Brookings: Experts - Eswar Prasad

The Road Ahead for China’s Economy

Tue, 16 Apr 2013 09:00:00 -0400

Event Information

April 16, 2013
9:00 AM - 4:30 PM EDT

Falk Auditorium
Brookings Institution
1775 Massachusetts Avenue NW
Washington, DC 20036

In recent years, China has increasingly confronted new challenges in economic policy, including rising labor costs, low household consumption, rapid urbanization and inefficient domestic investment. While it is now widely acknowledged in Beijing that major structural adjustments are needed to address these issues, implementing serious reforms pose major challenges for the newly installed leadership.

On April 16, the John L. Thornton China Center at Brookings and China’s Caixin Media Group hosted a conference to examine the daunting challenges confronting China’s new leaders. The morning panels featured a discussion of the financial sector as well as the relationship between the domestic agenda for financial reform and China’s evolving strategy for outbound investment. The afternoon panels took a close look at the political obstacles to implementing major economic reform in areas such as tax policy, the household registration system and land transfers, as well as explore the impact of environmental and natural resource constraints on China’s economic growth.

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20130416_china_economy

Soaring Reserves Put Renminbi Back in the Spotlight

Eswar Prasad and Karim Foda — Mon, 15 Apr 2013 12:26:00 -0400

Editor's Note: The following commentary originally appeared on the Financial Times website, and is based on data by the authors presented in the Financial Times' China Currency Tracker interactive feature.

View the China Currency Tracker at ft.com » (subscription required)

With China’s foreign exchange reserves soaring, the renminbi is back in the spotlight. Rising capital inflows have led to a surge in accumulation of reserves as China’s central bank tries to fend off pressures for the renminbi to appreciate. Further liberalization of capital outflows could help ease the pressure on the currency. Greater exchange rate flexibility remains in China’s interest and would also help pave the way for eventual convertibility of the renminbi.

Last year was a calm one for the renminbi. China’s trade and current account surpluses fell below 3 percent of GDP in 2012, suggesting that the economy was on its way to resolving its protracted external imbalances. Capital inflows eased off and capital outflows rose as the government liberalized controls on outflows. Net accumulation of foreign exchange reserves was just over $130 billion, compared to $330 billion in 2011 and an average of nearly $450 billion per year in the four years preceding that.

Pressures on the renminbi appeared to have become more balanced. In fact, for most of the year, the offshore non-deliverable forwards (NDF) market indicated expectations of mild renminbi depreciation relative to the U.S. dollar.

Pressures on the renminbi appeared to have become more balanced. In fact, for most of the year, the offshore non-deliverable forwards (NDF) market indicated expectations of mild renminbi depreciation relative to the U.S. dollar. In April 2012, the government increased the flexibility of the exchange rate, allowing the renminbi to rise or fall by 1 percent each day relative to the midpoint of the trading range determined by the People’s Bank of China (PBC). Soon after that, the renminbi briefly retreated in value against the dollar before returning to a slow pace of appreciation.

2013 could prove to be a more interesting year on the currency front. Capital inflows into China seem to have picked up due to a mix of pull and push factors. The economy’s short-term growth prospects seem solid, although Chinese equity markets have not performed well. The major advanced economies are likely to maintain protracted low interest rate and easy money policies, pushing capital out to China and other emerging markets.

The economy seems to have settled down to a pace of 7-8 percent GDP growth. Inflation appears under control, leaving room for a strong policy response to counter any slowdown in growth. There are many risks to this relatively benign scenario, including concerns about local government debt, the housing market, and financial system weaknesses.

Still, capital flows to China are likely to increase, particularly since the government has been easing restrictions on inflows. This will maintain appreciation pressures on the currency barring any major global financial turmoil—for instance from a flare-up of the euro zone debt crisis—that could pull capital back from emerging markets to the traditional safe haven currencies.

On a trade-weighted basis, the renminbi’s nominal effective exchange rate relative to its major trading partners has appreciated by 3 percent over the past twelve months. The inflation-adjusted real effective exchange rate has appreciated by 5 percent over this period--although China has maintained moderate inflation, many of its advanced economy trading partners have even lower inflation rates.

With the U.S. bilateral trade deficit with China hitting a new high of $314 billion in 2012 and U.S. job growth still at dismal levels, China’s currency policy could once again become a source of tension between the two countries.

Over the past twelve months (March 2012 to March 2013), the renminbi has appreciated relative to the currencies of virtually all of its major trading partners. In inflation-adjusted terms, the renminbi’s value has risen sharply against the yen--by nearly 18 percent. By this measure, the renminbi has also appreciated by 5.9 percent relative to the euro and 1.5 percent relative to the U.S. dollar. Measured relative to its recent low against the dollar in August 2012, the renminbi is now up by about 3 percent against the dollar.

The renminbi’s modest appreciation relative to the dollar suggests that the exchange rate is still being tightly managed by the PBC through its intervention in foreign exchange markets. Indeed, in the first quarter of 2013, China added $128 billion to its stockpile of reserves, pushing them to a level of $3.44 trillion.

With the U.S. bilateral trade deficit with China hitting a new high of $314 billion in 2012 and U.S. job growth still at dismal levels, China’s currency policy could once again become a source of tension between the two countries. This would not bode well for the bilateral economic relationship and could also raise global trade tensions, particularly as China and other emerging markets continue to feel victimized by aggressive monetary easing in the major advanced economies.

Continued liberalization of capital outflows will help take some of the pressure off from any increase in inflows. Still, there is a strong case for allowing more flexibility in China’s exchange rate. This would have many other domestic benefits as well. As China continues to open up its capital account, greater exchange rate flexibility will be important to make the process smoother and to facilitate the move towards free convertibility of the renminbi. It will also boost monetary and financial sector reforms.

Authors

Eswar Prasad
Karim Foda

Publication: Financial Times

Image Source: © Jason Lee / Reuters

Global Economic Recovery Stuck Below Takeoff Speed

Eswar Prasad and Karim Foda — Sun, 14 Apr 2013 12:17:00 -0400

Editor’s note: This commentary is based on research and analysis from the April 2013 update of Tracking Indexes for the Global Economic Recovery (TIGER) interactive map, which appears on the Financial Times Web site.

The global economic recovery remains stuck below takeoff speed, unable to achieve liftoff and facing the risk of stalling. Half-hearted fiscal austerity measures are proving to be a drag on growth and doing little to rebuild investor and consumer confidence.

Monetary policy continues to shoulder the burden of limiting downside risks and has kept financial markets buoyant even in the face of weak growth prospects.

The Brookings-FT Tiger index shows that growth momentum remains weak in nearly all major advanced and emerging market economies. The best that can be said about the weak pace of economic activity is that it has bottomed out in some key economies. However, prospects of a strong cyclical pickup in growth are likely to be hampered by continued policy uncertainty and concerns about further financial market turbulence, with the simmering euro zone debt crisis once again coming close to boiling over.

The US economy continues to be a relatively bright spot, with economic activity showing modest strength and equity markets booming. Consumer demand continues to prop up the weak recovery, although even that is tenuous as labor market performance remains weak. The Fed’s commitment to maintain easy monetary policy until the unemployment rate falls to 6.5 percent has boosted bond and equity markets. The Fed’s actions have also helped to limit downside risks to growth in the short term but at the cost of creating greater financial system risks. Fiscal policy, both directly and through the uncertainty about its future course, is hampering the recovery.

Growth in the core eurozone economies, including Germany and France, remains weak while the eurozone periphery remains mired in a danger zone.

Growth in the core eurozone economies, including Germany and France, remains weak while the eurozone periphery remains mired in a danger zone. The backstop provided by the ECB’s interventions bought some time for European policymakers, who have been squandering it with political squabbling. There has in fact been some progress on fiscal and structural reforms in countries such as Greece and Spain. However, in general the pace of reforms in the eurozone periphery economies has been far too slow. There are few grounds to anticipate improved growth momentum in these economies, which continue to post shrinking GDP levels. They also have dismal levels of business and consumer confidence, as well as financial systems that are still in distress and unable to provide much credit to finance a recovery. Moreover, recent developments such as the outcome of the Italian elections and the mishandled Cyprus bank rescue plan have raised the risks of an unpleasant end-game to the crisis.

