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Emerging Asia and The Safety Of Creditor Economies

Western Asset

Executive Summary

  • We expect China to allow a gradual appreciation trend of the RMB within the next six months.
  • If we are wrong and China chooses to maintain its US dollar peg, global imbalances should resurface.
  • It is possible that this could culminate in a sudden stop of inflows of capital to the US. Such a scenario would be exceedingly damaging to the US economy and, by extension, the US dollar.
  • Given existing appreciation pressure, a diversified exposure to emerging Asian local currency bonds funded from US dollar assets would serve as an extraordinarily cheap form of insurance against the threat of a US dollar sudden stop.

“The problems of the debtor can only arise if creditors are not choosing to make use of the purchasing power they have obtained.”

—John Maynard Keynes, 1941, on global imbalances

Global imbalances—large trade deficits in advanced economies offset by large trade surpluses in emerging economies—dominated policy discussions until early 2007, when the immediate threat of global financial collapse displaced this massive medium-term challenge.1 Today, after lying dormant for two years, the debate is reviving and appears to be more consequential than ever.2

The remainder of this paper details our view that exchange rates are the fulcrum on which global trade is balanced. Global imbalances will likely resurface unless China decides to allow sufficient renminbi (RMB) appreciation. We believe the sharp rebalancing seen during the past year is largely illusory, and will reverse once temporary factors pass.3 We expect China to allow a gradual appreciation trend of the RMB within the next six months. This should lift other regional currencies with it and help attenuate global imbalances. It may also augment the returns in US dollars of Asian local currency denominated investments.

If we are wrong and China chooses to maintain its US dollar peg, global imbalances should resurface. The US government failed to take appropriate fiscal measures earlier in the decade in response to large capital inflows. Rather than conduct countercyclical fiscal policy as an offset—a standard IMF recommendation—the US ran a more procyclical fiscal policy. We are skeptical whether any lessons have been learned and believe the US is subject to greater systemic vulnerabilities as a result. It is possible that global imbalances should culminate in a sudden stop of inflows of capital to the US. Given existing appreciation pressure, a diversified exposure to emerging Asian local currency bonds funded from US dollar assets would serve as an extraordinarily cheap form of insurance against the threat of a US dollar sudden stop. Unfortunately popular benchmarks are biased away from emerging Asia toward high (and rising) debt economies in the G7. Passive investors are probably underallocated as a result.

Exhibit 1
Global Imbalances
Source: International Monetary Fund

Global imbalances are just a reflection of domestic imbalances within two of the world’s largest economies, the US and China.4 China exports more than it imports. It runs a trade surplus because it saves more than it needs to fund domestic investments. To reduce the surplus and rebalance its economy, China would have to either raise its investment rate or lower its savings rate, either of which would reduce excess savings and raise the level of imports. In contrast, the US runs a trade deficit because it fails to save enough (Exhibit 1). Savings must rise and imports must fall. Thus, domestic imbalances within China and the US are mirror images that offset one another.

More importantly, US and Chinese domestic imbalances are also co-determinants, meaning imbalance in one economy encourages imbalance in the other—one cannot permanently improve without improvement in the other. There is an ongoing debate over the nature of co-determination: are excess savings pulled in by profligate US consumers who fail to save enough or are they pushed out by cautious Chinese authorities in search of a safe place to store newfound wealth? There is merit to both the “push” and “pull” arguments but we give greater weight to the “push” argument.

The Push Argument…

Exhibit 2
Net US Borrowing—A Temporary Rebalancing?
Source: Federal Reserve Flow of Funds

The rise in US household spending (and the savings shortfall) is an endogenous response to the massive inflow of purchasing power “pushed out” from emerging Asia. As the opening quote suggests, the root cause of global imbalances is the rapid generation of wealth in emerging economies, especially Asia, on a scale never before witnessed. The push argument implies that the ultimate resolution of global imbalances is up to emerging Asia. Its decision whether to retain its newfound wealth or send it abroad for storage will affect asset prices and volatility in advanced economies tremendously over coming years. The push argument does not imply that US authorities are impotent. Nor should it excuse highly indebted governments in the US, UK and Europe from putting their fiscal houses in order—limiting government spending would be the best defense against future capital inflows. It does imply that the net creditor nations (emerging Asia) which generate the bulk of new wealth drive the dynamic. US households reduced consumption (increased savings) in 2008/09 enough to offset the surge in government expenditure, driving a remarkable albeit temporary rebalancing of US domestic imbalances (Exhibit 2). Once capital inflows from emerging Asia recover, however, it is imperative the US government limit spending as an offset to the projected recovery of household consumption.

