Will the AIIB one day matter?

When Isaac, an editor at Foreign Policy, sent me an email two weeks ago asking if I could write a piece on the new Asian Infrastructure Investment Bank (AIIB), I quickly wrote back promising 1,200 words within a few days. I thought it would be pretty easy to come up with the points I wanted to make, and all I would need was one uninterrupted day to pull them together into a coherent article.

As I see it, the creation of the AIIB is not nearly as important as everyone seems to think, and if Beijing’s decision to create the AIIB, and Washington’s decision to oppose it, was part of the struggle for future geo-political dominance in Asia, let alone the world, they were both going to be wrong. There were only two useful parts to this story, it seemed to me. First, it showed that neither Washington nor Beijing understood very well either the functioning of the global balance of payments or the reasons why the West, and especially the US, dominates the regime that governs global trade and capital flows (but I guess we already knew that). Second, Washington had handled this whole process so ineptly that it had managed to transform a minor initiative by Beijing into a huge symbolic disaster for Washington and a great victory for Xi Jinping.

I thought it would be easy to explain this because the discussion over the AIIB was almost a caricature of the discussion over a number of other finance-related topics during the last decade or two, in which an overwhelming consensus quickly develops around some event concerning both its unprecedented nature and the nature of its transformative impact – the sustainability of China’s astonishing growth miracle, the creation of the euro, the abolishing of credit cycles by Washington, the consequences of the reserve status of the US dollar, the rise of the RMB, and so on. Both assumptions always turn out to be wrong – the event under discussion does have a very deep and very useful historical context, and this context suggests that many of the assumptions underlying the discussion are, in fact, quite implausible.

In the case of the AIIB I assume that readers of my blog are quite familiar with these assumptions, but on March 16 Singapore-based academic Kishore Mahbubani published an article that, perhaps predictably, exemplifies the more excited version of the consensus. He described the decision by Great Britain to join the AIIB as an “epochal event” signaling nothing less than “the end of the American century and the arrival of the Asian century”. He goes on to say:

Any objective and calm assessment of the Chinese decision to launch the AIIB would show that this is a bank whose time has come. The Asian Development Bank has estimated that Asia needs to spend at least $8 trillion in infrastructure investment. The American-dominated World Bank and related institutions cannot possibly fulfill this demand. China’s decision to use its reserves to boost Asian infrastructure investment was clearly welcomed in Asia. Given its spectacular success with developing world-class infrastructure in record time, China has a lot of expertise in this area. Asia needs this.

In spite of the fact that I disagree with nearly every part of this paragraph, and I think there are many, and very varied, precedents for Beijing’s initiative that show just how questionable many of these assumptions are, it actually turned out to be very difficult to write the article. On my first attempt I was well over the 3,000 word mark before I realized that there would be no way to finish the article and then cut it down to anything close to 1,200 words. I put the piece aside and started up the next day with a completely different strategy, but the result was the same – too many words. After the third attempt, with a new strategy but the same result, I realized that there was no way I could present my objections except in a much longer piece, and I wasn’t sure whether it was worth the effort.

The string of implausibilities

I think I know why it would take much longer than I expected to write the essay. The claims about the importance of the AIIB or the significance of London’s decision are based on a series of implicit and fairly abstract assumptions, and in order to dispute them I would have to specify all the possible ways in which these claims would be correct, and then show that each of them is implausible or even impossible. It is a little like the dispute over the value of reserve currency status. If someone claims that reserve currency status is valuable because it allows the country that issues the currency to reduce its borrowing costs, it is quite easy to show why this isn’t true, or is true only under very specific conditions that may or may not apply. But if someone simply claims that reserve currency status is self-evidently extremely valuable, it is much more complicated to dispute the claim because then you have to consider and refute all the possible ways that this might be true.

In this essay, I thought I would follow a different tack. It might be interesting not so much to dispute the importance of the AIIB, or of Britain’s decision, but rather to suggest some of the historical antecedents for Beijing’s initiative and show how similar perceptions turned out to be wrong before, and so suggest the ways in which they might be wrong again.

This is not to say that the AIIB cannot become as important an institution as some of the more excited commentary suggests. It can, but only under certain fairly implausible conditions. If China’s economic rise during this century leads it not just to overtake the United States but to achieve a level comparable to that of the United States in the 1940s and 1950s, and if the RMB becomes the world’s dominant reserve currency, with Beijing understanding and accepting the full costs of having the RMB as the dominant reserve currency, and if Beijing chooses to implement its foreign policy objectives at least partly through the AIIB, its importance will rival that of the Bretton Woods institutions.

However if the 21st Century evolves into a bi-polar world, or a multipolar world, or if it continues to be dominated by the US, the AIIB’s history will resemble that of its many antecedents. It will join the long list of much-hyped initiatives aimed at transforming the global trading regime but that now languish in obscurity, known primarily for absorbing university graduates from very prestigious schools who have failed their other job interviews.

This just means, in other words, that if Beijing occupies the same relation to the rest of the world that Washington did in the 1940s, and if, occupying this position, its ideas about what it expected from a global trade and currency regime had not changed during the next decade or two (which, given its very difficult expected rebalancing, as I will show, makes this very unlikely) then the AIIB can replicate the rather extraordinary impact of the Bretton Woods institutions. Note however that the AIIB itself will not play a role in China’s rise. It will be nothing more than one of the consequences of that rise, which is why even if this whole string of implausibilities were to become real, it is absurd to say that the AIIB itself changes anything.

Before discussing the precedents I thought I would make a quick digression about perfidious Albion. It is widely believed that David Cameron made a decision that shocked much of the world, including Beijing itself, for solidly pecuniary reasons. It was no secret that there was little David Cameron wouldn’t do to ensure that London became the leading offshore center for trading RMB, and was especially worried about the close relationships between Berlin and Beijing, which, he feared, might place Frankfurt in the lead in the race to become the main trading center for RMB. Many people have interpreted Cameron’s actions as implicitly anti-American, but to the extent that they matter, they were designed primarily to damage German ambitions for Frankfurt’s future role as a financial center.

Booting out Frankfurt was important because of the big pot of gold associated with becoming the dominant offshore trading center for RMB. Cameron seems to believe that the RMB will soon become one of the world’s major reserve and trading currencies, perhaps even overtaking the dollar, and London’s primacy as a global financial center would be guaranteed if it became the leading offshore trader of RMB-denominated assets.

But this was always silly. The reason London is the world’s major currency-trading center has to do with its very powerful institutional advantages. After all it was widely feared less than two decades ago that the establishment of the ECB in Frankfurt in 1998 had all but killed London’s continued future as the center of European finance. In fact the creation of the euro largely wiped out local currency centers and most of the market actually migrated out of the euro zone and into London.

The reason this happened – London’s unassailable institutional advantages – make it almost certain that, whatever Beijing’s preferences, offshore trading in RMB would migrate to London anyway. After all the traders at Aberdeen Asset Management, say, are not going to decide whether to have their trades executed in Frankfurt or in London based on their eagerness to please Beijing. I suspect their decision will be based primarily on their evaluation of which market is deeper, more liquid, clears more conveniently, and trades more efficiently.

Will the RMB become an important reserve currency?

More importantly the RMB will not become a major reserve currency any time soon, and while its importance as a trading currency will probably continue to rise, this is from an extremely low base and is mainly because compared to the currencies of other, smaller, developing countries, like the Mexican peso and Brazilian real, the RMB is hugely under-represented in international trade. So while it has a lot of catching up to do with the peso and the real, even if China is to become the word’s largest economy, the RMB is very unlikely to catch up to the dollar for many decades because of significant constraints in the governance of Chinese financial markets. The US, after all, was the world’s largest economy for fifty years prior to WW1, and Germany the world’s second largest economy, and yet the US dollar was of minor importance in international trade and the German goldmark only third in importance, behind the French franc and far behind sterling.

London had spent decades proving that it was far less likely to intervene in sterling markets then any of its competitors and so, as long as it did not do so, inertia alone allowed sterling to retain its primacy, but it certainly did not need to worry about a challenge from the dollar until WW1 completely transformed global governance and the institutions that characterized international finance. The dollar in the late 19th century did not enjoy high levels of confidence in the international markets because there were doubts about the quality and credibility of Washington’s governance and about whether Washington would resist intervening in its financial markets or in the currency if it felt that it was in the national interest to do so. Even if the dollar today were at risk somehow of losing the huge advantage inertia creates, the same constraints that prevented the dollar from mounting a challenge to sterling’s pre-eminence before WW1 make the ERMB an unreliable international currency.

While use of the RMB as a reserve currency or as a trading currency will probably rise in the next decades, this is mainly because of its still very low base. According to SWIFT, for example, which settles interbank trading orders and is one proxy for currency use, the RMB broke into the top five currencies at the end of last year, accounting for 2.2% of SWIFT transactions (the USD accounted for 45% and the euro 28%, and because all transaction involve two currencies, I think a 50% share is the limit any currency can have). Given China’s size, this is a tiny share, but even this may overstate the importance of the RMB if part of the transactions were driven by substantial amounts of currency speculation seeking to get around the rules that limit China’s capital account.

In fact it probably was. The latest SWIFT numbers, for February, show that the RMB has dropped to 7th place, with a 1.8% share, and that the number of companies expecting to increase their use of RMB has declined in the past year. It is probably not a coincidence that use of the RMB rose when expectations were that RMB appreciation was a sure thing, and is declining at the same time that uncertainty rises about the future value of the RMB.

Whatever its fate as a trading currency, however, the RMB cannot soon become a dominant reserve currency. To understand why, it might be useful to consider the following. There are only two scenarios under which foreign central banks can accumulate enough RMB-denominated Chinese government bonds (CGBs) for this to happen.

  1. As foreign central banks buy CGBs, the PBoC intervenes and the RMB does not rise, in which case the PBoC’s assets rise by exactly the same amount as foreign central bank purchases of CGBs.
  1. As foreign central banks buy CGBs, the PBoC does not intervene and the RMB rises enough that the rise in foreign purchases of CGBs is matched by the combination of a decline in China’s current account surplus and an increase in China’s capital account deficit. If the RMB rises, of course, we are unlikely to see an increase in China’s capital account and in fact may even see it decline into a surplus. This means that the current account surplus must decline by more than the amount of CGBs that foreign central banks purchase, and in fact could easily drive the current account into deficit.

Some have suggested as a third scenario that other Chinese entities could be forced to buy foreign assets purely in response to foreign central bank purchases of CGBs, but this would basically be a version of Scenario 1, with the only difference being that Beijing directed some other entity to play the intervention role of the PBoC.

Whether Beijing decides to go this path, or the PBoC intervenes directly, there are important consequences that make it implausible. Either the rise in RMB reserves would have to be matched with an increase in PBoC holdings of advanced country reserves, mainly US dollar and perhaps euro bonds (other advanced countries are too small to matter), or if Beijing wanted to stop accumulating dollars and euro, it would have to be matched with an accumulation of government bonds, or even infrastructure loans, in Malaysian ringit, Brazilian reais, Mexican pesos, Indian rupees, and other developing-country government bonds. Given China’s poor track record in lending to developing countries and the huge associated risks, Beijing is unlikely to want to do this. Remember that if we are expecting the RMB to become a major reserve currency (let alone the major currency) China has to be prepared to see some pretty huge inflows and matching outflows, running into the trillions of dollars.

Central bank swaps

The effect would be to have RMB reserves in all these other central banks — Brazil, Malaysia, India, Mexico and other developing countries – rise in exchange for an equivalent rise in the PBoC’s central bank reserves, denominated in all these various currencies. While the use of the RMB as reserves would certainly rise, there would be no net trade impact or monetary impact because centrals would simply swap government bonds with each other. In fact asset swaps have been among the major mechanisms by which RMB reserves have accumulated in foreign central banks.

But for the RMB to become an important reserve currency simply as a function of asset swaps between central banks has important risk implications. A few creditworthy countries might be willing to play this game in the beginning, giving the PBoC some of their government bonds in exchange for their central banks receiving CGBs, but why bother? It just means that they take on China credit risk and get no benefits at all, except to make Beijing happy.

In the days of the “China Century” when it was believed that whoever made Beijing the happiest would get rich by becoming the leading off-shore trading center for the world’s dominant reserve currency, there might have been some demand from the Switzerlands or Luxembourgs of the world, but I wonder if David Cameron might not be among the last people still to believe this, and anyway this game involves very small amounts of swaps and will only go on until London has already become the leading off-shore RMB trading center.

So who is left who will want to do these swaps with the PBoC? Pretty obviously the only contenders will be countries that have trouble raising credit. Beijing, in other words, can exchange trillions of dollars worth of CGBs and receive government bonds from pretty much every dodgy credit in Latin America, Europe, Asia and Africa. While I am sure that there are many who will hail this as a brilliant geopolitical move, I would have to say that if it really were a good move, and if having the dominant reserve currency was such a great advantage, then this strategy could and should have been replicated by other credit-worthy countries long before China had thought it up, and they could have easily taken away the exorbitant privilege from the US decades ago. After all there was a time when the yen was supposed to become the dominant reserve currency, and it had far better technical credentials then than the RMB does today, and yet Tokyo never followed this path.