The Bank of Japan’s new leadership has clearly signaled its intention to employ a broad and aggressive set of unconventional monetary policy measures to reverse deflation and support growth. For these measures to gain traction, they need to be supplemented by structural reform measures that are essential to revive the economy’s productivity and competitiveness. Bolstering Japan's productivity and long-term growth prospects requires reforms of the tax system, labor markets, and various aspects of the regulatory regime.

Emerging markets are treading water as their policy space becomes increasingly constrained and they continue to be buffeted by a weak external environment.

Emerging markets are treading water as their policy space becomes increasingly constrained and they continue to be buffeted by a weak external environment.

The outlook for China’s economy is evenly balanced, with some indicators such as industrial production suggesting that growth has stabilized. Inflation appears to have moderated, leaving room for policy stimulus if growth were to slow. The new leadership has hit the ground running in terms of laying out its economic reform agenda and making a series of statements and high-level appointments that bode well for reform prospects. The difficult task of developing specific action plans and implementing them lies ahead. Still, it seems clear that the government is prepared to accept lower growth than in the past decade so long as that growth is more sustainable and increasingly driven by private consumption and productive investment.

In India, the optimism engendered by a wave of modest but important reforms at the end of 2012 has given way to renewed gloom as the February 2013 budget did not sustain the reform momentum. The budget contained some steps to put public finances on a more sustainable path, but even the modest deficit reduction goals may be upended by weak growth. The large current account deficit remains a source of vulnerability and the high level of inflation has constrained monetary policy’s ability to support growth.

Latin American economies have hit a rough patch, with countries like Argentina and Brazil experiencing significant slowdowns. Even Mexico, one of the strongest performers in the region of late, is in danger of losing momentum as export growth has been hit hard by weak external demand.

Politicians around the world continue to avoid tough structural reforms, instead relying on central banks to continue propping up growth. Policy and political uncertainty remain sources of drag that could prevent the world economy from attaining liftoff, raising the risk of a crash.

Authors

Eswar Prasad
Karim Foda

Image Source: © Bobby Yip / Reuters

April 2013 Update to TIGER: Tracking Indices for the Global Economic Recovery

Eswar Prasad and Karim Foda — Thu, 11 Apr 2013 13:30:00 -0400

Editor's Note: In collaboration with the Financial Times (FT), Eswar Prasad and Karim Foda of Brookings have developed a set of composite indexes which track the global economic recovery. The Financial Times has produced the Tracking Indexes for the Global Economic Recovery (TIGER) interactive map, which appears on the Financial Times Web site.

The global economic recovery remains stuck below takeoff speed, unable to achieve liftoff and facing the risk of stalling. Half-hearted fiscal austerity measures are proving to be a drag on growth, and monetary policy continues to shoulder the burden of limiting downside risks.

The Brookings-FT TIGER index shows that growth momentum remains weak in nearly all major advanced and emerging market economies. Click a country name below the global Overall Growth Index to view charts for the main TIGER indexes by country and charts for the indicators that make up the indexes, which are broken down by real activity, financial and confidence indicators.

Learn more about the recovery in advanced and emerging markets (PDF) »

Click a country name below to view charts for the main TIGER indexes for that country and charts for the indicators that make up the indexes, which are broken down by real activity, financial and confidence indicators.

As well as tracking country performance, the TIGER indexes also track the performance of key indicators across groups of advanced economies, emerging markets and a composite total. Click on the following links to view the updated charts for the following key indicators:

Real Activity Indicators

Financial Indicators

Confidence Indicators

For detailed information on the composition and construction of the indexes and a comprehensive description of the data and source information, please refer to the updated technical appendix.

Read the full analysis and commentary: Global Economic Recovery Stuck Below Takeoff Speed »

Authors

Eswar Prasad
Karim Foda

Image Source: © Jo Yong hak / Reuters

The Steady Hand of China’s Central Banker

Eswar Prasad — Wed, 13 Mar 2013 09:46:00 -0400

Editor's Note: Fear of inflation and hope for reform in China’s monetary policy are both rising. Lesser men might have balked, but People’s Bank of China governor Zhou Xiaochuan is facing the challenge.

Two months ago, Mr. Zhou was expected to step down after a decade at the helm of China’s central bank, but banking and Communist Party officials have recently indicated that China’s leaders want him to stay on a little longer. During a nationally televised news conference on the sidelines of China’s annual parliamentary meetings on Wednesday, Mr. Zhou refused to say whether he would stay or go.

China Real Time caught up with Eswar Prasad, an expert on China’s economy at Cornell University, and threatened to keep 20% of his bank deposits in low-yielding reserves unless he shared his insights on Mr. Zhou’s record.

Tom Orlik: What was the economy that Zhou Xiaochuan inherited in 2002?

Eswar Prasad: When Governor Zhou became the head of the People’s Bank of China in December 2002, the economy was growing fast and recovering from a brief spell of falling prices. Foreign trade was expanding rapidly and foreign investors were thronging at China’s doorstep. However, some domestic policy tensions were also becoming apparent. The rate of bank credit expansion was already above nominal income growth and surging higher, there were concerns about bad loans in the banking system, and the PBOC was having to intervene heavily in foreign exchange markets to maintain the yuan’s peg to the dollar.

Tom Orlik: What did that mean for China’s monetary policy?

Eswar Prasad: China’s monetary policy was constrained by the need to keep the yuan’s value constant relative to the dollar. The trade surplus and capital inflows were putting pressure on the yuan to appreciate, which could have hurt China’s export competitiveness. The PBOC had started intervening aggressively in foreign exchange markets to offset these appreciation pressures by buying up dollars and other hard currencies. Low interest rates in many advanced economies were preventing the PBOC from raising domestic interest rates as that would draw in even more capital inflows. This also meant that interest rates could not be used to guide banks to tighten or loosen credit conditions; instead, the PBOC had to resort to quantity targets and other means that hampered banking reforms.

Tom Orlik: Mr. Zhou faced challenges with inflation in 2004, 2008 and 2011 – how did he deal with them?

Eswar Prasad: In each of these episodes, Mr. Zhou recognized that the expansion of bank credit needed to be controlled and took measures to limit this expansion. Unable to raise interest rates to the level that would be compatible with domestic price stability, he had to resort to measures such as quantity restrictions (setting ceilings for each bank’s credit expansion) and higher reserve requirements on banks.

Tom Orlik: In 2005, Mr. Zhou broke the yuan’s peg to the dollar – why was that?

Eswar Prasad: By 2005, the pressures on monetary policy were ratcheting up. Inflation had begun to come under control after the spike in 2004 but it was clear that the exchange rate regime had become a millstone around the neck of monetary policy. China’s interest rates could not deviate too much from U.S. interest rates, which were much lower than the rates that the PBOC would have preferred domestically. There were also increasing pressures on the yuan to appreciate, with the PBOC accumulating over $200 billion in foreign exchange reserves each year through its exchange market interventions. To start on the road to monetary independence, Mr. Zhou convinced China’s leaders that it was time to depeg the yuan from the dollar and allow it to appreciate. While there was considerable pressure from the U.S. and other advanced economies for this to happen, Mr. Zhou made the strong argument that such a move would be in China’s own interest and that the rate of appreciation could be managed in a manner that would give Chinese exporters time to adjust.

Tom Orlik: What’s the relation between China’s exchange rate regime and the U.S. financial crisis?

Eswar Prasad: China’s tightly managed exchange rate regime is one side of global current account imbalances. China’s purchases of U.S. Treasuries as part of its exchange market intervention helped keep interest rates lower for longer in the U.S., giving financial institutions cheap money with which they eventually wreaked havoc. While these imbalances were not at the root of the crisis, they played a role in perpetuating financial market excesses in the U.S. that eventually resulted in the global financial crisis. The case that some U.S. policymakers have made that these imbalances were the proximate cause of the crisis is, however, not tenable.

