Sunday, 30 September 2018

Dollar Dominance, BRICS & Shifting Wealth


Not least as a result of Shifting Wealth - the shift of the centre of gravity of the world economy towards Asia - the BRICS countries are seeking to replace the dollar as the leading currency with the Chinese yuan[1]. The shocks to the world economy caused by US President Trump's isolationism and willingness to impose sanctions can accelerate the rise of the yuan as a lead currency. (Meanwhile, the US are going insane under President Trump, as predicted by the Simpsons already in 2000!).




There is still a lot of plumbing to be done before the dollar dominance can be diminished. This work is in full swing with the establishment of new institutions outside the financial system dominated by the West, the establishment of new transport, energy and digital connections in the context of the Chinese Silk Road Initiative and the disintegration of global trade into regional trading blocks.


BRICS countries and dollar dominance

The five BRICS states form an association with different interests and strengths. If one topic unites these five, it is their rejection of the US-dominated monetary system. Thus the 10th BRICS Summit in Johannesburg in July 2018 once again ended with a call against the dominance of the US dollar. Since the Xiamen Summit in 2017, five selected emerging markets (BRICS Plus[2]) have been invited to promote the de-dollarisation of the global economy.

Since their first summit meeting in 2009 in Ekaterinburg, Russia, the BRICS states have been calling for the US dollar to be replaced as the international reserve currency. In the same year, under the fresh impression of the implosion of the global financial system in the wake of the Lehman bankruptcy, the UN Commission on the Reform of the International Monetary and Financial System headed by Joseph Stiglitz made the demand to replace the US dollar as an international reserve currency, possibly with the basket of Special Drawing Rights (SDR) of the International Monetary Fund. However, Special Drawing Rights are a form of art money that is not traded on foreign exchange markets. They do not fulfil all the functions of money: although SDRs can function as part of a country's official foreign exchange reserves, they cannot be used either to intervene in foreign exchange markets or as an anchor currency. So it's hardly surprising that the political impetus for the SDR as the reserve currency has silted up, even though the SDR basket has become more representative since the Chinese yuan joined in 2016.

The euro could be a serious candidate to reduce dollar dominance as a reserve currency if the institutional conditions were created[3]. In order to be attractive for global transactions, especially for reserve holdings, the euro should be stable in value and crisis-proof. But the reforms of the euro's financial architecture to date have not succeeded in establishing this confidence. Germany's restrictive fiscal policy is also curtailing the supply of risk-free Eurobunds; these would be the obvious alternative to US government bonds, the hitherto dominant form of official reserve holdings. After all, the mercantilist German economic model, which is pinned on external competitiveness, is standing in the way of the internationalisation of the euro because of the Triffin dilemma[4], just as it did in the past for the Deutsche Mark.


A Hundred Years of Dollar Dominance

Ever since the replacement of the British pound as the global reserve currency after the First World War the US dollar has dominated the world economy - for a century now.  The USA had already overtaken Great Britain as the largest economy at the end of the 19th century, and politically it dominated in the wake of the First World War. Today still, the dollar is enthroned in the bel étage of the international monetary system:

1. A large part of international trade, which far exceeds the share of the USA in world trade, is invoiced and settled in dollars. This is also due to the fact that the prices for most raw materials are quoted in dollars. The role of the dollar as the dominant invoicing currency in international trade and its widespread use as a transaction currency has so far been consolidated by network effects.  The global share of the dollar in international payments is now 40 percent, followed by the euro with 35 percent. By contrast, the yuan share has stagnated at just below two percent since 2016 due to devaluation pressure and the implementation of state controls to prevent capital outflows.
2. Network effects are less significant in terms of use as a reserve currency, in which not only liquidity aspects but also diversification arguments play a decisive role. Nevertheless, the dollar remains the dominant reserve currency. At the end of the first quarter of 2018, it accounted for 62.5 percent of the world's allocated official foreign exchange reserves. The euro was in second place at 20.4 percent. The yuan stands at only 1.4 percent[5].
3. The majority of bank financing outside the USA takes place in dollars: According to location-based statistics from the Bank for International Settlements, 62 percent of banks' foreign currency liabilities are denominated in dollars. Similarly, the corporate financing of non-American companies through bank loans and bonds is more denominated in dollars than in other hard currencies[6].