More pointedly, in 1965 French finance minister Valéry Giscard d’Estaing complained bitterly about the exorbitant privilege the dollar’s reserve status gave the US, allowing it to print as many dollars as it liked to finance its deficits, but France could have easily engaged in massive swaps with central banks around the world in the 1960s and 1970s under Giscard d’Estaing’s guidance. Had Paris done so, today the French franc would reign supreme among currencies, or, more likely, France would be totally bankrupt.

That’s why I think Scenario 1 of the two scenarios is almost impossible except as a way for the RMB to become a little more actively used as a reserve currency. If China really wants the exorbitant privilege, it is stuck with Scenario 2 and its associated trade implications. It can only gain reserve currency status by allowing unlimited amounts of foreign purchases of CGBs, with little to no commensurate PBoC intervention, in which case it gets the US privilege of being forced into current account deficits. I really don’t see any way around this.

If you believe, as most of us seem to, that Beijing is not willing to run large current account deficits in order accommodate the accumulation by foreigners of RMB reserves (especially if foreigners begin to accumulate RMB for the same trade-related reasons that the PBoC accumulated US dollar reserves), and if you also believe that the PBoC will not be willing to accumulate perhaps trillions of dollars worth of developing-country government bonds (i.e. lend trillions of dollars to developing countries), then you cannot also believe that the RMB will become a major reserve currency, let alone the dominant reserve currency, because you have eliminated the only two ways foreign central banks can accumulate sufficient amounts of RMB reserves.

What does history “prove”?

Most analysts do not understand the reserve accumulation process well enough to understand the logic of this argument, but they nonetheless are fairly confident about their predictions for the RMB on the grounds that history supports them. This is usually because, however, their understanding of history is not much better. One thing, we are often told, is that as the Chinese economy becomes the world’s biggest, its currency must become the dominant reserve currency because history proves that the world takes on the currency of its largest economy as its preferred reserve currency.

History proves no such thing. First of all, there is no “history” as such. There has only been one fiat currency in history that was a dominant reserve currency, and this was the US dollar, beginning either in 1944, or in 1971 after the “Nixon shock”, or some time in between, depending on your reading of the history. There has also been only one case in history in which a currency generally recognized as the dominant reserve currency was replaced by another, and this was the replacement of sterling with the dollar, some time in the 1930s or early 1940s, again depending on your read of history.

More importantly, as I discuss above, the US economy became the biggest in the world in the later 1860s or early 1870s, during which time Germany became the second, and yet the dollar was considered a fairly unimportant reserve currency right up until the late 1910s (and Germany only went on gold in the early 1870s). The dollar only became important, in other words, forty to fifty years after the US became the world’s largest economy, and the dollar only became the dominant reserve currency perhaps more than seventy years after the US had acquired its leading economic status.

For me the interesting question is why it took nearly half a century after the US became the world’s largest economy for the US dollar to become an important reserve currency and whether this has implications for China. The answer may be partly because of the uncertainty surrounding the dollar, and American commitment to gold backing (in fact the Federal Reserve System was not created until 1914), and given the structure of the Chinese political system and a wide range of financial market governance issues, it is not hard to imagine reasons why the RMB might also attract uncertainty.

The late use of the dollar may also be explained partly because during much of this time the US was running trade surpluses and, except for its bankers, it would not have benefitted from foreign interest in acquiring large amounts of dollars. China faces a very difficult rebalancing, and while status-seeking is an especially powerful urge in China, anyone in Beijing who can ignore the status that would come from managing the dominant reserve currency would see that substantial foreign acquisition of RMB-denominated CGBs would make the rebalancing so much more difficult that it would all but guarantee a failed adjustment. Even if China does become the world’s largest economy, in other words, the RMB may face some of the same constraints that prevented the dollar from becoming an important currency in the five decades before WW1.

There are other mistaken historical references. Some people have pointed out that the US was able both to run surpluses in the 1940s and 1950s and still have the dominant reserve currency, as was England at the end of the 19th century, but both cases occurred under conditions that do not apply to China today. In the former case, the US economy represented at least 50% of the relevant world back then (excluding among others communist countries like the USSR, China, and their various allies). Much more importantly, the system simply didn’t work. The world was not able to acquire nearly as many dollars as it needed, and the result was the famous “dollar shortage” which was severe enough that it threatened to derail the global recovery. Only the huge gift of the Marshall Plan was able temporarily to resolve it in Europe. China can replicate the US of the 1940s and 1950s, in other words, only if it were able to make as large a gift, even though it is much poorer than most countries and represents about one-third of the share of global GDP that the US represented.

As for the British example at the end of the 19th Century, in those days currency was part of reserve accumulation, but much if not most reserves were in the form of gold or silver, and while Britain had the most important reserve currency, the difference between central bank holdings of sterling and central bank holdings of other gold-based currencies, like the franc, were pretty small relative to total trade. The gap between British capital exports and the British current account surplus, in other words, could be quite small and still allow the world to accumulate enough sterling for sterling to be the dominant reserve currency. This is no longer the case. Reserves are held primarily in the form of government bonds and reserve accumulation is much greater relative to trade.

There was a reason Keynes supported bancor instead of dollars as the global reserve currency during the 1944 Bretton Woods conference, and it was not, as everyone assumes, just because of nationalist pride. He saw how sterling reserve status without the automatic constraints of gold backing helped undermine the British economy in the post-WW1 period as countries that needed to boost growth accumulated sterling. He knew this would happen to the US, and while this might not matter at a time in which the US was roughly half of the relevant world, and in which there was much more cooperation among major governments and central banks, eventually the US would no more be able to absorb the cost, just as England was not able to do so in the 1920s.

This is why I think the dollar will eventually lose its reserve status, not because it will be replaced by the RMB but rather because the US will eventually figure out that it entails too a high cost and that it is no longer willing to pay that cost. When this happens, unless there is a credible alternative, perhaps the SDR, the US will be better off by forcing the world to abandon the dollar but the rest of the world, especially developing Asia, would be much worse off. My main point, however, is not that the US should not accept its role any longer but rather that until China decides it is willing to pay that cost (assuming that it is able, which I very much doubt), I really cannot see how the world can possibly acquire enough RMB for it to become a dominant reserve currency.

Other things to consider for the AIIB

This blog entry is already far more than three times the length of the article I was supposed to provide for Foreign Policy, and I still haven’t fully addressed just the key reasons for skepticism about the importance of the AIIB. Because addressing them fully would take this essay easily into book length, let me just suggest them:

  1. We have a terrible track record of extrapolating from periods of rapid growth to predict which country is the “rising power”. In fact more broadly, depending on how you define them, there have been 30-40 “growth miracles” since WW2, of which perhaps only two came even close to achieving consensus expectations. In every case, including the “successes” the growth period was followed by a terribly and unexpectedly difficult adjustment that derailed all earlier expectations.

More relevantly, in the past century these growth miracle countries have included at least four rising powers that were expected to become the dominant geopolitical and financial power in the world – the US in the 1920s, Germany in the 1930s, the USSR in the 1950s, and Japan in the 1980s. In every case they rebelled bitterly against the existing global financial framework, complaining that it was designed to maintain the status quo and restrain their rise. Every one of these countries initiated policies aimed at transforming the world to align interests correctly and accommodate their rise to dominance. Only one of them succeeded.

The United States in the 1920s was the only country that met expectations. It had already been the world’s largest economy for nearly five decades, but played a minor role in the global system until WWI thrust it into center stage. In the 1920s the US experienced a period of spectacular growth during which institutional distortions forced up its saving rate and resulted in massive trade surpluses, along with the largest accumulation of central bank reserves in history (it is worth noting, by the way, that although the US in the 1920s experienced some of the conditions that characterized China’s growth model, of the four “rising powers” its economic growth was the least similar). Like Beijing today, during this period Washington demanded a greater say in the institutions that shaped global trade and capital flows, but was very suspicious of European initiatives designed, it believed, to enhance the status quo at American expense. For the most part Washington refused to participate, or attempted to create its own institutions. The “rising power” period, however, came to an end, along with most of the expectations generated during the 1920s. US growth was derailed in the 1930s as it was forced into a very difficult adjustment, and among the casualties were the ambitions associated with its geopolitical dominance.

In the 1930s Germany designed a version of the investment-driven growth model, with the two fundamental characteristics similar to China’s growth model that both caused soaring growth and deepening savings imbalances (policies that force up savings by constraining household income and the centralization of the investment process). At the time many if not most economists, not just in Germany but also in the US, expected that Germany would soon overtake the US economically and become the world’s largest economy. Of course WW2 interrupted the rebalancing process, but economic historians argue that had war not occurred, Germany would have probably faced a debt crisis by the early 1940s.

A fully developed version of the investment-driven growth model was implemented in the USSR after WW2 and led to such spectacular growth that, by the early 1960s, most economists and analysts, including apparently President Kennedy, fully expected the USSR to overtake the US both economically and technologically well before the end of the century. Instead, in the now familiar sequence, the USSR suffered a brutal rebalancing and an ultimately disruptive adjustment. Although the USSR participated in the Bretton Woods conference and approved the final agreement, Moscow almost immediately rescinded its agreement and proposed a number of financial initiatives within the Soviet or communist blocs, none of which survive. And while the USSR urgently sought to accumulate dollars for trade and reserve accumulation, its unwillingness to hold these dollars in US-based banks subject to pressure from Washington played a large part in the creation of the offshore market for dollars, and eventually for other currencies. This initiative can be listed as one of the few “reforms” by disgruntled “rising powers” to have survived and changed the global financial regime, but its effect, ironically, was not to undermine the Bretton Woods system so much as to extend it.

In the 1970s and 1980s Japan developed the most successful version to date of the investment growth model, with such stunning results that the Japanese economy was unanimously expected to overtake that of the US, and the yen replace the dollar, before the end of the century. During this period Tokyo complained bitterly about the Washington-dominated global regime and attempted a number of reforms whose consequence included a bitter dispute over the Asian Development Bank and Japan’s role in the regime that governed global trade and finance. Once again, however, a growth model based on structures that forced up both savings and investment generated very high growth levels, but at the cost, in its later stages, of deep savings imbalances and a soaring debt burden, the consequence of which was yet again an unexpectedly difficult adjustment in which all earlier expectations about needed reforms in the global system of trade and capital flows were either jettisoned or modified.

There have been four times in the past 100 years, in other words, in which we were more or less certain (absolutely certain in the cases of the US in the 1920s and Japan in the 1980s, very certain about the USSR in the 1950s, and arguably certain about Germany in the 1930s) that a country would become the dominant economic and geopolitical power, and only once did this turn out to be true. Anyone old enough to remember the 1980s will remember that we were even more certain about Japan’s rise in the 1980s than we are about China’s rise today, but in the Japanese case, as in every other case, we were flabbergasted by how difficult the economic adjustment turned out to be, which suggests at the very least that we might want to wait to see how Beijing manages China’s rebalancing before we insist that this time is indeed different.

  1. Whatever the outcome, the adjustment period has always overturned the institutions and expectations generated during the growth period. This is why even if China becomes only the second successful case of five in which our predictions about the “rising power” turn out to be correct, it is foolish to assume that the expectations that led to the creation of the AIIB will remain unchanged. China’s priorities will have shifted during its rebalancing to such an extent that today’s goals will not apply to the conditions that accompany its position of dominance. During the adjustment, domestic institutions and political conditions have always been so radically transformed that the country “before” the rebalancing period had a completely different set of objectives and goals from the country “after” the rebalancing period.

It is important not to underestimate this point. Regardless of whether or not it becomes the world’s largest economy, the China that emerges from the adjustment of the next decade or two will be a very different China, with different institutions, different objectives, and different priorities. Among the easier predictions, it is a virtual certainty that the imbalances that force China today to recycle massive current account surpluses will have reversed themselves, so that the recycling process will no longer be a major objective.

  1. The world is not starved of capital. In fact it has too much capital. The idea that the AIIB will be important because its accumulation of lending power will give it something important that the world needs is widespread but completely wrong. In fact the world is satiated with excess savings, to the point where it has driven interest rates in some countries negative. In fact China and the other founding members of the AIIB who know that they desperately need places to put their money but who do not understand why they have this problem are probably hoping that the bank will be able to increase credible demand for savings by transforming real demand from non-credible borrowers into real demand from borrowers whose credit has been mysteriously enhanced somehow by the AIIB.
  1. Management of the regime that governs global trade and capital flows depends not on the support of institutions like the World Bank and the IMF but rather on the willingness to underwrite the costs of trade volatility. The reason the US more than any other country sets the global rules for trade and capital flows is not because the US dominates the IMF and the World Bank, whose financial firepower underpins US power. It is because the US has been willing to absorb the volatility generated by trade policies of other countries, and this willingness is based not so much on the openness of its domestic markets for goods and services to foreign trade (although it is clearly more open than any other major economy) but on the fact that its capital markets are open. This point confuses many analysts, who think of the capital and current accounts separately. The right way for any country that wants to power domestic growth by boosting exports is by increasing productivity. In that case it will export more abroad, but the resulting increase in wealth will also cause it import more, and it will not obviously run either a surplus or a deficit, but rather a trade imbalance close to zero.