Read the full interview at the Wall Street Journal »

Authors

Eswar Prasad

Publication: The Wall Street Journal's China Real Time Report

The State of the Indian Economy: The Budget and Beyond

Mon, 04 Mar 2013 15:30:00 -0500

Event Information

March 4, 2013
3:30 PM - 5:00 PM EST

Saul/Zilkha Rooms
Brookings Institution
1775 Massachusetts Avenue NW
Washington, DC 20036

Over the last couple of years, India's economic growth rate has slowed. It remains one of the fastest-growing economies in the world, but the decline has caused concern within that country and outside of it. In the fall of 2012, the Indian government took measures to reverse the trend, but authorities acknowledge that much remains to be done. On February 28, P. Chidambaram, the Indian finance minister, will release the Union budget, which analysts will watch closely to determine the direction the government intends to take, especially with regard to economic reforms.

On March 4, the India Project at Brookings hosted a discussion of the state of the Indian economy, the highlights of the Indian budget, and prospects for further reforms and growth. Panelists also discussed the recently released International Monetary Fund annual staff report on India, which assesses Indian economic performance and lays out the risks and opportunities that lie ahead for the country. Panelists included Diane Farrell, executive vice president of the U.S.-India Business Council, Anne Krueger, professor of international economics at the School for Advanced International Studies, Johns Hopkins University, and Laura Papi, assistant director in the Asia and Pacific Department of the IMF. Brookings Senior Fellow Eswar Prasad, the New Century chair in International Trade and Economics, moderated the discussion.

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Beijing's Steady Progress Toward Rebalancing

Eswar Prasad — Tue, 19 Feb 2013 00:00:00 -0500

While the world's attention has been focused on the political and economic dramas in Europe, Japan and the U.S., one country has been quietly chipping away at some of its own economic problems. Recent data suggest a gradual but remarkable transformation in China's growth model. It is far too early to declare victory, however, and the new leadership has its work cut out for itself.

New data suggest that it is time to revise the view that China's growth is driven largely by exports and investment. Private and government consumption together accounted for more than half of China's output growth in 2011-12, signaling a big shift in the composition of domestic demand. Physical capital investment, the main driver of growth over the previous decade, is no longer the dominant contributor to growth. As for exports, a shrinking trade balance has in fact dragged down growth these past two years.

China has made substantial progress in reducing its external imbalances. Its trade and current account surpluses have shrunk steadily and markedly relative to their peaks in 2007, when they hit 7.6% and 10.1% of gross domestic product, respectively. In 2012, both of these surpluses were below 3% of GDP.

One reason for this shift is that China's strong growth, combined with economic weaknesses in its key export markets, has brought down the trade deficit. Another is that the government has eased restrictions on capital inflows and outflows, allowing Chinese investors and corporations to look to foreign investments for diversification purposes.

Capital outflows exceeded inflows in 2012, something not seen for over a decade. This has raised concerns about capital flight. But the reversal might simply reflect a maturing, richer economy with more open financial markets that allow investors to take advantage of diversification opportunities.

There are other signs of progress on domestic rebalancing as well. The decline in the share of private consumption in GDP has been halted. The share even went up slightly in the last two years, although it still remains well below that of every other major economy, advanced or emerging. Consistent with the government's objective of promoting the services sector, employment in this sector grew faster in 2012 than in the industrial sector. The shares of these two sectors in GDP are now equal.

This is not to say that all is well with the Chinese economy. There are problems lurking on the books of the big state-owned banks which have continued lending mainly to state enterprises. The shift away from state-owned to private enterprises has ground to a halt. Provincial governments have large levels of debt. Overall employment growth remains meager, and the environmental consequences of the growth model are painfully obvious. For all of these and other problems, however, the fact that the government has been able to gently steer the large and fast-moving economic ship in the right direction is a notable achievement.

Growth is the magic tonic that has helped China cope with the myriad of economic problems it faces. A declining labor force and limits to investment growth suggest that China will have to rely on faster productivity growth to keep up its GDP growth.

The big challenge now is to speed up reforms needed to improve the quality and efficiency of growth, continue the shift away from capital-intensive production, generate more employment and allow more of the benefits of growth to filter down to the average household. This will require more disciplined banks, broader financial markets, a stronger social safety net and other reforms that were clearly laid out in China's 12th five-year plan two years ago.

Earlier this month the government announced a plan to reduce inequality that incorporates some of these reforms. Trying to reduce inequality through government intervention is usually not a good idea, as it puts the focus on redistributive policies rather than ones that promote growth.

But this plan seems to use the goal of reducing inequality more as a framework for a broad set of reforms that will secure growth and improve income distribution. The proposed reforms include liberalization of interest rates to boost competition in the banking system, removal of restrictions on labor mobility to promote urbanization, and increased spending on social programs to reduce household savings and raise private consumption. Beijing has hit upon a clever strategy, as it will be a lot harder for vested interests to block reforms that are sold as being for the benefit of the masses.

China has a golden opportunity—with growth recovering and inflation low—to look beyond short-term demand management and focus instead on improving the balance, quality and sustainability of growth. While its new leaders have sung the appropriate paeans to reforms, now is the time to pick up the playbook from two years ago and act on it.

Authors

Eswar Prasad

Publication: Wall Street Journal

Image Source: © Stringer China / Reuters

Rebalancing and Reforms in China

Eswar Prasad — Thu, 07 Feb 2013 15:29:00 -0500

Editor's Note: In testimony to the U.S.-China Economic and Security Review Commission, Eswar Prasad discusses China's continued progress on reducing its external imbalances, the main policy reforms that are needed, and the implications for the United States.

Since the financial crisis, China has made substantial progress on reducing its external imbalances, with the surpluses on both the current account and the trade balance falling sharply from their peaks in 2007. China has also made some progress on domestic rebalancing. Recent data suggest that it is time for a revision of the view that the country’s growth is driven largely by exports and investment. Private and government consumption together accounted for more than half of China’s output growth in 2011-12, signaling a significant change in the composition of domestic demand. Physical capital investment, the main driver of growth over the previous decade, is no longer the dominant contributor to growth while a shrinking trade balance in fact made a negative contribution to growth in these two years.

Despite all of this progress, there remain major challenges to putting in place the reforms needed to improve the quality and efficiency of growth, continue the shift away from capital-intensive production, generate more employment, and allow more of the benefits of growth to filter down to the average household.

The twelfth five-year plan that was approved by the National People’s Congress in March 2011 appeared to herald a turning point in China's economic development. It represented, at least in rhetoric, a marked shift in emphasis from high growth to the quality, balance and sustainability of that growth. The longer-term objective of the plan was to reorient growth to make it more balanced and sustainable from different perspectives--economic, social and environmental.

While steady growth and low inflation have eased immediate policy concerns, China still faces a number of challenges related to the longer-term structural transformation of the economy.

There were promising signs of a push for reforms in the first half of 2012, as a number of modest but significant actions signaled continued progress towards economic reforms. This reform momentum stalled in the latter half of the year, however, partly due to some unexpected political turmoil in the lead-up to the political transition that got underway last fall. Nevertheless, the economy has continued to turn in a good performance despite a weak external environment. While steady growth and low inflation have eased immediate policy concerns, China still faces a number of challenges related to the longer-term structural transformation of the economy. The new leadership has indicated a desire to push forward with reforms, but there have been few indications of specific measures under consideration.

In this testimony, I will review progress on different aspects of China’s rebalancing, discuss the main policy reforms that are needed, and summarize the implications for the United States.

Read the full testimony » (PDF)

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Authors

Eswar Prasad

Publication: U.S.-China Economic and Security Review Commission

Image Source: © Stringer China / Reuters

New Paradigms for Financial Regulation: Emerging Market Perspectives

Masahiro Kawai and Eswar Prasad, eds. — Thu, 27 Dec 2012 00:00:00 -0500

Brookings Institution Press 2012 300pp.