The lead currency functions (means of payment, holding reserves and financing vehicles) are interlinked in multiple configurations[7]. The high proportion of internationally traded goods invoiced in dollars drives the demand for secure dollar claims. Risk-free investments in US dollars generally pay lower exchange rate adjusted returns than risk-free investments in most other currencies. The violation of the uncovered interest parity in turn favors the dollar as a cheap funding currency. This feedback loop applies in particular to the export firms of emerging markets. Because of this violation, taking out dollar loans is generally cheaper than taking out loans in local currency. This increases the incentive for the company to settle its exports in dollars, because it can thus plan its future dollar sales more reliably. This, in turn, enables the company to borrow in cheaper dollars with lower exchange rate risks.

The USA, as the issuer of the global lead currency, enjoys the ´extraordinary privilege´[8], to import foreign capital by providing international dollar liquidity while non-Americans mostly hold their dollar investments in low-interest US government bonds. Some of these capital imports are channelled by the US into high-yield foreign investments, which generates considerable interest gains for the United States. Nonetheless, the rest of the world has also benefited from the dollar's status as a reserve currency. The depth and liquidity of the US financial markets and the economic weight of the US economy make the dollar attractive not just as a transaction and reserve currency. Countries with less liquid financial markets, in particular, are benefiting from the dollar as the reserve currency, partly due to favorable refinancing conditions on the US bond markets. In addition, the dollar has exhibited low inflation rates and relatively high external stability in recent decades.


The Dollar Discomfort of Emerging Markets

So what do the BRICS have to object to the dollar as the lead currency?

1. A most immediate response is provided by the currency crises in Argentina and Turkey, which were only recently the preferred borrowers of foreign banks and global bond markets. Now, in 2018, they have to swallow a rapid collapse in the external value of their currencies; they are paying heavy fines on the ´original sin´[9] typical of emerging markets. As many emerging markets have quite illiquid and narrow financial markets, the violation of the uncovered interest rate parity tempts them to borrow in foreign currency. If the dollar borrowing is made by companies or banks that do not have corresponding dollar revenues, currency mismatches arise in corporate balance sheets. These balance sheet mismatches are a time bomb for private actors, but equally for public budgets via contingent liabilities for public bailouts.
2. Another current concern relates to the United States' ability to impose sanctions. Any transaction conducted in US dollars or through a US bank automatically results in trading partners being subject to US jurisdiction. The US is currently waging an economic war against a tenth of the world's countries with a cumulative population of almost 2 billion people and a GDP of more than 15 trillion dollars. These include Russia, Iran, Venezuela, Cuba, Sudan, Zimbabwe, Myanmar, the Democratic Republic of the Congo, North Korea, but also countries such as China, Pakistan and Turkey, targets of other economic sanctions. The resulting trade war similarly weakens the attractiveness of the dollar in international trade and financial transactions. Countries like Iran welcome the possibility of circumventing US sanctions by exporting goods to China that can be settled in yuan. In July 2018, SWIFT's RMB tracker[10] quoted a 9.9 percent increase in the value of yuan payments for July 2018 compared to June 2018, while transactions in all other currencies  declined by 2.5 percent that month[11].
3. From a wealth perspective, emerging markets are worried about the danger of a depreciation of the US dollar. China (including Kong Kong) and the twelve largest emerging markets recently held official foreign exchange reserves of 6.7 trillion dollars, almost 60 percent of the world's official reserves. Often motivated by their vulnerability to sudden stops (of capital inflows), the demand for foreign exchange reserves is forcing developing countries to transfer resources to the countries that issue these reserve currencies - a case of "reverse aid", particularly benefiting the US. Major emerging economies, often net creditors to the rest of the world and with substantial holdings of US sovereign debt, fear a deliberate devaluation strategy by the US that would devalue their vast currency reserves by hundreds of billions of dollars. China's net foreign wealth has risen steadily over the past three decades, to half of its rapidly growing gross domestic product (GDP). Due to their notorious consumption surplus, the US extended their net debt position to 40 percent of GDP over the same period (Fig. 1)[12]. 

Net foreign assets, 1990 – 2014,, % of GDP

Source: Lane & Milesi-Ferretti (2018).


4. Finally, it also matters when the global economic gravity shift from the USA to China will also be reflected politically[13]. Shifting Wealth is incomplete and possibly endangered in the long run if its economic pillar is not safeguarded by military deterrence and a reduction in dollar dominance. Historically, the global reserve currency came from the leading economy of the time. According to IMF data, China is the largest economy in the world after adjustment for purchasing power; its share of the world product today (2018) is 18.7 percent, while the US share is estimated at 15.1 percent.  Since the USA (and the traditional OECD countries) has lost relative economic weight, the query of the lead currency has been a recurring theme in the context of Shifting Wealth.


