Yves here. The financial media has attributed considerable importance to the fact that many of America’s close allies, including the UK, Australia, and Israel, have joined China’s new infrastructure bank against the clearly-stated desires of the US. While these moves seem to signal America’s declining influence, it does not necessarily follow that the infrastructure bank is destined to become a major international institution any time soon.
Michael Pettis deflates some of the hype surrounding this initiative, arguing that it is less significant from a geopolitical and practical perspective than virtually all commentators assume. China is simply not about to become the issuer of the reserve currency any time soon, and that limits how much financial clout it will have.
By Michael Pettis, a Senior Associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management. Cross posted from China Financial Markets
When Isaac, an editor at Foreign Policy, sent me an email two weeks ago asking if I could write a piece on the new Asian Infrastructure Investment Bank (AIIB), I quickly wrote back promising 1,200 words within a few days. I thought it would be pretty easy to come up with the points I wanted to make, and all I would need was one uninterrupted day to pull them together into a coherent article.
As I see it, the creation of the AIIB is not nearly as important as everyone seems to think, and if Beijing’s decision to create the AIIB, and Washington’s decision to oppose it, was part of the struggle for future geo-political dominance in Asia, let alone the world, they were both going to be wrong. There were only two useful parts to this story, it seemed to me. First, it showed that neither Washington nor Beijing understood very well either the functioning of the global balance of payments or the reasons why the West, and especially the US, dominates the regime that governs global trade and capital flows (but I guess we already knew that). Second, Washington had handled this whole process so ineptly that it had managed to transform a minor initiative by Beijing into a huge symbolic disaster for Washington and a great victory for Xi Jinping.
I thought it would be easy to explain this because the discussion over the AIIB was almost a caricature of the discussion over a number of other finance-related topics during the last decade or two, in which an overwhelming consensus quickly develops around some event concerning both its unprecedented nature and the nature of its transformative impact – the sustainability of China’s astonishing growth miracle, the creation of the euro, the abolishing of credit cycles by Washington, the consequences of the reserve status of the US dollar, the rise of the RMB, and so on. Both assumptions always turn out to be wrong – the event under discussion does have a very deep and very useful historical context, and this context suggests that many of the assumptions underlying the discussion are, in fact, quite implausible.
In the case of the AIIB I assume that readers of my blog are quite familiar with these assumptions, but on March 16 Singapore-based academic Kishore Mahbubani published an article that, perhaps predictably, exemplifies the more excited version of the consensus. He described the decision by Great Britain to join the AIIB as an “epochal event” signaling nothing less than “the end of the American century and the arrival of the Asian century”. He goes on to say:
Any objective and calm assessment of the Chinese decision to launch the AIIB would show that this is a bank whose time has come. The Asian Development Bank has estimated that Asia needs to spend at least $8 trillion in infrastructure investment. The American-dominated World Bank and related institutions cannot possibly fulfill this demand. China’s decision to use its reserves to boost Asian infrastructure investment was clearly welcomed in Asia. Given its spectacular success with developing world-class infrastructure in record time, China has a lot of expertise in this area. Asia needs this.
In spite of the fact that I disagree with nearly every part of this paragraph, and I think there are many, and very varied, precedents for Beijing’s initiative that show just how questionable many of these assumptions are, it actually turned out to be very difficult to write the article. On my first attempt I was well over the 3,000 word mark before I realized that there would be no way to finish the article and then cut it down to anything close to 1,200 words. I put the piece aside and started up the next day with a completely different strategy, but the result was the same – too many words. After the third attempt, with a new strategy but the same result, I realized that there was no way I could present my objections except in a much longer piece, and I wasn’t sure whether it was worth the effort.