But if increasing productivity is too hard, it can also boost exports simply by accumulating US assets, the most common of which ways to do so is to have the central bank acquire US government bonds. As its net capital exports to the US grow, its current account surplus and the corresponding US current account deficit will automatically grow by exactly the same amount. I have explained why this must be the case many times, including last year in the September 28 and October 5 entries in my blog. This consequence was why the UK remained so important after WW1, even though its economy was dwarfed by that of the US and was smaller than that of Germany. Countries that needed surpluses purchased British government bonds – at England’s great cost, as Keynes tried to explain.

Most analysts, even US government officials involved in international trade and foreign policy, simply do not understand how this works, but the confusion this causes does not make the accounting identities any less true. In fact the mechanism has been explained often enough by many economists whose work focuses on the functioning of the global balance of payments, from John Hobson and Charles Arthur Conant at the end of the 19th Century, to Keynes in the 1930s and 1940s, to Jared Bernstein and Kenneth Austin today.

Any discussion about how China is going to transform the global financial architecture, in other words, is primarily a discussion about when China will open up its capital markets to unrestricted foreign purchases of domestic assets, especially Chinese government bonds, and its willingness to allow other countries to power domestic growth by accumulating renminbi reserves. This of course also means that the discussion is ultimately about China’s willingness to run large current account deficits to stabilize employment elsewhere. And yet most people on either side of the discussion would probably say that it will be many decade, if ever, before China permits this kind of access to its markets.

  1. The only countries not reluctant to import the savings of other countries are those who capital exporters shun. These are developing countries who have obvious investment needs but in whom investors are very reluctant to invest because of low credibility. The AIIB has not addressed how it will differ in the way in which it supplies the estimated $8 trillion in infrastructure that Asia needs to ensure that it will be more successful than the many national and multilateral development banks that have made the same and similar promises.

And while people like Mahbubani might claim that China’s “spectacular success with developing world-class infrastructure in record time” gives us reason to expect success for the AIIB, the evidence suggests no such thing. While Beijing certainly has in recent years lent aggressively to developing countries, and many analysts at first hailed what they called a novel approach and hard-headed business intelligence, every time a new country, or group of countries, first begins to invest abroad aggressively, we hear exactly the same sorts of things.

But every time, as soon as global economic conditions turn, we discover that this most recent wave of investment has been successful largely because of its willingness to misprice risk. Inevitably it is followed by defaults and a very dramatic change in approach. It is too early to tell if China will prove to be the sole deviation from historical precedence, but a very depressing article three weeks ago in the Financial Times suggests that when it comes to lending to developing countries, China’s experiences are turning out to be remarkably consistent with those of its predecessors. It is not easy to lend large amounts to developing countries and get repaid.

This is such a heavily politicized subject that for many people skepticism about the transformative power of the AIIB is not the result of better or worse logic, deeper or shallower knowledge of history, or a more or less faulty understanding of how the balance of payments works. It is simply the result of whether or not one is hostile to the idea of China’s rise.

In fact most of the debate about China in the last decade has been held hostage to this absurd idea, even after the past decade has proven conclusively that a certain amount of skepticism is not only sensible, but would have resulted in much better policies and a less dangerously imbalanced economy. We have plenty of history to suggest that we should be skeptical about the importance of the AIIB and the role it is likely to play.

It is always a good thing when more money is devoted to developing infrastructure in poor countries, but there is a long history of national and multilateral development institutions that have pledged to do a better job than their predecessors. They have all discovered, however, that this is never as easy as it seems. The AIIB has not explained exactly how it plans to channel money into developing countries while avoiding the two big problems its predecessors have always faced: how to ensure that the money is not wasted, and how to channel large amounts of debt financing without creating financial distress and non-repayment risk. For now, for all the excited chatter, the AIIB is an institution laden with symbolic value, and little else.


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  1. I will not discount option 1) so fast. At university, we had an exercise where we were given economic data on various economies and were asked to assign credit ratings to these economies. One pattern that emerged from our collective answers was a consistently higher rating for most emerging market economies and a consistently lower rating for most developed market economies. Our professor told us that this pattern had been evident in previous years as well.

    If we look at the credit spread (to treasuries) for most US$ denominated emerging market corporate/sovereign bonds, we’d see that more than 90% of that spread is ‘risk premium’ – i.e. if you go by historical experience on the actual probability of default and loss given default, credit spreads should be much lower for both emerging market corporate as well as sovereign bonds – this is especially true for US$ denominated bonds from Asia ex Japan.

    This risk premium is, in effect, a sort of ‘rent’ being earned by financiers and is the chief reason behind the argument that emerging credit should be part of an investor’s portfolio. Beijing can easily demand a lower risk premium through AIIB and still come out ‘money good’ even as it finances Asia’s infrastructure needs.

    In fact, if the AIIB has a greater control over projects it finances than most private bondholders do, it can demand an even lower risk premium for its financing.

    Option 1) also seems to be in line with Beijing’s ‘economic rebalancing’ efforts. I do not share your conclusion that Beijing will be adamantly hostile to current account deficits – these are part of the rebalancing effort and last I remember, China’s current account surplus has already reduced substantially from 2007 to 2015.

    • I don’t think this is about credit ratings, Gaurav, but on what grounds did your class justify giving higher ratings to developing countries and lower to developed countries than did the rating agencies, and why do you think your class has done a better job? And does your professor really think that the credit ratings for developing countries as recently as three or four years ago were too low and credit spreads too high? If so, he should go back and check how often in the past 100-200 years we have over-rated developing-country credit when commodity prices are high, only to discover our mistake after commodity prices have fallen.

      I would argue that credit rating agencies have tended to over-rate both developed and developing countries, although their track record with developing countries is worse when you consider that a rapid series of downgrades for developing countries is pretty common, which shouldn’t be the case if they had correctly assessed the risk in the first place. At least part of the reason credit rating agencies have tended historically to give developing countries too high ratings is, in my opinion, because the criteria they use do not adjust for economic volatility and do not include the structure of national balance sheets and the impact of balance sheet inversion on both the expansion and contraction phases of the economy. I’d be curious to know if your class, or any of the previous classes, focussed at all on the structure of balance sheets in their assessments.

      At any rate, and regardless of the ratings, there is no lack of evidence that developing countries have a poor track record of absorbing significant amounts of external debt. It is hard to find developing countries with large amounts of external debt who do not also have long histories of default and debt restructuring.

      I am not sure what you mean when you say 90% of the credit spread is a risk premium, or that “this risk premium is, in effect, a sort of ‘rent’ being earned by financiers and is the chief reason behind the argument that emerging credit should be part of an investor’s portfolio”. Actually all of the credit spread is either a risk premium or a liquidity premium, and this premium is the only reason for including it in a portfolio.

      Why does any of this explain why you think China wants to take on a significant amount of additional developing-country exposure? In the last few years Beijing has been forced to learn what every country seems to have to learn for itself when it first begins exporting capital to developing countries during the heady days of rapid growth and high commodity prices — it is always easy to lend in good times but it becomes very complicated to get repaid in bad times. I would go further. Developing-country loans involve very highly correlated exposure, and simple risk management would tell you that the last thing China should invest its reserves in is an asset whose performance is highly correlated with China’s economic performance.

      As for China’s changing attitude towards its current account surplus as it rebalances, I think you may want to check the numbers and perhaps dig a little deeper. The contraction in China’s current account surplus has already reversed, and in fact the past six months may well have been the biggest half-year surplus ever. What’s more, while China certainly wants to rebalance the economy, the contraction in China’s current account surplus from 2007 was clearly not a consequence of Chinese rebalancing. If it was, we should have seen the savings share of GDP contract, but as I am sure you know it continued rising right through 2012-13, after which it has stabilized at a much higher share than it was in 2007. The post-2007 contraction in China’s current account surplus mirrored that of every surplus country, suggesting, not surprisingly, that it had more to do with the collapse in international trade following the 2007-08 crisis.

      Finally, you should work through the rebalancing process. Given the political difficulty in changing the credit allocation process in favor of small and medium enterprises, Beijing must choose mainly between higher debt (a function of higher investment), higher unemployment, or higher consumption (driven primarily by transfers from the government sector to the household sector). The third option, of course, is the preferred option and it is the option that is addressed by nearly every one of the important Third Plenum reforms, but of course it is politically the most difficult and it serves as the key constraint.

      As you work through the impact of a declining current account surplus (remembering that it is by definition equal to the excess of savings over investment) you should be able to work out that for any given level of transfers, the faster the decline in the current account surplus, the starker Beijing’s tradeoff between higher unemployment and higher debt. I am pretty sure it will be a long time, if ever, that Beijing will welcome a significant decline in its current account surplus, let alone a current account deficit. This doesn’t mean the contraction in the surplus won’t happen. It almost certainly will, but not because Beijing is encouraging the process.

  2. Wow Michael. Very detailed and insightful! I agree. The AIIB will flop. The world is going to be looking for a cooperative solution by 2033, wherein all nations agree to cooperate in managing a one-world reserve currency unit to climb out from catastrophic contagion coming (actually underway with Austria deciding to default, repeating the genesis of WW1 dominoes Minsky Moment). The dollar will have to crash and burn first, but the dollar will be rising until late in 2017.

  3. I found your analysis extremely illuminating, as it was such an artful mixture of history, economics and a concise explanation of the underpinnings of currency exchange and asset accumulation and how that determines a country’s economic position vis-a-vis its competitors. Admittedly, I’m no financial expert or academic, but, for whatever it’s worth, I couldn’t just read such a thoughtful, insightful piece of work without commenting on how marvelous I thought that it was to its author. Or maybe it’s just that I miss Doug Noland’s Saturday issuance of his Credit Bubble Bulletin. So it was a joy to find that there was someone who, although perhaps not agreeing with Noland’s analysis, is as refreshing to read, because you, like him, speak finance with such an articulate voice: you do for finance what Asimov does for the layman when he discusses science: you make it accessible, and for that I thank you.

  4. Prof. Pettis,

    With regards to institutions that’re designed to develop infrastructure in less developed countries, is there any way institutions could be designed via equity financing? That way, those whose capital is at stake can have an actual say in how these projects are taken up while countries don’t run the risk of having underwater balance sheets. What about having convertible debt/equity financing?

    The current theory in economics and finance would say that equity financing is more risky because it’s more volatile, but the risk of ruin in equity is far less than with debt. I don’t agree because using debt financing can lead to underwater balance sheets so I don’t quite get the logic that equity is more risky. I don’t see why anyone would say volatility is a good indicator of risk and I find the idea that volatility as a good measure of risk to be based on a complete fabrication of knowledge.

    • Yes, there certainly should be much more equity financing, or at least financial structures that do not impose financial distress costs. I am struck by the fact that the best developing-country investment story in history was probably the US in the 19th Century, and while there certainly was a lot of external borrowing (and a number of external debt crises, including the very big one after 1837) , much of the capital Europe exported to the US came in the form of equity, including huge land purchases.

      But one of the sillier side effects of modern nationalism seems have been a revulsion towards foreign investment in the form of equity, and so capital flows to developing countries seem to be dominated by debt flows to a far greater extent than flows to US (and not just in the 19th Century but also in the 20th). I think this at least partly explains the greater likelihood of both “growth miracles” and of “lost decades”. Debt exacerbates both the expansionary and the contractionary phases of growth and typically results in much more difficult adjustments.

      But the AIIB, like all development banks, is unlikely to direct much capital in the form of equity, partly because it has to match its assets with its funding base, and partly because infrastructure investments usually do not generate enough direct profits, if any, to justify the investment. They have to be paid out of higher tax revenue, and so they typically take the form of external debt financing.

      • Yes, there certainly should be much more equity financing, or at least financial structures that do not impose financial distress costs. I am struck by the fact that the best developing-country investment story in history was probably the US in the 19th Century, and while there certainly was a lot of external borrowing (and a number of external debt crises, including the very big one after 1837) , much of the capital Europe exported to the US came in the form of equity, including huge land purchases.

        But one of the sillier side effects of modern nationalism seems have been a revulsion towards foreign investment in the form of equity…

        And precisely what changed from the 1800s to the 1900s is the invention of the ubiquitous central bank and its ability to backstop bank runs to borrow from the future to reduce risk of default in the near-term, while leading to systemic collapse (ETA 2018) in the long-term.

        Suvy, I agree with you that volatility just implies leverage per some model such as Black-Scholes. Leverage is not inherently evil, is absolutely necessary to maximize efficiency, and rather leverage ratios should instead be regulated by the free market given more transparency[1].

        However, equity is not the same asset class as debt, mainly because equity is not fungible whereas with a central bank backstop debt is fungible, but therein lies the systemic collapse end game downside.