Outlook

The dollar still dominates the bel étage of the international monetary system with dominant positions in global payments, reserves and financing vehicles. In the basement, however, the Chinese are already busy laying the pipelines for a reduction in dollar dominance through the yuan. The establishment of new multilateral financing institutions outside the financial system dominated by the West, new transport, energy and digital connections along the Chinese Belt and Road as well as the disintegration of global world trade into regional trading blocs are the prerequisites for the internationalization of the Chinese currency.

According to Eichengreen's account of historical changes in the international monetary system[14], the sequence of internationalization of a currency is: 1. to promote its use in invoicing and settlement of trade; 2. to promote its use in private financial transactions; 3. to promote its use by central banks and governments as a reserve currency.

According to the latest data (2017) from the WTO, China was the largest exporting nation with over 2.26 trillion dollars and a 12.8 percentage share of world trade. China's imports amounted to 1.84 trillion dollars in 2017, making China the second largest importing country after the USA with a global import share of 10.2 percent. The USA's departure from multilateralism and world trade is promoting the rise of the yuan. Mega-projects focused on the US - the Transpacific Partnership (TPP) and the Transatlantic Trade and Investment Partnership (TTIP) - were suspended. Instead, the Pacific-Asian region is negotiating the China-led trading bloc ´Regional Comprehensive Economic Partnership´ (RCEP), which comprises thirteen countries alongside China, India and Japan and thus more than half of humanity.

Since the end of the yuan´s dollar peg in August 2015, there has been an empirically closer connection (comovement between currencies) between China's bilateral trade links and the respective yuan correlation. Therefore, the RCEP is likely to promote a yuan block in Asia. A rising influence of the Chinese currency has also recently been observed in some Latin American currencies. The growing yuan block will therefore also promote the yuan as a reserve currency in the future for reasons of stability and portfolio theory.

China's Belt-Road Initiative (BRI), with a planned investment volume of over 100 billion dollars, plays a key role in the internationalization of the yuan. The BRI was announced at the Silk Road Summit in Beijing in May 2017 by Xi Jinping, head of state and party leader, to 29 heads of state and government of the participating countries in Asia, Africa and Europe. The use of the yuan is to be promoted by the payment flows (yuan loans) in the countries along the routes accompanying the trading activities. The yuan loans originate, among others, from the Asian Infrastructure Investment Bank (AIIB) founded by China in 2016, which grants BRI infrastructure loans outside the Bretton Woods system dominated by the USA[15].





[1] Translated version of an invited contribution to debate the dollar dominance in Wirtschaftsdienst.
[2] Argentina, Egypt, Indonesia, Jamaica and Turkey.
[3] S. Dullien (2018), “The German barrier to a global euro”, ECFR, 30th August.
[4] The reserve currency country should continuously provide the world economy with risk-free liquidity through a current account deficit, which may undermine confidence in the reserve currency in the long run.
[5] IMF (2018), Currency Composition of Official Foreign Exchange Reserves (COFER), http://data.imf.org/?sk=E6A5F467-C14B-4AA8-9F6D-5A09EC4E62A4, 1st quarter 2018.
[6] G. Gopinath & J. Stein (2018), “Banking, Trade, and the Making of a Dominant Currency”, NBER Working Paper No. 24485, April.
[7] G. Gopinath & J. Stein (2018), op.cit.
[8] So already then French finance minister Giscard d´Estaing in 1965.
[9] B. Eichengreen, R. Hausmann, U. Panizza, U (2003), „ Currency Mismatches, Debt Intolerance and Original Sin. Why They Are Not the Same and Why It Matters”, NBER Working Paper  No. 10036, October.
[10] SWIFT is the acronym for the private Brussels-based service provider ´Society for Worldwide Interbank Financial Telecommunication´. RMB stands for Renminbi, the alternative name for the currency of the People's Republic of China.
[11] K. Yeung (2018), “ US-China trade war is helping to boost use of yuan in international transactions”, South China Morning Post, 9th September.
[12] P. Lane, G.-M. Milesi-Ferretti (2018), “The External Wealth of Nations Revisited: International Financial Integration in the Aftermath of the Global Financial Crisis”, in: IMF Economic Review, International Monetary Fund, Vol. 66(1), S. 189-222, March.
[13] Many think that US President Trump is “A Recipe for Disaster”, and the US going insane,  as  predicted in a Simpsons series in 2000 already. See “Simpsons writer says President Trump episode was 'warning to US', The Guardian, 18th March 2016.

[14] B. Eichengreen, “The renminbi as an international currency”, in: Journal of Policy Modeling, 2011, Vol. 33. 5, pp. 723-730.
[15] H. Reisen (2015), “Will the AIIB and the NDB help reform multilateral development banking?”, Global Policy, September, https://doi.org/10.1111/1758-5899.12250.