The String of Implausibilities
I think I know why it would take much longer than I expected to write the essay. The claims about the importance of the AIIB or the significance of London’s decision are based on a series of implicit and fairly abstract assumptions, and in order to dispute them I would have to specify all the possible ways in which these claims would be correct, and then show that each of them is implausible or even impossible. It is a little like the dispute over the value of reserve currency status. If someone claims that reserve currency status is valuable because it allows the country that issues the currency to reduce its borrowing costs, it is quite easy to show why this isn’t true, or is true only under very specific conditions that may or may not apply. But if someone simply claims that reserve currency status is self-evidently extremely valuable, it is much more complicated to dispute the claim because then you have to consider and refute all the possible ways that this might be true.
In this essay, I thought I would follow a different tack. It might be interesting not so much to dispute the importance of the AIIB, or of Britain’s decision, but rather to suggest some of the historical antecedents for Beijing’s initiative and show how similar perceptions turned out to be wrong before, and so suggest the ways in which they might be wrong again.
This is not to say that the AIIB cannot become as important an institution as some of the more excited commentary suggests. It can, but only under certain fairly implausible conditions. If China’s economic rise during this century leads it not just to overtake the United States but to achieve a level comparable to that of the United States in the 1940s and 1950s, and if the RMB becomes the world’s dominant reserve currency, with Beijing understanding and accepting the full costs of having the RMB as the dominant reserve currency, and if Beijing chooses to implement its foreign policy objectives at least partly through the AIIB, its importance will rival that of the Bretton Woods institutions.
However if the 21st Century evolves into a bi-polar world, or a multipolar world, or if it continues to be dominated by the US, the AIIB’s history will resemble that of its many antecedents. It will join the long list of much-hyped initiatives aimed at transforming the global trading regime but that now languish in obscurity, known primarily for absorbing university graduates from very prestigious schools who have failed their other job interviews.
This just means, in other words, that if Beijing occupies the same relation to the rest of the world that Washington did in the 1940s, and if, occupying this position, its ideas about what it expected from a global trade and currency regime had not changed during the next decade or two (which, given its very difficult expected rebalancing, as I will show, makes this very unlikely) then the AIIB can replicate the rather extraordinary impact of the Bretton Woods institutions. Note however that the AIIB itself will not play a role in China’s rise. It will be nothing more than one of the consequences of that rise, which is why even if this whole string of implausibilities were to become real, it is absurd to say that the AIIB itself changes anything.
Before discussing the precedents I thought I would make a quick digression about perfidious Albion. It is widely believed that David Cameron made a decision that shocked much of the world, including Beijing itself, for solidly pecuniary reasons. It was no secret that there was little David Cameron wouldn’t do to ensure that London became the leading offshore center for trading RMB, and was especially worried about the close relationships between Berlin and Beijing, which, he feared, might place Frankfurt in the lead in the race to become the main trading center for RMB. Many people have interpreted Cameron’s actions as implicitly anti-American, but to the extent that they matter, they were designed primarily to damage German ambitions for Frankfurt’s future role as a financial center.
Booting out Frankfurt was important because of the big pot of gold associated with becoming the dominant offshore trading center for RMB. Cameron seems to believe that the RMB will soon become one of the world’s major reserve and trading currencies, perhaps even overtaking the dollar, and London’s primacy as a global financial center would be guaranteed if it became the leading offshore trader of RMB-denominated assets.
But this was always silly. The reason London is the world’s major currency-trading center has to do with its very powerful institutional advantages. After all it was widely feared less than two decades ago that the establishment of the ECB in Frankfurt in 1998 had all but killed London’s continued future as the center of European finance. In fact the creation of the euro largely wiped out local currency centers and most of the market actually migrated out of the euro zone and into London.
The reason this happened – London’s unassailable institutional advantages – make it almost certain that, whatever Beijing’s preferences, offshore trading in RMB would migrate to London anyway. After all the traders at Aberdeen Asset Management, say, are not going to decide whether to have their trades executed in Frankfurt or in London based on their eagerness to please Beijing. I suspect their decision will be based primarily on their evaluation of which market is deeper, more liquid, clears more conveniently, and trades more efficiently.