…Implies Exchange Rates are the Key Balancing Mechanism

China’s exchange rate regime is the mechanism that “pushes out” its newfound wealth. An undervalued RMB facilitates China’s export-led growth strategy and is the impulse behind transmitting its domestic imbalances to the US. The rest of emerging Asia must remain competitive with China, and is following China’s lead on currency regime.

Just as a stock share represents a claim on the future purchasing power of a corporation, a currency note represents a claim on the future purchasing power of the economy as a whole, including the corporate, household and government sectors. Inflation erodes purchasing power and pressures a currency to depreciate. Likewise, a currency must appreciate as an economy’s ability to produce goods and services becomes more efficient through productivity enhancements. This is the kind of gradual appreciation that currencies undergo via the development process, and parallels the rise in per capita GDP.

Emerging Asia continues to rapidly converge toward advanced economy wealth levels (Exhibit 3). Yet currency appreciation has been limited. This drives a disconnect between the purchasing power generated by producers and that realized by consumers, with consumers left far behind. Ken Rogoff, former chief economist at the IMF, calls China’s exchange rate regime its chief “expenditure compression policy.”5 Government authorities in China have had to sequester more than $2.25 trillion of wealth, keeping it outside the Chinese economy in predominantly US markets instead (Exhibit 4). If the authorities ceased sequestering purchasing power, Chinese consumer spending would rise to meet production capacity, forcing currency appreciation in the process, drawing in more imports and unwinding the export-led growth model. The dynamic is similar across much of Asia.

Exhibit 3
GDP Growth
Source: International Monetary Fund
Exhibit 4
China Reserves
Source: Bloomberg

As Chinese producers discover more efficient ways of generating purchasing power, the government must sequester an increasing amount each month in order to keep the RMB pegged at current levels (Exhibit 4). Chinese productivity and per capita GDP have both grown at an unparalleled pace in recent years. From 2000 to 2008, Chinese per capita GDP grew by roughly 9% per year, a cumulated gain of 100%. In comparison, US and European per capita GDP grew by roughly 1.5% per year, a cumulative gain of just 10%. So China’s per capital GDP expanded ten times as much. Yet the RMB gained just 20% on the US dollar. The situation is even more problematic for the eurozone: the RMB depreciated by 17% against the euro. The Real Effective Exchange Rate (REER), which adjusts for inflation and is based on trade-weights, provides a more complete measure than these individual nominal cross rates. The REER is the exchange rate that balances production and consumption in a general equilibrium sense and is at the heart of China’s imbalances. China’s REER was up just 12% over the same period (Exhibit 5).

Exhibit 5
China’s Exchange Rate
Source: Bloomberg, JPMorgan

Accordingly, China’s domestic imbalances worsened over the period and the government had to sequester increasing amounts of purchasing power each month until the financial crisis hit. Unless authorities permit significant RMB appreciation, we suspect imbalances will worsen as financial conditions normalize. Domestically-oriented policies aimed at encouraging consumer spending would have little impact in the absence of currency appreciation.6 China understands this better than anyone. On the other hand, the consequences of China’s decision would fall disproportionately on US dollar based investors rather than the Chinese themselves, as Keynes recognized. He wrote that “the main burden of adjustment [falls chiefly] on the country which is in the debtor position on the international balance of payments.” In an ideal world, the main burden of adjustment would fall on the creditor economies (emerging Asia) to expand imports rather than the debtor economy (US) to contract imports, thereby avoiding a deflationary/recessionary rebalancing.