Thursday, 30 August 2018

Erdogan's macro populism is far from over


China, Ruanda or Singapore show that autocratic regimes can stay in power for a long time - provided that they can be effectively controlled and removed by a "selectorate"[1]. Recep Tayyip Erdogan's "career", however, has more of a role model in the emerging countries of Latin America. Rudi Dornbusch and Sebastian Edwards created the typical phantom image of the macropopulist in 1991, with the four phases he usually goes through[2]:

·         As a rule, populists exploit widespread unease among the population about inadequate economic performance, often as a result of an austerity policy demanded by the IMF. A blatant unequal distribution promotes dissatisfaction, because the poor and middle class usually pay the bill for the fund's stabilisation programmes. At the same time, a successful IMF programme will lead to higher foreign exchange reserves and lower budget deficits. Cash is seductive - the call for expansion is getting louder. The situation described by Dornbusch and Edwards was exactly right when Erdogan first took office in 2003.
·         Growth by stimulating demand (to increase popularity) and redistribution (to ensure proximity to the people) have top priority in the second phase. Erdogan, the underdog from Istanbul's rough neighborhood Kasımpaşa, finds his support especially among the "Dark Turks" - the poor and orthodox Anatolian masses[3].
·         Parallel to the postulate of growth and distribution, the macro populist typically (under)assesses the macroeconomic risks of price inflation, consumptive deficit financing and external imbalances as secondary. If necessary, from the populists' point of view, dampening inflation calls for suppression of corporate profit margins as well as price and rent controls - that is phase three. Macropopulist governments generally avoid massive wage increases being offset by currency devaluation. The artificial undervaluation of imports (and implicitly of tradable agricultural products) puts the unruly urban population at rest, as this increases the purchasing power of their wages.

Beside the last point, the sketch of Dornbusch/Edwards applies to Turkey. So far, the country has been characterised by an open capital account and flexible exchange rates. This can probably be explained by the fact that Erdogan is more committed to rural Anatolia than to the urban area of Istanbul. In contrast to the dictum of Friedrich August von Hayek that capital controls mean the "Road to Serfdom", Turkey went this direction under Erdogan with free movement of capital.

But what about phase four of the phantom image - namely the end of the macro populist regime?


Erdogan´s Achievements

When Erdogan took office in 2003, Turkey was undergoing a reform process led by IMF and Economics Minister Kemal Dervis to overcome the severe financial crisis of 2001. The fruits, for example in the form of a steep rise in per capita income, were harvested primarily by the ruling party AKP led by Erdogan. Outside agriculture in particular, the AKP generated strong employment growth in poor Anatolia. The absolute poverty rate (below $4.30 per capita income) declined steadily. Erdogan's economic achievements were considered a blueprint, especially in the Arab region. Measured in terms of the top half of OECD member countries, Turkey was able to catch up economically. This convergence process slowed just before the failed military coup in 2016, though (Fig. 1).


Figure 1: Turkey´s Convergence, GDP/cap
- in % of the mean upper half OECD by GDP/cap –



Erdogan´s Failures

China has shown that autocrats need high economic growth for legitimation. In order to maintain his rule and a strong economy, Erdogan used pro-cyclical monetary and fiscal policies to fuel overall economic demand, after the global financial crisis in 2009 and then again after the military coup in mid-2016. In addition to generous money supply and high deficits in the state budget, public loan guarantees for private companies fueled output. Infrastructure investment was booming but increasingly debt-financed (Fig.2). Although private banks and companies in particular have incurred increasing foreign currency debt, they often represent state contingent liabilities.


Figure 2: Investment and Debt, Turkey (% of GDP)



As a result of the increasing legal arbitrariness under Erdogan, the high current account deficit was less and less underpinned by direct investment. The demand stimulated by Erdogan met supply-side capacity bottlenecks, resulting in rising inflation that could not be effectively combated by the government controlled central bank. The erosion of investor confidence increasingly weakened the Turkish lira, which further fueled inflation.

The rising demand for gold from the Turks, who increasingly distrusted the arbitrariness of Erdogan's rule, had the same effect. Since 2017, annual inflation has been in double figures. So it was only a matter of time before Turkey became the victim of a currency crisis, especially since the strong US dollar put a global burden on emerging markets. Emerging economies can be defined not only by their poverty or economic growth - but also by their dependence on the dollar exchange rate through balance-sheet asymmetries and commodity markets.