Will the RMB Become an Important Reserve Currency?
More importantly the RMB will not become a major reserve currency any time soon, and while its importance as a trading currency will probably continue to rise, this is from an extremely low base and is mainly because compared to the currencies of other, smaller, developing countries, like the Mexican peso and Brazilian real, the RMB is hugely under-represented in international trade. So while it has a lot of catching up to do with the peso and the real, even if China is to become the word’s largest economy, the RMB is very unlikely to catch up to the dollar for many decades because of significant constraints in the governance of Chinese financial markets. The US, after all, was the world’s largest economy for fifty years prior to WW1, and Germany the world’s second largest economy, and yet the US dollar was of minor importance in international trade and the German goldmark only third in importance, behind the French franc and far behind sterling.
London had spent decades proving that it was far less likely to intervene in sterling markets then any of its competitors and so, as long as it did not do so, inertia alone allowed sterling to retain its primacy, but it certainly did not need to worry about a challenge from the dollar until WW1 completely transformed global governance and the institutions that characterized international finance. The dollar in the late 19th century did not enjoy high levels of confidence in the international markets because there were doubts about the quality and credibility of Washington’s governance and about whether Washington would resist intervening in its financial markets or in the currency if it felt that it was in the national interest to do so. Even if the dollar today were at risk somehow of losing the huge advantage inertia creates, the same constraints that prevented the dollar from mounting a challenge to sterling’s pre-eminence before WW1 make the ERMB an unreliable international currency.
While use of the RMB as a reserve currency or as a trading currency will probably rise in the next decades, this is mainly because of its still very low base. According to SWIFT, for example, which settles interbank trading orders and is one proxy for currency use, the RMB broke into the top five currencies at the end of last year, accounting for 2.2% of SWIFT transactions (the USD accounted for 45% and the euro 28%, and because all transaction involve two currencies, I think a 50% share is the limit any currency can have). Given China’s size, this is a tiny share, but even this may overstate the importance of the RMB if part of the transactions were driven by substantial amounts of currency speculation seeking to get around the rules that limit China’s capital account.
In fact it probably was. The latest SWIFT numbers, for February, show that the RMB has dropped to 7th place, with a 1.8% share, and that the number of companies expecting to increase their use of RMB has declined in the past year. It is probably not a coincidence that use of the RMB rose when expectations were that RMB appreciation was a sure thing, and is declining at the same time that uncertainty rises about the future value of the RMB.
Whatever its fate as a trading currency, however, the RMB cannot soon become a dominant reserve currency. To understand why, it might be useful to consider the following. There are only two scenarios under which foreign central banks can accumulate enough RMB-denominated Chinese government bonds (CGBs) for this to happen.
- As foreign central banks buy CGBs, the PBoC intervenes and the RMB does not rise, in which case the PBoC’s assets rise by exactly the same amount as foreign central bank purchases of CGBs.
- As foreign central banks buy CGBs, the PBoC does not intervene and the RMB rises enough that the rise in foreign purchases of CGBs is matched by the combination of a decline in China’s current account surplus and an increase in China’s capital account deficit. If the RMB rises, of course, we are unlikely to see an increase in China’s capital account and in fact may even see it decline into a surplus. This means that the current account surplus must decline by more than the amount of CGBs that foreign central banks purchase, and in fact could easily drive the current account into deficit.
Some have suggested as a third scenario that other Chinese entities could be forced to buy foreign assets purely in response to foreign central bank purchases of CGBs, but this would basically be a version of Scenario 1, with the only difference being that Beijing directed some other entity to play the intervention role of the PBoC.
