Opinion: Asia Must Adjust to Changing Financial Landscape
The world is ever-changing. We have been fortunate to witness the rise of China as the second-largest economy in the world, a rise that has been a remarkable story of its interaction with the global economy and financial system. China has changed the world, and the world has changed China.
This change converged with major trends of climate change, middle-class emergence, technological advancement, geopolitical rivalry and other forces to create a global financial crisis in 2007-09, followed by massive financial regulatory reforms. Ten years later, how has the structure of Asian finance changed?
The rise of the Asian global supply chain, led by Japan, created an Asian-Pacific financial loop. Asia ran a current account surplus with the U.S., and recycled the savings back into the U.S., which then acted as a global banker, sending the funds back as foreign direct and portfolio investment. Wall Street acted as a banker, then as an investment banker, even as the U.S. enjoyed more and more consumer goods from the rest of the world, paid for by printing U.S. dollars. Hong Kong and Singapore were feeder hubs to the Wall Street and London core centers.
In hindsight, there were two global supply chains — one in Asia (which received most attention), the other in Europe, especially Germany, which created the first eurodollar financial system. Germany dropped out of that surplus situation when East and West Germany unified in 1990. But today, Germany (and Europe as a whole) has re-emerged as a major surplus economy, with the current account surplus rising to more than 8% of gross domestic product (GDP). Europe now has a current account surplus equal to roughly 3.3% of GDP.
Taking a step back, the broader picture of the U.S. as a major deficit country, financed by the rest of the world, has not changed, but there are fundamental shifts in the pattern of production and finance.
First, the present U.S.-dollar-dominated multilateral trading and financial system, centered on the World Trade Organization (WTO) and the International Monetary Fund, which the U.S. created to its advantage, is changing because the U.S. is turning inward and becoming more protectionist. From a major provider of global public goods, including the provision of a security umbrella, the new Trump administration is seeking to tax the rest of the world for its services, including the military umbrella for its allies. Moreover, the U.S. will relocate production to “Made in U.S.A.”
Second, the global financial system is still U.S.-dollar-dominated, but a multipolar order, with the U.S. complaining of currency manipulation by China, Japan and even Europe, means that the nondollar region must defend its own interests. President Xi Jinping, at the World Economic Forum annual meeting in Davos, Switzerland, in January, signaled that the rest of the world must defend the globalization of trade and investment. This is best achieved with U.S. cooperation, but if not, then alternative arrangements will have to be found.
Third, the U.S. trade deficit position owes less to the exchange rate argument, and more to the very low rate of U.S. savings, stuck at around 6% of GDP. Much of this was due to the large fiscal deficit, with $4 trillion spent on the Iraq and Afghanistan wars. Trump’s tax cuts, $1 trillion infrastructure spending, and more weaponry for the military are music to the ears of the rich and defense hawks, but can only be paid for by slapping on a border tax of 20% or more. That would lead to a trade war, on top of the abandonment of the Trans-Pacific Partnership and possible renegotiation of the North American Free Trade Agreement (NAFTA) and even abandonment of the WTO.
The current flexible exchange rate system adopted since 1971, when the U.S. abandoned the link to gold, is that the hard budget constraints imposed by fixed exchange rates was lost. Politicians in all countries have the soft option of devaluing to solve their own pain of restructuring and reform, using quantitative easing in the guise of monetary policy to hide a true trade objective.
But the lowering of advanced country interest rates has caused what Bank for International Settlements (BIS) economists call a global “carry trade.” When the dollar was weakening, it paid to borrow dollars and invest in emerging markets. Now that the dollar is strengthening, the reverse carry trade is happening, putting huge pressure on emerging markets with capital outflows, leading to devaluation, higher interest rates and declining trade. What China is facing in the yuan and capital outflow area is exactly this carry-trade reversal.
Given the fact that Asia remains the fastest-growing region, with the highest savings, why is Asia still exporting capital to New York and London and reimporting such capital in the form of foreign direct investment and portfolio investment?
The cumulative flow of current accounts and change in the net international investment positions of the Asian surplus economies show why the region is still dependent on the U.S. dollar. Japan, the Chinese mainland, Hong Kong, Taiwan, South Korea and Singapore all ran current account surpluses with the U.S., amounting to $5.8 trillion between 2004 and 2015. You would expect the net increase in foreign exchange wealth to be at least equal to hard earnings from the current account (mostly trade) surpluses. But the net stock of foreign exchange wealth was $7.3 trillion at the end of 2015, almost identical to the U.S. net investment liability at the end of 2015. However, the net change in stock position was $4.4 trillion, or $1.4 trillion lower than the cumulative increase in current account. Asia was earning less on its assets and paying more on its liabilities.
The flip side is that the U.S. cumulative current account deficit was $6 trillion, but the deterioration in net liability position was offset by $1.1 trillion of valuation changes, giving a net change in stock position of $4.9 trillion.
In simple terms, Asia earns foreign exchange (mostly invested in U.S. dollar or euro official reserves) earning low returns. The U.S. reinvests back in Asia in direct and portfolio investments earning high returns. The result is that in revaluing the assets and liabilities in foreign exchange, the U.S. assets in Asia are valued more (especially if Asian currencies appreciate against the dollar). The U.S. is the better investment bank. Going forward, it will import less in hardware and earn more in software.
Two decades after the Asian financial crisis of 1997-98, the leading investment banks in Asia are non-Asian, meaning that Asians do not know how to invest in high-growth, higher-risk Asia. This puts Asia at risk of the U.S. dollar reverse carry trade. When capital flows back to advanced markets as their interest rates rise, who is to blame?
In other words, Asians are good at hardware exports, but bad at software of managing savings with high return on assets. Improving financial intermediation is a software issue that deserves policy attention.
The problem of “Trump’s dollar, Asian savings” is totally within the control of Asians, who are the surplus savers. If we do not understand this basic fact, then Asians will always be victims of fluctuations in U.S. policies.
Andrew Sheng is a distinguished fellow at the Asia Global Institute at the University of Hong Kong.
Andrew Sheng is a distinguished fellow at the Asia Global Institute, University of Hong Kong.
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