In the hot summer of 2018 nothing could stop the Turkish lira´s crash (Fig. 3). After his re-election in June, Erdogan had announced that he would have a stronger influence on economic policy in the future; in July he appointed his son-in-law as Minister of Finance. At the same time, the USA and Turkey overdid themselves with punitive tariffs, which further weakened the lira. Finally, the three major rating agencies put Turkey's creditworthiness even deeper into the junk status. When the lira crashed on 13 August, the Turkish currency, although already severely undervalued, was now worth just under 50% less than in June. Erdogan's macro populism had failed.


Figure 3. Turkish Lira/Euro, Summer 2018




Is Erdogan at the End as Many Hope?

For the time being, he does not want to resort to classical austerity measures. Restrictive monetary policy, especially higher interest rates to support the currency and fight inflation, is an abomination for Erdogan. The central bank is on a short leash, and interest rates are "mother and father of all evils" for Erdogan.

Indeed, higher interest rates would at best support the Turkish lira in the short term - in the medium term the largely credit-financed economy and the banks would collapse, which in turn would probably weaken the currency. The IMF could support the Turkish central bank by adding to its rather meagre foreign exchange reserves, in order to secure the refinancing of the Turkish economy's foreign exchange debts. Erdogan doesn't want to hear about that either: "We know very well that those who propose a deal with the IMF are actually proposing to give up our country's political independence," he said. Erdogan does not want to be domesticated from outside.

Erdogan not only has orthodox instruments at his disposal to keep himself at the top until his desired departure in 2025, especially since Turkey has become member of the BRICS Plus grouping since the BRICS summit 2017 in Xiamei..

The Russian Foreign Minister recently visited, and the Qatari ruling family has already promised USD 15 billion. That is only about 10% of the liabilities due next year. But in the area of global development banks (AIIB, NDB) and with China's new Silk Road, powerful resources have opened up outside the multilateral financial system dominated by the West. The "charm" of these new donors to autocrats like Erdogan is that the governance rhetoric about democracy, human rights and the rule of law plays little role. Even Germany, in the hands of Erdogan as a result of Merkel´s  migration deal, wants to help out.

Erdogan could also have recourse to capital controls. Prime Minister Mahathir responded to the speculative attacks of George Soros' Quantum Fund in 1997 with strict capital controls during the so-called Asian crisis, thus saving Malaysia from ruin. However, capital export controls only make sense for Erdogan if Turkey's external deficit is reduced to a level that can be financed by the new donors. However, this should be achieved with a degree of austerity that does not upset Erdogan's position of power.

Alas, Erdogan is far from over.


[1] Helmut Reisen (2018), „Paradigm Lost“, OECD Development Matters, 10. April.
[2] Rudi Dornbusch & Sebastian Edwards (1991), „The Macroeconomics of Populism in Latin America”, NBER, January.
[3] Jan-Werner Müller (2017), What is Populism?, Penguin Books.

Monday, 30 July 2018

Europe´s migration trilemma*



According to the latest data from the United Nations High Commissioner for Refugees (UNHCR), 68.5 million people were on the run at the end of 2017 - around three million more than in the previous year and more than at any time since the end of the Second World War. Overall, the countries in the global South bear the main burden of receiving refugees: 85 percent of all refugees registered by UNHCR worldwide have found refuge in developing regions. 
Africa's future migration potential is of particular concern to politicians. The first worry is of demographic nature as the decline in birth rates is painfully slow south of the Sahara. According to UN projections, Africa's population will double to 2.5 billion by 2050. Although medical progress and the expansion of health systems are increasing life expectancy, the standard of living has remained low, not least because of high birth rates.
The second worry are, despite improvements, much of Africa´s economic perspectives: Low training and labour market opportunities for a young growing population feed migration. According to the IMF, 85 percent of African migrants are economically motivated.
The proportion of African migrants who actually leave their continent has increased from a quarter to a third in the last quarter of a century, to six million today. Population growth and the increasing proportion of intra-African migrants suggest that their number will rise to 20 million in the coming decades. Most of these Africans nowadays want to migrate to Western Europe. Sure, actual migration to Europe has declined since the peak in 2015/16. This is due to Frontex, border closures, drowning and enslavement of migrants - but it says little about Africa´s future migration potential.
According to Dani Rodrik's globalization trilemma, democracy, national sovereignty and global economic integration are mutually incompatible: combine any two of the three, but never have all three simultaneously and in full. Politics can only choose two of three options: full global market liberalization (hyper globalization), national sovereignty or democracy. If it accepts unrestricted globalisation, politics must abandon its own course. A good example is the gold standard prevailing until the beginning of the 20th century, to which an independent monetary policy had to be sacrificed. Alternatively, autocratic or technocratic governments could decree that full market liberalization or the globally harmonized rules negotiated by the government must be accepted by all. Finally, a fairly unrealistic alternative would be a world government: democracy and the global market would be maintained, national sovereignty renounced. An international government and a global parliament would correct the mistakes of globalisation.