Whether Beijing decides to go this path, or the PBoC intervenes directly, there are important consequences that make it implausible. Either the rise in RMB reserves would have to be matched with an increase in PBoC holdings of advanced country reserves, mainly US dollar and perhaps euro bonds (other advanced countries are too small to matter), or if Beijing wanted to stop accumulating dollars and euro, it would have to be matched with an accumulation of government bonds, or even infrastructure loans, in Malaysian ringit, Brazilian reais, Mexican pesos, Indian rupees, and other developing-country government bonds. Given China’s poor track record in lending to developing countries and the huge associated risks, Beijing is unlikely to want to do this. Remember that if we are expecting the RMB to become a major reserve currency (let alone the major currency) China has to be prepared to see some pretty huge inflows and matching outflows, running into the trillions of dollars.
Central Bank Swaps
The effect would be to have RMB reserves in all these other central banks — Brazil, Malaysia, India, Mexico and other developing countries – rise in exchange for an equivalent rise in the PBoC’s central bank reserves, denominated in all these various currencies. While the use of the RMB as reserves would certainly rise, there would be no net trade impact or monetary impact because centrals would simply swap government bonds with each other. In fact asset swaps have been among the major mechanisms by which RMB reserves have accumulated in foreign central banks.
But for the RMB to become an important reserve currency simply as a function of asset swaps between central banks has important risk implications. A few creditworthy countries might be willing to play this game in the beginning, giving the PBoC some of their government bonds in exchange for their central banks receiving CGBs, but why bother? It just means that they take on China credit risk and get no benefits at all, except to make Beijing happy.
In the days of the “China Century” when it was believed that whoever made Beijing the happiest would get rich by becoming the leading off-shore trading center for the world’s dominant reserve currency, there might have been some demand from the Switzerlands or Luxembourgs of the world, but I wonder if David Cameron might not be among the last people still to believe this, and anyway this game involves very small amounts of swaps and will only go on until London has already become the leading off-shore RMB trading center.
So who is left who will want to do these swaps with the PBoC? Pretty obviously the only contenders will be countries that have trouble raising credit. Beijing, in other words, can exchange trillions of dollars worth of CGBs and receive government bonds from pretty much every dodgy credit in Latin America, Europe, Asia and Africa. While I am sure that there are many who will hail this as a brilliant geopolitical move, I would have to say that if it really were a good move, and if having the dominant reserve currency was such a great advantage, then this strategy could and should have been replicated by other credit-worthy countries long before China had thought it up, and they could have easily taken away the exorbitant privilege from the US decades ago. After all there was a time when the yen was supposed to become the dominant reserve currency, and it had far better technical credentials then than the RMB does today, and yet Tokyo never followed this path.
More pointedly, in 1965 French finance minister Valéry Giscard d’Estaing complained bitterly about the exorbitant privilege the dollar’s reserve status gave the US, allowing it to print as many dollars as it liked to finance its deficits, but France could have easily engaged in massive swaps with central banks around the world in the 1960s and 1970s under Giscard d’Estaing’s guidance. Had Paris done so, today the French franc would reign supreme among currencies, or, more likely, France would be totally bankrupt.
That’s why I think Scenario 1 of the two scenarios is almost impossible except as a way for the RMB to become a little more actively used as a reserve currency. If China really wants the exorbitant privilege, it is stuck with Scenario 2 and its associated trade implications. It can only gain reserve currency status by allowing unlimited amounts of foreign purchases of CGBs, with little to no commensurate PBoC intervention, in which case it gets the US privilege of being forced into current account deficits. I really don’t see any way around this.
If you believe, as most of us seem to, that Beijing is not willing to run large current account deficits in order accommodate the accumulation by foreigners of RMB reserves (especially if foreigners begin to accumulate RMB for the same trade-related reasons that the PBoC accumulated US dollar reserves), and if you also believe that the PBoC will not be willing to accumulate perhaps trillions of dollars worth of developing-country government bonds (i.e. lend trillions of dollars to developing countries), then you cannot also believe that the RMB will become a major reserve currency, let alone the dominant reserve currency, because you have eliminated the only two ways foreign central banks can accumulate sufficient amounts of RMB reserves.
What Does History “Prove”?