The global financial crisis has led to a sweeping reevaluation of financial market regulation and macroeconomic policies. Emerging markets need to balance the goals of financial development and broader financial inclusion with the imperative of strengthening macroeconomic and financial stability. The third in a series on emerging markets, New Paradigms for Financial Regulation develops new analytical frameworks and provides policy prescriptions for how the frameworks should be adapted to a world of more free and more volatile capital.

This volume provides an overview of the global regulatory landscape from the perspective of Asian emerging markets. The contributors discuss the many challenges ahead in developing sound and flexible financial regulatory systems for emerging market economies. The challenges are heightened by the rising integration of these economies into global trade and finance, the growing sophistication of their financial systems as globalization and emergence processes accelerate, and their potential vulnerability to instability arising from the financial markets in the advanced economies.

The contributors provide guidance about pitfalls to be avoided, general principles that should guide the creation of sound regulatory systems, and valuable analytic perspectives about how to continue to broaden the financial sector and innovate while still maintaining financial and macroeconomic stability.

Specific topics covered by the volume include:

Implications of global regulatory changes for emerging markets, with particular emphasis on Asian emerging markets
Effective design of regulatory and policy frameworks to promote financial system development and stability
Monetary policy frameworks to enhance financial stability and international policy coordination
Principles for a sound global regulatory architecture

This is the third in a series of books edited by Kawai and Prasad—copublished with the Asian Development Bank Institute—on international financial regulation and reform in the wake of global crisis, focusing on emerging markets. The first two books in the series are Asian Perspectives on Financial Sector Reforms and Regulation and Financial Market Regulation and Reforms in Emerging Markets.

ABOUT THE EDITORS

Masahiro Kawai

Masahiro Kawai is dean of the Asian Development Bank Institute and a former chief economist for the World Bank’s East Asia and the Pacific region.

Eswar Prasad

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The New Renminbi Landscape

Eswar Prasad and Karim Foda — Tue, 30 Oct 2012 00:00:00 -0400

Editor's Note: The following commentary originally appeared on the Financial Times website, and is based on data by the authors presented in the Financial Times' China Currency Tracker interactive feature.

View the China Currency Tracker at ft.com » (subscription required)

The renminbi is in the spotlight again. The U.S. Presidential election campaign features both candidates vowing to be tough on China, with Mitt Romney promising to “call China a currency manipulator on day one” if elected. In fact, based on data for this year, there isn’t a strong basis for a charge of currency manipulation. Meanwhile, with growth slowing and the leadership transition taking many unexpected twists, there are concerns about capital flight from China that could also have implications for the renminbi. While capital inflows have fallen and outflows have increased, there is little evidence of massive capital flight that could destabilize the economy.

During 2012, the renminbi has continued on its path of gradual appreciation relative to the U.S. dollar. Since end-2011, the renminbi has appreciated by 1.2 percent against the dollar. But it has not been a slow and steady one-way march. The renminbi in fact depreciated modestly by about 0.7 percent over the summer. Since the end of July, the currency has resumed its appreciation and risen in value by 2 percent against the dollar.

One reason for these fluctuations is that China, like many other emerging market economies, has experienced significant swings in its net capital flows during 2012. This has led to two-way movements in the currency. The People’s Bank of China has accommodated these fluctuations and appears to be increasingly comfortable allowing the currency’s value to be determined by market forces. Nevertheless, it still keeps a tight lid on day-to-day volatility in the currency.

Interestingly, in inflation-adjusted terms, the renminbi’s value relative to the dollar is now almost exactly where it was at the beginning of this year. During 2012, inflation in the U.S. has been higher than in China, with the differential offsetting the nominal appreciation of the renminbi.

Since the value of the euro relative to the dollar is now almost exactly at the same level as at the end of 2012, the year-to-date nominal appreciation of the renminbi relative to the euro is also 1.2 percent.

On a trade-weighted basis, the nominal effective exchange rate is barely unchanged from its level at the end of 2011. Given lower inflation in China than in most of its trading partners, the real effective exchange rate has in fact depreciated slightly.

Seen from a broader context, movements in the currency indicate an altered landscape for the currency’s short-term prospects. Based on data for the first three quarters of 2012, the current account surplus is likely to remain under 3 percent of GDP while the trade balance could come in at around 2 percent of GDP in 2012. The nondeliverable forwards market is not indicating expectations of renminbi appreciation; in fact, for much of the last year, it has been signaling market anticipation of a slight depreciation.

The level of foreign exchange accumulation, which is one measure of intervention in foreign exchange markets, has been substantially lower since mid-2011 than in preceding years. During the first three quarters of 2012, net accumulation of foreign exchange reserves was just over $100 billion, compared to $330 billion in 2011 and nearly $450 billion per year in the four years preceding that.

In short, recent data make it harder to support the case that foreign exchange market intervention by China’s central bank is perpetuating undervaluation of the renminbi in the short run. Pressures on the renminbi appear to have become more balanced.

Weaker inflows and stronger outflows (including an increase in foreign currency deposits) have led to a more balanced position on the financial account. These swings seem to be quite similar to those experienced by many other emerging markets. While gross capital outflows have increased significantly over the past two years, these are consistent with the government’s steps to liberalize outflows. Non-government outflows are likely to increase further as Chinese corporations look for investment opportunities abroad and as financial market development allows households to take advantage of avenues to diversify their savings into foreign investments

All things considered, there is still a strong case to allow for greater flexibility in China’s exchange rate, which would have many domestic benefits. However, recent data should dispel the notion that what’s needed is a big appreciation of the currency rather than more flexibility. There is also little reason (so far) to panic about China’s rising capital outflows—they may be a sign of a maturing economy rather than a troubled one.

Authors

Eswar Prasad
Karim Foda

Publication: Financial Times

Image Source: © Petar Kujundzic / Reuters

Global Lenders Rebuild Identities After the Crisis

Eswar Prasad — Fri, 12 Oct 2012 16:45:00 -0400

Just five short years ago, the International Monetary Fund and the World Bank were struggling for an identity. Practically the entire global economy, from poor to rich countries, was enjoying a golden period of growth and stability — and seemed unlikely to need a hand, or a handout, from either of these two institutions.

Those existential questions were erased by the global financial crisis that began in September 2008. And in dealing with the aftermath of that crisis, it has become clear that the world needs both institutions more than ever.

The IMF is now helping the euro zone cope with its sovereign debt crisis, going back to the fund’s roots at the Bretton Woods conference in New Hampshire in 1944, when it was set up to manage the fixed exchange-rate system among the major industrial economies.

The World Bank, also a Bretton Woods creation, is helping low-income economies deal with the collateral damage from the financial crisis, as well as declines in world trade and the surge in commodity prices.

Yet even as their angst over their usefulness to the world has dissipated, both institutions now face a different challenge: adapting to the rapidly shifting structure of the world economy.

Emerging market economies now account for an increasing share of global gross domestic product and the major share of global growth. With the advanced economies strapped for cash and facing rising levels of public debt, the emerging markets will determine not only the relevance but also the funding base of the Bretton Woods institutions.

These institutions cannot afford to ignore this growing middle. And, in fact, recent changes to governance structures will help in strengthening legitimacy among emerging markets. These economies are getting bigger voting shares, and the compositions of the governing boards are being altered to reflect the declining economic importance of advanced economies.

But both the IMF and the World Bank still have much to do to build trust among emerging markets and make a convincing case that they are not merely instruments of the rich economies.

Many emerging-market countries had to go hat in hand to the IMF during the currency and banking crises that hit them in the 1980s and 1990s. The fund’s assistance typically came with many conditions attached, requiring necessary but painful policy changes. This evolved into a deep distrust of the IMF, which came to be seen as a handmaiden of the advanced economies, parroting those countries’ views about free and unfettered financial markets.

Given their rising income levels, many emerging economies have also come to see the World Bank as less relevant to the challenges they face.

The role the IMF plays in dealing with the next phases of the euro zone debt crisis will influence the credibility it has with emerging markets.

The euro zone does not lack the financial wherewithal to stem the crisis. What it lacks is the political will. The European Central Bank has committed to buying sovereign bonds of euro zone countries that agree to undertake policy overhauls. The Spanish government has agreed to do its part by implementing fiscal austerity measures and other changes.