Analogous to Rodrik's Trilemma, Europe looks increasingly confronted with a migration trilemma. Only two out of three options can be achieved at the same time: mass immigration, a self-determined social contract or democracy with respect for human rights. In his much maligned book Exodus: How Migration is Changing Our World, Paul Collier discusses a limit beyond which immigration could be harmful to a society's complex social model due to alienation and erosion of public trust. In his long essay After Europe, Ivan Krastev argues how massive immigration promotes populist parties and threatens the future of the entire European project. In her 1943 essay We Refugees, Hannah Arendt had already pointed to the dilemma between mass refuge and respect for human rights. Allowing massive refuge means respecting human rights but, according to Arendt, losing national sovereignty, i.e. self-determination.
These trade-offs of the migration trilemma certainly lack rigour. But they cannot be denied. It is possible to promote immigration and become a melting pot, just as in the past in Argentina, Australia, Brazil and North America, all sparsely populated areas before settlement. The multicultural melting-pot perspective is quite tempting and shows its appeal not only in France's soccer team. The settlement strategy requires immigrants to identify with the host country and to feel that they belong to their new country. Historically, inclusion of immigrants has worked best with the help of compulsory military service, the right to vote and, above all, patriotic education and training. However, the urban ghettos of, say, Brazil, France or the United States also testify to blatant integration deficits that are intolerable for socially homogeneous societies.
From an ethical point of view, the global governance of migration would be a possible way out of the migration trilemma. This route remains unrealistic as national jurisdiction on migration would have to be subjugated in a legally binding manner. The recently adopted draft 2018 global migration compact - signed by all UN member states except the USA – has so far not passed that legal threshold and remains a legally non-binding document laying down principles for dealing with migrants and refugees.
Thus, akin to national capital controls under the Bretton Woods compromise in Rodrik's globalization trilemma, a realistic option remains the control of migration flows through national immigration laws that legalize a selection of admitted immigrants. As suggested by former Mexico-US border evidence, regular migration (if paired with ´robust enforcement´) can reduce the inflow of clandestine migrants. To be sure, the offset between legal and illegal immigrants is one only if all migration is regularized. Migration laws can attenuate the trilemma presented here; they cannot solve it.


*Originally published in German: https://makronom.de/europa-im-migrationstrilemma-27303

Saturday, 30 June 2018

A New Geography of Development Finance




Especially since the early 2000s, large emerging countries have become important providers of development funds. Shifting Wealth has allowed governments to tap a bigger pool of ´transformative infrastructure finance´ (Xu and Carey, 2017) and to choose from more financing options. From a long-term development perspective, infrastructure finance is arguably the most important prerequisite to close the infrastructure gap that has been identified as the major bottleneck for delivering on growth and on the SDGs, notably in Africa. Much of the new funding supply is through official bank credit outside the Paris Club framework, however.  So concerns that a new debt overhang might be building in the absence of a concerted mechanism for debt prevention and resolution have become louder recently.

The rise in South-South finance is being channelled through three major vehicles: i) a rise in remittances within the non-OECD area, often resulting from oil riches; ii) growing corporate equity participation via mergers and acquisitions as well as greenfield FDI by emerging multilateral companies; and iii) an extension of bilateral and multilateral bank credit supply, notably by China. The overall rise of development funds occurred despite a downward trend of official development assistance (ODA) as a fraction of recipient countries rising GDP. Western donors, including private, had reduced in the past decades investment in infrastructure, instead devoting more attention to poverty reduction, health, good governance, and climate change mitigation.

Research at ODI (Prizzon, Greenhill and Mustapha, 2016) found total external development finance to all developing countries to have more than doubled between 2003 and 2012 to $269 billion. In 2012, development finance flows beyond ODA by DAC donors – excluding FDI and portfolio equity and remittances - accounted for $120 billion, or around 45%. 13%  of this $120 billion by so-called emerging donors (13%), such as Brazil, China, the Gulf States, India, Malaysia, the Russian Federation and Thailand. 