Most analysts do not understand the reserve accumulation process well enough to understand the logic of this argument, but they nonetheless are fairly confident about their predictions for the RMB on the grounds that history supports them. This is usually because, however, their understanding of history is not much better. One thing, we are often told, is that as the Chinese economy becomes the world’s biggest, its currency must become the dominant reserve currency because history proves that the world takes on the currency of its largest economy as its preferred reserve currency.
History proves no such thing. First of all, there is no “history” as such. There has only been one fiat currency in history that was a dominant reserve currency, and this was the US dollar, beginning either in 1944, or in 1971 after the “Nixon shock”, or some time in between, depending on your reading of the history. There has also been only one case in history in which a currency generally recognized as the dominant reserve currency was replaced by another, and this was the replacement of sterling with the dollar, some time in the 1930s or early 1940s, again depending on your read of history.
More importantly, as I discuss above, the US economy became the biggest in the world in the later 1860s or early 1870s, during which time Germany became the second, and yet the dollar was considered a fairly unimportant reserve currency right up until the late 1910s (and Germany only went on gold in the early 1870s). The dollar only became important, in other words, forty to fifty years after the US became the world’s largest economy, and the dollar only became the dominant reserve currency perhaps more than seventy years after the US had acquired its leading economic status.
For me the interesting question is why it took nearly half a century after the US became the world’s largest economy for the US dollar to become an important reserve currency and whether this has implications for China. The answer may be partly because of the uncertainty surrounding the dollar, and American commitment to gold backing (in fact the Federal Reserve System was not created until 1914), and given the structure of the Chinese political system and a wide range of financial market governance issues, it is not hard to imagine reasons why the RMB might also attract uncertainty.
The late use of the dollar may also be explained partly because during much of this time the US was running trade surpluses and, except for its bankers, it would not have benefitted from foreign interest in acquiring large amounts of dollars. China faces a very difficult rebalancing, and while status-seeking is an especially powerful urge in China, anyone in Beijing who can ignore the status that would come from managing the dominant reserve currency would see that substantial foreign acquisition of RMB-denominated CGBs would make the rebalancing so much more difficult that it would all but guarantee a failed adjustment. Even if China does become the world’s largest economy, in other words, the RMB may face some of the same constraints that prevented the dollar from becoming an important currency in the five decades before WW1.
There are other mistaken historical references. Some people have pointed out that the US was able both to run surpluses in the 1940s and 1950s and still have the dominant reserve currency, as was England at the end of the 19th century, but both cases occurred under conditions that do not apply to China today. In the former case, the US economy represented at least 50% of the relevant world back then (excluding among others communist countries like the USSR, China, and their various allies). Much more importantly, the system simply didn’t work. The world was not able to acquire nearly as many dollars as it needed, and the result was the famous “dollar shortage” which was severe enough that it threatened to derail the global recovery. Only the huge gift of the Marshall Plan was able temporarily to resolve it in Europe. China can replicate the US of the 1940s and 1950s, in other words, only if it were able to make as large a gift, even though it is much poorer than most countries and represents about one-third of the share of global GDP that the US represented.
As for the British example at the end of the 19th Century, in those days currency was part of reserve accumulation, but much if not most reserves were in the form of gold or silver, and while Britain had the most important reserve currency, the difference between central bank holdings of sterling and central bank holdings of other gold-based currencies, like the franc, were pretty small relative to total trade. The gap between British capital exports and the British current account surplus, in other words, could be quite small and still allow the world to accumulate enough sterling for sterling to be the dominant reserve currency. This is no longer the case. Reserves are held primarily in the form of government bonds and reserve accumulation is much greater relative to trade.
There was a reason Keynes supported bancor instead of dollars as the global reserve currency during the 1944 Bretton Woods conference, and it was not, as everyone assumes, just because of nationalist pride. He saw how sterling reserve status without the automatic constraints of gold backing helped undermine the British economy in the post-WW1 period as countries that needed to boost growth accumulated sterling. He knew this would happen to the US, and while this might not matter at a time in which the US was roughly half of the relevant world, and in which there was much more cooperation among major governments and central banks, eventually the US would no more be able to absorb the cost, just as England was not able to do so in the 1920s.