Disaster has been averted, but this comfort will not last for long. Markets may trust the ECB to keep its word, but they do not fully trust politicians to keep their end of the bargain. Recent riots on the streets of Greece and Spain show how difficult it will be for European governments to enact the necessary changes.

Europe, therefore, needs a credible and tough disciplinarian. The ECB remains the only institution that fills the bill. But for all the talk of conditions attached to ECB money, the pushback from countries like Spain that hope to benefit from the ECB’s largess will only intensify as their domestic political circumstances deteriorate.

And the pushback will continue even after commitments are made. The ECB cannot credibly threaten to retreat from its defense of any euro zone country that accepts its conditions, even if the commitments to undertake overhauls subsequently remain unfulfilled.

In short, Europe needs the IMF The question is whether the fund will now use its extraordinary leverage to set a course correction for Europe and for itself.

To serve as an effective and honest broker, the IMF needs to restore its own credibility along with its broader legitimacy.

Early on in the crisis, the IMF pumped large sums of money into the European periphery. This money came with conditions but also twisted the fund into the position of looking through rose-tinted glasses at harsh realities, in order to rationalize its lending decisions.

Moreover, it cost the IMF some credibility to lend large amounts to a small economy like Greece’s. Many emerging-market policy makers viewed this as a double standard at work, noting that they would probably not have been able to count on such largess.

Without putting more of its own money at stake, the IMF is now in a position to speak the truth. To rebuild credibility, it will have to be blunt. In the case of countries like Greece, the understandable desire to play up the positives has to end. What is needed is a direct and open assessment of the prospects of each distressed economy and what it will take for each of those economies to regain its footing, either within or outside the euro zone.

The IMF should also take a broader view of what Europe as a whole needs. For far too long, the core euro zone economies have apparently held the view that different rules should apply to them compared with their less virtuous neighbors.

All of Europe needs to hear some harsh truths about what it will take for the euro zone to hold together and prosper. Using the power of its megaphone rather than its purse strings, the IMF can not only redeem its own credibility but also do a lot of good for Europe and the world economy.

As for the World Bank, in an era of rising incomes it is clear that the emerging markets do not need the institution’s money as much as they need its technical expertise. To stay relevant to this group, the institution must do a more skillful job of tying together policy advice on major macroeconomic issues, including fiscal and monetary policies, with more ‘‘micro’’ development issues, like health care and education.

Jim Yong Kim, the new president of the World Bank, has a distinguished record on innovative and nonideological approaches to development issues and policies to implement them at micro levels. This is exactly along the lines of what emerging market economies need.

The IMF and the World Bank have proved their worth in tough times and have become important instruments of change in rich and poor economies, respectively. The challenge they face in order to remain relevant in a fast-changing world economy is to retool themselves so that the countries in the middle, the fast-growing emerging markets, also see them as useful institutions that are not beholden to the club of rich countries and that adapt well to changing circumstances.

Authors

Eswar Prasad

Publication: New York Times

Image Source: © Yuriko Nakao / Reuters

Global Economic Recovery Hits the Ropes

Eswar Prasad and Karim Foda — Sun, 07 Oct 2012 14:01:00 -0400

Editor’s note: This commentary is based on research and analysis from the October 2012 update of Tracking Indexes for the Global Economic Recovery (TIGER) interactive map, which appears on the Financial Times Web site.

The global economic recovery is on the ropes, battered by political conflicts within and across countries, lack of decisive policy actions, and governments’ inability to tackle deep-seated problems such as unsustainable public finances that are stifling growth. Growth in global trade has weakened and the spectre of currency wars, with countries looking to maintain export competitiveness by keeping their currencies weak, has returned to the fore.

The Brookings-FT Tiger index shows growth momentum has dissipated in nearly all major advanced and emerging market economies. Central banks of the major advanced economies have responded with a range of conventional and unconventional policy monetary policy actions. These measures have put a floor on short-term financial market risks but have been unable to reverse declining growth momentum. As a result, financial markets continue to go through short-term cycles of angst and euphoria even as indicators of real economic activity remain mired in weakness.

The US economy remains the sole bright spot, with economic activity, employment and financial markets all showing unexpected although still modest strength. There are signs housing markets have stabilised in many hard-hit areas, which could set the stage for a rebound in consumer demand. The Fed’s aggressive approach of combining unconventional monetary policy measures and forward guidance of a low interest rate path through 2015 seems to have contributed to a more benign outlook. However, the looming fiscal cliff and the prospect of continued political gridlock after the presidential elections is putting a damper on business and consumer confidence.

Growth in the core eurozone economies, including Germany and France, has slowed sharply while the eurozone periphery remains in free fall. Eurozone financial markets revived briefly in the wake of the ECB’s actions to directly support the financing needs of governments that commit to fiscal austerity and structural reform measures. It seems increasingly unlikely, however, that governments of periphery countries such as Spain can overcome the popular resistance to such measures. Consequently, sentiments have turned negative again and are contributing to a slowdown across the eurozone.

The Bank of Japan has been uncharacteristically aggressive in employing a broad range of unconventional monetary policy measures to support growth, in part by limiting appreciation of the yen. The economy has not responded positively to these measures, however, and they have only created a temporary respite for Japanese financial markets.

Emerging markets are running out of steam as their available policy space becomes increasingly constrained and they continue to be buffeted by adverse external factors, including a weak global trade outlook and volatile commodity prices.

Emerging markets are running out of steam as their available policy space becomes increasingly constrained and they continue to be buffeted by adverse external factors, including a weak global trade outlook and volatile commodity prices.

The outlook for China’s economy has turned gloomier as numerous indicators suggest a slowdown that threatens to push growth below the government’s target of 7.5 percent. Weaknesses in major export markets, the overhang of excess capacity from the 2009 to 2010 bank-financed investment surge, and a weak housing market have all hurt aggregate demand.

China may be holding back some policy firepower to deal with further unfavourable developments abroad, but policy options to restore growth will become increasingly constrained if the slowdown intensifies. Political intrigue and jockeying in the lead-up to the leadership transition also appear to have contributed to the lack of a decisive and concerted policy response.

In India, recent reforms have created a surge of optimism that more are on the way and that the government may finally start to rein in the budget deficit. The pushback against the reforms has created some short-term political uncertainty that is holding back economic activity and financial market performance. While the reforms do not directly address India’s vulnerabilities such as its large budget and current account deficits, the overwhelming sense of malaise has been replaced by guarded optimism.

Latin American economies have hit a rough patch, with countries like Argentina and Brazil experiencing significant slowdowns. In Mexico, strong export performance has kept growth more stable than in other countries in the region.

With fiscal policy and other policy tools hamstrung by high debt levels and political uncertainty, monetary policy remains the first and often only line of defence in most G20 countries. Central banks are being forced to continue shouldering the twin burden of limiting downside risks and stimulating growth, resulting in reduced traction for monetary policy in boosting growth and also setting the stage for future financial system imbalances. In the absence of a broader range of decisive policy measures - including fiscal, financial system and structural reforms needed in many countries - the world economy may soon be down for the count.

Authors

Eswar Prasad
Karim Foda

Publication: Financial Times

Image Source: © Yuriko Nakao / Reuters

October 2012 Update for TIGER: Tracking Indexes for Global Economic Recovery

Eswar Prasad and Karim Foda — Sun, 07 Oct 2012 17:40:00 -0400

Editor's Note: In collaboration with the Financial Times (FT), Eswar Prasad and Karim Foda of Brookings have developed a set of composite indexes which track the global economic recovery. The Financial Times has produced the Tracking Indexes for the Global Economic Recovery (TIGER) interactive map, which appears on the Financial Times Web site.

The global economic recovery is on the ropes, battered by political conflicts within and across countries, lack of decisive policy actions, and governments’ inability to tackle deep-seated problems such as unsustainable public finances that are stifling growth. The Brookings-FT Tiger index shows growth momentum has dissipated in nearly all major advanced and emerging market economies.

