Tuesday, September 2, 2014
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The “Asset Crisis” of Emerging Economies

BEIJING – In theory, the difference between capital inflows and outflows in developing countries should be positive – they should be net capital importers, with the magnitude of the balance equivalent to the current-account deficit. Since the 1997-1998 Asian financial crisis, however, many East Asian countries have been running current-account surpluses – and hence have become net capital exporters.

Even odder is the fact that while they are net capital exporters, they run financial (capital) account surpluses. In other words, these countries lend not only the money they earned through current-account surpluses, but also the money they borrowed through capital-account surpluses – mainly to the United States. As a result, East Asian countries are now sitting on a huge pile of foreign-exchange reserves in the form of US government securities.

While China has attracted a large amount of foreign direct investment, it has bought an even larger amount of US government securities. Whereas the average return on FDI in China was 33% for American firms in 2008, the average return on China’s investment in US government securities was a mere 3-4%. So, why does China invest its savings so heavily in low-return US government securities, rather than in high-return domestic projects?

One answer lies in the fact that China’s FDI policy over the past 30 years has crowded out Chinese investors from high-return projects, forcing them to settle for less lucrative projects. But there are still potential investors who cannot find any suitable investment opportunities in China, generating excess resources, which in turn are invested in US government securities.

But, while China’s foreign assets are denominated in US dollars, its liabilities, such as FDI, are mostly denominated in renminbi. As a result, when the dollar depreciates against the renminbi, the value of China’s foreign liabilities increases in dollar terms, while that of its foreign assets remains unchanged. As a result, China’s net international investment position (NIIP), which is the difference between China’s gross assets and its gross liabilities, automatically worsens. The deterioration of China’s NIIP is a reflection of the transfer of wealth from China to the US. 

Since the 2000’s, China’s gross assets and gross liabilities have increased dramatically, owing to the success of China’s trade-promotion and FDI policies. As a result, China’s net international investment position has become very vulnerable to the devaluation of the dollar.

Meanwhile, capital inflows into developing countries have surged since the 2007-2009 global financial crisis. In 2010, China’s capital-account surplus stood at $230 billion, and capital inflows remain large this year. With ever-increasing gross dollar assets and gross renminbi liabilities, a stronger renminbi means that China will suffer additional welfare losses from the valuation effect of exchange-rate movements. (It is worth noting that this is not solely a Chinese phenomenon; all major emerging-market economies are faced with the same fate.)

During the 1997-1998 Asian financial crisis, East Asia’s economies paid heavily for excessive accumulation of dollar-denominated debts. Because governments failed to defend their currencies, they lost hundreds of billions of dollars in foreign-exchange reserves to international speculators.

Whether for self-insurance or to maintain a competitive exchange rate, East Asia has since then accumulated a huge volume of dollar-denominated assets. This time around, thanks to the deterioration of the US fiscal position and the Federal Reserve’s expansionary monetary policy, “the long-term risk [for] emerging markets’ external balance sheets is shifting,” as Eswar Prasad of the Brookings Institution has pointed out, “to the asset side.”

Rather than confronting a debt crisis, as in 1997-98, emerging-market economies now face an “asset crisis,” but they will suffer the same result: great capital losses on their foreign-exchange reserves. Indeed, the magnitude of the losses will be on par with that of Asian financial crisis, if not higher.

While China’s government should make greater efforts to rebalance the economy by conventional measures, it also should focus more attention on adjusting the currency structure of the country’s gross assets and gross liabilities. In particular, China should try to replace its dollar-denominated assets with renminbi-denominated assets, and its renminbi-denominated liabilities with dollar-denominated liabilities.

If China cannot do very much about existing gross assets and gross liabilities, it should address new assets and liabilities in order to minimize future capital losses. In short, China must take into consideration the ongoing asset crisis facing emerging economies, especially when considering highly consequential questions such as full renminbi convertibility and the currency’s internationalization.

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