Archive for August 23rd, 2010
Mckinnon reviews three books on China in the paper:
- Deborah Brautigam, University Press, 2009 The Dragon’s Gift: The Real Story of China in Africa, Oxford: Oxford
- Vivien Foster, William Butterfield, Chuan Chen, Natalyia Pushak: Building Bridges: Growing Role as Infrastructure Financier for Sub-Saharan Africa. China’sWashington: The World Bank, PPIAF, 2009.
- Stephan Halper, The Beijing Consensus: How China’s Authoritarian Model Will Dominate the Twenty-First Century New York, Basic Books, 2010.
These three books complement each other in describing the truly astonishing growth of China’s aid, investment, and trade in Sub-Saharan Africa since 2000. For China, foreign aid, investment, and trade are not really distinct categories. As Deborah Brautigam emphasizes, these parts are bound together by intricate financial arrangements under China’s Export-Import Bank with other commercial arrangements orchestrated by the Ministry of Commerce, within which the Department of Foreign Aid is nested. Foster, Butterfield, Chen and Pushak are World Bank economists who bring additional data to bear on aid by China compared to Western sources. Stephan Halper focuses more on the political implications of the remarkable rise of China, and worries about the decline of the United States and its “Washington Consensus” as a model for developing countries.
Now China has this very interesting foreign aid model. First the organisation structure is different from OECD countries. In OECD you have these dedicated departments like USAID in US, OFID in UK etc. So you have a formal donor-recepient relationship where the donor imposes certain conditions etc.
In China, all this formal structure is absent:
Because China is still fairly poor by most per capita income measures, and because most of its “aid” projects are mutually beneficial commercially, it largely escapes the stigma of a donor-supplicant relationship. Each project is designed and financed to be potentially in the mutual economic interest of both China and the recipient countries, most of which are in Africa. But China now has aid projects throughout the developing world in Asia and Latin America. In July 2010, the Chinese and Argentine governments announced a gigantic $10-billion project to rebuild Argentina’s huge but dilapidated railway network while providing finance for new locomotives—no doubt Chinese made. That Argentina had defaulted on its old debt did not hinder the agreement, but gave China an entrée.
What is more interesting is the conditions for bilateral Chinese aid. Usually the recipient returns the aid via payback of principal + interest. In China, they have a quasi barter system and payback usually happen in commodities and natural resources.
Generally China avoids giving or lending cash up front to the recipient countries. Rather, most deals are quasi-barter. Chinese construction and engineering companies, employing a large phalanx of skilled Chinese workers and some local workers, receive funding directly from, say, the China Export-Import Bank. Then over several years the host country agrees to repay the bank in commodity terms—oil or, say, iron ore, whose production and marketing may be facilitated by the construction project itself. To increase leverage in assuring repayment, China may also provide follow-on maintenance crews for the railway, port, or power plant—as well as dangling the possibility of complementary projects in the future.
Because of China’s huge and growing industrial production at home, its need to import vast amounts of industrial raw materials, foodstuffs, and other primary commodities is obvious. However, several years ago when first learning about these quasi-barter deals, i.e., infrastructure for commodities, with developing countries, I was puzzled. China produces a wide variety of consumer manufactures that it exports on a large scale without needing to undertake complementary overseas investments. By extension, China could just buy the commodity inputs it needs in organized world commodity markets—which often provide very convenient forward covering facilities against price risk. Undoubtedly, China still purchases many imported inputs in conventional open markets. But, increasingly, it secures access to minerals and some agricultural products by negotiating complex overseas aid and investment programs in return. Why?
The answer is as exciting. Basically increase in Chinese aid is because Chinese savings are more than investments. This flow if it comes back will lead to appreciating pressure on Chinese currency and undermine China’s export driven model. Hence, the need for government to intervene:
The upshot is that China’s central government steps in to intermediate and control the country’s saving surplus in several different ways.
1. The accumulation of huge liquid official reserves of foreign exchange, currently
about $2.5 trillion, in the State Administration of Foreign exchange (SAFE).
2. The creation of sovereign wealth funds, like the China Investment Corporation
(CIC) which invests overseas in bonds, equities, or real estate.
3. Encouraging China’s large state-owned enterprises such as SINOPEC to invest
in, or partner with, foreign oil companies in exploration and production.
4. Quasi-barter aid programs (the central theme of this paper) in developing
countries which generate a return flow of industrial materials.
Each of these techniques generates claims on foreigners that are in “safe” government hands. That is, they won’t be suddenly liquidated if, say, there is suddenly a new scare that the RMB will be appreciated. This minimizes, but does not eliminate, the possibility of hot money inflows back into China that could destabilize the exchange rate and make monetary control more difficult.