This is why I think the dollar will eventually lose its reserve status, not because it will be replaced by the RMB but rather because the US will eventually figure out that it entails too a high cost and that it is no longer willing to pay that cost. When this happens, unless there is a credible alternative, perhaps the SDR, the US will be better off by forcing the world to abandon the dollar but the rest of the world, especially developing Asia, would be much worse off. My main point, however, is not that the US should not accept its role any longer but rather that until China decides it is willing to pay that cost (assuming that it is able, which I very much doubt), I really cannot see how the world can possibly acquire enough RMB for it to become a dominant reserve currency.
Other Things to Consider for the AIIB
This blog entry is already far more than three times the length of the article I was supposed to provide for Foreign Policy, and I still haven’t fully addressed just the key reasons for skepticism about the importance of the AIIB. Because addressing them fully would take this essay easily into book length, let me just suggest them:
- We have a terrible track record of extrapolating from periods of rapid growth to predict which country is the “rising power”. In fact more broadly, depending on how you define them, there have been 30-40 “growth miracles” since WW2, of which perhaps only two came even close to achieving consensus expectations. In every case, including the “successes” the growth period was followed by a terribly and unexpectedly difficult adjustment that derailed all earlier expectations.
More relevantly, in the past century these growth miracle countries have included at least four rising powers that were expected to become the dominant geopolitical and financial power in the world – the US in the 1920s, Germany in the 1930s, the USSR in the 1950s, and Japan in the 1980s. In every case they rebelled bitterly against the existing global financial framework, complaining that it was designed to maintain the status quo and restrain their rise. Every one of these countries initiated policies aimed at transforming the world to align interests correctly and accommodate their rise to dominance. Only one of them succeeded.
The United States in the 1920s was the only country that met expectations. It had already been the world’s largest economy for nearly five decades, but played a minor role in the global system until WWI thrust it into center stage. In the 1920s the US experienced a period of spectacular growth during which institutional distortions forced up its saving rate and resulted in massive trade surpluses, along with the largest accumulation of central bank reserves in history (it is worth noting, by the way, that although the US in the 1920s experienced some of the conditions that characterized China’s growth model, of the four “rising powers” its economic growth was the least similar). Like Beijing today, during this period Washington demanded a greater say in the institutions that shaped global trade and capital flows, but was very suspicious of European initiatives designed, it believed, to enhance the status quo at American expense. For the most part Washington refused to participate, or attempted to create its own institutions. The “rising power” period, however, came to an end, along with most of the expectations generated during the 1920s. US growth was derailed in the 1930s as it was forced into a very difficult adjustment, and among the casualties were the ambitions associated with its geopolitical dominance.
In the 1930s Germany designed a version of the investment-driven growth model, with the two fundamental characteristics similar to China’s growth model that both caused soaring growth and deepening savings imbalances (policies that force up savings by constraining household income and the centralization of the investment process). At the time many if not most economists, not just in Germany but also in the US, expected that Germany would soon overtake the US economically and become the world’s largest economy. Of course WW2 interrupted the rebalancing process, but economic historians argue that had war not occurred, Germany would have probably faced a debt crisis by the early 1940s.
A fully developed version of the investment-driven growth model was implemented in the USSR after WW2 and led to such spectacular growth that, by the early 1960s, most economists and analysts, including apparently President Kennedy, fully expected the USSR to overtake the US both economically and technologically well before the end of the century. Instead, in the now familiar sequence, the USSR suffered a brutal rebalancing and an ultimately disruptive adjustment. Although the USSR participated in the Bretton Woods conference and approved the final agreement, Moscow almost immediately rescinded its agreement and proposed a number of financial initiatives within the Soviet or communist blocs, none of which survive. And while the USSR urgently sought to accumulate dollars for trade and reserve accumulation, its unwillingness to hold these dollars in US-based banks subject to pressure from Washington played a large part in the creation of the offshore market for dollars, and eventually for other currencies. This initiative can be listed as one of the few “reforms” by disgruntled “rising powers” to have survived and changed the global financial regime, but its effect, ironically, was not to undermine the Bretton Woods system so much as to extend it.
