For any leading euro area finance minister to doze off during key negotiations to settle the economic future of another euro area member is an embarrassing dereliction of duty. Perhaps Mr. Moscovici was assured that his 70-year-old German counterpart, Wolfgang Schäuble, would defend French taxpayers’ interests. Moscovici’s staff – which failed to wake him up – seemingly agreed. Or perhaps Paris simply viewed the German-led bail-in solution in Cyprus as a fait accompli about which they could do little. Or perhaps the French government’s support for costs imposed on creditors and uninsured depositors was stronger than it wished to acknowledge. Taking a nap during the negotiations could thus have been a subtle way of Moscovici stepping outside the door at the key decision moment.

The other euro area finance ministers could probably be forgiven for letting sleeping ministers lie. But by failing to wake Moscovici up, they effectively rendered France’s potential input as irrelevant. Probably to avoid that implication, Lagarde woke up her successor.

Whatever the underlying motives for Moscovici’s sidelining at the Cyprus negotiations are, the broader reasons for France’s evident loss of influence in the EU since the beginning of the crisis are several.

Paris has been hit by bad timing luck in European affairs. My colleague John Williamson once explained that a period of “extraordinary politics” follows serious crises, compelling leaders to establish new institutions, such as the so-called Permanent Five members (P-5) in the United Nations Security Council or the de facto clout wielded by US and European members of the IMF Board resulting from their dominant global role in the 1940s. In European affairs today it matters for a country to be economically strong in a time of severe crisis.

Ironically, Chancellor Angela Merkel and Germany are reaping the unforeseen national benefits of reforms instituted by her predecessor, Gerhard Schröder, a decade ago in response to Germany’s status then as the “sick man of Europe.” Its weakness mattered little because nothing dramatic was happening at the time to the European institutional design following the collapse of the constitution treaty negotiated under the leadership of former French President Giscard de Edtaing. Today Germany is negotiated under the leadership of former French President Giscard de Estaing. Today Germany is strong when it matters, and able to play a leading role in the birth of important and permanent new European institutions like the updated fiscal surveillance framework (two-pack/six-pack, fiscal treaty), the European Stabilization Mechanism (ESM), and now the banking union. These redesigns have been largely devoid of obvious French fingerprints, even if France can take credit for helping to goad Germany into taking action at critical moments.

If Germany benefited from Schröder’s early reforms, France’s situation results from its profound misreading of the effects of the euro introduction, and the political dynamic of crises. Germany’s original agreement to give up the Deutsche mark for the euro back in the 1990s has historically been seen as a concession in return for France’s acceptance of German reunification. (Chancellor Helmut Kohl also saw the euro as a reunified Germany’s anchor in Europe.) With the euro’s advent, Paris was free from the yoke of having to pursue German monetary policies to defend the “Franc Fort” in the 1980s. The crisis, however, has bestowed disproportional political power to Germany, which as the euro’s anchor has been able to set the crisis response agenda.

For two decades, France has failed to reform its economy, yielding power to Berlin and the European Central Bank to demand domestic reforms in other euro area member countries. Meanwhile, the government of President Francois Hollande has done little to arrest France’s path of gradual decline since adoption of the Maastricht Treaty in 1992. Neither Presidents Jacques Chirac nor Nicolas Sarkozy succeeded from the center right, and the consensus-seeking socialist Hollande does not seem to have the political will to face down entrenched special interests blocking reforms either. The alleged left-right divide in France is obsolete. Both sides favor the status quo and are fearful of street protests blocking any serious attempts at reform.¹

The parallel with fears of “Arab street” protests blocking reforms in the Middle East is evident. But with its founding myth of storming the Bastille, France has embraced its identity as a place where farmers, truck drivers, and average citizens are easier to mobilize. By protesting, French citizens are engaging in an intrinsic element of being French. Like the National Rifle Association in the United States, French labor unions, public sector representatives and protected industries appeal to patriotic fervor to promote their political and economic interests. As a result, international competitiveness suffers, the size of the public sector continues to grow, unemployment rises and debt and deficits begin to approach damaging levels.

Unable to muster the political capacity to reform itself in the absence of a deep crisis, France fits the political definition of a peripheral country in the euro area, except that things have not gotten as bad as they have in Greece, Portugal, Ireland, and arguably Spain and Italy in recent years.

To be sure, France is far from an economic basket case. It has avoided the build-up of huge post-euro imbalances. It does not have Italy’s history of free-spending governments, and it enjoys some of Europe’s most favorable long-term demographics and a first-rate public infrastructure. Were it to experience a crisis, it is inconceivable that Germany (and the ECB) would not come to the rescue. As a result, despite its growing differentials in French and German economic competitiveness, unemployment and debt, France is likely to keep getting a pass from financial markets and tracking German interest rate levels closely.

Lacking financial market pressure, however, France’s status quo parties will likely continue to derive the functional equivalent of America’s “exorbitant privilege” and enjoy interest rates lower than its own economic fundamentals would dictate. France’s problem is not a sudden speculative attack, but rather continued malaise, stagnation, and decline.

Though he never used the word “malaise,” President Jimmy Carter described the American mood in 1979 in ways that seem suitable to the predicament in France: “The threat is nearly invisible in ordinary ways. It is a crisis of confidence. It is a crisis that strikes at the very heart and soul and spirit of our national will. We can see this crisis in the growing doubt about the meaning of our own lives and in the loss of a unity of purpose for our nation.” Hollande’s government continues to shun globalization by blocking foreign investments in France. The latest sad example is the blocking of Yahoo!’s proposed takeover of successful French internet start-up, Dailymotion. He has, on the other hand, overseen some new labor market rules accepted by the social partners, and has committed to reforms of the social insurance system later this year in return for a two-year delay in achieving a deficit target. But these consensus-driven steps are unlikely to shake France out of its paralysis or earn much respect elsewhere in the euro area, and especially not in Berlin.

The euro area’s required institutional reforms can be divided into two groups: one that is urgently required and one that takes the form of highly desirable institutional innovations. The most urgent steps that are needed to convince markets and voters that a euro collapse is not imminent include establishment of the ESM as a de facto European monetary fund to serve as a backstop if a euro area member loses market access; the ECB’s outright monetary transaction (OMT) program, serving as a conditional lender-of-last-resort; and the banking union, which will integrate banking supervision with resolution in cases of insolvent banks, and establish a system of deposit insurance. All these new institutions have been implemented under financial market pressure and in response to the political desires of Germany. France’s input has mattered little.

But neither financial markets, nor Brussels technocrats, nor central bank pressure can be factors in the other group of institutional reforms, such as deeper political and fiscal integration in the euro area and revisions of the EU Treaty. Only the democratically elected leaders of Europe can bring about these changes. These steps will be close to impossible to achieve without support and agreement from France and Germany, the two countries historically at the heart of the European integration project.

Regrettably, France’s lack of domestic economic reforms will ensure that Germany will likely refuse to discuss deeper fiscal and political union in Europe for the foreseeable future. The road to any potential form of euro area fiscal integration, whether in the form of debt mutualization or an increased euro area fiscal capacity, will have to pass through a French reform-driven domestic economic revival first. Germany will not agree to permanent burden-sharing with a France that does not reform itself first.

This does not mean the collapse of the euro or the European project, only an end to most longer-term progress on the project. Just as the United States political system can stagger through political crises with one of the two larger parties on the political fringes, the euro area can staffer on under de facto German leadership for as long as France’s inaction exiles itself from real influence. As with the US fiscal negotiations, this state of affairs ensures that progress will be minimal, based on the least common denominator, rather than arrived at by a grand bargain between France and Germany.

France’s inability to reform itself puts Europe at risk, in short, and condemns France to subpar influence in Europe and thwarted aspirations. For its own sake and Europe’s, France must do better.

Note

1. I have benefited greatly from many discussions with my colleague Nicolas Véron about the “status quo party” in France.