China is in the Driver’s Seat

Emerging Asia’s decision to build large foreign currency reserves was a rational decision given economic realities. That decision was rewarded last year, and the incentive to build even larger reserves has increased with the recent financial crisis. However, the consequences of this decision fall disproportionately on investors in debtor economies that are dependant on emerging Asia’s excess savings. Rogoff and Obstfeld (2009) state that “Chinese [exchange rate] policy is subsidizing the country’s export of current consumption power in the world asset markets, thereby keeping world real interest rates below their true equilibrium levels.” Should China decide to permit the RMB to appreciate, allowing consumers to realize more purchasing power, real yields would rise in the US and other economies that had been recipients of these inflows, all else equal.

Box 1

Household versus Corporate Savings

Chinese authorities publicly agreed at the G20 summit in Pittsburgh earlier this year to expand social safety nets in an effort to reduce precautionary household savings. Expanded health care and education provision, more efficient savings vehicles and the development of an insurance market would all help encourage greater consumer spending. Besides being incongruent with China’s chief “expenditure compression policy,” they miss the target. Corporate savings (undistributed corporate profits) account for the majority of China’s excess savings.7 Policies aimed at restructuring the corporate sector and deflating artificially high corporate profit margins would have a more meaningful influence on domestic imbalances. To this end, policies aimed at fundamental industrial reform, such as eroding monopolistic pricing power, the privatisation of state-owned enterprises, the removal of export subsidies, reducing barriers to entry and mandating the disbursal of dividends, would do more to relieve China’s domestic imbalances than policies aimed at households. Still, these must all be carried out in conjunction with currency appreciation.

In 2005 Alan Greenspan fretted over the “conundrum” that longer-dated Treasury rates were not rising despite a rising Fed funds rate. The Economist magazine captured concerns well when it wrote, “The yield on ten year bonds is currently lower than before the Fed started to lift interest rates in June 2004. America’s sovereignty over its monetary policy has therefore been eroded, with a given rise in short-term rates producing much less monetary tightening than in the past. To that extent, global monetary policy is increasingly being set in Beijing as well as in Washington.” That same year, Warnock and Warnock found that US 10-year rates were about 90 basis points lower than they would have been had foreign capital inflows to the US remained at historic average averages. We are not saying that real interest rates need to rise anytime soon; quite the contrary since we believe foreign capital inflows will resume. But it is valid to ask whether the US housing bubble would have been so pronounced if longer-dated real interest rates hadn’t been driven below equilibrium levels. The general point is that the closed-economy framework no longer captures reality. Overseas developments, particularly in emerging Asia, matter for US asset prices.

China’s exchange rate decision is highly consequential and requires vigilance. It most likely had and will continue to have a significant influence not just on real interest rates in the US but on wider asset prices. It would be more concerning if China chose not to appreciate or simply to appreciate insufficiently. In this event we would expect elevated tail-risk and a possible (though improbable) chance of a US dollar sudden stop.

Risk Scenarios

Coined by Guillermo Calvo, the term “sudden stop” describes the situation where an over-reliance on foreign funding ends abruptly, often with tremendous damage to the debtor economy. This has been a repeated problem for emerging economies but a rare problem for advanced economies. Then again, it was considered rare for advanced economies to suffer severe banking crises until last year.

Exhibit 6
Breakdown of Index Performance: Currency versus Bond Returns
Performance from Oct 2005 – Oct 2009
Source: HSBC Asian Local Bond Index

Emerging economies have periodically undergone what has become an all-too-familiar sequence: large capital inflows push asset prices to unjustifiable levels, the bubble bursts, capital flows reverse abruptly, the currency collapses and there is a financial crisis and ultimately a deep recession. The US suffered an eerily similar sequence of events during the 2000s. The only missing component was the currency collapse—the dollar actually strengthened as global financial conditions deteriorated. It is possible that this component was not avoided but merely delayed due to the US dollar’s special reserve status.