        [1] Leverage is good; centralized regulation is bad
        Functioning economies require variable leverage
        Degrees-of-freedom and non-linear fitness require leverage in finance
        Delving a bit into systemic risk versus leverage
        (the last linked forum post is from a mathematician, the prior two are myself)

        • I do not think leverage is good, but regulation in finance rarely works. It exacerbates the booms and busts. The problem with government involvement is that they use leverage to their advantage at the expense of everyone else, but in the case of war, you use as much financing as you need to win and hopefully you can get enough loot from the spoils of victory to help pay the debts incurred.

          I agree with most of what you’ve attached, particularly the point of how any entity large enough to regulate the financial system on such a scale will be a much larger source of instability than virtually anything else.

          One point of disagreement is on the “enslavement” of the “vulnerable majority”. The “vulnerable majority” will naturally be in debt and do not underestimate the wealth that can come from households having access to finance even though they may appear “enslaved”. You have to have an internal way for people to invest in their families and in the families of a society for a society to function. What I have a problem with is transferring the debt from households to governments rather than destroying it, restructuring it, or somehow swapping it for equity.

          • Suvy, we don’t disagree on debt being useful. I refined my understanding on debt after contemplating the degrees-of-freedom and fitness point. And that is why I also think leverage is good. I think the problem with leverage is the lack of self-annealing in the free market due to top-down control over reserve ratios which via regulatory capture leads always to lack of transparency. The free market can’t anneal political collectivism. Well it does route around that Coasian barrier by collapsing the entire economy instead later once the default contagion forces to do so have accumulated. I think we are that juncture again in world history. Current ETA is collapse to accelerate over the period 2016 – 2019. Europe first, then USA in late 2017 after the strong dollar from the safe haven capital flows chokes off the USA economy. Asia will bottom first because Asia doesn’t have the burden of demographics, massive unfunded liabilities for boomers, and bankrupted pensions due to ZIRP.

  5. Singapore-based academic Kishore Mahbubani is no economist but an official Singapore PAP government apologist, and that is his official job.

  6. How would the US go about abandoning its’ role as the reserve currency country?
    I presume by restricting the supply of US dollars and restricting the use of US dollars. By issuing fewer US debt securities and implementing protectionist measures?

    Your point 3. re the excess of savings is interesting. I had assumed that at some point China would need to start to retain savings to pay for increased social welfare, old age pensions and healthcare if it does want to rebalance to a consumption led economy. Or that a consumption led economy would mean less saving on the part of the citizens of China. In that case setting up an international investment bank is a way to take control of others savings for uses you see fit when you no longer had such ready access to capital from your own savers.

    The point of savings is probably moot in the countries that China has in mind – the silk road countries and the string of pearls countries. I had assumed that Chinas’ strategy was to influence and invest in those countries on its’ borders as it has done in the imperial past. It could no doubt issue govt debt to finance any neighbouring country project, and insist on the purchase of Chinese building materials and the use of Chinese construction crews without the need for an investment bank.

    • There are a number of ways the US could do so, including simply imposing a tax on foreign purchases of government bonds, or by treating reserve accumulation as a form of trade intervention no different than imposing tariffs, and so subject to trade retaliation. Probably the best way would be for the US to support the use of some kind of modified SDRs as the main foreign currency reserve, and ensure that the dollar is no more than 20-25% of this SDR.

    • The use of the Silk Road predated the advent of deep-water navigation. Now, more trade goes through the Indian Ocean and around Southeast Asia to get into China. Transport costs by water are much cheaper than those by land because of basic physics (buoyancy and friction, or lack there of) and engineering (no infrastructure required). Large-scale investment in the Silk Road is a waste of resources. Small populations, vast spaces of land, harsh terrain, and high infrastructure maintenance costs make projects in the Silk Road economically destructive to invest in.

      • There is no such thing as the Silk Road, the Silk Road is a creation of admiring Historian Orientalists who tried to find a way to describe the varied methods and modes of trade across the Eurasian landmass. Cambridge has fine histories on South East, South, East, and Central Asian History that will tell in detail the transit of goods, and trade relations, between the many varied groups and peoples, and routes that have become fictionalized as the Silk Road.

  7. For those who might be interested, here is an article from “Emerging markets” that I recently read and that suggests just how difficult it is to come up with better ways of assessing risk in developing countries:

    China to turn off tap of easy credit to ‘errant’ LatAm states
    28/03/2015 | Elliot Wilson
    Chinese officials in Beijing are growing increasingly unhappy with the government’s policy of offering cheap loans without conditions to troubled Latin American states that might never be able to repay them.

    China faces a painful struggle to rein in its urge to lend cheap credit to friendly but troubled Latin American countries, as it prepares to set up a new global development bank that is likely to define the country’s role in the world for years to come. Beijing has spent the past decade channeling increasingly vast amounts of capital to Latin America in the form of everything from hard currency loans to central bank currency swaps to cash-for-oil deals.
    Venezuela alone has secured more than $45bn in Chinese loans since 2003, in return for oil used to fuel the mainland’s once red-hot economy. A further $10bn will be lent to Venezuela in the coming months, a precise blend of bilateral financing and funding for oilfield development projects. Yet China’s largesse — the use of valuable state reserves to support creaking Latin American economies with little hope of securing repayment on soft loans — is belatedly coming under fire back at home.
    Xiang Songzuo, chief economist at the state-run Agricultural Bank of China, said mainland financial experts were “complaining that the country places insufficient conditions on loans made to errant Latin American governments”. Loans to Latin America by Chinese state banks may have jumped to $22bn in 2014, from $13bn the previous year, according to data from the IADB. But that might be where the market tops out: the Chinese government has begun properly to ponder the importance of imposing the “right conditionalities” on loans extended to regional countries, Xiang said.
    Andrew Polk, senior economist at The Conference Board’s China Centre for Economics and Business in Beijing, pointed to rising irritation and anger in Beijing at the use of state money to underpin struggling but resource-rich Latin American states. “That sentiment wouldn’t be there but for the fact that these loans, extended to debtor countries struggling in the face of falling commodity and energy prices, simply aren’t going to be repaid. “So China is thinking ‘hang on, why are we propping up governments, why are we committing our precious financial resources to places that are unlikely ever to be able to settle their debts?’”
    Yet there could be a concealed blessing here — less for wheezing Latin American states like Venezuela and Argentina, than for China’s long-term aims to become, and to be treated as, a true global superpower. China’s efforts to create a China-led development lender, the Asian Infrastructure Investment Bank (AIIB), will create a sharp and direct challenge to the country’s current way of assessing the moral hazard of lending to a foreign state.
    China in recent years has become quietly aware of the value of its financial resources, and is slowly waking up to the need to husband its cash better. The AIIB, says the TCB’s Polk, will only accelerate that perception. “The point of multilaterals is to share risk, and China has taken on too much risk by lending to these Latin American countries. The country is increasingly tired of going it alone: tired of lending Venezuela $500m with no hope of getting that money back.”
    He added: “Lending to politically-empowered state interests or players at home [in China] is one thing. But once you become a serious, integral part of the global financial system, it really does matter” who you lend to “as if you are lending in hard currency, you’re going to want your cash back at some point.”

  8. Thanks for the brilliant blog post. I always look forward to your straightforward analysis on China, as most of the rhetoric gets kicked up pretty hard in the press, and it’s really nice to read a piece that is so well versed in economics and history.

    Helps me explain things to my high school economics class, plus I learn a ton from you. Thanks again.

  9. Do you know any good options pricing books that I could just pick up and learn on the fly?

    • This guy may be one to ask…not sure, http://optionsdr.hubpages.com/

      • I was looking for something more technical. I wanna start working on research about this stuff. Most people think advancements in mathematics usually come from physics, but that’s not the case. Advancements in mathematics usually come from finance or enterprise, not from academics and physicists. For example, the random walk model that these academics got a hold of in the past 40-60 years was actually a model that was used before the 1860’s and was published in 1863 by a broker. Then Louis Bachelier took it a bit further around 1900 or so. The only thing is that mathematicians don’t like publishing this stuff because they usually don’t know much about finance. So these math guys that get involved in this end up just focusing on making money rather than getting notoriety.

        Taleb actually talks about it all the time. I’d actually argue he’s a very good example, if you read his technical papers. Even he doesn’t publish in normal mathematical journals or where most academics do–although he is correct in his statements that academia in mathematics or the mathematical sciences isn’t bullshit. Mathematics forces rigor, which is what makes bullshittery in mathematics close to impossible. Mathematics can’t really be misinterpreted.

  10. biggestbrotherofthe mall

    I check this website from time to time and today found another thrilling read!

    I hope every politician in the whole wide world is reading this blog. They ought to.

    In less than 1200 words?
    What decreases the importance of the AIIB: institutional Inertia (it will take longer than you may think if it happens at all) , political caprice and whether decisions are perverted by advancing the interests of an elite above those of Mr Market(Warren Buffets term), and what happens during rebalancing – the ensuing shock will either be creative or destructive destruction – and even that depends upon whose side you are on.

  11. MIchael – brilliant as usual and it is startling how “alone” you are. You would think there would at least be some healthy dialogue on the identity based analysis you provide. I do have one criticism though, which maybe you purposefully avoid for to discuss this topic seems to allow most to simply delete and forget as seems fantastical. The four “cases” you provide in the last century – US, Germany, Russia and Japan centralized investment based growth models – had three very dire outcomes and not so for Japan. The US Germany and Russia either led to war and extreme civil unrest if not revolution, or near catastrophic nuclear war and its complete annihilation as a country for Russia. Japan “ate” the Lost Decades as they were already occupied militarily by the USA so could no revert to war or civil war. A strong case can be made Germany and the US ended with World War II, if not the near civil war in the USA during the Great Depression. The point I am making is that your thoughts are especially urgent as the dedication to investment based growth by China to date is perhaps the most intense application of this model of any in the last century. Perhaps Germany had more on the line in terms of survival, but that is debatable. This means your feared outcome in terms of the “rebalancing” are not just tough times for China but likely the setting that has risk levels that World War will break out to a degree not experienced since 1938. That makes your thoughts of vital concern for the national and international security concerns of every significant nation. Perhaps if it is seen in this light it moves from “one-offs” brilliant blog posting and occasional essays you do to being a key issue for all – at least to prove your framing is wrong.

  12. biggestbrotherofthe mall

    And I guess if brevity is key, you can just use words that elsewhere you have described in more detail – like Rebalancing.

  13. The advantages of the Asian Infrastructure Investment Bank (AIIB) to borrowers is that China has been much more willing to forgo the conditionality of the Bretton Woods institutions.

    China, in its desperation to vent its surplus savings has not done much due diligence on the creditworthiness of borrowers, although that could change. The Opera Bouffe government of Venezuela, the recipient of so much ill-advised Chinese lending, will probably implode spectacularly soon. It will be a real chuckle to watch China show up at the Paris Club and try to collect its odious debt. The Breton Woods institutions have a legitimate concern about the damage such reckless lending might do and probably wish to preserve their positions as senior creditors. You can be sure that after the AIIB makes every old mistake of the old imperialists, China will insist that the AIIB receive equal treatment with creditors who learned by their own mistakes 30 years ago. But China must repeat those mistakes in order to learn. As Bismark said, “Only a fool learns from his own mistakes. The wise man learns from the mistakes of others.”

    Maybe more important, Bobby Kennedy Jr and the National Resources Defense Council will have no influence on the AIIB. If the poor of Asia want grid electricity powered by massive hydropower projects or coal-fired plants, the AIIB will provide with little or no concern for the environmental movements of Europe or the U.S.

    • This is a joke right, and then you are going to discuss tied aid, etc….
      The interesting thing about the AIIB is whether and to what degree other countries contractors, and manufacturers, and not merely investors, or receiver countries get to participate in the moneys expended.

      Quite some time ago, long before the AIIB has risen as a topic, I postulated on this blog, that as growth slowed, China would seek a way to rationalize not merely the excess capacity that they had built prior to the 2007-2006 global crisis, but even more so, for what they have done in the aftermath, then Michael and other commentators remind that these sectors, are the power centers of the elite, where significant rents can be gained, which is why reform will be slow. But inevitably these sectos are the remnants, the relics of the industrialization drive, where the real meat and potatoes is a multi-point consumption driven economy; not an economy too largely compreised of the sectors that drive industrialization, because India, and Kenya, and Nogeria will be building these, as Chile, Brazil, Argentina, Germany, the UK and the US had before.

      So, the real question is if the AIIB is merely a point to support elite interests where their power bases lie, because they are reluctant to move on, and to give up some of the power which they would inevitably have to.

      I think the AIIB is likely counter-productive to reform in China. But I think for all the attention, it will be interesting to see how countries contractors will compete for awarded contracts. Especially as the Chinese are absolutely everywhere bidding below cost, with their masses of workers in ramshackle housing; from MENA to Africa and further afield.