Copyright © 2013 the Peterson Institute.

My favorite school of thinking is a bit far-fetched, but has a certain geopolitical flair to it. This links the Daulat Beg Oldie intrusion with the Chinese takeover of the Pakistani port of Gwadar. The Depsang plateau’s northern ridge overlooks the Karakoram Pass – China’s gateway to Pakistan and lands beyond.

Beijing’s demands that India cease and desist its recent attempts to improve its border defenses are an attempt to neutralize the plateau as a site for Indian military deployments. An artillery line or two, or even some sort of a helipad on Depsang’s heights, and it’s hunting season for any vehicle, train or container crossing the Karakoram Pass.

Similarly there has been amazement at China’s recent announcement that it will invest $750 million in developing Gwadar – a port connected to nothing, where a ship docks every half year, situated next to the fully developed port of Karachi.

Are these events connected? They would be, physically, if China extended its plan to be Eurasia’s infrastructure hub to encompass Pakistan and the Arabian Sea.

As a Global Times article pointed out, a pipeline running from the Karakoram to Gwadar would allow China access to West Asia without the hindrance of the Straits of Malacca. Such a corridor would additionally boost Pakistan’s economy. Cleaning up the Depsang would be part of any strategy to secure such an enormous project.

It sounds nice, but formidable in terms of funds and engineering. I suspect therefore it was more of a few Chinese commanders getting together, saying India needs to be taught a lesson, and someone piped up: “Let’s do it on the Depsang plateau then, we need to keep that clear anyway.”

Or maybe the Prime Minister’s visit to Japan was on their mind. Or sheer orneriness. Or all of the above.

Copyright © 2013 the Hindustan Times.

For Italy, a Fresh Start, a Youthful Team, but No Guarantees of Success

In Italy, Enrico Letta has taken office as the prime minister, heading a coalition of his own center-left Democratic Party, former Prime Minister Silvio Berlusconi’s People of Freedom Party, and the centrist Civic Choice bloc of former Prime Minister Mario Monti.¹ Some see this new grouping as another “technocratic” regime, a Monti 2.0, but with a few more politicians in key positions. But that is a matter of debate.

Letta himself is a centrist. A nephew of Berlusconi’s chief of staff, he started his career in the disgraced Christian Democratic Party, which collapsed in the “Clean Hands” corruption scandals in 1992-94. At the age of 25, he became president of the center-right European People’s Party’s youth wing, before joining the center-left predecessor of the Democratic Party in 1994. He was the youngest ever government minister (for European affairs) in the late 1990s and has been his party’s deputy secretary since 2009. Letta is decisively a Europhile, a former member of the European Parliament and author of wonkish books with titles like Dying for Maastricht and Dialogue Around Europe. In a party long dominated by elderly former Italian communists, including Italy’s president, Giorgio Napolitano (once described as Henry Kissinger’s favorite communist), Letta’s ascension shifts the left toward the center, potentially turning the party into a more modern collection of European social democrats.

 The new cabinet, moreover, is dominated by seasoned and safe veterans as well as technocrats. The minister for the economy and finance is 70-year-old Fabrizio Saccomanni, director general of the Bank of Italy and a former close associate of Mario Draghi, president of the European Central Bank (ECB). The new foreign minister is a 65-year-old former European commissioner, Emma Bonino, the first woman in this post. The head of the government statistical office and a former chief statistician of the Organization for Economic Cooperation and Development (OECD), Enrico Giovannini, is labor and welfare minister. The career bureaucrat Anna Maria Cancellieri shifts from interior minister under Monti to justice minister. Angelino Alfano, a 42-year-old ally of Berlusconi (and another former Christian Democrat), is deputy prime minister and interior minister.

But whether this generally capable, pro-European government, which enjoys a broad majority in Parliament, can pursue needed structural reforms is a difficult question to answer. Italy’s problems are deep and have been festering for decades, and it seems unlikely that they can be solved during a single parliamentary term.

One factor to watch is the extent to which Letta and his relatively youthful team can compete against Bepe Grillo, the volatile comedian and leader of the Five Star Movement, which has chosen to remain outside the government. Letta himself is nearly 20 years younger than Grillo, who may be able to seize the mantle of “agent of change” with that generational advantage alone.

Grillo’s decision to remain outside the government, despite his movement’s success in getting more than a quarter of votes in the election, could mean that his influence has peaked. Grillo will probably need to share the political limelight with younger members in order to duplicate his success in the next election, even if Letta’s government fails to restore economic growth and reform momentum. In this bleak scenario, fear for the future is likely to outweigh anger at the establishment as the main political concern for many still affluent Italian households,² and they are likely not to forget that Grillo refused to capitalize on his political success to make a difference in the Italian crisis.

For Cyprus, a Risk of Delay in Lifting Capital Controls

On April 30, the Cypriot parliament voted narrowly (29-to-27) to approve the financial assistance deal reached last month with the Troika of the European Commission, the European Central Bank and the International Monetary Fund. This action clears the way for the bailout to proceed and for a more substantive discussion of when Cyprus’s capital controls can be lifted. Had the vote failed, the controls would likely have had to remain in place for the foreseeable future. Meanwhile, new data from the Cypriot central bank shows that the country’s capital controls have been reasonably effective. Deposits declined 5.5 percent in March to €63.7 billion, reaching the level they had been before the crisis in Greece in early 2010. Domestic resident deposits dropped 3 percent, while other euro area resident deposits dropped 13 percent, and residents of the rest of the world took out €1.9 billion, or 9 percent of their deposits.

Thus only a modest amount of money has left the banking system, much of it withdrawn immediately by hard-hit Cypriot retail depositors. The Central Bank of Cyprus balance sheet [PDF] shows, however, that a sizable part of the total €3.75 billion monthly deposit outflows was replaced by an increase from €1.2 billion to a record €11.4 billion in emergency liquidity assistance (ELA) from the European System of Central Banks (ESCB), which comprises the European Central Banks and the central banks of other members of the European Union. (The Central Bank of Cyprus identifies this lending on its balance sheet as other claims on euro area credit institutions denominated in euro.) Such assistance now equals 64 percent of Cypriot 2012 GDP. Deposit levels and ELA provision since Cyprus adopted the euro in 2008 are in Figure 1.

Figure 1 also reflects the remarkable stability of deposit levels in the Cypriot banks, despite the crisis, while illustrating the rapid ELA increase for Cypriot banks after they lost access to the wholesale funding market following the Greek debt restructuring in March 2012. Figure 1 shows further how, only after the March 2013 bailout did the ECB’s ELA provision directly replace the withdrawn deposits of some of Cyprus’s banks, notably the doomed Laiki Bank. Initially ELA only replaced lost access to wholesale funding for such banks.

The issue of potential ECB exposure from the ELA will help determine the timetable for lifting Cypriot capital controls. Some commentators assert that Cyprus’s capital controls have created a de facto dual currency in the euro area, where capital controls are not allowed except in the most dire of emergencies. The euro area will have to lift its capital controls as soon as possible, and avoid the Icelandic scenario of having them linger on for years. Being part of a common currency area must make a difference in this matter.

Reports that the Cypriot government may wait until September 2013 to lift the controls, after the restructuring of the Bank of Cyprus and Laiki Bank is completed, are disheartening. It is difficult to see the rationale for keeping capital controls in place for all Cypriot banks, while awaiting the completion of the restructuring of just the two big banks. The Bank of Cyprus has already begun its swap-to-equity arrangement for uninsured deposits in excess of €100,000, converting 37.5 percent of them into A-shares, while holding another 22.5 percent as an additional buffer for potential future conversion. The Bank of Cyprus’s recapitalization needs and the size of losses inflicted on uninsured depositors should be known by June. The acknowledged liquidation of Laiki Bank, most likely with a complete wipe-out of creditors, including uninsured depositors, should also hasten the lifting of capital controls.

Unless, of course, the ECB thinks that lifting them is too risky.

