Monetary globalization, North-South wealth distribution and useful resource transfers
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Yilmaz Akyüz is former Director, UNCTAD and former Chief Economist, South Centre, Geneva
– At a time when the global economy appears primed for further financial turmoil, it is widely recognized that emerging market economies (EMEs) are particularly vulnerable due to their deeper integration into the global financial system. Less appreciated is the impact of financial globalization and integration on the external distribution of wealth between emerging and developed economies and the transfer of resources from the former to the latter.
This is the subject of a new study by this author on emerging market external balance sheets, which focuses on nine G-20 EMEs (Argentina, Brazil, China, India, Indonesia, Mexico, Russia, South Africa and Turkey) and four major advanced economies , the US, Japan, Germany and the UK.
The new millennium has seen rapid growth in emerging market gross foreign assets and liabilities, both as a result of ultra-loose monetary policy in the major advanced economies (AEs) and capital account liberalization in emerging markets — a process of deepening integration dubbed “playing with “ means fire.
Almost 90 percent of G-20 emerging market countries’ outstanding foreign assets and liabilities have been accumulated since the turn of the century. Although debtor-creditor relationships and foreign direct investment (FDI) have been growing rapidly within the Global South, a very large proportion of emerging market countries’ gross foreign assets and liabilities are still held by AEs. This applies not only to financial assets and liabilities, but also to foreign direct investment. Even in China, other emerging markets account for less than 20 percent of the stock of foreign direct investment.
While foreign investment and credit to emerging economies have reached unprecedented levels, even emerging economies with current account deficits have been able to accumulate large amounts of gross foreign assets, as capital inflows often exceeded what was needed to fund deficits. With the exception of China and Russia, which have run current account surpluses since 2000, all foreign asset accumulation in emerging G20 countries has been based on borrowed money, leading to significant leverage in external balance sheets.
There are also significant changes in the structure of the external balance sheets of emerging companies. The equity (FDI plus portfolio equity) portion of total external liabilities increased and the debt portion decreased as governments sought to switch from debt to equity by opening up equity markets and liberalizing FDI regimes as equity financing became more stable and less riskier than debt.
The proportion of equities in gross foreign assets also increased, but not as much as in liabilities. As a result, the net equity position (external equity less liabilities) of the G20 EMUs taken together, which was already negative at the beginning of the century, continued to deteriorate.
The share of international reserves in total foreign assets rose rapidly as countries sought to self-insure against speculative attacks, often with borrowed money. The local currency’s share of external government debt increased as bond markets were opened to foreigners to bear currency risk. But the corporate sector is responsible for a growing share of emerging companies’ foreign debt, increasingly borrowing in dollars from international markets to take advantage of lower interest rates.
These changes in the size and composition of emerging market external balance sheets have not only created new transmission channels for external financial shocks (as described in Playing with Fire), but have also led to a significant transfer of resources from emerging market countries to corporate entities.
South-North resource transfers through financial channels will continue unabated as long as capital flows remain unhindered and the international reserve system favors a handful of rich countries who can pursue self-interested policies regardless of their global implications. First, they have made the value of their existing holdings of international assets and liabilities more sensitive to changes in global financial conditions, particularly asset prices and foreign exchange rates, resulting in capital gains and losses, and their Net International Asset Position (NFAP or Net International Asset Position, i.e. is the difference between Gross International Assets and -liabilities).
In the short term, these valuation changes may be far more important than current account balances in the movement of NFAP, particularly during periods of severe instability such as that seen in 2008-09. As foreign assets and liabilities of emerging companies reside primarily with AE, these gains and losses lead to a redistribution of external wealth between the Global South and the North.
Indeed, in the new millennium there is a strong negative correlation between the annual changes in the net international investment position of nine G20 EMEs and four large AEs, and much of this change is due to capital gains and losses rather than current account balances.
The long-run current account remains a key determinant of nations’ net external assets, but capital gains and losses arising from valuation changes can also be important. Since the beginning of the century, the NFAPs of most G-20 emerging economies have deteriorated due to persistent current account deficits.
The NFAP of two surplus emerging emerging economies, China and Russia, improved but not as much as their combined current account surpluses as they both suffered large capital losses on their outstanding foreign assets and liabilities.
For example, China had a cumulative current account surplus of over $3 trillion between 2000 and 2016, but its net external assets increased by only $1.6 trillion. In contrast, the US had a cumulative current account deficit of over $8 trillion over the same period, but its net external debt worsened by less than $7 trillion on capital gains. Although some smaller G-20 EM countries also recorded capital gains, the nine EM countries collectively suffered capital losses in the range of US$1.9 trillion between 2000 and 2016, while the four AEs recorded capital gains in excess of US$1.6 trillion .
Second, with the expansion of gross foreign assets and liabilities, international capital income receipts and payments have become more important in the current account. In general, emerging markets are negative in net international investment income not only because their external liabilities exceed their assets, but also because the return on their external assets lags behind the return on their external liabilities.
Their liabilities are concentrated in high-yielding stocks, while a large part of their wealth consists of low-yielding currency reserves. For this reason, even some emerging markets with positive net asset positions abroad, such as China and Russia, have deficits in net income from international investments.
In addition, all emerging market economies, including China, earn lower returns on their foreign direct investment than on their inbound direct investment. They also pay more risk premiums on their foreign debt than they receive on their foreign debt, including reserves (US Treasuries), other borrowings, or deposits abroad. The shift by governments from emerging markets to local currency debt has widened the yield gap between debt and assets as foreign investors have to offset foreign exchange risk.
In contrast, the yield differential between foreign assets and liabilities is positive for all four major AE. The US has the highest positive yield differential and has a surplus on its international investment income despite having a negative net foreign wealth of the order of about 25 percent of its GDP.
The return on its FDI is higher than any other country and far exceeds the return it pays on its FDI. As the country that issues the dominant reserve currency, the US also earns higher yields on its external debt than it does on its external debt (mainly government bonds), and thus enjoys what is commonly known as “exorbitant privilege.”
The nine G-20 emerging economies combined transferred about 2.7 percent of their combined GDP per year to AE in the new millennium, largely due to the negative yield gap between their foreign assets and liabilities and capital losses due to changes in asset prices and exchange rates.
In large part, these resource costs arise because emerging economies prefer a particular external balance sheet structure (highly liquid low-yielding assets, less liquid high-yielding liabilities) that is believed to be more resilient to external financial shocks.
This means that emerging economies are actually transferring large sums of resources to AE to protect themselves from the shocks caused mainly by the same countries’ policies. This is underpinned by an international reserve system that allows a handful of reserve-issuing countries, most notably the US, to constantly draw resources from the rest of the world.
On the other hand, it is not clear whether emerging markets can adequately protect themselves against shocks if capital can move freely. Judicious use of capital account measures can ensure adequate protection while avoiding such costs.
For example, one would not have to issue high-yield debt to acquire large holdings of low-yielding foreign exchange reserves for self-insurance if the inflow of volatile capital is effectively controlled.
South-North resource transfers through financial channels will continue unabated as long as capital flows remain unhindered, the international reserve system favoring a handful of rich countries who are free to pursue self-interested policies regardless of their global repercussions.