The updated interactive map below displays how fast individual G-20 economies are faring in global economic recovery.

As the impacts of the euro crisis loom over the rest of the world, a new euro periphery group has been added to the interactive. Greece, Ireland, and Portugal are now featured, complementing Spain and Italy, already featured as G-20 economies, to round out the euro periphery group.

Underneath the map, links to updated key indicators display how fast those indicators are recovering for advanced economies, emerging markets and a composite total of those two groups.

To view this page, you must have both JavaScript enabled and version 8 of the Adobe Flash Player installed. Download the Flash Player

Click on an individual country in the map to view charts for the main TIGER indexes for that country and charts for the indicators that make up the indexes, which are broken down by real activity, financial and confidence indicators.

Real Activity Indicators

Financial Indicators

Confidence Indicators

For detailed information on the composition and construction of the indexes and a comprehensive description of the data and source information, please refer to the updated technical appendix.

Read the full analysis and commentary: Global Economic Recovery Hits the Ropes »

Authors

Eswar Prasad
Karim Foda

Image Source: © Stringer China / Reuters

Banks and Cross-Border Capital Flows: Policy Challenges and Regulatory Responses

Wed, 26 Sep 2012 14:59:00 -0400

This report was written by the Committee on International Economic Policy and Reform, a non-partisan, independent group of experts, comprised of academics and former government and central bank officials. Its objective is to analyze global monetary and financial problems, offer systematic analysis, and advance reform ideas. The committee attempts to identify areas in which the global economic architecture should be strengthened and recommend solutions intended to reconcile national interests with broader global interests. Through its reports, it seeks to foster public understanding of key issues in global economic management and economic governance. Each committee report will focus on a specific topic and will emphasize longer-term rather than conjunctural policy issues. In this September 2012 report, the committee lays out a framework for cross-border banking flows and for improved regulatory coordination.

Committee Members

Markus Brunnermeier, Princeton University
José De Gregorio, University of Chile
Barry Eichengreen, University of California, Berkeley
Mohamed El-Erian, PIMCO
Arminio Fraga, Gavea Investimentos
Takatoshi Ito, University of Tokyo
Philip R. Lane, Trinity College Dublin
Jean Pisani-Ferry, Bruegel
Eswar Prasad, Cornell University and Brookings Institution
Raghuram Rajan, University of Chicago
Maria Ramos, Absa Group Ltd.
Hélène Rey, London Business School
Dani Rodrik, Harvard University
Kenneth Rogoff, Harvard University
Hyun Song Shin, Princeton University
Andrés Velasco, Columbia University
Beatrice Weder di Mauro, University of Mainz
Yongding Yu, Chinese Academy of Social Sciences

REPORT INTRODUCTION

The world has become more integrated, not just through trade but through financial flows. Financial integration offers many benefits but also poses risks. This observation in turn points to the question of how best to benefit from greater financial integration while limiting adverse effects. A complicating factor in improving the benefit- cost tradeoff from financial integration is that banks often play a central role in intermediating these flows. Banks behave in ways that differ from those predicted by textbooks of atomistic participants in financial markets. In addition, they are subject to uncoordinated regulatory and political forces that are and hard to predict.

In this report, we draw on the growing body of evidence on cross-border capital flows in an effort to better understand their effects in practice. Building on this analysis, we suggest ways in which policy should be adapted to reap the benefits of the flows while minimizing their costs. While bank flows cannot be studied in isolation, our analysis and policy recommendations focus on banks, as they intermediate a substantial fraction of cross-border capital flows, are highly volatile, and pose specific regulatory and policy challenges.

The textbook case for financial integration is well known. It allows capital to flow from capital-rich to capital-poor economies, where returns should be higher. These flows complement limited domestic saving in capital-poor countries and reduce their cost of capital, thus boosting investment and growth. Financial integration can also help cushion the impact of adverse shocks, since consumption can be smoothed by external borrowing even if incomes are volatile, while capital flows can help to sustain investment. Financial integration can provide risk diversification by allowing residents to transfer domestic risks to foreign investors while gaining exposure to foreign investment opportunities.

In addition, financial flows may have “collateral” or indirect benefits. Foreign direct investment (FDI) can bring new technologies, along with managerial and organizational expertise, to the receiving country. International investors tend to demand more transparency and better governance of local firms. By providing risk-bearing capital, financial integration can help domestic firms specialize, fostering faster productivity growth. Monitoring by international investors can discipline macroeconomic policies, encouraging governments to pursue sustainable fiscal policies and enlightened prudential strategies. These indirect benefits of financial openness thus promise faster economic growth.

Even diehard proponents of liberalized, open financial markets make some allowance for a slower pace of financial integration for developing or emerging economies, citing their weaker institutions and more limited capacity to absorb and benefit fully from the inflows of capital. In their view, however, the ideal of full capital account convertibility should still serve as the North Star that emerging-economy to which policy makers should navigate, even if they must steer close to land initially so as to avoid the perils of the open ocean that only advanced economies can navigate safely.

At the same time, recent events, from the subprime crisis in the United States to capital flow reversals and the banking crisis in Europe, have shaken faith that even advanced economies can harness the benefits of greater financial flows and deepen financial integration without incurring costs. The advanced countries that have been swept up first by the subprime crisis and now by the eurozone crisis are not the stereotypical emerging economies with weak institutions. Spain, for example, ranks high on traditional yardsticks of financial development such as the ratio of commercial bank assets to GDP, or of markers of financial integration such as cross-border liabilities as a proportion of GDP. And yet, those same measures of financial integration and development that were held up as yardsticks of progress have turned out instead to be the engines of financial distress as capital flow reversals have gathered pace in Europe. In contrast, it has been the emerging economies with what were presumed to be “weak” institutions and underdeveloped financial markets that have best weathered the storm.

These topsy-turvy outcomes have been disorienting for those who believed in the desirability of moving toward the ideal of liberalized, open financial markets in incremental steps. In this report, we will take stock of the traditional case for financial liberalization and offer our perspective on which principles have withstood the test of recent events and which ones now need rethinking.

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Publication: Committee on International Economic Policy and Reform

Banks and Capital Flows: Policy Challenges and Regulatory Responses

Wed, 26 Sep 2012 14:00:00 -0400

Event Information

September 26, 2012
2:00 PM - 3:30 PM EDT

Falk Auditorium
Brookings Institution
1775 Massachusetts Avenue NW
Washington, DC 20036

Financial integration offers many benefits, but also poses risks. Recent events—from the U.S. subprime mortgage crisis to capital flow reversals and the European banking crisis—have shaken the faith that even advanced economies can harness the benefits of greater financial flows and deepen financial integration without incurring costs. These observations point to the question of how best to benefit from greater financial integration while limiting adverse effects, especially the risks posed by cross-border banking flows.

On September 26, Global Economy and Development at Brookings hosted a discussion to launch a new report by the Committee on International Economic Policy and Reform (CIEPR)—a group of independent economic experts that includes academics as well as former government and central bank officials. In this report, the committee draws on the growing body of evidence on cross-border banking flows in an effort to better understand their effects in practice. Building on this analysis, the committee makes specific policy proposals for improving domestic banking regulation and also for cross-border regulatory coordination. Panelists included committee members José De Gregorio, former Chilean central bank governor; Hyun Song Shin of Princeton University; and Jean Pisani-Ferry of Bruegel. Brookings Senior Fellow Donald Kohn also joined the panel. Brookings Senior Fellow and Cornell University Professor Eswar Prasad, who is also a member of CIEPR, moderated the discussion. After the program, the panelists took audience questions.

You can follow the conversation on this event on Twitter using the hashtag #CIEPR.

Read the CIEPR report, titled "Banks and Cross-Border Capital Flows: Policy Challenges and Regulatory Responses" »

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Options Open on Economy

Eswar Prasad — Mon, 10 Sep 2012 15:33:00 -0400

China’s economy has been the leading contributor to global growth since 2009 and became the second largest in the world in 2010. Small wonder that fears of a growth slowdown in China are causing trepidation around the world.