Following the transfer of Laiki’s emergency liquidity liability to the Bank of Cyprus, the European central bank system will have the dubious distinction of being the largest single counterparty in the new combined legacy bank entity in Cyprus. Yet the riskiness of the ESCB’s ELA provision is alleviated by the liquidation of Laiki and the Bank of Cyprus’s restructuring, enhancing its ability to sustain itself without the need for more emergency lending. But the market consequences of lifting capital controls in Cyprus are inherently unpredictable. While March data are somewhat reassuring, no one knows if everyone will simply take the money and run when they can, exposing the ECB to at least some risk. The ECB is obliged to provide liquidity to any solvent bank, and the Troika program assumes that all other Cypriot banks except for the two biggest are solvent). But no bank is solvent if it suffers a bank run as part of a general panic in a country’s banking system. As a result, the ECB might in extremis have to replace all the remaining €63.7 billion in deposits in the system. Such an extreme outcome is not likely. But if a run starts, would the ECB be willing to provide another €20 billion to €25 billion to Cypriot banks, bringing its lending to nearly 200 percent of GDP?³ Perhaps the ECB would rather wait a little longer to make sure.

A more pertinent question is whether the German government would take such a risk before elections on September 22,⁴ if another round of ECB emergency loans fans anti-euro sentiment. For the junior German coalition partner, the Free Democratic Party, which is polling close to the 5 percent threshold for parliamentary entry, this is a very serious risk. The political dynamics in Europe are such that it is impossible to ignore the electoral calendar of the regional hegemon, Germany.

But there are also risks entailed by delay. Cyprus’s recovery is likely to be impeded by shackling the country’s working capital inside its banks. If all Cypriot banks end up affected by most of the capital controls in force today until September, no doubt the 2013 economic contraction will be massive, exceeding current official assumptions. If that happens, Cyprus’s future financing needs from the Troika would surpass the allocated €10 billion (equal to 60 percent of GDP). Of course, Germany and the ECB may accept the risk of delay, especially because the amount of money is small in the larger scheme of things in Europe. Even if, like Greece, Cyprus needs euro area debt write-downs to help meet its future financing needs, euro area leaders may accept this possibility to protect the ECB today and help smooth the German election campaign. Such an approach, however, would show little care for the short-run plight of Cypriots. It would also render the coming IMF debt sustainability analysis (DSA) irrelevant.

Then there is the issue of whether a dual currency – “the Cypriot bank euro”  - would actually develop and trade at a lower rate than the regular euro during prolonged capital controls. The prospects for such a dual market are currently low, provided the consensus holds that controls are lifted by the end of 2013. Cypriot bank depositors would have to place a high value on immediate access to their bank deposits – for example, a 10 percent discount for each euro in a Cypriot bank that is blocked another 6 to 9 months. Such “Cypriot bank euros” might theoretically then be traded in their own market, but it is unlikely that anyone would be willing to take as much as a 10 percent haircut on them. And since the AAA euro yield curve is essentially zero out to 18 months,⁵ a “Cypriot bank euro” frozen in accounts under capital controls seems unlikely to lose much value or trade lower than the regular euro. Exceptions to this would occur if foreign depositors in desperate need of cash to sustain consumption during the crisis are willing to take a bigger upfront loss to get access to their euros.⁶

Were “Cypriot bank euros” nonetheless to be offered at a sizable discount to regular euros, the headline risk for the euro area would be serious. But any risk is unlikely to be widespread. The fears by some of a thriving market for discounted “Cypriot bank euros” thus seems excessive.

The timetable for lifting Cyprus’s capital controls seems mostly dependent on how deep a recession in Cyprus for the euro area and the ECB are willing to contemplate in 2013. The close vote in the Cypriot parliament in favor of the bailout suggests, however, that a euro area strategy aimed at minimizing the financial risks to the ECB and German electoral politics by keeping capital controls in place for too long – and thereby deepening the recession in Cyprus – could produce a political backlash in Nicosia. The Cypriot Troika thus faces tough choices between its own needs and what is best for Cyprus.

Notes

1. SC is the Italian acronym for civic choice, or Scelta Civica.

2. Recall that the median household wealth in Italy is a hefty €173,000, according to the new ECB Household Finance and Consumption Survey discussed last week.

3. Since it would be hard to imagine that the Cypriot banks would have sufficient ECB-eligible collateral to replace large amounts of lost deposits, ELA against uncertain collateral would seem the only way the ESCB could keep the Cypriot banks afloat.

4. I am indebted to my colleague Nicolas Véron for pointing out the similarity between the Cypriot government’s September deadline and the German election date.

5. Since Cypriot bank deposits are either insured deposits, or deposits in banks that have not been affected by the recent Troika banking sector restructuring and hence must be assumed to be solvent, they are essentially locked-up cash with no realistic future credit risk. Hence using the AAA euro yield curve is appropriate.

6. I am indebted to my colleagues Doug Rediker, Anders Åslund, and Nicolas Véron for fruitful debate of this issue.

Copyright 2013 the Peterson Institute.

Inflows are picking up again and more deals are lined up: In Q1 2013 Chinese firms completed eight M&A transactions and nine greenfield projects, together worth $2.2 billion. Chinese US acquisitions currently under discussion or awaiting regulatory approval amount to more than $10 billion, the strongest pipeline we have ever recorded.  

Private firms are stepping up their US investment: In the past 15 months private Chinese firms spent more on US deals than in the 11 years before combined. In the same period they accounted for 80% of transactions and 50% of total transaction value, a dramatic change compared to previous years when state-owned firms dominated Chinese capital flows to the US.

Chinese firms are increasingly capable of managing complex deal risks: The recent track record of Chinese investors illustrates that they are increasingly capable of closing complex transactions and successfully operating in the US regulatory and political environment.

Trends and Patterns

In Q1 2013, Chinese firms spent $2.2 billion for eight acquisitions and nine greenfield projects in the United States. Closed M&A transactions include CNOOC’s acquisition of Nexen’s US operations, Wanxiang’s $257 million takeover of bankrupt A123 Systems, BGI Shenzhen’s purchase of Complete Genomics, Hanergy’s acquisition of MiaSole, and Shanghai Fosun Pharmaceutical’s stake in Saladax Biomedical. The most prominent greenfield projects were a manufacturing facility by Shenzhen Superwatt Power International in Virginia, a joint venture by China’s biggest property developer Vanke with Tishman Speyer in San Francisco, and new offices by search engine giant Baidu in California that are said to be expanded into an artificial intelligence lab. Those deals underscore that high-tech manufacturing and modern services are emerging as mission critical for Chinese investors as their fast-changing home economy matures.

Another trend is that private enterprises have become an important driver of Chinese investment in the United States. From 2000-2011, private firms (which we define as firms with less than 20% government ownership) accounted for more than 70% of transactions, but state-owned enterprises still dominated in value terms (70% of deal value in the same period). Since the beginning of 2012 those patterns have started to change, with private firms accounting for 80% of transactions and close to 50% of total transaction value. Out of 17 deals recorded in Q1 2013, 16 were done by privately owned firms.

Two factors are responsible for this shift. For one, investments by SOEs dropped over the past year, possibly due to the political leadership transition and the related re-shuffling of executive teams at major Chinese SOEs. Second, we observe that private firms are now interested in medium and large-scale deals, not just the smaller transactions seen in the past, and they are increasingly capable of managing those investments. In the past 15 months private firms have spent as much money on FDI transactions in the US as in the 11 years before combined.

The acquisition of several firms with a significant workforce in Q1 2013 (A123, Nexen, Complete Genomics, Miasole) pushed up the number of US jobs provided by Chinese-owned entities. We estimate that the US subsidiaries of Chinese firms employed around 32,000 people at the end of Q1 2013, up by 2,000 compared to the previous quarter. Several firms are also hiring for new greenfield facilities (like Lenovo’s planned manufacturing operations in North Carolina) or the expansion of existing US operations (for example Nexteer, which intends to hire an additional 325 workers for its manufacturing and R&D facilities in Michigan). On the downside, the closure of Suntech’s solar panel manufacturing facility in Arizona lead to the loss of about 100 jobs, reminding us that Chinese firms are not immune from market volatility.

