates have dropped by almost 2 points.
Thus the soaring savings surplus of emerging Asia is the result of rising savings rates and, in some cases, of falling investment rates as well. Moreover, if China’s massive investment rate were to fall to levels that are normal elsewhere, its current account surplus could jump to enormous levels.
Now to the next question: what is the role of deliberate policy? The answer is: a big one. The proximate cause of the higher savings and lower investment in the newly industrialised countries and the Asean four was certainly the shock of the financial crises. Since, then, however, policy has played a large role in generating the surplus savings that are the domestic counterpart of the current account surpluses.
Without active sterilisation of the monetary impact of accumulations of foreign currency reserves, one would expect rising domestic credit expansion, stronger spending on both investment and consumption, higher inflation, an appreciating real exchange rate and ultimately a declining current account surplus. The Asian emerging market economies have, however, worked very hard to sterilise the monetary impact of the reserves. Thus, the excess of the increase in foreign currency reserves over the expansion of their monetary base has been very large: between 2002 and 2004, it was 19 per cent of GDP in the newly industrialised countries, 11 per cent in China and 8 per cent in India.
Currency intervention has itself been the consequence of a deeper objective: exchange-rate targeting. China, Hong Kong and Malaysia have fixed pegs against the dollar. But most other Asian economies have intervened heavily to limit movement of their exchange rate against the dollar-renminbi pair. As a result, the real exchange rates of emerging Asian currencies depreciated almost as rapidly as the dollar from the beginning of 2002, despite their huge current account surpluses and net inflows of private capital (see chart).
A principal aim and effect of this policy has been to preserve export competitiveness. So long as exports remain competitive and trade balances strong, the need to promote domestic demand, thereby reducing the surplus of savings over investment, is diminished. Net exports support demand instead. This is modern mercantilism. The adverse reaction now seen in the US Congress is predictable and understandable.
What would happen if governments did not intervene is also clear: exchange rates would soar. This would tend to drive current accounts into deficit. The impact would be reinforced if governments took action to promote domestic demand, to offset the lost stimulus from exports and import substitution.
So do these trends matter? The answer depends on whether the explosive increases in current account surpluses in emerging market economies and in the counterpart deficits of the US are themselves important. They are. They generate growing protectionist pressure in the US; they force the US into monetary and fiscal policies whose consequence is growing indebtedness, both domestically and externally; they are likely to end up in a brutal correction; and that correction is likely to be more brutal the longer it is delayed.
Finally, what should be done? Some analysts argue that Asian policies make good sense. One argument is that a fixed exchange rate provides a monetary anchor. But in standard theories, the monetary impact of such an anchor should not be sterilised. A rapid accumulation of foreign currency reserves should, instead, be allowed to work its way through demand, inflation and so ultimately competitiveness.
A trio of economists writing for Deutsche Bank argue that China’s policies are a rational way to generate rapid growth and high employment.* It is questionable, however, whether accumulation of foreign currency reserves on the present scale is a sensible use of scarce resources in a poor country. Nor, for that matter, has the present degree of export competitiveness been deliberately chosen.
Above all, it is hard to believe that current trends are sustainable for many years. A country of China’s scale cannot continue to drive trade ratios ever upwards. Already its ratio of trade (exports plus imports) to GDP is 70 per cent. This is much the same as for South Korea. A country with a population of 1.3bn cannot grow at 10 per cent a year and remain as dependent on trade as one with just 50m without provoking a backlash from its trading partners.
Other economists argue that there is nothing unreasonable about huge current account surpluses and recycling the capital inflow. Yet it is evident that large deficits cannot be adjusted if surpluses are not adjusted as well. Moreover, this cannot be combined with a buoyant world economy if domestic demand does not pick up in the surplus countries.
Some of these countries will even have to run deficits. Fast-growing economies with excellent investment opportunities and huge long-term capital inflows are the obvious candidates. China, for example, is forecast by the IMF to have a net inflow of $70bn in FDI this year, plus a current account surplus of $77bn. This makes an overall surplus in its long-term basic balance of payments this year of about 8 per cent of GDP – which is enormous by any standards.
China is not the only significant surplus country. But it is likely to generate well over a sixth of the overall current account surplus of emerging market economies (including the oil exporters) this year. It also has an extremely strong capital account position. Most important, it is the focal point for the rapidly integrating economies of the Asian region. Most are unwilling to let their currencies appreciate against the renminbi, but may well be prepared to follow it upwards.
A world in which emerging market economies not only run vast current account surpluses but also recycle the capital that investors want to place in their economies is unprecedented, undesirable and unsustainable. The surpluses of oil exporters may be temporary. But those of Asian emerging market economies seem likely to prove less so. Yet this dynamic region is among the best placed in the world to let long-term foreign capital finance current account deficits.
The reserves these countries now possess are big enough to cope with any conceivable shocks. China, for example, has foreign currency reserves that are already almost as big as annual imports. With current policies, these reserves are likely to continue to grow rapidly for the indefinite future. This is not a reasonable pattern of development in the medium term.
At the moment, however, the policymakers are fighting the adjustments that markets desire to make. Global adjustment will be impossible if the important emerging market economies are not prepared to adjust. China, above all, will have to play a role commensurate with its growing impact. As the world’s third largest trading power and most dynamic economy, it has achieved greatness. It must now accept the responsibility that goes with its new status.
* The US current account deficit and economic development: collateral for a total return swap. National Bureau for Economic Research working paper 10727, Áugust 2004. www.nber.org |