In the 1970s and 1980s Japan developed the most successful version to date of the investment growth model, with such stunning results that the Japanese economy was unanimously expected to overtake that of the US, and the yen replace the dollar, before the end of the century. During this period Tokyo complained bitterly about the Washington-dominated global regime and attempted a number of reforms whose consequence included a bitter dispute over the Asian Development Bank and Japan’s role in the regime that governed global trade and finance. Once again, however, a growth model based on structures that forced up both savings and investment generated very high growth levels, but at the cost, in its later stages, of deep savings imbalances and a soaring debt burden, the consequence of which was yet again an unexpectedly difficult adjustment in which all earlier expectations about needed reforms in the global system of trade and capital flows were either jettisoned or modified.
There have been four times in the past 100 years, in other words, in which we were more or less certain (absolutely certain in the cases of the US in the 1920s and Japan in the 1980s, very certain about the USSR in the 1950s, and arguably certain about Germany in the 1930s) that a country would become the dominant economic and geopolitical power, and only once did this turn out to be true. Anyone old enough to remember the 1980s will remember that we were even more certain about Japan’s rise in the 1980s than we are about China’s rise today, but in the Japanese case, as in every other case, we were flabbergasted by how difficult the economic adjustment turned out to be, which suggests at the very least that we might want to wait to see how Beijing manages China’s rebalancing before we insist that this time is indeed different.
- Whatever the outcome, the adjustment period has always overturned the institutions and expectations generated during the growth period. This is why even if China becomes only the second successful case of five in which our predictions about the “rising power” turn out to be correct, it is foolish to assume that the expectations that led to the creation of the AIIB will remain unchanged. China’s priorities will have shifted during its rebalancing to such an extent that today’s goals will not apply to the conditions that accompany its position of dominance. During the adjustment, domestic institutions and political conditions have always been so radically transformed that the country “before” the rebalancing period had a completely different set of objectives and goals from the country “after” the rebalancing period.
It is important not to underestimate this point. Regardless of whether or not it becomes the world’s largest economy, the China that emerges from the adjustment of the next decade or two will be a very different China, with different institutions, different objectives, and different priorities. Among the easier predictions, it is a virtual certainty that the imbalances that force China today to recycle massive current account surpluses will have reversed themselves, so that the recycling process will no longer be a major objective.
- The world is not starved of capital. In fact it has too much capital. The idea that the AIIB will be important because its accumulation of lending power will give it something important that the world needs is widespread but completely wrong. In fact the world is satiated with excess savings, to the point where it has driven interest rates in some countries negative. In fact China and the other founding members of the AIIB who know that they desperately need places to put their money but who do not understand why they have this problem are probably hoping that the bank will be able to increase credible demand for savings by transforming real demand from non-credible borrowers into real demand from borrowers whose credit has been mysteriously enhanced somehow by the AIIB.
- Management of the regime that governs global trade and capital flows depends not on the support of institutions like the World Bank and the IMF but rather on the willingness to underwrite the costs of trade volatility. The reason the US more than any other country sets the global rules for trade and capital flows is not because the US dominates the IMF and the World Bank, whose financial firepower underpins US power. It is because the US has been willing to absorb the volatility generated by trade policies of other countries, and this willingness is based not so much on the openness of its domestic markets for goods and services to foreign trade (although it is clearly more open than any other major economy) but on the fact that its capital markets are open. This point confuses many analysts, who think of the capital and current accounts separately. The right way for any country that wants to power domestic growth by boosting exports is by increasing productivity. In that case it will export more abroad, but the resulting increase in wealth will also cause it import more, and it will not obviously run either a surplus or a deficit, but rather a trade imbalance close to zero.