The RHG China Investment Monitor is now updated and allows for a comprehensive view on patterns of Chinese investment from 2000-Q1 2013 by entry mode, ownership and geographic location.

Key Transactions

Wanxiang – A123 Systems: A Demonstration for How US Deals Are Done

After a long battle, Wanxiang Automotive in January 2013 closed the acquisition of battery manufacturer A123 Systems. Aside from underscoring the technology component of Chinese deal-making in the US, the deal is particularly significant as it sends a strong signal to Chinese investors and policymakers that even difficult deals can be done in the US with the right strategy and the right partners.

Wanxiang had to battle with various concerns: first, it had to pass CFIUS’s review among warnings from domestic defense lobbyists about the sensitive nature of A123’s battery technology; second, the firm had gotten funds from the Department of Energy under the American Recovery Act and politicians were criticizing the deals as state-sponsored technology transfer to China; third, local competitors that were interested in the same assets and tried to politicize the deal. Despite those headwinds, Wanxiang managed to convince A123’s management, the bankruptcy court, regulators and other stakeholders of the desirability of its offer and found ways to work with CFIUS on divesting security-related assets. After completing the deal, Wanxiang America’s President Pin Ni sent a clear message to other prospective investors on how to get US deals done: “You just need to understand the rules, follow the rules, be very transparent and let them make the decision.”

ENN: Building the Infrastructure for the US Natural Gas Boom

In past years the largest Chinese state-owned energy companies (Sinopec, CNOOC, CNPC and Sinochem) have put significant capital into the development of unconventional oil and gas resources in the United States. In Q4 2012 the first private Chinese company, Haimo Oil & Gas, invested in a US shale play, a $27.5 million joint venture with Texas-based Carrizo Oil & Gas. A new initiative led by China’s largest privately-owned energy company shows how Chinese firms also seize opportunities in the infrastructure sector arising from the unconventional oil and gas boom in the United States.

In a joint venture with Utah-based CH4 Energy Corporation, China’s ENN Group has begun to build a nation-wide network of natural gas fueling stations for trucks along US highways. The first two “Blu LNG” fueling stations for trucks are already operational in Utah and four more are under construction. The company plans to build up to 50 more stations throughout the United States this year. ENN, which already operates an extensive natural gas supply network in China including more than 200 gas stations, is the first Chinese private company that is entering the US LNG infrastructure market. Its major competitor will be Clean Energy Fuels Corp., which already owns around 70 stations in the US. In February, ENN also announced a partnership with Westport Innovations, a developer of truck engines powered with LNG. The entry of ENN can bring expertise to the emerging US natural gas transportation market and accelerate the build-out of infrastructure necessary to make commercial use viable in the long term.    

Policy Developments  

National security remains the dominant topic in the US-China investment relationship. A federal court confirmed the role and position of CFIUS in response to a lawsuit brought by Sany-related Ralls, but allowed the firm to proceed with its due-process claim. Meanwhile, the public debate in thefirst quarter was dominated by a report documenting large-scale cyber espionage efforts originating from China and associated with official actors, setting a negative tone for the overall US-China economic and political relationship.

United States: Clarifying CFIUS Mandate and Debating Espionage Threats

In February the US District Court for the District of Columbia came to a ruling in a lawsuit filed by Ralls Corporation against a Presidential Order to divest assets it had acquired near a US Naval base. The federal judge dismissed Ralls’ claims of violations of the Exon-Florio Amendment as beyond the scope of judicial review, reaffirming the President’s broad authority to block foreign acquisitions based on national security concerns. However, the court allowed Ralls to proceed with its claim that the divestiture requirements were unconstitutional because they were not done through due process of law. In April, Ralls decided to proceed with those claims, citing earlier Supreme Court rulings against the federal government over alleged terrorist organizations. The next round of “Ralls vs. the US government” should help to clarify the extent to which CFIUS has to inform parties about the reasons for its decisions and the related procedures. 

At the same time, CFIUS approved several Chinese transactions which had attracted heavy domestic resistance. In late December BGI Shenzhen received approval to acquire Complete Genomics despite claims it would pose biological warfare risks. The takeover of US assets of Canadian oil producer Nexen was approved in early February, but CFIUS reportedly imposed conditions through a mitigation agreement. In January, CFIUS green-lighted Wanxiang’s takeover of battery producer Wanxiang, despite strong criticism from commercial competitors and US defense lobbyists. The sale of A123 (and similar cases such as MiaSole or Fisker) also prompted lawmakers to introduce legislation to prevent foreign acquisitions of federally-funded technology firms.

Meanwhile, espionage concerns are increasingly impacting the US-China investment relationship. In February private security firm Mandiant released a report that documents systematic cyber-attacks originating from a military complex in Shanghai. Following the report, the US government and business executives have stepped up the rhetoric against government-sponsored cyber theft. The implications of these tensions for the broader China-US investment relationship are twofold. First, although the direct linkage between equipment and hacking remains unclear, recent dynamics will probably further shut the door for Chinese suppliers to participate in US telecommunications networks – some institutions are in fact even removing Chinese equipment from existing infrastructure, such as the Los Alamos National Laboratory. Second and more importantly, the allegations of state-sponsored hacking and the half-hearted Chinese response (“we are a victim too”) will damage the reputation of China Inc. among the business community and the broader public and create additional mistrust towards firms headquartered in China — which in turn may provide fertile soil for future attempts to politicize deals.

Along with alleged cyber-attacks, cases of “offline” espionage and violation of export control rules continued to make headlines. A December 2013 report by the Justice Department documents nearly 100 cases in which individuals or firms have been charged by the Justice Department with stealing trade secrets or classified information for Chinese entities or exporting military or dual-use technology to China. In January, press reports linked Huawei’s CFO to a company illegally offering HP equipment to Iran.  In March, a Chinese citizen working for a NASA subcontractor was arrested by the FBI while allegedly preparing to flee to China with sensitive information. Another Chinese citizen was sentenced to more than five years in federal prison for violating the arms embargo by taking military information to China. In the same month, a US citizen was charged with handing over sensitive information to his Chinese girlfriend.

Cross-border regulatory cooperation remains another point of tensions in the US-China investment relationship. There was not much progress in the negotiations between China and the US on sharing audit working papers and allowing inspections of Chinese firms by foreign regulators. The inactivity on the Chinese side drew criticism from US officials, among them outgoing Chairwoman of the US Securities and Exchange Commission Mary Shapiro. Looking forward, the US Foreign Accounts Tax Compliance Act (FATCA) could open another front in US-China tensions over regulatory cooperation. FATCA, which will come into effect in early 2014, requires foreign financial institutions to report overseas holdings of US citizens. Last year officials from China’s central bank had criticized FATCA as burdensome and privacy-violating.

China: Fine-tuning the Regulatory Framework for OFDI

China’s top officials continue to criticize national security reviews of Chinese investment. At the sidelines of the National People’s Congress (NPC) in March, China’s Commerce Minister Chen Deming complained that “roughly one dollar of every three dollars we want to invest in the US gets approved”. He stressed that the criteria of the CFIUS review process were not transparent enough and said that China needs “clearer guidelines on what conditions might violate US security”. He added that CFIUS attached “unfair” conditions to the approval of the takeover of Nexen US through CNOOC.

