This is a guest post by Shrey Verma, a graduate student at the Johns Hopkins University School of Advanced International Studies. You can follow him on Twitter at @shrey7.
Earlier this month, the International Monetary Fund downgraded its outlook for global economic growth, citing weaker expansions in the Eurozone and several emerging markets. IMF chief Christine Lagarde warned that the economic recovery is “brittle, uneven and beset by risks” and that the world might experience “a new mediocre” era of subpar growth for a long time.”
At a time when inadequate demand, high debt and low investments continue to pose challenges to a sustained economic recovery in the West, the spotlight is again shifting to the big dog of the emerging world, China. This time, however, the focus is not on China’s growth prospects, but the potential for Chinese capital to revive growth in the developed world.
A new report by Deutsche Bank, The Wide Angle: The Age of Chinese Capital,argues that China’s large current account surpluses will define the next round of economic expansion globally in what could be termed “Bretton Woods Three.” According to the author, Sanjeev Sanyal, global strategist at Deutsche Bank, the scale of capital outflow could be so large as to negate the effects of monetary tightening pursued by central banks around the world.
Is this a far-fetched assertion? The popular belief among economists is that rising wages, liberalization of the financial sector and gradual opening of the capital account could shrink China’s current account surplus in the medium term. But this is where the report gets interesting. It argues that brand new infrastructure, excess manufacturing capacity and a shift to services will lead to a decline in China’s investment rate, which will fall faster than the savings rate. Thus, China’s “economic rebalancing” could actually widen the savings-investment gap, leading to sustained surpluses in the years ahead. The IMF estimates China’s current account surplus at 3% of GDP or $439 billion by 2019. This flood of excess capital, according to Sanyal, could hold down the long-term cost of capital. In so doing, it has the potential to direct massive amounts of investment into the U.S. and the developed world.
Talk of outbound Chinese investments is not new. Traditionally, Chinese overseas investment has targeted mostly trade facilitation and natural resources in developing countries and resource-rich nations such as Australia and Canada. But in recent years, as Chinese companies have sought out advanced technologies and consumer brands, Chinese capital has begun to flow into technology and innovation-intensive sectors in advanced economies.
Chinese investment in the U.S. doubled to $14 billion in 2013, while total Chinese investment stock in the EU stood at €27 billion by the end of 2012. Yet these numbers are tiny when compared to China’s financial muscle. According to data compiled by The Heritage Foundation, China’s total outward investments to the U.S. and Europe since 2005 equaled $173.5 billion, which is just 10% of China’s U.S. treasury holdings and only 4% of China’s total forex reserves of $4 trillion.
Toward Bretton Woods III
So how can China leverage its vast foreign exchange resources to ramp up investment activity abroad? Qiao Yu, a senior fellow at Brookings, recommendsthe use of ex ante debt-equity swaps to redeploy China’s significant foreign reserves in real business sectors. According to Yu, this facility involves a three-step process: First, the Chinese central bank trades U.S. Treasury bonds with Chinese investment entities in exchange for yuan. Second, the investor swaps the bonds for equity in target companies in the U.S. Third, the bond-receivers place the U.S. Treasury as collateral to raise capital for new investments.
Whether China’s foreign reserves can be relocated to attractive investment opportunities in the developed world depends on the willingness of Chinese authorities to free-up capital controls and privatize a substantial chunk of the nation’s forex stock. And giving up either direct control over the exchange rate or discretionary control over monetary policy seems anathema to Chinese policymakers. Recent efforts by China’s central bank to inject fresh liquidity into the banking system demonstrates how heavily Chinese policymakers rely on monetary tools to sustain growth—a luxury they may be reluctant to trade off by lifting capital controls in the near term.
Even so, China is quietly building the foundations for a long-term strategy to direct capital to real assets in developed countries. So far, China has carried out investments in a passive manner, through bridging vehicles such as private equity funds. Several government-controlled entities in China have channeled forex reserves through private equity structures into direct investment stakes in Europe. Mandarin Capital Partners, for example, has invested directly in European companies, with financing from China Development Bank and the Export-Import Bank of China. Similarly, another well-known Chinese private equity firm, Hony Capital recently acquired British restaurant chain PizzaExpress for £900 million with funding from state-sponsored Legend Holdings.
What’s more, the new Shanghai Free Trade Zone (FTZ) is facilitating a new wave of overseas investment by Chinese players, as investors take advantage of the zone’s more lax controls on foreign currency and simplified regulatory framework for cross border trade and investment. With an estimated 6,000 private equity funds registered in China managing $325 billion of assets, the FTZ is likely to accelerate outbound private investments in the future.
Channeling China’s surplus through numerous small and medium-sized private equity funds and entrepreneurs could also lead to “disaggregation” of outbound Chinese investments, reducing the dominance of state-owned enterprises and their ability to carry out big-scale acquisitions that often elicit national security concerns among Western countries. Reform of the financial sector and privatization of the forex stock will further accelerate the disaggregation process, curtailing fears of potential “Trojan Horses” and allowing investments into advanced technology sectors that have remained out-of-bounds for Chinese investors and companies.
Sanyal, the global strategist at Deutsche Bank, says “Bretton Woods Three,” whereby the U.S. and other developed countries absorb China’s vast surpluses, is key to reviving both investment in the U.S. and economic growth on a global scale. Yet its success is not ensured.
As China pursues its own rebalancing efforts towards a consumption-driven growth model, it will seek to expand welfare of the Chinese people through social security, healthcare and other financial benefits in order to alter people’s conservative savings behavior and encourage them to consume more. In this case, China could begin to absorb its excess savings to support its welfare expansion program, rather than lend to the outside world.
Such a scenario would mean a failure of Bretton Woods Three and a weaker financial investment environment in the West, which could further depress growth in the developed world. In such a case, Christine Lagarde’s warning that a new era of mediocre growth is upon us could prove to be right.