Wednesday, 11 October 2017

SWFs for Germany: A crazy idea?

Small and medium income earners have few capital assets, have limited resources to save or smooth out income fluctuations, and are therefore unable to skim off risk premiums on assets. Political Germany has therefore recently been increasingly discussing the creation of a Sovereign Wealth Fund (SWF) as a solution to societal challenges such as increasing poverty among the elderly, increasing income and asset polarisation or intergenerational justice. Following Corneo's lead (2017)[1] and inspired by Thomas Piketty, it is now recommended that a broader diversified capital stock be built up with the creation of an SWF investing in securities and distributing the return annually to the population at equal amounts per capita without any further conditions than a minimum duration of residence in Germany.

The original motivation for the creation of SWFs was to preserve intergenerational justice in countries that exchanged their exhaustible natural resources for foreign exchange by extracting and exporting them. Without the establishment of sovereign wealth funds, such countries would have effectively used up their total assets at the expense of future generations, i. e. their total savings would have been negative[2]. But what is to be thought of sovereign wealth funds in countries such as China and Germany, which generate excess savings and export surpluses as a result of domestic investment and consumption deficits? Would the establishment of an SWF for Germany come at a favourable time in the long term? This essay tries to approach these questions.

World champion of net capital exports
Germany is not only the world champion in soccer, but also in net capital exports. The German current account surplus in 2016 amounted to 297 billion US dollars (268 billion euros) and China took second place with a surplus of 245 billion US dollars. Both China and Germany are characterized by a rapidly aging population. Rapid aging coupled with an aversion to immigration does incite to save for old age. Indeed, Germany's surpluses are structural in nature: since the turn of the century, it has not recorded a current account deficit; its domestic savings have always exceeded domestic investment. While China's current account surplus has been declining as a fraction of its GDP since the Great Financial Crisis, the German surplus has since then fluctuated between 6 and 8 per cent of its GDP.

In 2016, the German external surplus amounted to 8.5 per cent of GDP. As formerly in China, corporate savings, or rather corporate investment deficits, and the public sector budget have contributed to the high saving ratio in Germany[3]. In 2016, Germany saved 12.2 per cent of its disposable income; the savings rate of non-financial corporations was 4.3 per cent. The saving ratio of the consolidated government sector was 1.7 per cent, due to Wolfgang Schäuble´s 'Black Zero' policy. The corporate and government investment deficit and the consumer deficit corresponded to a savings surplus of 10.3 percent for Germany with the rest of the world. If Germany were a closed economy, it would suffer from a large demand deficit, low capital returns and deflation.

High returns are rarely achieved through massive net capital exports, however. Formerly known as a producer of 'cheap goods´, China has long been referred to as provider of 'cheap savings', which the country made available to the USA. As a large part of the FX reserves were invested in low interest rate US Treasury bonds and the US had (and still has) a corresponding current account deficit with China, China granted the Americans cheap vendor loans[4]. The accumulated FX reserves became a legacy burden due to the build-up of interest rate and exchange rate risks and the threat of the central bank losing monetary control.  This was followed by speculative bubbles on the real estate and equity markets. As a result, China turned part of its financial assets into tangible assets - through accelerated growth of sovereign wealth funds. According to the latest SWF Institute data, four Chinese sovereign wealth funds are among the top ten, with total assets of over USD 2 trillion at the end of September 2017, compared with Norway's Government Pension Fund Global, the world's largest single sovereign wealth fund, which has reached a total of USD 1 trillion[5].

Although Germany, as a member of the euro zone, does not hold exorbitant FX reserves, factors comparable to China have a negative impact on the economic return of its capital exports.  German banks and insurance companies have invested their savings in US subprime and Greek government bonds over the past few decades, resulting in heavy losses on these foreign investments. 2,200 billion euros have been invested abroad on a net basis since 2000, but in 2016 Germany's foreign assets amounted to only 1,600 billion euros. Germany's capital loss amounted to 600 billion euros, 7,500 euros per capita[6]. Since the outbreak of the euro crisis, German savings have no longer been transferred abroad primarily via commercial bank loans, but via public channels, as Germany´s voluntary private transfer dried up. Since then, the Deutsche Bundesbank's net foreign position has multiplied; at the end of September 2017, Target II claims amounted to around 850 billion euros. Since the beginning of 2016, the ECB has been paying interest zero percent on these balances.

In the autumn of 2017, after the German federal elections, the question arises as to how much German capital exports will collapse if the (liberal party) FDP's refusal to make the Eurozone a transfer union prevails. Would SWFs be a way out for Germany if its capital exports collapsed within the euro zone?

Dynamic inefficiency, aging and return on investment
For China and Germany, dynamic inefficiency can be diagnosed. An economy is dynamically efficient if gross investment income exceeds gross fixed capital formation on a sustained basis, whereby investment income is defined as the sum of profit, rent and interest income. If this is the case, then the financial sector will provide more resources for future consumption than it consumes. Conversely, if investments exceed investment returns, the financial sector withdraws resources from the economy. This is inefficient, because the whole purpose of investment is to increase future consumption opportunities[7].  In Germany today (as in China before) too little is being consumed. 

However, the creation and financing of SWFs from excess savings would only perpetuate the dynamic inefficiency in countries, such as Germany, where SWF financing does not derive from the export earnings of exhaustible raw materials (Arab Gulf States or Norway). SWFs that are financed from domestic demand deficits (instead of raw material revenues) do not therefore promote intergenerational justice but undermine it at the expense of today's generation.