Over recent years, remittance flows - funds sent by migrants living and working abroad to their home countries - have been increasing rapidly. Booming oil prices translated in higher demand for immigrants in the construction and other service sectors of the Gulf States and Russia.  While private capital mainly flows to emerging countries, remittances are particularly important in poorer countries where they can represent up to a third of GDP. India, China the Philippines and Mexico are the largest remittances receiving countries in the world. As a share of GDP, however, smaller countries such as Tajikistan (42 percent), the Kyrgyz Republic (30 percent) and Nepal (29 percent) were the largest recipients.

The top six immigration countries, relative to population, are outside the high-income OECD countries (World Bank, 2016b): Qatar (91 percent), United Arab Emirates (88 percent), Kuwait (72 percent), Jordan (56 percent), and Bahrain (54 percent). As a consequence of an upsurge in migration, remittance flows into developing countries sprung up in the 1990s, becoming another important financial resource for developing countries. During the period 1970-2000, workers´ remittances to Sub-Sahara Africa had only reached 2.6% of GDP, an inflow clearly lower than its official inflows that added up to 11.5% of Sub-Saharan Africa´s GDP (Buch and Kuckulenz, 2010). This was in contrast to North Africa and the Middle East that received almost 9% of GDP through remittances over the timespan.  By 2015, remittances represented the largest source of external finance for many developing countries, ahead of ODA and FDI. Then, worldwide remittance flows were estimated to have exceeded $601 billion. Of that amount, developing countries are estimated to receive about $441 billion, nearly three times the amount of official development assistance.

Table 1: Developing-Country FDI Outflows and Inflows, bn $
FDI Outflows
1990
2000
2008
2016
LDCs
0.0
2.1
18.4
11.9
China
0.8
0.9
55.9
183.1
Total Dev
13.1
90.0
288.6
383.4
FDI Inflows




LDCs
0.6
5.3
32.3
37.9
China
3.5
40.7
108.3
133.7
Total Dev
n.a.
233.8
592.7
646.0
Source: UNCTAD, World Investment Report 2017,  http://unctadstat.unctad.org/wds/ReportFolders/reportFolders.aspx


Traditionally, and until the late 1990s, developing countries have rather hosted than homed FDI flows. While inward FDI have plateaued for many of the emerging economies in the 2010s, much of the dynamism is now taking place in outward FDI.  Table 1 provides evidence on FDI outflows and inflows for the years 1990, 2000, 2008 and 2016. It shows that FDI flows have increasingly turned into a two-way street since the GFC. Up to the GFC, Latin American companies used to spearhead outward investment from emerging economies. Since then, China raised its percentage share in developing-country FDI outflows from 1% in 2000 to almost half by 2016. Chinese multinationals have increasingly taken the mergers and acquisitions (M&A) route for their overseas expansion, particularly after the global financial crisis of 2008-09.

Greenfield investment is an important mode of entry for Indian and Malaysian multinationals compared to mergers and acquisitions, behind China the only two other emerging countries listed among the top 15 countries for greenfield FDI in 2016. Emerging countries continue to primarily invest South-South in other emerging and developing economies, as most emerging economies’ regional markets serve as the primary destination for their outward greenfield FDI flows. However, the share of the E20 group OFDI projects (in value) directed to the Asian-Pacific region has declined while the shares of Africa, Latin America and especially North America increased (Casanova and Miroux, 2017).

It is noteworthy that the poorest countries classified by UNCTAD as LDC group has started to participate at last in hosting considerable FDI inflows, as a proportion of their GDP. South-South FDI contributed to that new trend, with growing activity from many firms in China, Brazil, India and South Africa. Keep in mind that net FDI flows do not constitute net capital flows as they are often financed in the host country´s domestic financial markets, as multinational companies try to keep currency and expropriation risk down.

In the 2000s, China became a global leader in official bank credit for infrastructure funding, benefitting Africa above all, by building roads, dams, bridges, railways, airports, seaports, and electricity grids. Meanwhile, China has established a number of bilateral and multilateral funds across the world, in addition to two policy banks, the China Development Bank (CDB) and the Export Import Bank of China (C-EXIM). Figure 22 suggests (for Africa) that in recent years bilateral official lending flows have been substituted for multilateral flows. Despite steady growth in private sector funding in the past decade, official development finance backs 80% of Africa´s infrastructure funding, for example (ECN, 2015).  ). China has also pioneered a host of bilateral and regional development funds in the wake of founding the Belt and Road Initiative (BRI) in 2013 (see next section). These funds add upwards of $100 billion in development finance; a major portion of these Chinese investments is in Asia, with the largest being the $40 billion Silk Road Fund established in 2014 (Kamal and Gallagher, 2016).