At the same time, China continues to debate the overhaul of its own regulatory framework for outward FDI. At the NPC, firms and delegates called for better regulatory framework for OFDI.  A comprehensive regulation that integrates and simplifies the existing layers of bureaucratic procedures (an “OFDI Law”) has been under discussion for several years but no breakthrough has been made. Two new regulations have come out in Q1 2013 that impact overseas investment decision-making: First, the Ministry of Commerce and the Ministry of Environmental Protection issued environmental protection guidelines for overseas investment projects, aimed at reducing related disputes. Second, following two pilot programs for easier transfer of FX across borders launched last year, the State Administration of Foreign Exchange in January officially announced a new office that will use part of China’s FX reserves to co-finance overseas investments by Chinese firms. The office was apparently created in 2012 but its budget, operational procedures and balance sheet remain opaque.

Outlook                                                                                                                                

As of April 2013, the pipeline of potential Chinese deals in the United States is stronger than ever, with deals worth around $10 billion currently pending or under negotiation. The most important M&A transactions pending are the $4.2 billion stake of a Chinese consortium in AIG’s aviation leasing unit International Lease Finance Corp. (ILFC); a bid for a 40% stake of the GM building in New York valued at $1.4 billion led by Soho CEO Zhang Xin; a $1.5 billion real estate project in Oakland by Zarsion Holdings Group in partnership with local developers; and a potential purchase of IBM’s x86 server business assets through Lenovo for up to $5 billion. The return of state-owned enterprises to global deal-making after the leadership reshuffle presents significant potential upside for Chinese investment in the US in 2013.

But it more usefully updated India’s nuclear weapons status in a way that hasn’t happened since the release of the draft nuclear doctrine back in the early 2000s.

The most striking part of the speech doctrinally responded to Pakistan’s supposed move to develop tactical nuclear capability. Saran made it clear that India wouldn’t distinguish between a kiloton weapon aimed at tanks or a megatonner aimed at a city. “The label on a nuclear weapon used for attacking India, strategic or tactical, is irrelevant from the Indian perspective. A limited nuclear war is a contradiction in terms. Any nuclear exchange, once initiated, would swiftly and inexorably escalate to the strategic level. Pakistan would be prudent not to assume otherwise as it sometimes appears to do, most recently by developing and perhaps deploying theatre nuclear weapons.”

The speech also fitted in place missing bits of India’s nuclear puzzle.

He confirmed that the two legs of India’s nuclear triad – airborne weapons and rail and mobile land-based nuclear warheads – have been completed. And he laid out a timetable for the completion of hte third submarine-based leg.

He also confirmed that an official nuclear doctrine has been approved, and bemoaned the fact that it has not been made public.

“Since January 4, 2003, when India adopted its nuclear doctrine formally at a meeting of the Cabinet Committee on Security (CCS), it has moved to put in place, at a measured pace, a triad of land-based, air-delivered and submarine-based nuclear forces and delivery assets to conform to its declared doctrine of no-first-use and retaliation only. It has had to create a command and control infrastructure that can survive a first strike and a fully secure communication system that is reliable and hardened against radiation or electronic interference.” Saran argues that if the doctrine cannot be revealed, then India should at least release an annual Strategic Posture Review.

I feel Saran pulled his punches on arguing for the doctrine to be made public. Deterrent works only by being transparent about intent and capability. Otherwise, an opponent may conclude the deterrent is a bluff. At a time when Pakistan is slowly losing its political marbles, the logic of such transparency is stronger than ever.

The speech also lays out a potted history of India’s nuclear posture. One of the more forceful parts of the speech refutes the argument that India went nuclear largely for reasons of prestige. It was China, China and China, Saran makes clear.

“I find somewhat puzzling assertions by some respected security analysts, both Indian and foreign, that India’s nuclear weapons programme has been driven by notions of prestige or global standing rather than by considerations of national security.”

He also makes the argument that India’s nuclear environment with its three-nation minuet makes a lot of the strategy that evolved in the West irrelevant. “It is because of this complexity that notions of flexible response and counter-force targeting, which appeared to have a certain logic in a binary US-Soviet context, lose their relevance in the multi-dimensional threat scenario which prevails certainly in our region.” This is an interesting game but needs a lot more explaining than this speech was able to.

Copyright © 2013 the Hindustan Times.

Superficially, therefore, poor German households seem to be bailing out richer members of the euro area.

Any result showing that Germans are poorer than Slovaks hardly passes the smell test. Note that in Figure 1, the average (rather than the median) household wealth in Germany at €195,200 is higher than it is in six other euro area members and close to the euro area average of €230,800. The large difference between median and mean ranking suggests that wealthy German households are wealthier than their counterparts in many other euro area countries. Still, the mean wealth position of German household remains surprising and a potential political issue.

But there is more to these survey results than their headlines. The ECB, first, should be applauded for filling a statistical gap by collecting the first large population dataset [PDF] (covering about 62,000 households) in a harmonized and cross-country comparable way. This accomplishment enables comparative analysis of euro area household assets, liabilities, and net wealth levels. Several caveats are in order, however.

First is the issue of when the data were gathered, and how much of a lag there was before it was published. This first wave of the survey occurred between the end of 2008 and the end of 2011, as Europe’s economy collapsed. It matters that the Greek data were collected in 2009 (before its crisis began in the spring of 2010), and that the Spanish data are from late 2008/early 2009, again before its economic crisis. With the exception of French data (from end-2009/early 2010), data from the 13 other reporting euro area members are all from 2010/2011.

Second, German household wealth levels more than 20 yeas after German reunification are affected by differences in wealth accumulation between East and West Germany. Figure 2 breaks the two out and compares them with the rest of the available euro area countries.

Figure 2 shows that the ratio of West to East German net household wealth levels is 3.5 to 1. East German households have lower median net wealth levels than Slovakia, suggesting that the large fiscal transfers from West to East Germany since reunification have not enhanced the East’s household net wealth. West German net wealth levels are comparable to Austria’s, while the mean German levels are comparable to the euro area and French average.

Third is the role played by home ownership, because a person’s main residence is usually his or her largest personal asset. Differences in home ownership are especially revealing in the HFCS survey. Figure 3 shows that Germany has the lowest home ownership ratio in the euro area.

Only 44 percent of German households own (or partially own because of a mortgage) their main residence. The number drops to 31 percent in the lower 60 percent of the income scale. In many southern euro area countries, the same rate is above 70 percent (even though recent foreclosures in Spain and elsewhere will lower that level). Low German household net wealth levels can thus be explained by the absence of a main residence for many households.

The role of home ownership can also help explain policy differences in the euro area. Consider for comparison’s sake that the difference between Germany and Slovakia of more than 45 percentage points in home ownership is twice the range between the highest home ownership US state (West Virginia at 76.7 percent) and the lowest home ownership state (New York at 53.1 percent).²

Germany’s low home ownership, for example, rules out or minimizes housing wealth effects (and the associated consumption increases) in the German economy, especially because mortgage equity withdrawals are also not possible in Germany.³ Getting Germans to spend more because of the currently low interest rate environment will be difficult, because house price increases will not affect most households.

The flipside of low home ownership in Germany is that this phenomenon helps Germany’s focus on headline inflation, which usually matters more than core inflation numbers to renters, because rents are an important part of any customer price index (CPI) basket. Indeed, lower middle income swing voters are more likely to be renting their home than the already low German average.⁴ German politicians (and European central bankers in Frankfurt who need their political support) are thus forced to pay attention to headline inflation. Put another way, for all the talk about inflation of the 1920s, German elections are decided by renters who dislike inflation for contemporary reasons more than history!

Net household wealth, being net, considers households’ assets and liabilities (i.e., debts). But the differences in main residency ownership ratios (and by extension mortgage debts) dwarf other differences in household real assets/liabilities like car ownership and other real estate holdings. Another way to look at wealth is to exclude homes and cars and examine bank deposits, mutual fund holdings, bonds, and investment shares and other financial assets. Figure 4 shows the relatively large differences in euro area household ownership of financial assets.