In a closed economy where savings by definition equal investments, investment income would fall below investment expenditure as a result of excessive capital accumulation. If the return on capital falls below the growth or wage rate, a pay-as-you-go pension scheme is superior to funded pensions in a closed economy. To be sure, pay-as-you-go schemes for old-age pensions are largely influenced by changes in real wage growth and the ratio of contributors to pensioners (support ratio). The pay-as-you-go system is therefore essentially enclosed into the ageing economy and cannot escape the demographic pressure resulting from the expected drop in the support ratio, except by raising the retirement age.

However, even fully funded pension systems cannot escape demographic pressure, even if there are significant flows of capital between the ageing and younger parts of the world. Firstly, higher life expectancy will put pressure on the calculation of funded pensions. Secondly, the ageing of the population will exacerbate the pressure on returns by reducing the profitability of pension funds and insurance companies. An economic-demographic simulation model (MacKellar and Reisen, 1998) with two scenarios (relative self-sufficiency versus financial globalisation of pension schemes) predicts a decrease in the return on investment due to the fall in the labour force for both scenarios. In the autarchy scenario, the capital intensification associated with ageing will reduce investment income by 150 basis points by 2050 and by 110 basis points in the globalisation scenario[8].

Piketty (2011)[9] has postulated in his famous book, based on many years of empirical evidence, that the rate of return on capital, r, has usually been higher than the growth of production, g. If wealth is not heavily taxed or decimated by the consequences of war, the inequality r > g leads to a concentration of wealth, according to Piketty. The formula refers to the return on investment (r) to the growth rate (g), where r comprises profits, dividends, interest, rent and other investment income before taxes; g denotes the growth of disposable income or wages. Note that Piketty´s formula would preclude the formation of a middle-class, especially in fast-growing countries.

However, Piketty conceded that the tendency to higher wealth inequality was reversed between 1930 and 1975, in his judgement due to one-off circumstances. Interestingly, 1975 coincides with the beginning of the integration of 50 percent of the unskilled labour force into the world economy, triggered by the opening of China, India and the disintegration of the Soviet bloc (in my terms: Shifting Wealth Phase I).  A simple Cobb Douglas production function, in which capital contributes a third of the income (the rest is provided by unskilled labour and know-how), shows that doubling the global labour supply has reduced unskilled labour productivity by a good 16 percent[10]. This led to a corresponding reduction in equilibrium wage for basic skills. Meanwhile, the original wage effects of the integration of China, India and other emerging markets have been coming to an end.

It cannot be ruled out that "Piketty is history", as Goodhart and Pradhan predict in a recent BIS study[11], as longstanding demographic developments that caused income and wealth inequality will now change. This is supported by the fact that several trends, which have been valid for forty years since the entry of post-communist states and emerging Asian countries into the market-economy organized world economy, have ended. Goodhart and Pradhan forecast for the coming decades:
·         The ageing and shrinkage of the world's labour force (outside the Sahel Zone) and thus a higher share of wages in world income;
·         The decline in massive outsourcing to China and Eastern Europe, thus putting an end to price deflation for labour-intensive goods and hence provide scope for a more restrictive monetary policy in advanced economies, probably leading to asset price deflation; and
·         The trend reversal in the global development of factor relations with an increase in the capital ratio in production and a reduction in returns on capital[12].

Both pay-as-you-go and funded pension systems are being burdened by the ageing process (especially in Germany, China and Japan). However, the predicted improvement in real wages relative to return on capital discourages to persue wealth and generational equity by building SWFs. While pay-as-you-go systems of old-age provision will be less burdened by global wage trends, the projected reduction in the return on capital employed will put a strain on funded old-age provision and sovereign wealth funds.             

[1] Giacomo Corneo (2017): Ein Staatsfonds, der eine soziale Dividende finanziert, Freie Universität Berlin Fachbereich Wirtschaftswissenschaft, Diskussionsbeiträge 2017/13, Mai.
[2] Helmut Reisen (2008), How to Spend It: Commodity and Non-Commodity Sovereign Wealth Funds, OECD Development Centre Policy Briefs No. 38, OECD, Paris, September.
[3] OECD (2010), Perspectives on Global Development: Shifting Wealth, Figure 2.6., OECD, Paris; Statistisches Bundesamt (2017), Volkswirtschaftliche Gesamtrechnungen: Sektorkonten, Destatis, Wiesbaden.
[4] The term vendor loan needs to be handled with caution, as there is no bilateral link between current account and capital account balances in an open global economy; for example, the USA was not only indebted to China via its purchase of government bonds but also through loans provided by European banks.
[5] Chinas four SWFs listed by the SWF Institute are China Investment Corporation; Hong Kong Monetary Authority Investment Portfolio; SAFE Investment Portfolio; National Social Security Fund. See
[6] Marcel Fratzscher (2017), „Der deutsche Sparirrsinn“, Die Zeit, 17.2.2017.
[7] See A. Abel,  G. Mankiw,  L. Summers , R. Zeckhauser (1989), „Assessing Dynamic Efficiency: Theory and Evidence“, The Review of Economic Studies, 56.1, Januar, S. 1–19. 
[8] Landis Mackellar und Helmut Reisen (1998), A Simulation Model of Global Pension Fund Investment, Technical Paper No. 137, OECD Development Centre, Paris.
[9] Thomas Piketty (2013), Le capital au 21e siècle, Editions Seuil, Paris.
[10] Helmut Reisen (2006), „Globalisierung, Proletariat und Prekariat“, Internationale Politik, January 2006.
[11] Charles Goodhart and Manoj Pradhan (2017), “Demographics will reverse three multi-decade global trends“, BIS Working Paper No. 656, Bank for International Settlements, Basel.
[12] Piketty (2013) argues that the capital deepening goes is compatible with an increase in the return on capital. This, however, requires a substitution elasticity between labour and capital greater than one.

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