  14. No, there is a third course for China and the one I believe they wish to take.

    It is to encourage private sector companies or quasi state companies to go out across the world and buy real assets, strategic assets, shares, infrastructure assets – ownerships – and in return let foreigners acquire low yielding Chinese bonds and Chinese cash.

    And this is quite compatible with continuing large trade surpluses.

    The deal is – we make all your manufactured goods, in return we own stuff (and send holidaymakers).

    This is not a terrible deal all round – but it’s clear which country is put in a vulnerable situation. And which country is not.

    • That is an unrealistic plan, because nobody really wants Chinese cash (at least, they don’t want it anything like as much as they want USD, Euros and their own local currencies) for the reasons clearly explained in the above article.

      PRC goon: “Hey, my partners and I want to buy a big fancy office building in London to get loads of mianzi and build up assets in your country because we don’t trust our own government not to throw us in prison at short notice and rob our stuff”
      *London property guy’s eyes briefly turn to Dollar signs, and make a ka-ching noise*
      London property guy: “Naturally sir, please look at our brochures…”
      *London guy flatters PRC goon for a while, agrees that China is indeed an ancient culture and soon, a price is agreed upon*
      PRC goon: “Okay, so time to arrange the details of the financing”
      *London property guy thinks about upgrading his yacht*
      PRC goon: “We have only one condition: we want to pay in RMB”
      London Property Guy: “Hahaha! Who ever said the Chinese don’t have much of a sense of humour?”

  15. biggestbrotherofthe mall

    Ken Today, and tomorrow i hope, if productivity and secular stagnation increase due to technology are the new enemies in the west, so much so that there BIG government may be a good thing, then might the relatively inefficient investment in green infrastructure over say coal fired plants may be the answer? I mean why did a ditch and fill it, or erode a mountain so a train doesnt have to drive up hill, when you can build green infrastructure?

    • @Biggestbrotherofthe Mall,

      I agree with your macroeconomic point (which may apply even more to China than the West), that countries suffering from “secular stagnation” (excess savings) can vent them abroad (the old imperialist solution). China’s old, new imperialism was buying US$ reserves. That’s not working anymore (the parasite risks killing its host). Lending money to Venezuela won’t work (and the Monroe Doctrine precludes sending gunboats to collect). The AIIB is the newest Chinese imperialism. Whatever they do will lose money.

      So as you pointed out, Green Energy is a great way to flush money down the toilet. Don’t get me wrong, if you have never had electricity at all, a solar panel and car battery is a great way to power cell phones, small computers so that kids can study, LED bulbs so that women can stay up late and sew and gossip, and men can stay up to watch the local version of the Tonight Show (best method of population control). But solar panels will NOT get you serious refrigeration, running water, or industrial power.

      Even in the West, “green energy” only makes sense if it is backed up and subsidized by the grid. You can pay the subsidies from some other source, but you still need the fossil fuel back up when the wind doesn’t blow and the sun don’t shine. That’s why no one goes off the grid when they get solar panels. Rich people building vacation homes off the grid in remote Montana either pay huge connection fees or use diesel generators. RFK Jr is connected to the grid. What is worse is when the grid is used in a back up capacity it is just as expensive and may use almost as much fuel (back-up generators running stop-and-go are very energy inefficient). That’s why Germany is using more coal http://www.reuters.com/article/2014/11/11/germany-sweden-vattenfall-idUSL6N0T112620141111. RFK Jr is happy to claim that wind and solar can do it, but there is no such prototype of an appropriate, all-renewable, green grid. Let’s mandate that RFK Jr build one in a remote village in Bangladesh that doesn’t have a grid connection. Grid electricity is what really moves you into the emerging middle class and poor countries want it even if Bobby Kennedy won’t let them have what he has.

      Oh, and I forgot, the AIIB will be happy to finance Chinese-designed nukes. That will light the lamps of Myanmar!

      • Another one of the reason’s Germany is using so much coal is because of the lack of cloud cover on the North European Plain. They increased their solar capacity at least 4-5-fold, but they don’t even get close to that in terms of power generation.

      • I don’t necessarily disagree with the idea that you need the grid to subsidize power, but please recognize that oil and nuclear are also heavily subsidized. No insurer will cover nuclear without government backing, and oil is de facto subsidized by the US military (although, perhaps, this will eventually change if Pettis’ predictions are correct that the US will have to withdraw or substantially reduce its commitments going forward) .

        It would be interesting to work out what the unsubsidized price of energy truly is. I suspect that the numbers would be mind boggling.

        You can pay the subsidies from some other source, but you still need the fossil fuel back up when the wind doesn’t blow and the sun don’t shine.

        Or you need very good developments in ultracapacitors and battery storage. These developments are coming fairly quickly, although it will take quite a qhile for them to be cheap and widely available.

        • There’s a difference between the US reducing its commitments and no longer protecting any trade. The US is already yanking out most of its geopolitical presence, but I don’t think the Americans just do as they please cuz there’re way too many tail risks.

          If the US did stop protecting the world’s oceans, transport and security costs would spike. There are entire portions of the world that import >50% of their calories with regimes heavily reliant on high commodity prices to sustain their governments. If the US withdrew completely, you’d see massive population corrections in many of these regions (I think they’re likely regardless, but I don’t know when). There will be spillover effects. I suspect if things get too unstable, European governments start imposing stability to extract natural resources they need. I think we’re likely to see a return to colonialism or imperialism.

        • Claire,

          Subsidies are a complicated issue. There are studies that come up with large figures for oil subsidies based on redefining the word “subsidy.” The IMF has done that by redefining subsidies as untaxed externalities, but that makes more objective economists gag. But there were no subsidies when Watt’s steam engine displaced windmills, sails, and horses. Fossil fuels did the job better and drove the industrial revolution — sans subsidies.

          You can make anything economic, including digging holes and filling them up again, if someone can pay enough money. However, if intermittent energy sources only make sense if they are subsidized by the utility, but bankrupt the utility, that just won’t work.

          Large, grid-scale storage has been a goal of the utility industry since Thomas Edison. Until now, all they have is pumped hydro. The fact that windmill enthusiasts suddenly want it won’t drive technological progress any faster. To eliminate fossil-fueled backup of intermittent generation would take something still in the science fiction stage (why not skip directly to dilithium crystals in that case?). It’s one thing to store power for a few days at great expense, but to store it for months is on no one’s radar. California is proposing a storage mandate. It would marginally reduce the carbon penalty if integrating renewables into the grid by storing power during the day.


          but the mandate is a little baffling because 1.3 megawatts would produce the power of a small generator (a good-sized nuke has a generating capacity over 1000 MW). But gigawatts aren’t even a quantity of electricity. Your electric bill comes in kilowatt HOURS. The California mandate will help back up the grid when the sun ducks behind a cloud for a few minutes.

          When someone comes up with a feasible storage system that would allow the elimination of fossil-fuel back up, let’s celebrate it and build it. Until then, it’s hypocritical of the West to impose something that doesn’t work on poor countries.

          • I must correct myself. The California mandate is for 1.3 gigawatts: the size of a large nuclear power plant. Nonetheless, the mandate still will not allow solar and wind to become a reliable alternative to fossil-fuel based grid power since it will only store power for a very short term.

          • The fall in storage costs seems to be happening and it’s happening sharply. The study is for electric vehicles, but this has more potential in solar energy because all you have to do isn’t to drop the mean cost of the storage, but the upper bound to drop enough. I don’t think this is useful for vehicles, but it is in terms of independence from the grid.

          • Suvy,

            I am a great believer in electric vehicles. Within 10 years I expect to see a combination of pure battery-electric and plug-in hybrids reach a price performance point that make conventional internal combustion engine (ICE) vehicles obsolete. Because electric motors are four times as energy efficient as ICE motors, even when powered by relatively inefficient coal generated power, they produce marginally less CO2.

            But the economics of storage for home solar are very different. You can’t just charge the batteries at will. Solar is intermittent and sometimes not available for charging for weeks or months in some areas (places with long winters or monsoons). That’s why no one buys solar and goes off the grid. That’s why there are battery powered UPS systems to keep your computer going for an hour until you shut it down, but if you need to keep the air conditioning and lights on, you buy a diesel-powered back-up generator. Cut the price of li-on batteries 75% and the Chevy Volt is probably competitive on price. But cut the cost of Tesla’s Powerwall system 75% (from $3500 per 10 Kwh) it’s still going to cost a minimum of $175K to buy 2000 Kwh to get you through the winter in Buffalo NY.

            Yes, the utilities are buying some of these systems. In part, because they are forced to and in part because even very short-term storage helps reduce the incredible expense of integrating unreliable wind and solar into the grid. Solar only makes sense if it is backed up by the grid, but backing up the grid may potentially bankrupt the utilities — taking us back to square one. Besides, when utilities back up intermittent power sources with fossil fuels, they generate lots more CO2 and that defeats the environmental benefits of solar and wind.

            However, long before backing up solar makes sense, storing surplus nighttime power from a nuke to use during the peak afternoon period will be splendidly economic.

            But when very rich people buy expensive retreats off the grid in Montana and power them will solar and batteries rather than diesel, I’ll reconsider. Until then, it is hypocritical to insist that poor countries like Bangladesh forgo conventional electricity.

          • You have to consider the amortisation as well, currently the consumer lion have 500 cycle life, it means 0.2$/kwh lifetime cost, a bit more than the price of electricity, if we consider $/kwh.

            Additional you have to consider the cycling (charge/discharge) loss, that should be in the 20-30% range.

            So you have an insanely costly PV installation,and you burn 30% of the electricity from that to cyce the lion batteries.

          • Ken Today and M,

            What do you guys know about the risks of nuclear power? In particular, I’m interested in your take towards the new Thorium reactors.

            I’m still worried about nuclear, primarily in certain places that lie on geological fault lines (ex. Japan, California, etc.). The problem, as it seems to me, is that the total amount of energy generated by nuclear power is huge (we only capture <1% of it, if I remember correctly).

          • Suvy,

            Because of the long design, regulatory approval, and construction lead times, who knows when we will see the first thorium reactor. I’m not a nuclear engineer. There are three basic risks with nukes: meltdown, proliferation, and waste disposal. Supposedly thorium is much better at the latter two, although there are those who claim that fissile material can be diverted from the thorium cycle. Almost all the current reactors are second generation. Those being built today are third or fourth-generation and they are supposedly much safer. All of these risks are both real and subject to exaggeration by RFK Jr. and the anti-vaxers.

          • The discussion about the nuclear fuel cycles is a bit off-topic on this blog 🙂

            I will make a nice big description about the thorium cycle in my blog, but in a nutshell :
            Thorium means breeding and closed fuel cycle, that means reprocessing capability for the given country, and that means capability to make nuclear bomb material in short period of time, with low chance of discovery.
            So no, the US won’t support this kind of research.Ever.
            Even a low pressure , high safety reactor will be considered as non-proliferation risk. That kills majority of the low cost – low risk reactor designs.

        • Oil and Nuclear are not subsidized- I price energy everyday. That is ridiculous. They are tortured industries with high levels of regulation and interference. A free-market for oil exploration, seperable mineral rights for landowners and engineers being allowed to build a nuclear reactor with technology newer that 50 years old would cause the price of energy to be well below half of current prices.

          The US military intervention in the middle east has on balance increased the cost of oil. OPEC and Inefficient National Oil Companies (NOCs) could not exist in a competitive world of oil exploration. You can easily compare to more competitive global industries in mining and agriculture.

          Lastly, insurance has always arisen from private actors- and you can buy insurance for anything- please dream up the most exotic unusual risk that you can think of, and I promise you I can get a price quote for it. It is a highly flexible marketplace.

          • Well, you can get insurance for MOST “exotic unusual risk”, but not all. There are some domains insurance companies simply will not touch (including GMOs BTW).

          • … everything is insurable … it’s just a question of premium….

          • Not everything is insurable, regardless of the premium. In cases with systemic risk, it doesn’t matter what the premium is. A good insurer is never gonna give you insurance for it, period, if the risk is systemic. They have no way to pay if something goes wrong because insurance relies on the diversification of risk. If risk can’t be diversified, there’s no effective way to insure against the risk in question.

  16. Prof. – What is the chance the AIIB is not a good samaritan effort to join the world’s financial community and to project Chinese soft power? but instead an off balance sheet vehicle to dump poorly performing international loans into a “bad bank”, Is Xi trying to join the international community and participate in a positive way? Or could there be something nefarious in the offering, since it was announced with so little fanfare.

    I have no insight in China’s political machine, and no ax to grind, but it always seems like a good question to ask the incentives of anybody setting up such a structure… particularly without a crisis in front of it, and the world awash in capital.

  17. MP: “Either the rise in RMB reserves would have to be matched with an increase in PBoC holdings of advanced country reserves, mainly US dollar and perhaps euro bonds (other advanced countries are too small to matter), or if Beijing wanted to stop accumulating dollars and euro, it would have to be matched with an accumulation of government bonds, or even infrastructure loans, in Malaysian ringit, Brazilian reais, Mexican pesos, Indian rupees, and other developing-country government bonds.”