Almost all euro area households have some form of financial assets. (A quarter of Greek households report no financial assets, however.) Euro area household financial assets consist largely of bank deposits, illustrating the importance of the banking system to the euro area economy. Significant differences exist also in the holdings of voluntary private pensions/life insurance products. Share ownership – with the exception of Cyprus and Finland – is no more than 10 percent, limiting the potential for wealth effects from the stock markets affecting euro area households. Figure 5 lists the median value of euro area household financial assets.

Looking only at the (very) partial financial asset metric for household wealth, Germany is above the euro area average at €17,100 euros in median household wealth, while the median household in the Mediterranean island nations and the Benelux countries own more financial assets still. (Note that median Cypriot household wealth will likely decline because of the recent losses suffered by large deposits.) Recalling the differences between median and mean net household wealth in Figure 1, one should be careful in interpreting the levels and relative positions of euro area household wealth listed in Figure 5. Median values for financial assets owned are just one of many potential such metrics. A single such data series cannot shine credible light on the broader question of euro area household wealth and welfare.

In conclusion, the new ECB household financial wealth and consumption survey contains enough new information to reinforce various viewpoints of pundits and politicians. But because some of the misleading data in Figure 1 might play a role, statistical nuances must be remembered. For this author, finally, the high levels of net household wealth across the euro area periphery underline the difficulty for any country seeking to leave the euro area. According to the HFCS, even the median Italian household has more than 173,000 reasons to want to stay in the euro at all costs.

Notes

1. No data are available for Ireland or Estonia.

2. Data from Q4 2012 are from the US Census. [XLS]

3. See Table 4. [PDF]

4. See Bundesbank datatables 2.1 to 2.3 [PDF]. Higher income voters and rural voters in Germany, who are far more likely to own their own homes can generally be assumed to be safe votes for the German center-right. There is also a regional difference in Germany, as the home ownership ratio in former East Germany is just 34 percent, against 47 percent in the former West Germany.

Copyright © 2013 the Peterson Institute.

A large swing in the financial account due to changing currency expectations: China’s financial account swung from a surplus of $260 billion in 2011 to a deficit of $21 billion in 2012. This shift is attributable not to massive hot money outflows, but rather to temporary shifts in the foreign exchange position of Chinese firms and households in response to RMB appreciation expectations.

Further expansion of net foreign assets, but still negative investment returns: Net outflows of $21 billion under the financial account, the addition of $97 billion to official reserves and a $44 billion upward adjustment in the valuation of existing assets abroad lifted China’s net foreign assets from $1.69 trillion at the end of 2011 to $1.74 trillion in 2012. Despite this hefty net surplus in foreign assets, China remains a net interest payer to the world due to lower rates of return on its overseas assets.

Return to a financial account surplus in Q1 2013 but macro headwinds ahead: The financial account should have returned to a surplus in the first months of 2013 on the back of stronger domestic growth and renewed RMB appreciation expectations. However we expect China to face headwinds by mid-year 2013, triggering a swing in capital flows similar to Q2 and Q3 2012 – until the government finds ways to bolster confidence in medium-term growth.

Capital Flows in 2012

China’s balance of payments shows a dramatic change in cross-border capital flows in 2012. The financial account as a whole swung from a surplus of $260 billion in 2011 to a deficit of $21 billion in 2012. This was the first financial account deficit since 1998, when the Asian financial crisis triggered capital outflows. This shift was widely seen as evidence of capital flight in reaction to a slowdown in economic activity in the first two quarters of 2012. A dissection of the financial account shows that the reality is less portentous, having mostly to do with changing near-term perceptions about currency appreciation in combination with more freedom for firms and households to hold onto foreign exchange instead of surrendering it immediately to the central bank.

The balance of foreign direct investment (FDI) dropped from $232 billion in 2011 to $191 billion in 2012. The narrowing surplus results from both a rebound in outward FDI, which reached a new record high of $62 billion after a temporary drop in 2011, and a slight drop in inward FDI  from $280 billion in 2011 to $253 billion in 2012. Possible explanations for this drop are a decrease in manufacturing investment in light of rising labor costs; diminished investment capacity due to economic malaise in Europe and other key investor countries; and a drop in the speculative “hot money” portion of FDI in light of a general growth slowdown and property sector tightening. While the gap between direct investment inflows and outflows is narrowing, outward flows are still far from catching up with inward flows (Figure 2).

The portfolio investment surplus more than doubled from $20 billion to $48 billion. Inward flows shot up from $13 billion to $54 billion on the back of new policy initiatives to boost the participation of foreign institutional investors in China’s stock market through the Qualified Foreign Institutional Investor (QFII) scheme and other windows (Figure 3). Attractive valuations for Chinese securities also may have played a role, as the bulk of inflows occurred in Q4 when the Shanghai Composite Index hit a 3-year low. On the outbound side, signs of economic recovery in the US and stability in the Eurozone encouraged Chinese banks and qualified domestic institutional investors to invest in overseas securities in the second half of the year, after a period of downsizing their overseas holdings. Despite this increase in two-way flows, the value of portfolio investment flows remains small compared to the rest of China’s external balance sheet.

The most significant change in China’s financial account occurred in the “other investment” line of the BOP, which includes cross-border loans, trade credit, deposits and “other” flows. The balance here has changed from modest inflows of $9 billion in 2011 to a record $260 billion of outflows in 2012, driven by loans and deposits (Figure 4). These patterns do not represent large-scale capital flight but rather a temporary change in the foreign exchange position of Chinese firms and households. Before 2007, China’s foreign exchange regime forced firms and households to convert all income from current account transactions immediately into renminbi. This “surrender requirement” has been gradually loosened since then, giving firms and households more flexibility to hold FX they earn abroad. In the past, Chinese residents had an interest in immediately converting their FX income in expectation of further appreciation of the RMB. Last year, however, those expectations reversed, motivating a desire to maintain foreign currency deposits.  We saw a similar pattern, briefly, in 2008 when RMB adjustment was put on hold, but the scale is much larger this time (Figure 5). The “loan” position is similarly affected by currency expectations as banks and firms that are in a position to make choices between keeping foreign exchange or trading it in for RMB optimize their FX exposure. 

The $270 billion swing in the financial account and record high errors and omissions of $80 billion are responsible for another major change in China’s external patterns: a sharp drop in the accumulation of new official reserves. Despite a current account surplus rebound from $136 billion in 2011 to $193 billion in 2012, China’s State Administration of Foreign Exchange only added $97 billion to its existing $3.26 trillion in reserves, the lowest annual addition since 2002 (Figure 6). As explained above, this mostly represented a shift of foreign exchange from the central bank to the balance sheets of domestic banks.

Valuation Changes

A second factor changing the profile of China’s international investment position (IIP) is fluctuation in the valuation of existing assets – as summarized in Table 2. On the asset side, China’s IIP booked gains on almost every position except “other investment”, resulting from exchange rate effects and changes in market valuation. Foreign assets in China also profited from mark-to-market adjustments, with the exception of foreign direct investment assets which were unchanged.  

Accounting for those valuation changes, China’s international assets grew by $441 billion or 9% in the course of 2012, resulting in a year-end position of $5.2 trillion. China’s international liabilities – foreigners’ claims on assets in China — grew by $393 billion to $3.4 trillion at year-end 2012, an increase of 13% over the previous year. China’s net foreign assets (NFA) — international assets minus liabilities – therefore grew from $1.69 trillion in 2011 to $1.74 trillion in 2012, a year-on-year increase of 3%. The pace of net foreign asset growth has slowed to an annual average of 4% in 2009-2012, compared to more than 50% in the pre-crisis years (2004-2008). China’s year-end 2012 IIP position is summarized in Figure 1.