 In 2015, two new multilateral financial institutions of consequential size and scope came into existence as legal entities: The Asian Infrastructure Investment Bank (AIIB), a Chinese led initiative, and the New Development Bank (NDB), an effort championed and owned by the BRICS nations (Brazil, Russia, India, China and South Africa) to strengthen cooperation among themselves and beyond. The advent of these new multilateral development banks is emblematic of a decentralization of power from the Bretton Woods system. It reflects a shift in terms of soft power distribution beyond the G-7. Their potential role and influence stems from: 1) the size of their lending activity, even relative to long-established institutions such as the World Bank and the Asian Development Bank (ADB); 2) their relatively high capitalization; and 3) their focus on infrastructure—a sector that is vital for growth and development. AIIB and NDB are expected to add significant financing capabilities with combined loan portfolios estimated at $230 billion (Reisen, 2015).

Staying outside the relatively transparent DAC framework, China does not disclose comprehensive or detailed information about its international development finance activities. Aid Data (Dreher et al., 2017) constructed a dataset with a new methodology for tracking underreported financial flows. According to these new data, the scale and scope of China´s overseas infrastructure activities now rival or exceed that of other major donors and lenders. Between 2000 and 2014, the Chinese government committed more than $350 billion in official finance to 140 countries and territories in Africa, Asia and the Pacific, Latin America and the Caribbean, the Middle East, and Central and Eastern Europe. Transport and power generation are the two main sectors financed. Chinese cooperation also invests significantly in health, education, water and sanitation, agriculture, and other social and productive sectors.

Chinese official finance consists of Official Development Assistance (ODA), which is the strictest definition of aid used by OECD-DAC members, and Other Official Flows (OOF). China provides relatively little aid in the strictest sense of the term (development projects with a grant element of 25 percent or higher). A large proportion of the financial support that China provides to other countries comes in the form of export credits and market or close-to-market rate loans. Table 2 provides a calculation of the weighted average of China´s development finance that was extended at concessional ODA terms: 24.5 percent for the period 2000 – 2014.



Table 2. Recipients of Chinese Official Finance, 2000 - 2014
World Region
Total, $bn
ODA Terms, %

No. of Projects

Africa
118.1
58

2345

Eastern Europe
56.7
3

171

Latin America
53.4
12

317

South Asia
48.8
10

423

Southeast Asia
39.2
7

507

Other Asia
28.5
6

183

Middle East
3.1
1

93

Pacific
2.8
3

265

Total/Average
350.6
24.5

4304

Source: Aid Data (2017); authors´ calculation


Table 2 shows that Africa benefitted most from Chinese development finance during the period 2000-14 – in terms of amounts, degree of concessionality (percentage share at ODA terms) and number of projects. Zimbabwe, Angola, Sudan, Tanzania, Ghana, Kenya and Ethiopia headed the ranking of Africa´s recipients in number of projects. Africa has received more Chinese ODA-like finance than all other developing regions in the world combined.

Infrastructure funding has risks for low-income countries with low debt tolerance, however, despite its transformative nature. Much of China´s and other emerging creditors´ new funding supply is through official bank credit outside the Paris Club framework.  Concerns have become louder recently (notably in Washington DC) that a new debt overhang might be building in the absence of a concerted mechanism for debt prevention and resolution. The expansion of available borrowing opportunities has provided more room to expand development-oriented spending and address infrastructure gaps. But long-term growth is enhanced only if borrowed funds are used productively, yielding a high economic rate of return that exceeds borrowing costs. The IMF (2018) has noted, however, that higher budgetary borrowing levels have been associated with a drop in public investment in many LIDCs.

The Fund is particularly worried by the rise since 2013 and by the composition of debt in several post-HIPC countries now judged by then IMF at high risk of or in debt distress. Those countries are all African: Cameroon, Chad, DR Congo, Ethiopia, Ghana, Mauritania, Mozambique and Zambia. Their rise in debt levels has been financed by a mix of emerging bilateral creditors, commercial external creditors, and the domestic financial system. By contrast, the contribution of traditional creditors (the multilateral development banks, Paris Club creditors) has been modest as they tend to limit their provision of loans to countries at high risk of/in debt distress, or are more likely to provide grant finance in such cases.

Washington DC is also worried by prospective debt distress in connection with the BRI. A recent policy paper at CGD (Hurley, Morris and Portelance, 2018) cites media sources, according to which the BRI could span at least 68 countries with an announced investment as high as $8 trillion over the coming years and decades. The CGD paper identified a subset of 23 countries to be significantly or highly vulnerable to debt distress, of which ten are Asian and four African.

Are these concerns more than ´sour grapes´?