We have a similar case of Singapore which also does the same thing:
Tiny Singapore is also an immature creditor whose own currency is not used for
international lending and whose government, like China’s, tightly controls overseas financial intermediation. Singapore’s net saving (current account) surpluses have been persistently the world’s largest at about 15 to 20 percent of its GNP. To prevent hot money flows, it essentially nationalizes the internal flow of saving by requiring all Singaporeans to deposit what had been as much as 30 percent of their personal incomes into the Singapore Provident Fund—a state-run defined-contribution pension scheme. Then, beyond financing internal investments within Singapore, the proceeds from the Provident Fund are lent to two giant sovereign wealth funds: the Government Overseas Investment Corporation (GIC), which invests in fairly liquid overseas assets, and Temasek, which is more of a risk taker in foreign equities and real estate.
Singapore has larger trade surplus as a % of GDP but does not get criticised as China. Japan has also followed similar policies in the past:
This “Singapore Solution” to international financial intermediation by an immature creditor country, while preserving monetary control, was described in McKinnon (2005, ch. 8). Singapore is too small for Americans and Europeans to complain about its disproportionately large trade (saving) surplus, and demand that the Singapore dollar be appreciated. China (and Japan before it) are not so lucky. Although China’s trade surpluses are proportionately much smaller than Singapore’s, their large absolute size draws the ire of American mercantilists in the form of “China bashing” for the RMB to be appreciated. Although the common theory that exchange rate appreciation will reduce a saving surplus of a creditor country is wrong (Qiao 2005, McKinnon 2010), the fear of appreciation still induces large hot money inflows into China despite the immunization of its overseas investments—as described by points 1 to 4 above.
Surplus-saving Japan is also an immature international creditor because the yen is not much used to denominate claims on foreigners. But, unlike China’s or Singapore’s, the Japanese government does not dominate the international intermediation of its saving surplus as much. How then is Japan’s saving (current account) surplus financed internationally?
Large Japanese corporations make heavy overseas direct investments in autos, steel, electronics, and so on. But, in addition, Japanese banks, insurance companies, and pension funds, have become big holders of liquid assets, at different terms to maturity, denominated in many foreign currencies such Australian, New Zealand, as well as U.S. dollars —which until fairly recently had much higher yields than yen assets.This part of the Japanese system for overseas investment is vulnerable to hot money flows. Over the last 20 years, carry trades out of low yield yen assets have been commonplace with a weakening yen. But they can suddenly reverse. The Japanese economy is then vulnerable to sudden runs from dollars (largely owned by private Japanese financial institutions) into yen that create damaging sharp appreciations in the “floating” yen/dollar exchange rate. Investment within Japan is inhibited while making it more difficult for the stagnant economy to escape from its zero-interest liquidity trap (McKinnon 2007).
Really really fascinating.
The authors then discusses how China is moving into African infrastructure space:
Chinese finance often goes to large-scale infrastructure projects with a particular focus on hydropower generation and railways. At least 35 African countries are engaging with China on infrastructure finance deals, with biggest recipients being Nigeria, Angola, Ethiopia, and Sudan. The finance is channeled primarily through the China Export-Import Bank on terms that are marginally concessional, though significantly less so than traditional official development assistance. A large share has gone to countries that are not beneficiaries of recent debt relief initiatives. ….Chinese financial commitments to African infrastructure projects rose from around US$.5 billion in 2001-03 to around US$1.5 billion in 2004-05, reached at least US$7 billion in 2006—China’s official “Year of Africa”—then trailed back US$4.5 billion in 2007.” (Foster et al, 2010, xi-xii).
Finally there is another very interesting aspect of China. Now, like other developed countries have certain conditions for giving aid. They have been called (read criticised) as Washington Consensus. Does China have its own Beijing consensus?
The Beijing Consensus is hard to write down as a precise set of rules because of its pragmatism involving “a commitment to innovation and constant experimentation” (Ramo 2004)—as per the old Chinese saying “crossing a river by feeling the stones”. It is also associated with China’s specific commercial interests in, say, investing for extracting minerals on favorable terms—which enhances sustainability on both sides. In contrast, the Washington agencies in principle are more selfless (at least since the end of the Cold War) in aiming to raise per capita incomes and welfare in the recipient countries—but run the risk that aid recipients become permanent supplicants.
Now most people criticise Washington consensus (WC) saying China and India have grown without following them. Even posterboys of WC like Korea, Taiwan etc did not follow WC if we look at them carefully (Dani Rodrik has said this in so many papers). McKinnon says the reverse is true:
20 years later, should the meteoric rise of socialist China—both in its own remarkable growth in living standards, and in the effectiveness of its foreign “aid” to developing countries, undermine our confidence in Williamson’s Washington Consensus?
Surprisingly, no. The Chinese economy itself has evolved step-by-step (feeling the stones) into one that can be reasonably described by Williamson’s 10 rules! Chinese gradualism avoided the “big bang” approach to liberal capitalism, with the financial breakdowns that were so disastrous for Russia and some smaller Eastern European economies in the early 1990s, while retaining financial control in a model textbook sense (McKinnon 1993). So let us look again at Williamson’s 10 rules to see how well they fit China today in comparison to the United States.