Investment Income Flows                                        

Despite its hugely positive net creditor position, China’s net investment income balance remains deeply negative. In 2012, China paid $201 billion in investment income to foreigners but only received $143 billion in investment income from abroad (Figure 7). The negative income balance reflects the contrasting composition of holdings on the asset and liabilities side. China’s global assets are dominated by reserves holdings and “other investments” while higher yielding asset classes such as portfolio investment in equities or direct investment stakes still account for only a small share of China’s global assets. The picture is reversed on the liability side, which is dominated by foreign direct investment and portfolio investment in equities – assets that historically have higher returns. Using the data points provided in China’s IIP and BOP, the implied difference in the effective rate of return between Chinese overseas assets and foreign assets in China hovered around 3-4% in recent years (Figure 8). In 2012 the gap was in the lower range due to a drop in rate of return on foreign assets in China while Chinese returns on foreign assets only slightly edged down. 

Outlook: Capital flows in 2013 and Beyond

Going forward the evolution of China’s IIP will depend largely on the pace and extent of financial account liberalization. The extension of Zhou Xiaochuan as PBOC Governor beyond normal retirement age augers well for faster opening, but there are many countervailing factors. At the National People’s Congress in March2013 and other recent appearances, Zhou reaffirmed that China was committed to liberalizing the financial account by 2020. In a recent paper, researchers at the Hong Kong Institute for Monetary Research have mapped out what this would mean for China’s IIP using parameters from the historical patterns of other economies (Figure 9).

In the near term the most important determinant of Chinese capital flows is sentiment on the domestic economy. Since Q4 2012, the growth outlook for China has improved and the financial account should have return to surplus in Q1 2013. The FDI and portfolio investment balances are largely stable, while the “other” investment balance should return to pre-2012 patterns with more confidence in growth and further RMB appreciation. Indeed after the modest full year 2012 additions to China’s official reserves, $110 billion in additions were reported for January 2013 alone. However our macro view is that China will encounter economic headwinds by mid- 2013, as discipline in property and return to more normal outlays on rail and other infrastructure depress the contribution of fixed investment to growth. Baring another expensive stimulus program we are likely to see a repeat of some version of the events of Q2 and Q3 2012, with firms holding on to their foreign exchange in onshore and offshore accounts, and some hot money flowing out through the FDI and trade channels.

Beyond short term currency expectations, China’s macroeconomic policy course will be an important determinant of cross border capital flows in the coming years. Beijing’s reaction to sagging growth and the challenges of a “middle income trap” will almost surely include steps toward market efficiency, regulation, corporate governance, rule of law, and market contestability for private and foreign firms.  Each of these moves will be attractive for global capital.  At the same time, that liberalization will entail still greater mobility for domestic Chinese capital, slower (though sustainable) domestic growth, and the approach of equilibrium for exchange rates and interest rates. All those factors will encourage Chinese residents to consider diversifying away from their present “home bias” to a more balanced portfolio. In short, if Beijing takes the route of significant “big bang” reforms to sustain domestic growth, we will see significant growth in two-way capital flows in coming years. The huge pool of foreign exchange reserves accumulated over the past decades gives Beijing a big enough buffer against the short-term volatility in capital flows that could result from such a path. 

New growth projections from the International Monetary Fund (IMF) clarify how serious these concerns are. The IMF fully revises its World Economic Outlook, or WEO, annually (there is a partial update once a year as well). There has been a robust internal debate at the IMF in recent years over GDP growth projections for China, and for the current account surplus. After the epic surpluses China ran from 2005 to 2010, the Fund was slow to trim their forecasts, even as actual surpluses narrowed in recent years. The WEO projections released at the spring meetings of the IMF and World Bank last week foresee a moderate Chinese current account surplus – defined as under 3% of GDP – through 2014. 

However the medium-term IMF projection is more concerning. The WEO shows China running a 4.3% of GDP current account surplus in 2018, which, at projected growth rates, would mean a nearly $641 billion surplus in five years’ time – tripling from 2012. An even better way to think about the size of that surplus is as a share of world GDP: by that metric China’s surplus more than doubles, from 0.3% to 0.7% of the size of the global economy.

These projections raise a number of concerns. First, while we can debate whether the world can bear those huge external imbalances as a practical matter, the direction of the trend is clearly unacceptable. As China reaches a more mature stage of development it is expected to achieve a more balanced international position, not mushrooming surpluses. If the IMF is even close to right, then not only will China fail to be an engine of growth for the rest of the world, it will in fact be a major negative shock to expectations. Second, if China is running two-thirds of a trillion in annual surplus, somebody needs to accept an equally gargantuan amount of deficit. And who will that be? Europe? The United States? India? Latin American (which is running a large trade deficit with China on the whole)? It’s not clear how major economies stay on a responsible course to recovery while serving as consumers of last resort for a tripling of China’s current account surpluses. Nor is it clear what the impact is for those nations if Beijing has $640 billion a year that needs recycling into Treasury Bonds, shale gas fields and other assets instead of the $200 billion from current account surplus it must presently put to work each year.

Finally, the developmental consequences of swelling Chinese global surpluses for the less advanced economies trying to follow it up the growth ladder are important. If China continues to rely on global demand to fuel its “miracle” even now that it has reached the middle income ranks, what opportunity does that leave for poorer nations to absorb lessons from China’s impressive rise? If China’s surplus as a share of the global economy doubles, even while OECD economies struggle to reduce their net imports in order to honor their debts and pay their bills, then where is the export led growth potential for the Myanmars, Cambodias, Liberias and Egypts of the world?

It is important to recognize that the IMF’s projections have been off before and may well be again. The GDP growth assumptions used to reach 2018 are optimistic, and if China undershoots those levels then the current account percentages will amount to less in real terms. In fact a whole day can usefully be spent grappling with the assumptions in the IMF numbers. Nonetheless, these are the mostly widely employed and stress-tested projections of comparable country growth data for the medium-term that are available. China is intimately involved in the WEO process and has ample opportunity to shape the assessment internally – more and more so, in fact, as time goes by and Beijing’s influence at the Fund increases. The April 2013 WEO projections for China are therefore the starting point for a critical conversation: does Beijing concur with the Fund’s projections, and if not, why not? And if so, how should responsible policymakers on the flip side of China’s burgeoning external surpluses respond? One thing is clear: you don’t have to invent theories of Western hostility or conspiracy to contain China to understand why Washington, Brussels and other partner governments push Beijing so hard over trade and investment-related policy grievances. 

Portugal and Ireland Get Debt Relief

First, I am happy to report that one of my year-end 2012 predictions for 2013 has arrived with a further stealth fiscal transfer to Portugal and Ireland. It came in the form of a lengthening of weighted average loan maturities of up to seven years by the European Financial Stability Mechanism (EFSM) and European Financial Stability Facility (EFSF). This modest forgiveness was conditional on the two countries continuing their program implementation [PDF] under the terms dictated by the Troika of the European Commission, the European Central Bank (ECB), and the International Monetary Fund (IMF). More important, it highlights the widely held and superficial mischaracterization of euro area policies as austerity and nothing else. The euro area, as should now be obvious, can grant member states burdened by adjustment programs at least some de facto debt relief – when the conditions are right.

The timing of Ireland and Portugal’s debt maturity extensions is critical. They were granted because of the political assessment of moral hazard. Many macroeconomists masquerading as euro area commentators never see a fiscal transfer they don’t like or that isn’t necessary to revive economic growth, without which they are certain that the euro area will break apart and reignite the extremism of the 1930s.

But these commentators forget that the more fiscal transfers in the euro area (and elsewhere) mean that the funds come out of someone’s tax revenue. Taxpayers, moreover, have a right to know and indeed influence how their money is spent. Absent such influence, a critical democratic deficiency opens up. Cross-border fiscal transfers will thus never derive from macroeconomic computerized generalized equilibrium (CGE) models of what might be optimal for short-term economic growth in the recipient country. Rather, realistically, the transfers will be limited by taxpayer demands on how their money is spent. This is obviously the core justification for the IMF’s decades-old conditional lending model for financial crisis assistance that the euro area has adopted since 2010.

Accordingly, the stealth fiscal transfers for Ireland and Portugal have been granted only after moral hazard has been reduced, as two countries come to the end of their three-year Troika programs, and are seen as having done their reform homework. It has become politically safe – as well as economically sensible to avoid an increase in future funding – to provide such debt relief to program countries this late in their reform programs.