    Instead of increasing holdings of foreign debt why couldn’t China purchase real productive assets of other countries, for example: Natural resources, farm land, buildings, factories, companies, corporate stock. It seems that perhaps they have already started doing this.

    • “why couldn’t China purchase real productive assets of other countries, for example: Natural resources, farm land, buildings, factories, companies, corporate stock. It seems that perhaps they have already started doing this.”

      You are right, they can purchase real, productive assets. That is what China’s Sovereign Wealth Fund, the China Investment Corporation, does. China’s state-owned banks are doing the same thing. Earning a positive return on those assets is the trick. They are just not good investors and there is no reason to expect that they will be much better at finding good investments than more experienced Western institutions who are really pretty bad over the long run. And even with a limited track record, Chinese investors manage to tick off the locals. (China repeats every insensitive flub or screw-up made by Westerners.)

      The other problem is that these investments would be illiquid and cannot hedge against a sudden redemption of RMB reserves. This means that the shock would be transferred directly to China’s real and/or financial sector. This would give China some of the burdens of issuing a reserve currency as well as the useless prestige.

  18. Re: “…much-hyped initiatives aimed at transforming the global trading regime but that now languish in obscurity, known primarily for absorbing university graduates from very prestigious schools who have failed their other job interviews.” Ouch. Do other readers know what institutions he is alluding to?

  19. biggestbrotherofthe mall

    The ditch digging and filling would involve wind turbines and smart grid world over. Pity the birds of prey being sliced and diced. Wonder what consequence that would on the ecosystem.


    And I am with those who think that as nuclear is inevitable part of mix nuclear now is better than nuclear after climate change.

    But yes doesnt solve the China/US/Emerging economy balance of power/trade reserve currency status, where to put the surplus, what will happen to the bond market, rebalancing conclusion. Its great to come to this blog to remind myself that even it is not exactly kumbya-all-in-together then we should be aware that macro economics is all about trade and balance and relationships including that of parasite/host or slave/master, driver/miss daisy, pilot-fish/fish….

    And as an aside I believe I heard once that Teddy Kennedy greenness stopped short of building off shore Wind Turbines in front the family compound in Massachusetts!

  20. Great post.

    I’m not quite sure the AIIB will fail though. I think it will succeed. It will not live up to the hype. It will lend money to projects similar to the way the ADB and friends do. There is no secret sauce. The primary contractors on the projects will be Chinese. Morsels will be distributed to companies from the UK and other AIIB participants. There will be defaults.

    All this does not mean failure. Will it matter more than the IMF? Perhaps not. But if Beijing wants to try, more power to them.

  21. Thank you, Mr. Pettis for giving a “motive” for Britan’s actions (to gain an advantage over Germany); confirming your previous statements on why China would not wish to accept the “exorbitant burden” of becoming a reserve currency; and researching and summarizing the relevant historical precedents (I didn’t know that a fiat global reserve dominant currency has never existed before in history; and doesn’t immediately correlate with the then largest economy). Your insights and observations are not “mainstream” and therefore very much appreciated by me.

    My view is similar to the Financial Times article you referenced; and that is that China is “exporting” its “bridge to nowhere” and “ghost cities” massive infrastructure investments to emerging economies (exporting its “misallocation” of resources). As you have pointed out, China does not have a strong “credit evaluation” culture.

    Here is where I think the AIIB will have “partnership” fights: Will the partners in AIIB share (prorata) in the engineering and constructions contracts that are being financed by the AIIB? This is in addition to question that the Financial Times asks: Will the partners in AIIB approve loans made in part to promote the political agenda and reach of China (that may not make “efficient” economic sense)?

    I think not. Time will tell.

  22. Fantastic blog entry. Indeed, I was very interested in your view Professor Pettis, since your views are always so much more nuanced and informed that some of the others in regard to the Chinese economy.

    However, it seems to me from the perspective of the USA that we are foolish not to join such initiatives, at the very least as an observer and quiet supporter. What do you think of Ambrose Evans Pritchard’s view of things?


    Do you agree that politically it would make more sense for the USA to actually join and tacitly support such gestures? I agree with you that this initiative is not likely to work, but isn’t there something to be said for being “in the tent”?

    I fear that Evans Pritchard is correct – the USA is blundering around a great deal here in Asia, with mixed signals all around.

  23. Another excellent post Michael. Perhaps to reinforce your argument, about the desire of others to have their currency held as reserves,
    you could have mentioned Japan’s reaction to China buying a large share of Yen.

  24. Professor Pettis, you wrote: “There are a number of ways the US could do so, including simply imposing a tax on foreign purchases of government bonds, or by treating reserve accumulation as a form of trade intervention no different than imposing tariffs, and so subject to trade retaliation. Probably the best way would be for the US to support the use of some kind of modified SDRs as the main foreign currency reserve, and ensure that the dollar is no more than 20-25% of this SDR.”

    My question is, why do you think the U.S. does not do this, which is so obviously in its favor? Is it dogmatic adherence to free trade orthodoxy, old habits die hard? I understand Republican reluctance as that party is rabidly anti-tax, anti-interventionist regardless of the cost or logic as almost a religion, but Democratic refusal, i.e., Obama, confounds me. It confuses me because I think the politician in the U.S. that comes out for this would be widely approved and supported. I know I am asking for your political opinion, but what do you think holds the U.S. back from doing this? Thanks.

    • I’m just as interested as you in hearing what Michael has to say concerning this question.

      So far as I know, the primary reason the US has done this since the NAFTA days, and probably before, is that big US companies have wanted to manufacture abroad and import the manufactured products back to the US, and did not want tariffs to be applied to the round-tripped products. It has created a situation where there is a (big) net cost to the country in terms of unemployment, but a huge gain to the relatively small group of very large and profitable companies (Apple is the most obvious at present; HP and its printer division was one of the drivers back in the NAFTA days) who wanted to shift much of their operation abroad. On top of this, in the early days of China’s opening up (I’m thinking of the 90s) the high tech community in the US — Motorola for example — was sure that they would end up holding a whopping big share of China’s market. It was a big miscalculation in hindsight, but they were no doubt telling Congress etc. that they were going to bring home enormous revenues. And they have, in many cases, but when you net it out it looks like a loss overall to the US, to me.

      • Luddy, very astute analysis. I agree with you, but it is depressing to come to terms with the fact that these multinationals are controlling our policy in this regard even when it is a huge net loss for the country’s economy and they know this but don’t care. A sense of regulatory capture if there ever was one. Even more disappointing is Obama’s total failure to address this. Either he has drank the free-trade Kool-Aid as well or he is just another shill for these companies. This paper sums it up perfectly: http://www.epi.org/publication/china-trade-outsourcing-and-jobs/.

        “Gagnon recommends that the rules of the WTO be changed to allow countries to impose tariffs on imports from currency manipulators. Since changing the rules of the WTO requires unanimous consent of all members, Gagnon observes that “the main targets of currency manipulation—the United States and euro area—may have to play tough. One strategy would be to tax or otherwise restrict purchases of U.S. and euro area financial assets by currency manipulators” (Gagnon 2012a, 1). Such financial taxes would be “consistent with international law” (Gagnon 2011).

        In addition, Congress can help end currency manipulation by passing pending legislation (H.R. 1276 and S. 1114) that would allow the Commerce Department to treat currency manipulation as a subsidy in countervailing duty trade cases (OpenCongress.org 2014a and 2014b). In addition, the president and federal agencies possess the tools needed to end currency manipulation with the stroke of a pen (Scott 2013b). The Treasury and Federal Reserve have the authority needed to offset purchases of foreign assets by foreign governments by engaging in countervailing currency intervention (Bergsten and Gagnon 2012). By taking these steps, the U.S. government could make efforts by foreign governments to manipulate their currencies costly and/or ineffective.”http://www.epi.org/publication/china-trade-outsourcing-and-jobs/

        It seems we will never do this though and we will continue to allow ourselves to be victimized even though we have easy solutions…

        • Right. The United States has not come to terms with the fact that it’s big companies are not “American” companies in any meaningful sense any more. We (Americans) are very sensitive to the notion of foreign companies influencing policy — even though that happens more that we’d probably like to admit. But a big high tech company that earns and spends most of its revenue abroad isn’t very much like the “old” American companies like AT&T, etc., which were overwhelmingly local in their operations. Hence Apple’s faux pas that they have no obligation to create jobs in the US. That kind of talk grates people who realize that enormous public R&D expense has gone into creating the technology that Apple sells.

          • Yes, and we are sticking it to ourselves again with this TPP trade deal, which doesn’t appear, thus far, to have any real, actual (as opposed to vague verbal goals) protections against currency manipulation and other stealth mercantilist practices. I don’t see anything good coming from it, at least for workers in the USA, and particularly our manufacturing and engineering economy.

          • Well, in all this, ironically from the standpoint of Liberal Cosmopolitanists, and contrary to the notions that may have supported these policies of nationalistically minded Westphalian Territorialists, or at least more true Liberals (in the enlightenment, not modern pop-cultural sense), this has been done to pursue what is supported by the US as its main foreign policy goal, that is continued advancement of as market based as possible global system, which had fed industrialization and movement of countries toward advanced country status, while advancing humanity across all measures and indices of development; from caloric intake, to increased birthrates, lessened child mortality, numbers of years of schooling, and per capita GDp, etc and ad infinitum.

            The interesting thing is that it is in success that we meet these challenges, and it requires maturity and change on other countries parts to ensure that this process can continue, for others. Because a horse has won the triple crown more times consecutively in interesting then ever could have been imagined previously, and because new factors weigh upon notions of success or doing well, succeeding in this changed environment, does not lessen the success that has been had behind all imagination.

            It seems to me that the excesses have driven structures that can not be maintained, and may be addressed rather soon, because of what has been given up to provide this benefit to an ungrateful world, that largely misunderstands what has been provided due to materially driven blinders. Soon after the impetus is withdrawn, there will be added impetus from those very parties who merely misunderstood or hoped to use ideological weapons to advance in the space opened of the inability to structures to hold in the system. US – Wages, Social Safety, Price of Goods, Rising Income Inequality, Rising Ages, Demographics where wealth is concentrated, and short term dysfunction in these which will see a reversal…globally, many parties having been able for decades to siphon off demand, others siphoning far too much under a constrained period of time, still other important players wanting that added impetus for industrialization, where previous parties, demand drivers, from Europe to East Asia, have not moved and made room to accommodate that necessary function for global cooperation and cohesion, as people keep sneezing, ah, the US, as the host reminds the XXXX that YYYY, once again.

  25. Michael mentions a “bitter dispute” between the US and Japan over the Asian Development Bank. I know of no “bitter dispute.” In fact, the establishment of ADB went ahead quite smoothly after President Johnson, in a speech in Balitmore in April 1965, announced support for the ADB. Johnson also announced that he would support a $1 billion contribution to the Bank. This does not seem to indicate any “bitter dispute”.

  26. Lost in technicalities, the professor is clearly missing the big picture. What this AIIB affair really showed is that US is fast losing trust and influence. The most important commodities for anyone wishing to have a reserve currency. Not even its closest allies listen to what Washington says anymore. US wanted to isolate both Russia and China, it ended up isolated itself.

    Professor repeatly writes about China striving for “dominant” reserve currency. That´s a nonsense. Unlike US, China doesnt seek a dominant reserve status for yuan. China wants a multicurrency reserve system, exactly the world we´re heading to.

    And finally, the professor claims that the only way how yuan can become a reserve currency is for China to run large trade or current account deficits. That´s an obvious misconception. Eurozone have never run large CA deficits, yet 26-28% of reserves are held in euros. PBOC can simply just print trillions of yuans and put it in the hands of foreigners as credit, provided by chinese commercial banks. Just what FED or ECB are doing.

    • If China wants a multicurrency reserve system there is nothing stopping them from doing it now. The USD is used as a reserve currency not because of any ordination but due to the factors the Professor has explained. As it is now, as it was when the majority of accumulation occurred, China is long USD and short RMB. The reason that an SDR type reserve currency appeals to China is that would allow them to (at least partially) unwind that ridiculous position and mitigate the loss.

    • biggestbrotherofthe mall

      As I see it this is not (as yet) about the US losing trust and influence particularly as there is no one better to trust with China is slowing and suffering from dramatic asset misallocation due to years of cronyism, Europe long-suffering a mismatch between centralized currency status and decentralized political power and a relatively immobile workforce, and India, now outpacing Chinas growth and having the added advantage of wider English literacy and a democracy, still has a long way to go – but that there are pluses and minuses to being the country with the reserve currency. It benefits from a lower cost of borrowing because countries like china buy US Treasuries but at the same time it raises the demand (for dollars ) which makes exporting more costly and so decreases exports and so yes involves usually a current account deficit. Europes CAD is a mix of Germanys huge surplus and the deficits of the rest. Not sure on the stats.