But if increasing productivity is too hard, it can also boost exports simply by accumulating US assets, the most common of which ways to do so is to have the central bank acquire US government bonds. As its net capital exports to the US grow, its current account surplus and the corresponding US current account deficit will automatically grow by exactly the same amount. I have explained why this must be the case many times, including last year in the September 28 and October 5 entries in my blog. This consequence was why the UK remained so important after WW1, even though its economy was dwarfed by that of the US and was smaller than that of Germany. Countries that needed surpluses purchased British government bonds – at England’s great cost, as Keynes tried to explain.
Most analysts, even US government officials involved in international trade and foreign policy, simply do not understand how this works, but the confusion this causes does not make the accounting identities any less true. In fact the mechanism has been explained often enough by many economists whose work focuses on the functioning of the global balance of payments, from John Hobson and Charles Arthur Conant at the end of the 19th Century, to Keynes in the 1930s and 1940s, to Jared Bernstein and Kenneth Austin today.
Any discussion about how China is going to transform the global financial architecture, in other words, is primarily a discussion about when China will open up its capital markets to unrestricted foreign purchases of domestic assets, especially Chinese government bonds, and its willingness to allow other countries to power domestic growth by accumulating renminbi reserves. This of course also means that the discussion is ultimately about China’s willingness to run large current account deficits to stabilize employment elsewhere. And yet most people on either side of the discussion would probably say that it will be many decade, if ever, before China permits this kind of access to its markets.
- The only countries not reluctant to import the savings of other countries are those who capital exporters shun. These are developing countries who have obvious investment needs but in whom investors are very reluctant to invest because of low credibility. The AIIB has not addressed how it will differ in the way in which it supplies the estimated $8 trillion in infrastructure that Asia needs to ensure that it will be more successful than the many national and multilateral development banks that have made the same and similar promises.
And while people like Mahbubani might claim that China’s “spectacular success with developing world-class infrastructure in record time” gives us reason to expect success for the AIIB, the evidence suggests no such thing. While Beijing certainly has in recent years lent aggressively to developing countries, and many analysts at first hailed what they called a novel approach and hard-headed business intelligence, every time a new country, or group of countries, first begins to invest abroad aggressively, we hear exactly the same sorts of things.
But every time, as soon as global economic conditions turn, we discover that this most recent wave of investment has been successful largely because of its willingness to misprice risk. Inevitably it is followed by defaults and a very dramatic change in approach. It is too early to tell if China will prove to be the sole deviation from historical precedence, but a very depressing article three weeks ago in the Financial Times suggests that when it comes to lending to developing countries, China’s experiences are turning out to be remarkably consistent with those of its predecessors. It is not easy to lend large amounts to developing countries and get repaid.
This is such a heavily politicized subject that for many people skepticism about the transformative power of the AIIB is not the result of better or worse logic, deeper or shallower knowledge of history, or a more or less faulty understanding of how the balance of payments works. It is simply the result of whether or not one is hostile to the idea of China’s rise.
In fact most of the debate about China in the last decade has been held hostage to this absurd idea, even after the past decade has proven conclusively that a certain amount of skepticism is not only sensible, but would have resulted in much better policies and a less dangerously imbalanced economy. We have plenty of history to suggest that we should be skeptical about the importance of the AIIB and the role it is likely to play.
It is always a good thing when more money is devoted to developing infrastructure in poor countries, but there is a long history of national and multilateral development institutions that have pledged to do a better job than their predecessors. They have all discovered, however, that this is never as easy as it seems. The AIIB has not explained exactly how it plans to channel money into developing countries while avoiding the two big problems its predecessors have always faced: how to ensure that the money is not wasted, and how to channel large amounts of debt financing without creating financial distress and non-repayment risk. For now, for all the excited chatter, the AIIB is an institution laden with symbolic value, and little else.