Exhibit 7
Region/Country Weights—Total Market versus Index
Bond Indices Favour Japan over Emerging Asia
* Total Bond Market per BIS USD 60.8 trillion. As of 31 Dec 08.
** Citigroup’s popular global government bond benchmark, as of 30 Sep 09.
Source: BIS Quarterly Review, Citigroup

Steady erosion in confidence could yet escalate into a stampede by foreign creditors to reduce dollar holdings. Identifiable triggers include breeching some critical level of the debt-to-GDP ratio or a perceived threat to the Federal Reserve’s independence. Under this scenario, the dollar would lose significant value, real yields would soar and riskier asset prices would plunge. Investors could profit handsomely from a diversification into the currencies of net creditor nations, particularly emerging Asia. We find predictions of such a scenario alarmist and improbable. Still, China and other net creditor nations will eventually reach a saturation point where they no longer want to hold US dollar assets. It is impossible to know in advance where that threshold will lie, but it draws nearer with every tick higher of America’s debt-to-GDP ratio.


We believe that reallocating funds toward fast growing, net creditor nations away from slow growing, net debtor nations will be an efficiency enhancing strategy in many cases. The Chinese economy casts a wide influence across the region and we would expect RMB appreciation to encourage broad-based appreciation across much of emerging Asia. A diversified exposure to local Asian bonds offers compelling risk-reward potential. Economists at the Petersen Institute estimate that the RMB requires a one-off appreciation of roughly 15-25% to resolve existing imbalances. In addition, the RMB would have to appreciate by roughly 7% on an annual basis to keep pace with per capita GDP convergence. Substantial currency gains on top of underlying bond yields would then combine for potentially healthy total returns (Exhibit 6). While difficult to quantify, the position could add further value from its properties as a hedge against a US dollar sudden stop.

Unfortunately, popular benchmarks such as the Barclays Capital Global Aggregate Index and the Citigroup World Government Bond Index have a built-in bias toward high debt-to-GDP ratio countries (Exhibit 7). Japan is the only heavily represented Asian economy. Emerging Asia is heavily under-represented due to its fiscal prudence. As the US, Japan and Europe continue to run massive government budget deficits, their weights will expand as they fall deeper in debt to emerging Asia. There have been recent attempts to remedy this distortion with GDP-weighted benchmarks, but these are not without their own drawbacks. We believe actively reallocating to Asian local currency bonds, funded out of US dollar assets, is a straightforward way of getting around the weighting distortions.

Box 2

Equity versus Fixed-Income Trade-Offs

It is much more common for investors to take exposure to emerging markets via an equity allocation. This gives the currency exposure in addition to the upside potential of the corporate sector’s profit generation ability. There is nothing wrong with this approach but we would caution that the volatility of equity markets is far greater than that of bond markets. Over the past 10 years, the annual volatility on the MSCI EM Equity Index has been two times that of the JPMorgan EMBI Bond Index, at 25% versus 11%. An additional concern was highlighted in the previous callout box. Equity prices have increased 16% in the past five years. This partly reflects the strong growth potential of emerging market economies. But it also reflects the potential profit opportunities within the corporate sectors. If we are correct about currency appreciation and if China does carry out industrial reform, the corporate sector should experience an increasingly competitive environment with eroding profit margins. This would weigh on equity valuations but would be positive for fixed-income.


  1. The current account balance is technically the better metric. It includes net transfer payments and net income on foreign assets. Still, these two additions are relatively small. The balance on trade is far and away the largest component of the current account balance.
  2. Ben Bernanke, Hank Paulson and Mervyn King have all clearly stated such. Jagannathan, Kapoor and Schaumburg (2009) “Why are we in a recession? The Financial Crisis is the Symptom not the Disease!” is a relatively straightforward exposition of the general argument. Also see footnote 5 for an alternative argument but with a similar conclusion.
  3. Voxeu, Richard Baldwin post:

  4. Oil exporters are also major drivers but we consider these economies as benefiting from a positive and exogenous terms-of-trade shock via a rising price of their chief export, oil. If one agrees that oil prices are rising because of the economic growth of emerging Asia, then, indirectly, the success of oil exporters is more “leaked purchasing power” from emerging Asia.

  5. Rogoff and Obstfeld (2009), “Global Imbalances and the Financial Crisis: Products of Common Causes” (October 2009).

  6. The only way to correct domestic imbalances without currency appreciation is via encouraging investment rates to rise toward savings rates. With investment rates running at 45%, increasing investment from current levels runs the danger of deteriorating returns and a serious misallocation of capital.

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