The fears are palpable given that virtually all indicators of economic activity are pointing down. Growth in gross domestic product, industrial production and retail sales have all slowed markedly. Alternative indicators like electricity consumption suggest an even sharper slowdown. Foreign trade has not helped, with export and import growth falling sharply as well.

Then there are the longer-term concerns that a rapidly aging population is going to limit the economy’s growth potential, snaring China in the “middle-income trap.” With fear in the air, foreign capital is no longer pouring into China and some domestic investors are even taking capital out.

Inflation has eased to 2 percent and some of the froth has come off the property market, but these are seen by many as signs of deeper malaise rather than as positive developments. All told, it appears to be the season for China bears, who are exulting as their views appear — finally — to be validated.

The burden of pulling along world growth while the major advanced economies — the United States, Europe and Japan — continue to post anemic growth and remain in a state of policy paralysis has clearly taken its toll on the Chinese economy. Moreover, many emerging markets and even some advanced economies that rely on commodity exports have been riding on China’s coattails during a difficult period in the world economy. Thus, China’s growth is seen as a bellwether of an even rockier period ahead for a global economy whose recovery has stalled.

For all the angst about China’s growth, the government does have room to stimulate the economy through fiscal and monetary policies. This is in contrast to many advanced economies, which seem to have exhausted their policy options. With a leadership transition looming, the Chinese government appears to be holding some of its fire to be able to respond strongly to external shocks.

Attaining this year’s growth target of 7.5 percent is likely to be difficult but not insurmountable. The real challenge Chinese policy makers face is how to sustain growth in the short run without creating more risks over the longer term.

A bank-financed investment surge lifted economic growth during the global financial crisis. The temptation to use this policy tool again is strong. But another wave of bank-financed investment would also create big risks, including excess capacity in many industries and more bad loans in the banking system.

The mix of policies also has implications for making growth more balanced. Until recently, the Chinese economy was beset by two imbalances — an external one, reflected in a high trade surplus, and an internal imbalance, reflected in a low and falling ratio of private consumption to G.D.P.

The external imbalance has dissipated, at least temporarily. China’s trade surplus has fallen steadily from its recent peak of 7.6 percent in 2007 to 2.1 percent in 2011, and below 2 percent in the first half of this year. Part of this decline is because China has been growing far more strongly than its trading partners. Another factor is that the currency, the renminbi, has appreciated in value against the currencies of China’s major trading partners, reducing export competitiveness.

By contrast, domestic growth remains unbalanced, with investment still accounting for a major share of G.D.P. growth. The share of private consumption in G.D.P., which is only about one-third — already much lower than in virtually every other economy — continues to decline.

There was a spark of hope in the first quarter of 2012, when private consumption accounted for the major share of G.D.P. growth. But this proved fleeting, and investment has once again taken over as the main driver of growth. Investment-led growth of the sort China has experienced is not entirely a plus — it does not lift employment growth by much, has deleterious environmental consequences and limits the benefits that the average household gets from fast growth.

What is to be done? Fiscal policy, if well targeted, would be a better tool to stoke demand in the short run without creating too many long-term risks. For instance, a better safety net would help spread the benefits of China’s strong economic performance more evenly and reduce the incentives for households to “self-insure” against risks of unemployment by saving more. Raising social expenditures on health and education would not only give households more incentive to spend rather than save but also help improve the productivity of labor.

For the longer term, the main priority for the government is to improve productivity rather than rely on high investment or an expanding labor force. This will also require a better financial system and more effective policy tools.

The financial system needs to improve its efficiency in allocating capital to more productive uses, including providing capital for small and midsize enterprises that could generate more employment, and providing savers with a higher return on their deposits. A better monetary policy would help in this objective and that, in turn, requires a greater freeing up of the exchange rate over time so that the central bank can use interest rates to guide credit allocation.

The economy faces other enormous challenges, including corruption and dismal corporate governance at Chinese enterprises. The twelfth five-year plan, issued last year, laid bare these problems and deficiencies in the policy-making process. An authoritarian government can certainly do what would be infeasible in a democracy, where such an admission would be politically fatal. But it is difficult to think of another government, democratic or not, that so bluntly acknowledges major problems and areas where its policies have failed to deliver much progress. In the midst of the gloom, that allows a glimmer of hope that Chinese policy makers will continue to embrace an agenda of much-needed reforms.

Despite the difficult economic environment and a looming, rockier-than-anticipated political transition, there has been progress. This includes modest but significant steps taken in recent months toward greater flexibility of the renminbi’s exchange rate, liberalization of domestic interest rates, and freeing up of restrictions on capital inflows and outflows.

This opportunistic and gradual approach to economic overhauls is one way to make progress given the significant constraints, both political and institutional, that the government faces. But China’s leaders may not have the luxury of time or a benign environment, either domestic or global, to limit themselves to such a slow, even if steady, pace.

The country’s policy makers have proven adept at managing a high-wire balancing act for a number of years, keeping growth strong even while managing the many problems the growth process has created. Gusting winds from abroad have now exposed many of these tensions and threaten to bring the act crashing down.

A more aggressive push for reforms is needed to help secure short-term growth while improving future prospects and reducing risks. Not moving forward on these reforms may be the biggest risk of all.

Authors

Eswar Prasad

Publication: The New York Times

The Downside of Renminbi Flexibility

Eswar Prasad and Karim Foda — Thu, 16 Aug 2012 10:27:00 -0400

The renminbi has become more flexible but, in light of global financial market turmoil and concerns about China’s growth, the notion that the renminbi can only go in one direction has been repudiated.

Greater flexibility of the renminbi should serve China well, but could prove to be a mixed blessing in the short run for China’s major trading partners.

In view of the economic slowdown and the upcoming leadership transition, the Chinese government is likely to do what it can to keep the renminbi’s value reasonably stable relative to the dollar. An appreciation would hurt export growth, which is already weak, while a significant depreciation could suggest a loss of economic control and sharpen concerns about China’s growth prospects.

The FT China currency tracker summarises the twists and turns in the renminbi’s fluctuations relative to the currencies of China’s major trading partners.

Over the past 12 months, the renminbi has appreciated by just 1 per cent relative to the US dollar, although the renminbi-dollar rate has fluctuated significantly in both directions over this period. The dollar’s strength during a period of continued global financial turmoil has resulted in the renminbi’s appreciation against the currencies of virtually all of China’s major trading partners.

On a trade-weighted basis, the renminbi has appreciated by about 8 per cent over the past year in both nominal and inflation-adjusted (real) terms relative to the currencies of a broad group of China’s major trading partners.

Despite the much higher inflation rates in Brazil and India compared to China, the weaknesses of the real and rupee over the past year have resulted in the renminbi’s sharp appreciation relative to those currencies even in inflation-adjusted terms (19 per cent versus the rupee; 30 per cent versus the real).

More troubling for China is that the renminbi has appreciated by about 17 per cent relative to the euro over the past year. The EU is the leading market for China’s exports. The eurozone’s economic weakness coupled with the renminbi’s appreciation relative to the euro will continue to dampen prospects for China’s export growth.

Since the beginning of 2012, and especially since the widening of the floating band in April, the renminbi has shown some flexibility in both directions. On a broad trade-weighted basis, the renminbi has appreciated by about 1.6 per cent relative to the currencies of its major trading partners (0.9 per cent in inflation-adjusted terms).

Interestingly, the renminbi has depreciated by about 1 per cent relative to the US dollar, in both nominal and inflation-adjusted terms, since the beginning of this year. This probably reflects weaker capital inflows due to concerns about the Chinese economy and global economic uncertainties, as well as greater outflows as China continues to open up its capital account and reduce outflow restrictions. The renminbi has, however, continued to appreciate sharply relative to the euro.

During 2012, the renminbi has appreciated in both nominal and real terms relative to the currencies of some its major Asian trading partners such as Korea, Malaysia and Singapore. The falling Indian rupee has resulted in a sharp nominal appreciation of the renminbi relative to that currency. However, the much higher inflation rate in India relative to China implies that, in inflation-adjusted terms, the renminbi has in fact depreciated against the rupee.