He then shows how China’s reforms closely follow WC! Waiting for Rodrik to write a paper contradicting the claims.
But what a paper. So many insights on China…
IMF staff economists look at the relationship between monetary policy and bank risk taking in this paper. Do low central bank interest rates lead banks to take on more risks?
The authors explain there are 3 channels via which low-interest rates can lead to high risk taking:
The arguments in support of this thesis can be broadly grouped under three headings: asset substitution, search for yield, and procyclical leverage.
The asset substitution argument goes as follows. Under relatively general conditions, a lower real yield on safe assets will lead to a decrease in their weight in bank portfolios. Risk-neutral banks will increase their demand for risky assets—hence, in aggregate, reducingtheir yield—until in equilibrium returns on both types of investments are again equalized. Risk-averse agents will generally reallocate their portfolios in a similar fashion under most utility functions (however, agents with decreasing absolute risk aversion will instead decrease their holdings of risky assets).
A related mechanism operates through a “search for yield.” Financial institutions with long-term commitments (such as pension funds and insurance companies) need to match the yield they promised on their liabilities with what they obtain on their assets (Rajan, 2005). When interest rates are high, they can generate the necessary revenue by investing in safe assets. When they are low, they are forced to invest in riskier assets to continue to match the yield on their liabilities (assuming a positive pass-through between the policy rate and the yield on longer-term safe assets).
A complementary view is the leverage channel advanced by Adrian and Shin (2009). They assume that financial institutions target constant (in the case of commercial banks) or procyclical (in the case of investment banks) leverage ratios. When faced with shocks to their portfolios or profits, banks react by buying or selling assets rather than by distributing dividends or raising new capital.
Further they add that with limited liability and information asymmetry, banks might end up taking even more risk. The findings:
The view that monetary policy easing induces greater risk taking by banks through a search for yield or its effects on leverage and asset prices has become increasingly popular. This paper broadly supports this view. But it also shows that the relationship between real interest rates and bank risk taking is more complex. The reason is that, at least in the short term, two opposite forces are at work. Portfolio reallocation and search for yield effects protected by limited liability points in the opposite direction. The balance depends on the degree to which banks have skin in the game.
Preliminary empirical evidence is consistent with these predictions. Monetary policy easing will increase risk taking, but less so for poorly capitalized banks. These results imply that the impact of monetary policy on bank risk taking is likely to differ across countries and time and be dependent on local banking market conditions (such as bank leverage and charter values and the contestability of banking markets) and factors that affect these conditions (such as business cycles).
Hmm. What about the interactions between monetary policy and proposed macroprudential policy?
These findings bear on the debate about how to integrate macroprudential regulation into a macroeconomic policy framework to meet the twin objectives of price and financial stability. Whether price and financial stability are substitutes or complements will depend on the types of shocks the economy is facing and on whether portfolio effects or risk shifting are the dominant force at play.
For instance, there may be no trade-off between price and financial stability when an economy nears the peak of a cycle (when banks tend to take more risk and prices are under pressure). Under these conditions, according to the prevalent view based on portfolio effects and to most empirical evidence, monetary tightening will decrease both risk taking and price pressures. In contrast, a trade-off between the two objectives would emerge in an environment with low inflation but “excessive” risk taking (as may happen when asset price or housing bubbles develop). Under these conditions, the policy rate cannot deal with both objectives at the same time: tightening may reduce risk taking, but will lead to an undesired contraction in aggregate activity (and/or to deflation). The opposite trade-off may manifest itself in the wake of a currency crisis, when inflation is on the rise due to a depreciation of the exchange rate and bank capital is depleted. Then, fighting inflation pressure may come at the cost of increased risk taking.
This is even more interesting and complicated. The linkages between monetary policy, business cycles and financial regulation makes it all so complex. Though there is some clarity on when to use macroprudential policy.
When a trade-off between price and financial stability emerges, macroprudential measures can complement monetary policy and fine-tune its stance by acting in a discriminatory fashion on selected sectors of the economy (IMF, 2010)….
Regulatory policy may be more effective in limiting bank risk taking, either by taxing or restricting financial activities….. For example, capital requirements can be raised to reduce leverage, and lending criteria can be tightened to reduce the risk of banks’ loan portfolios (e.g., limits on loan-to-value ratios can help curb a house price boom).
The next question is should central bank be managing both price and financial stability? The authors say evidence points in centralisation of both the tasks:
If one accepts the notion that the combination of monetary policy and regulation provides an effective set of tools to deal simultaneously with price stability and financial stability, the question of how to make such policy operational remains. Specifically, this raises the issue of how to coordinate monetary and regulatory authorities. Should these be separate entities or should one agency have responsibility for both stability concerns? The potential interaction among banking market conditions, monetary policy decisions, and bank risk taking implied by our analysis can be seen as an argument in favor of the centralization of macroprudential responsibilities within the monetary authority. And the complexity of this interaction points in the same direction.
IMF Staff Notes have always been very useful and this one is another useful piece.