The actions toward Ireland and Spain, moreover, have important implications for Greece and Cyprus. Athens should not expect any additional debt relief for several more years, given how much more Greece’s needs are and how many reforms remain unimplemented. Because Cyprus faces far worse growth prospects than projected, Nicosia should implement the Troika program to the letter early on, and await debt relief in later years, as it gets closer to market access.

Europe Moves Toward Its Version of an FDIC

A second important development at the ECOFIN meeting came when Michel Barnier, the European Commissioner responsible for drafting a Single Resolution Mechanism (SRM) as the next step toward a European banking union, indicated the form the mechanism will take. He laid out the future creditor pecking order for who gets hit when banks are dissolved or restructured: first shareholders, then junior bondholders, then senior bondholders, and then if necessary uninsured depositors, followed last by a resolution/deposit insurance fund to reimburse insured depositors.

As discussed several times, this hierarchy of haircuts will end up looking like the ranking of the Federal Deposit Insurance Corporation (FDIC) in the United States. In that sense, Cyprus set a precedent after all, no matter what officials said at the time. Also at the ECOFIN press conference, the ECB’s Jorg Asmussen went further and stated that the EU should signal such a tanking to international investors ahead of time, so that European banks are not placed at a disadvantage from having a different ranking than the ones adopted by other market participants, especially the United States. It is now clear that Europe’s policy goal is to replicate the FDIC’s approach to banking resolution. This is the strongest statement to date from a key European policymaker about how – as stated several months ago – Europe’s banking union will ironically make the European banking regulatory system look far more like that in the United States.

The biggest policy disagreement remaining on this matter seems to be the organization of the new European resolution/deposit insurance fund. On one hand, the ECB vice president, Vitor Constancio, indicated his support of a “European level initiative” to deal with cross-border banking resolutions. By contrast, the European Commission remains wedded to its earlier proposal to coordinate national resolution funds, while Germany remains opposed to a single integrated fund.

 The ECB has been relatively indifferent about the urgency of agreeing on and implementing a European deposit insurance fund, most likely because of the political opposition in Germany. Constancio’s comments represent a new and clearer ECB position on the issue. But it remains uncertain whether the ECB wants a European-level initiative for all the roles of a fund across the members of the banking union, or merely some of them.

As discussed earlier, this author believes that a single joint euro area resolution/deposit insurance fund is required to serve as a new single sovereign-guaranteed anchor in the European banking system. The need is underscored now that more costs are imposed on creditors (except for insured depositors) in bank restructurings. This is the political price that the rest of the euro area should demand of Germany in return for its agreeing to the next-to-no ESM bank recapitalization system envisioned by Barnier’s proposals for creditor ranking. Direct bank recapitalizations by the European Stability Mechanism (ESM) seem highly unlikely, except perhaps in times of crisis to help countries maintain full market access.

Is a Treaty Change in the Offing?

Third and finally, a new scare has arisen because of comments by the German finance minister, Wolfgang Schäuble, about the need for a “treaty change” to proceed with the single resolution mechanism. As usual in the euro crisis, the editorial pages of the Financial Times went overboard, describing his utterances as another “German hand grenade lopped into the banking union discussion.” The paper’s concern was that talk of a potential future referendum indicates German cold feet about the banking union. The reality is different, fortunately.

Barnier’s statements indicate, in fact, that Germany is largely getting the banking union it wants – full creditor haircuts (or “bail-ins”) and a high bar before the ESM recapitalizes banks. Why would Germany delay the very new institutions it has favored? Were Germany to retract its backing for the banking union, an unlikely occurrence, Berlin could simply say “nein.” Why would Europe’s political hegemon have to resort to calling for a treaty change to achieve its desired outcome? However unfathomable it would be to the financial times, Germany likely favors a treaty change in order to establish a solid legal foundation for a banking union. Changing the EU treaty would be somewhat more cumbersome, but such a step need not slow progress toward the banking union.

That is because the EU Treaty is a flexible beast. EU leaders, under similar circumstances, have already revised it in this crisis and can do so again if Germany wants. In December 2010, EU leaders changed Article 136 to create the ESM through a “simplified revision procedure” to enable the ESM to come into force by January 1, 2013 at the latest [PDF]. The ESM was inaugurated last October 8, within this timeframe, even if all EU countries have not yet ratified the amendment according to their national parliamentary procedures.¹

Article 48 in the EU treaty describes the simplified treaty revision procedure, an option when the change: (1) relates to the internal policies and actions of the Union; and (2) does not increase the competences conferred on the Union in the treaties. In a simplified treaty revision, the European Council must act unanimously after consulting the European Parliament and the commission, and the European Central Bank in the case of institutional changes in the monetary area. Thus as long as all EU member governments agree among themselves and with the EU Commission, Parliament, and (sometimes) the ECB on this type of issue, they can amend the EU Treaty quickly.

Schauble did not make clear what changes he had in mind. But Germany’s concerns about the independence of the ECB’s monetary policy and its separation from banking regulatory responsibilities are well-known. If Germany’s concerns derive from the goal of insulating the ECB politically from a future single resolution mechanism, whether located within the central bank or outside it, a simplified treaty revision procedure seems straightforward. Like the ESM launch in 2012, the introduction of the SRM raises issues related to the internal activities of EU institutions and does not confer new competences to the EU as a whole. These issues make a simplified treaty revision the legal solution.

The Financial Times can relax. A treaty change, even if Germany demands one, will not delay implementation of the EU banking union.

Note

1. The Czech Republic is the only country to not yet have ratified the amendment.

Copyright © 2013 the Peterson Institute.

The past five years of U.S.-China economic relations illustrate this tectonic shift. Annual outbound direct investment (investment to create new businesses or acquire equity stakes of 10% or higher) from China to the U.S. has grown by more than 300% since 2007, according to official statistics. Alternative sources accounting for flows through third countries, such as Rhodium Group’s China Investment Monitor, point to an even sharper increase of up to 1,300%.

Tourism from China to the U.S. is also substantially higher today than five years ago. The number of mainland Chinese tourists visiting America exploded from a mere trickle to more than 1.5 million in 2012. The U.S. has become the leading destination for Chinese tourists outside Asia, and Chinese travelers have one of the highest per capita spending ratios of all foreign visitors.

Traditional modes of economic interaction are growing at slower or negative rates. Direct investment by U.S. companies in China, Chinese exports to the U.S. and Chinese purchases of U.S. Treasury securities are all well off their peak growth rates. The new flows are growing from a low base, and a high growth rate still yields only modest total values. But as the new flows speed ahead, so too do their relative share and importance.

This trend will continue. China needs to shift to a more sustainable growth model, and adopting a new growth strategy will trigger a structural catch-up process in global investment and consumption. China Inc. is only as far along toward investing in the U.S. as Japanese firms were in the 1970s. We project China’s global direct investment stock to grow from its current $400 billion to more than $1 trillion by 2020, with an increasing share of investment flowing to developed economies. 

The changing nature of the U.S.-China economic relationship may also change the political climate. Past integration with China brought mostly abstract benefits, such as lower prices for consumers, and several immediate downsides, such as diminishing manufacturing employment—a recipe for controversy.

But now, Chinese investment dollars are increasingly creating jobs, generating tax revenue and producing myriad other local benefits. Chinese firms employed 30,000 Americans by the end of 2012, up from fewer than 10,000 five years ago. Chinese customers are increasingly important for sustaining U.S. jobs in export industries and local services including hospitality and retail.

Sustaining those flows will require a serious update of attitudes and policies. The still fragile global economy spurs plenty of cutthroat competition to attract Chinese investors, tourists and shoppers, and the U.S. is putting itself at a disadvantage if it does not adapt to those new realities.

Read the full article at the Wall Street Journal.

Copyright 2013 The Wall Street Journal