The prognosis for the renminbi’s value over the remainder of this year is one of stability relative to the dollar and a rollercoaster ride relative to other currencies, in tandem with the dollar’s fluctuations against other major currencies.

Of course, whether concerns about the US economy or global financial turmoil will push the dollar up or down is anyone’s guess.

Authors

Eswar Prasad
Karim Foda

Publication: Financial Times

Reform by Stealth is Reason for Optimism about China

Eswar Prasad — Mon, 06 Aug 2012 10:14:00 -0400

China pessimists are claiming vindication as growth slows in the world’s second-largest economy. Optimists point out that Beijing has fiscal room to respond but there are risks to any short-term policy measures. A surge in bank-financed investment, for example, could boost growth but it is also likely to increase the stock of non-performing loans in the banking system and set back the goal of rebalancing growth by promoting private consumption. An aging population and a rocky leadership transition strengthen the bears’ case.

However, there are grounds for hope. Recent political turmoil, including the Bo Xilai affair, put reactionary forces in the Communist Party of China on the defensive. Meanwhile, reform-minded officials pushed through some modest but significant financial market reforms.

The government has long recognised that reforming the financial sector is needed to improve the balance and sustainability of growth. Why has it not acted more forcefully before? The present system works well – for some. State-owned banks provide cheap financing for state enterprises, which are key fiefdoms of political patronage. Banks also provide financing to powerful provincial officials through shell corporations that bankroll pet investment projects. This is financed by paying Chinese households low or negative inflation-adjusted returns on their voluminous bank deposits.

All of this needs fixing, but the best of intentions can backfire. In an economy with many policy problems, getting rid of one or two can have unintended consequences. In 2008, asking banks to limit credit growth and avoid new non-performing loans were sensible moves. But banks had a lot of outstanding loans to weak state enterprises – starving them of credit would have turned those loans into non-performing loans in short order. So banks continued lending to state enterprises and shut off lending to the private sector, meeting the government’s conditions but thwarting its intentions.

Recent moves indicate that the government has learnt its lesson. It increased the flexibility of the exchange rate (in principle) when the renminbi was not under pressure to appreciate, relaxed the cap on interest rates paid on deposits, increased foreign investors’ access to capital markets and encouraged certain informal financial companies to become part of the formal banking system. Each of these moves has broader significance.

For example, giving informal financial companies the opportunity to join the formal banking system serves multiple ends. It brings them under the ambit of the banking regulator and reduces the risks they pose to financial stability. Moreover, they now provide more overt competition for established banks.

The need for interest rate liberalisation is widely recognised inside and outside China. Freeing up deposit rates and abandoning the fixed spread between deposit and loan rates would result in better returns for depositors and encourage banks to sharpen their lending practices. The big banks have resisted this fiercely as it would cut into profits. So the government cleverly took a small step when it cut rates recently – freeing up banks to offer deposit rates marginally higher than the base rate, arguing that this would make the rate cut more palatable to depositors.

A one-shot approach to breaking up big banks or freeing interest rates risks a backlash and concerted opposition that could block changes altogether. Reform-minded officials are taking a more subtle approach – using a megaphone to draw attention to the problems and introducing small but tangible changes.

One can make a strong case that, with its economy growing more complex and market-oriented, China needs to move beyond this cautious approach. The 12th five-year plan issued last year laid bare the range of problems, including corruption and dismal corporate governance among Chinese enterprises, and deficiencies in the policy making process. Given the severe political constraints China’s leaders face, however, modest reforms by stealth are better than no reforms at all.

This strategy may slowly turn China in the direction it needs to go. Whether this will be enough to outrun the many demons China faces remains the big question.

Authors

Eswar Prasad

Publication: Financial Times

Image Source: Aly Song / Reuters

The Economic Recovery is Floundering

Eswar Prasad and Karim Foda — Sun, 17 Jun 2012 10:06:00 -0400

Editor’s note: This commentary is based on research and analysis from the June 2012 update of Tracking Indexes for the Global Economic Recovery (TIGER) interactive map, which appears on the Financial Times Web site.

In the lead-up to the G20 summit in Los Cabos, the Brookings-FT Tiger index shows that this stop-and-go global recovery has stalled once again.

The engines of world growth are running out of steam while the trailing wagons are going off the rails. Emerging market economies are facing sharp slowdowns in growth while many advanced economies slip into recession.

Political fragmentation and gridlock have hurt confidence and stunted the effectiveness of macroeconomic policies. Financial markets have shed their optimism and investors are clamoring to retreat to safe havens as confidence has tumbled.

The US economy had been a relatively bright spot, although a fragile one, but growth is showing signs of slowing and employment growth has weakened even as the economy gets closer to an impending fiscal crunch. The UK and many of the eurozone economies are in or at the edge of recession. Even the once-mighty German economy seems to have lost its footing while Japan’s economy is stirring but remains mired in weak growth.

In the eurozone and other advanced economies, politicians seem unable to come to terms with the need for decisive policy actions, instead settling for half-measures and defensive policy interventions when backed into a corner. This often compounds the cost of policy measures, especially if the delay contributes to a worsening of the macroeconomic environment. For instance, the recent move to shore up the Spanish banking system brings into sharp relief how expensive it will now be to cordon off the rest of the eurozone periphery if the elections in Greece were to trigger a meltdown.

Emerging markets are running out of steam as they continue to be buffeted by weak environments in global trade and finance.

China’s growth outlook has darkened as the economy grapples with domestic policy challenges, an unexpectedly rocky political transition, and uncertainties in global trade and finance. China’s government still has considerable policy room and has signaled its intention to respond aggressively if adverse spillover effects from the eurozone debt crisis were to intensify.

Monetary policy is fighting a lonely battle to sustain growth, tamp down inflation and contain the plunge in the value of the rupee. The burden of making up for structural economic weaknesses, a large fiscal burden and policy paralysis has driven monetary policy to a corner.

In India, fiscal policy is adrift while the reform process has ground to a halt, eroding confidence in economic prospects and scaring away many foreign investors. Monetary policy is fighting a lonely battle to sustain growth, tamp down inflation and contain the plunge in the value of the rupee. The burden of making up for structural economic weaknesses, a large fiscal burden and policy paralysis has driven monetary policy to a corner.

Brazil, Russia and many other emerging markets are also facing mounting headwinds, both from home and abroad, which threaten to blow their recoveries off course.

The time has come for a policy reboot. A better mix of policies would relieve monetary policy of the entire burden of preventing cataclysm as well as supporting growth. The right mix and timing of policies is necessarily country-specific, but in most countries fiscal policy and structural reform measures need to shoulder more of the burden of restoring financial stability, rebuilding confidence and reviving growth.

In the US, the looming fiscal crunch in the absence of a budget deal could once again lead to a messy short-term compromise that does little to tackle long-term fiscal sustainability issues. In the peripheral economies of the eurozone, harsh austerity measures are hammering growth and eroding political support for structural reforms that are essential to regain competitiveness.

The concern is that even if they could articulate such a plan, policymakers may have lost credibility to deliver.

What’s needed in countries with vulnerable fiscal positions is a detailed and realistic plan for deficit reduction over the next three to five years rather than strict austerity at a time of weak growth. The concern is that even if they could articulate such a plan, policymakers may have lost credibility to deliver.

There is one way out of this conundrum: front-loading structural reform measures in order to rebuild credibility and create some space for back-loading measures to bring public debt accumulation under control. This will take serious political resolve as such reforms to labour, product and financial markets involve taking on powerful vested interests, but there may be little choice when it comes to restoring long-term competitiveness.

The global economic recovery is being held hostage by political brinksmanship that has created policy paralysis, undermined confidence and stymied the effectiveness of macroeconomic policy tools. In the absence of political leadership to undertake decisive and concerted policy actions, it is hard to see the recovery gaining traction.

Authors

Eswar Prasad
Karim Foda

Publication: Financial Times

Image Source: Brendan McDermid / Reuters

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