    • Lintner

      Not really, the US, and it likely thought other partners, with the Euro’s normally huffing and puffing the loudest over these matters, especially considering their dominant role in the IMF, ironically, took the long-term perspective and reflection, a continuity for transparency and governance.

      China says it wants this or that, because it can, say that, and hope to influence, apparently people like you, I guess, China can say all it wants, now about SDR, but it’s currency, with its closed capital, debt and asset markets, and control of the currency and the entire financial system for the benefit of party elites and the needs of the central government, is not a likely candidate to be supported by global central banks or international investors but for those on a short term and highly speculative basis. As to China can just print money, like the FED and ECB. Uhmmmmm….on par, China has printed far more money these last ten years than even the ECB or FED (likely even both combined printing of the last decade in the last few years by China) despite having a much smaller GDP and not laying the foundation for transiting the middle income trap, which seems to have altered in the minds of reviewers, ie what that is, to suit the possibility that China still can do so.

  27. It will join the long list of much-hyped initiatives aimed at transforming the global trading regime but that now languish in obscurity, known primarily for absorbing university graduates from very prestigious schools who have failed their other job interviews.

    So first off, I just want to tell you that as much as I enjoy reading almost everything you write, this is by far my favorite passage. It’s too bad you used it in your blog instead of saving it for the back cover/inside jacket of your next book.

    Only the huge gift of the Marshall Plan was able temporarily to resolve it in Europe. China can replicate the US of the 1940s and 1950s, in other words, only if it were able to make as large a gift, even though it is much poorer than most countries and represents about one-third of the share of global GDP that the US represented.

    I’m not completely sure I understand this point exactly. I don’t believe that China has ever expressed much interest in global domination. I thought that it intended the AIIB as a way to influence (and perhaps temporarily stablilize, if necessary) small neighbouring Asian countries–or at least give such countries an alternative option to the IMF. In other words, I don’t believe that China has any intention of bailing out all of Europe, but it would be interested in countries such as (for example) Pakistan, Indonesia, Bhutan, Nepal, etc. For these countries, it may well be willing to run indefinite current account deficits, and (I think?) China should be big enough to be able to do so. Am I wrong on this point?

    Having read your post, am I also wrong in concluding that the most likely winner from the development of the AIIB would be the countries who can now play the AIIB off against the IMF when negotiating packages?

    • I don’t know how many countries actually want to dominate the world, including the US. I think they usually have trade commitments or something else of the kind that basically forces them to intervene. Take the modern day US as an example, where the country did not (and still doesn’t) want to be an empire, but when you have trade on both the Atlantic and Pacific Oceans, you have no choice. If someone starts disrupting the movement of your trade ships, you have to intervene. Of course, this is exactly how US foreign entanglement in other countries started. Empires were designed for trade; nation-states were designed for war.

      If you read The Federalist Papers, Alexander Hamilton references the United States as an empire (several times across different essays). Hamilton also suggested the US expand its frontier towards the Western Americas to make sure the country secures the Greater Mississippi Basin. The US, until recently, really didn’t have the strict kind of borders that you see everywhere else. Instead, it had something much closer to a frontier that it tried to expand. If you look at the political and geopolitical structure of a country, many will tell you it has the structure of a nation-state democracy. If you actually look at its origins and the way it was set up (and look at the roots of the republic), you’ll see that it’s actually structured as a old-school multiethnic empire–a throwback to the past. The design of the American Republic is designed to protect individual sovereignty of state/local governments over the principle of equal representation in every single part of the government. Calling the US a democracy is a complete joke and a horrible mistake; it’s no such thing of the kind. I actually look through it here.

      Similarly, China is closer to an empire than it is to a nation-state. China imports 2/3rds of its energy with most of that energy coming through trade routes around the Indian Ocean and around Southeast Asia (ditto for Japan).

      What’s my point here? Just because you express no interest in global domination or in global affairs doesn’t mean that they don’t matter and it sure as hell doesn’t prevent the growth or contraction of empire. As long as you have trade, you will have empire.

      Does this mean we have to see the kind of imperialism that we saw when these European nation-states took over the world? No and I hope we don’t see it ever again. These nation-states looked to exploit look, not to create trade or commerce. If you don’t believe me, look at the example of France and the Louisiana territory vs Haiti. Napoleon, when he sold the Louisiana territory to the US, thought Haiti was gonna bring him much more money, but all of the money Haiti brought in was from labor intensive harvesting of sugar. It was built on extraction and loot. The Greater Mississippi Basin holds the world’s largest navigable waterway that’s all integrated into a network overlaid on the world’s most arable land. It’s much easier to develop and had way more economic productivity potential than Haiti, as Alexander Hamilton duly noted, but France thought the Louisiana territory was a waste because there was little loot to be taken from there. Unfortunately, Napoleon didn’t recognize the difference between genuine investment in productive capacity that comes from integration of diverse regions across trade networks vs. just taking loot (rent extraction). The former develops capital; the latter destroys it. The former is sustainable and brings about sustainable wealth. The latter is unsustainable and brings about temporary riches.

      Sorry for the rant on what seems like a tangent, but I think that’s a very important point which seems to get glossed over.

      • Well said Suvy, excellent. But you realize with Hamilton, empire, as the Colonies as States joined together would be empire-esque, and this before taking the continent, and regardless of that for the post-modern critics who just can seem to see facts free of post-modern critique, for the sake of a fact, merely, rather than a Sartrean despair at the world found around us.

      • A bit off-topic (and late) but have you read this recent article from Taleb in Foreign Affairs?


        Taleb’s comments on France’s potential for going to the far right and his analysis of China seem very much in synch with Pettis’ views (as does his view that high debt levels cause fragility, although Pettis doesn’t use the same term).

        Anyway, it’s not a bad read, although Pettis’ balance-sheet approach seems a lot cleaner and less convoluted (IMO).

        • I actually posted the same article on this blog a while back.

        • Here is the comment where I posted the article. The resulting thread ended up in a pretty cool discussion.

        • France potential for going to the far right is greatly enhanced by President Hollande disastrous performance. After 34 months of his mandate, unemployment has increased by 587k people, meaning he’s on a run rate of +1m unemployed over the duration of his 60 months mandate, to be compared with 16m private jobs in France. Public debt is on a run rate of increasing cumulatively by €500bn over 5 years, equivalent to 25% pts of GDP. Taxes are on a run rate of increasing by €150bn nominally from starting levels that were already too high to allow any chance of economic recovery (hence they yield hardly anything in aggregate while being hurtful individually to those who have to put up the cash or lose their job as a result of the decline in productive spending). 95% of the total value added produced by the private sector is taxed and redistributed at negative incremental returns, further pressuring French living standards. These are the precise things you’d do if you wanted to get the far right elected. Hollande is Le Pen best recruiter, sending her waves of dissatisfied voters every week. Especially since Hollande disastrous performance follows Sarkozy disastrous performance, which followed Chirac, Mitterrand and Giscard d’Estaing disastrous performance, so patience is running rather short. At this point, it is therefore becoming crucial that those who have no ideas how to fix the pressing economic issues of our times have the elementary decency of not running for elections, hence giving a chance to the emergence of more able personalities. If one really wanted to prevent extremists to gain power, one would have first to give it a genuine try (which means addressing the primary causes of the economic problem) and one should definitely avoid giving them a big boost (by doing nothing or by simply resorting to expedients to temporarily suppress the symptoms) for the sole satisfaction of advancing one’s personal career against the best interests of the country. The current crisis is above all a deep intellectual and leadership crisis whose peaceful resolution most likely requires as a necessary – though insufficient – condition, a complete renewal of the current set of policymakers. Obviously, this might well be true for many countries, not just France. As the campaign kicks off, this question might very well be relevant to the US for instance.

          • In the US, we’ve already started to see a pronounced shift. On the Republican side, Ben Carson came out and said he’d be in favor of reinstating Glass-Steagall. Rand Paul and other “fringe” Republicans has been going after the Fed for a while. On the Democratic side, Bernie Sanders and Elizabeth Warren are saying we need to break up the big banks.

            The writing is on the wall. The shifts are happening. The political alignment since Ronald Reagan has broken. It’s now the edges vs the center. Once the purge of the old elites has occurred, we’ll see a new axis which is more in line with traditional American politics. One side will be for the big bank and the other will be against. Yet again, we’ll have Hamilton vs Jefferson.

    • I forgot to attach this link on the US not being a democracy or even being built on democratic principles. The way most people define things today obscures the difference between a democracy and a republic by saying everyone’s basically a republic, which is not the case. Democracies are built on the principle of equal representation to every voter. Republics are built on individual autonomy to the states, particularly the US. The entire structure of the US is anti-democratic and it’s designed like an empire where some democracy does play a role, but it plays the role of the check. It’s a fundamentally different type of system than a country like France or Germany.

    • Influence neighbor countries a side benefit, rationalize the extensive over build of the commanding heights if the economy, the industries of industrialiation, which they have overbuilt extensively, and where elite intersts coincide across the country, and use government coffers, and savings, to continue to support.

      Influence neighboring countries is a political story, that coincides with how the story is commonly told, with power, strategy and politics, a political contest, of the economic trends. But really this is more internally driven, important, and told, when useful, on the soft power side of the equation, as some Hollywood types misunderstand everything, continuously, and continually, even creating the notion, the Obama administration miscalculated, which is itself, a domestic issue as well, and globally people still consider this non-sense a story.

  28. Hypothesis: The necessary and sufficient condition for the reserve currency is a naval power that better than the second /third naval power together.

    1. The pound lost the reserve currency status AFTER the US became the NO one navy, and by huge margin .
    2. By sea shipment it is possible to reach 94% of the humankind, and best part of the earth population is arranged around the seashores.
    3. The country with the biggest navy can close/open the sea lanes, and it means that for every trading country they are the table point.Every other country can be blocked by the given country – so the currency of the sea superpower has the lowest risk.

    Based on the above logic the currency of China can replace the dollar only if the Chinese navy will be the No.1 sea power.

    At that point the Yüan will set the value of everything,and the world will force China to accept the reserve currency status,.


    During the II. WW the US build 7.6 times more ship than Britain.

    • M – Excellent logic. Can’t beat this argument! 🙂

    • This might be a hypothesis for history; not the future.

      • What is the difference today/ tomorrow?

        Why you think that the past methods/ problems are not relevant today?

        The US can close the shipping lines to China, and China can’t keep them open.
        So if you have dollar then it still worth something, but if you have yüan then it worth nothing as soon as the US decide to block China access to the sea.

        The CCCP never had free access tote oceans, only on the far east side, but the population centre has been on the European side.

        • China isn’t even the strongest naval player in its region, never mind the world. On top of this, China imports around 2/3rds of its energy and all of those imports go through the Indian Ocean and around Southeast Asia. India, Taiwan, Vietnam, Malaysia, Indonesia, Australia, and Japan are all US allies too. It’s not just the US that can close Chinese shipping lanes, but India or Japan could do it too.

          On a slightly related note, I just finished Asia’s Cauldron by Robert Kaplan. It’s not bad, but he doesn’t really understand finance very well IMO. He just assumes China’s growth rates are sustainable and that China’s defense spending can keep rising at its current rate because he just assumes their growth rates will continue. I have doubts about this and I think he’s completely ignoring demography and other issues.

          Now that I’ve read more Kaplan, I can talk more about him. He’s actually a very good storyteller and has very good fluidity with his language, but his style just doesn’t resonate with me. He knows geopolitics pretty well for the most part, but his understanding of finance is sub-par IMO.

          • I think it is a bit stretch to say that India or Vietnam is US ally.

            Say that : due to the military power balance many country can continuous anti-chinese military and foreign policy in the region,and around the life critical Chinese sea routes.

            However as soon China develop a capable Naval force any anti- Chinese military/foreign policy will have the same effect on Japan, Vietnam ,Malaysia or any other country in the region as the ant -US policy for Cuba or the anti Russian policy for Ukraine.

            Say that the US has the advantage of the many friends because they are the dominant naval power in the region.As soon as there is another dominant player in the region everyone there will try to align to him.

            China military industry: the consumption in China is quite low.
            One of the oldest way to increase consumption by government force is the military spending.China has low personal consumption and high investment, so it is fairly easy to increase by a magnitude the military spending , even with increasing consumption and stagnant GDP.
            Good reading :The Wages of Destruction: The Making and Breaking of the Nazi Economy

          • Good reading M? No. Great reading. But somehow Adam Tooze’s next book, “The Deluge”, blows it away completely.

          • I think it’s safe to say Vietnam is a US ally (a strong ally IMO). I agree about the Chinese building a “anti-navy” navy, but what if someone sets up a blockade of your energy imports from the Indian Ocean?

            With military spending, isn’t it better to think of military spending as investment, at least in the industrial age? You need large manufacturing plants in order to build ammo, you get run-ups in inventories if this stuff isn’t used, you build infrastructure to link up all of these networks and supply chains for stuff that’s effectively completely useless outside of warfare, and so forth.

          • Vietnam allowing to Russia to use military bases on its territory.

            Military production:
            You using the same iron smelter, hot forming machine, you using the same dock ,the same metal cutting/bending machine, and finally the same developer/ machine supplier and worker to make warship and cargo ship.

            The same true for air planes , say a wide body passenger plane requiring the same infrastructure/supply chain like a heavy bomber or refuelling plane, or a fighter jet.

            For an engineering firm it is irrelevant if they have to make machinery for ammo making line, or for a yoghurt potting line.

          • He’s a journalist, well traveled, has a body f work that is admirable; is simple, Realpolitick, devoid of convolution, and does write books that are easily read, re-told, and abe to be conveyed along a fairly simple narrative. have read the cauldron as well.

            I watch his videos and read his books.
            Don’t watch TV.

            With that said, he is better than Friedman, freedman, and Zeihan, IMHO.

            Actually, i can not think of a contemporary who brings Geography as concisely, back into a picture, that started to, prematurely, conceive of the world as a single unit. If the world wants that, and the impetus that provides for development, there is much work to be done, by those who have been belaboring the industrialization model, in stead of moving more in the direction of consumption, and higher wage shares of domestic workers. Many have taken steps, many more steps are needed.

          • Yea, I don’t like him as much as you do. To say he’s better than Friedman or Zeihan? I don’t know about that. While I do think Kaplan writes in a fluid manner, he’s still not very exciting.

          • I started reading both The Deluge and The Wages of Destruction from the library. The Wages of destruction is really, really long and The Deluge is pretty long too. I ordered both of them on Amazon today and I’ll have them by Friday. Both books don’t feel like easy or quick reads to me. It seems to me like they take some time and investment. From the looks of it, The Wages of Destruction will take at least two full readings to fully grasp every bit and I suspect The Deluge will be similar. However, I think both books are certainly books to keep around and own for a myriad of reasons.

          • Csteven,

            I’ve been reading a good bit of Kaplan. He’s clearly a journalist and a very good writer, but he’s got an absolutely horrible way of thinking about risk. For example, take a look at the way he talks about American foreign policy interventionism in The Revenge of Geography. He starts talking about how the cost of invading Iraq and Afghanistan was basically nil in its effect on the national debt or on the American financial position, which is complete BS.

            First off, the cost of interventionism in Iraq and Afghanistan is SEVERELY underestimated by looking at its financial cost. What about the cost of the lives of the soldiers whose lives got fucked up? What about the resources we spent on nation-building in Iraq and Afghanistan that weren’t used here. Kaplan naively uses the deaths of soldiers and the total number of casualties as saying the wars in Iraq and Afghanistan weren’t that bad, which is stupid. What about all the young men and women who spent an entire decade of their lives in a warzone, then come back to see a large part of the lives of their families’ and children gone by? What about the fact that they were patrolling some area in a danger zone instead of in school or at home or working or developing skills or whatever? Those are costs too and it’s naive to remove those costs from the analysis that don’t show up on a balance sheet, but are just as important.

            If we were spending money on building infrastructure and stabilizing governments in places that have rarely been legitimately stable for extended periods of time, what if instead we used a portion of those funds for infrastructure development in the US? That would cause our deficit and our debt to decline sharply because of the productive use of resources. This is something Kaplan completely ignores in his analysis.

            The biggest national security threat in the US comes from the North American drug war (I also wonder how many buddies Kaplan has in the DEA and other federal agencies that benefit from such destructive policies and how much Kaplan himself has benefited from such policies). You’re creating an incentive for people to come to the US purely to undermine our institutions and rule of law while creating unnecessary violence whereby guys in the federal agencies doing blow and hookers all the time get off the hook while some college kid nickel and diming bud gets fucked by the law. On top of this, you create an incentive for the worst kind of illegal immigration and Kaplan claims that anyone who points out this as a bigger threat than stabilizing Iraq and Afghanistan has a dangerous thought process?! Yea… I smell bullshit.

            The thing about the Mexican-American border is that it isn’t really a border; it’s a frontier. As you get closer and closer to the border, it seems like you’re in this strange borderland with a mixed culture that’s slowly changing. Why? It’s because it isn’t really a border at all. It’s a frontier. Rather than economically developing Mexico by using massive amounts of foreign investment to create incentive structures so that Mexicans don’t want to cross the border because they have happy lives over there, he claims it’s better to use funds to try to stabilize places that’re inherently unstable except when under Muslim empires.

            Let me put it this way, having places like Juarez right near our turf is a way bigger national security threat than some crazy nuthead in Iraq. The inner city gangs are literally being wiped out by far more cruel and despicable Mexican drug lords.

            BTW, comparing the Vietnam war to the wars in Iraq and Afghanistan is like comparing apples and oranges. The former was done as a containment strategy to box in the USSR’s influence. The latter was done by some eggheads in power–Bush II, Cheney, et al–wanting to give handouts to their cronies.

            The main problem in Iraq and Afghanistan was that there was no definition or goal in the idea of “victory”. If you don’t know what victory is, you shouldn’t be going to war in the first place, especially when you have internal issues created by issues on your southern frontier.

          • Additionally, the way Kaplan talks about the drug cartels is flat-out stupid. The problem is not Mexico and the US taking on the drug cartels. The reason the drug cartels exist is because of demand for drugs from north of the border. Saying that the Mexican government needs to beat out the drug cartels in warfare is attacking a symptom, not the underlying disease.

            Drugs can cause problems with serious social costs. In other words, it’s a public health problem. You don’t fix public health problems by making those who need treatment into criminals. That’s beyond all reasonable sense and logic. Why the hell is pot illegal? That makes absolutely no sense. Alcohol and cigarettes are more harmful and dangerous while marijuana has genuine and widespread medical uses. For example, someone that suffers from physical pain would be much better off by smoking some pot than by being given prescription strength painkillers, which are far more dangerous and can be extremely addictive. In my case, taking prescription strength painkillers makes me nauseous and gives me HORRIBLE stomach cramps (I have a very sensitive stomach), but that’s what they gave me after I had surgery on my broken foot. After my surgery, I was in pain, but I didn’t take any of those painkillers because the pain from my broken foot was way better than taking those painkillers. I’d have been better off if I’d been smoking pot rather than taking painkillers, but that’s illegal because of some egghead in the DEA (and others in power) claiming they know better about issues whereby the incentives are aligned in such a manner whereby what they do is destructive to society at large.

            Kaplan refuses to acknowledge even the most basic truths about this.

  29. Perhaps to reinforce your argument, about the desire of others to have their currency held as reserves

  30. I think the AIIB is wonderful, a stroke of genius. I, however, don’t think the AIIB is a tool for the RMB to become the world’s leading reserve currency. Rather, it was proposed to solve real world problems as well as to benefit China and other participants.

    According to “THE PENTAGON’S NEW MAP”, the world is divided into a “functional core” where good things happen and a “non integrating gap” where a lot of bad things happen regularly. The approach of the US to integrate the gap is violence followed by country building (transmission of “good” cultural content Peking duck style) and followed by more violence and more country building. Net results: the gap is getting more non-integrated and/or integrated the wrong way in the form of ISIS. In comparison, the AIIB will integrate the region by providing infrastructural “connectivity”. Build the roads and the people will mix and trade and the region will develop like China. Optimism. Yes. Unlike Westerners, Chinese in general believe human nature is good, not born evil.

    The other issue is how to mobilized the huge foreign currency reserve accumulated by the Asian economies as a mean of self insurance. Japan had suggested an Asian Monetary Fund to escapte the dollar trap. However, the idea was shoot down by the US. It is obvious to me that some kind of monetary fund would be on the AIIB’s agenda.

    • I wouldn’t assume that Westerners believe that people are born evil, I don’t. But then, I don’t believe they are born good. I believe they are born. Then, i can have true or wrong perspectives on them as being good or evil; or can refrain from such because it seem s a horribly irrelevant practice. Regardless, to move from the intentions of nations, and the flows of relations, from the AIIB to a notion of humanity, on a consideration of the GROUP believes in optimism, well, is ridiculous. And to say of the Chinese, is likely nothing more than a meme that has been promulgated by certain parties, during the transition from a completely centrally planned to a lessor centrally planned economy.

      These countries have not slef-insured, they have exacerbated excess due to an inability to alter, there is only a small percentage of the reviewers on these matters that have suggested this is self-insurance, and it is more a likely counter-action to the 1997 currency crisis. Japan, this and that, you realize that you are spouting someone’s preferred ideologically drivel, that doesn’t stand here.

  31. Michael:

    In point 3 under Other Things to Consider for the AIIB you state that the world is not starved for capital but has too much. The world is certainly awash in money. But too much capital? As I understand it, capital consists of means of production and means of subsistence, to use Marxist terminology. Do we really have more of these things than we need to meet the needs of over seven billion people with rising aspirations? Every time excess money rushes into hot or popular investment “themes” the relevant factors of production are bid to the sky. I take this as evidence that capital is not abundant, regardless of the low interest rates on money loans.

    There is a great deal of confusion about many basic aspects of economics. One of the most pervasive is confusion about what is and what is not capital. Your thoughts on this topic would be very helpful to many people who are trying to make sense of the world around us.

    Thank you for your fine books and for your fine blog.

    • We should start by throwing out Marxist terminology and perspectives (they have very little to offer us and Marx was an egghead). Instead, we should start straight from the d

      There’s too much production and any input in production that’s not land (natural resources) or labor is, by definition, capital. If we have too much production, we either have too much land/natural resources (maybe), too much labor usage (this is not the case), or too much capital. Clearly, it’s not the second and the first is definitely true, but the ability to extract and use natural resources is (again, by definition) a form of capital. Therefore, we definitely have too much capital in virtually every respect.

      • *start straight from the definitions

      • Or it is just difference between the few well connected and the many not well connected. If the person with lot of money has higher return on investment than the person with small amount of money then in long run there will be more investment than consumption.
        this state can be reached by taxation, inheritance, corruption, bribing the decision makers, restricting the competition, mending the law and so on.

        The bottom line is if the worker earn less than the profit of the employer then the consumption growth will be smaller than the growth of the economy.

        • “If the person with lot of money has higher return on investment than the person with small amount of money then in long run there will be more investment than consumption.”

          What about the risk of loss for the guy at the top vs the possible gain from the guy that doesn’t have anything? It’s not like “higher returns” come at no expense. The small always has a convexity advantage, so it benefits from uncertainty in the underlying variable (Jensen’s Inequality). This is one of the KEY flaws with the Marxist perspective.

          The emphasis should be on MOBILITY across the class structure. It was actually a rise in the classes of entrepreneurs, merchants, traders, and finance guys–the capitalist classes–that led to the creation of Parliaments and Congresses. It shifted power structures and these classes forced kings/monarchs to give ground, introduced class mobility, allowed the development of a middle class to consume their goods, and limited the power of power-hungry eggheads.

          Now, I agree that rent-seeking behavior should be eliminated, but we needn’t go so far as to say that we want equality for everyone and turn to the opiates of the masses. That will lead to monarchs and dictators. What we need are political institutions whereby the grievances of the people can be addressed.

          Can inequality cause problems? Absolutely, but proper incentive structures that lead to wealth creation will cause winner-take-all effects in wealth and income. The problems created by income inequality should be dealt with as technical problems. The problem with large amounts of inequality is that it creates a rise in the savings rate, which must either be unsustainably prevented from rising (by debt-fueled consumption), or something else on the demand side must offset that supply side shift. I wrote about it here, if you’re interested.

          • My argument is actually the same that Mr Pettis highlighted as the major money transfer mechanism between the average Chinese and the factory owner Chinese in China.

            My statement was quite simple: if the average person return on investment is lower, than the billionaire return on investment, then in long term the country will have overcapacity and under-consumption.

            In the UK it is prevented by inheritance tax.

            All other stuff, like the risk of losing everything or the chance to be a millionaire can be normalised to simply average return number.

            One of the best way to prevent it is by keeping the unemployment as low as possible, and force everyone in the market to fight for workforce,and found ways to be more efficient.

            That made the US to the biggest industrial powerhouse, and that made them the most efficient in the world.

          • I don’t know if the risk of loss can be normalized, as you simply assume it can. In fat-tailed domains, the risk of loss can never be normalized because outliers account for most of the variation.

          • Hypothesis:

            The consumption share from the GDP will fall if the Return On Investment for small savers will be significantly lower than for big savers

            Past value of the difference between small saver and big saver ROI can be calculated easily.

            Best example the consumption share from the GDP decreased dramatically between 2000-2015 in China.

            For a long-time Mr Pettis arguing about that the lower than inflation interest rate was a hidden channel to transfer money from the consumers to the investors.

            If someone try to correlate the average wealth of any individual in China with the average yearly interest then I’m 85% sure it will be highly correlated.

            Obviously if we want to calculate it for the future then it is a different kind of matter.

            At the moment we are in an eigenstate, chaotic attractor or whatever you wean to call it.

            The process periodicity falling back to the eigenstate, so to calculate the ROI easy, it simply following a normal distribution in the given eigenstate.

            However as soon we will move out from this eigenstate it will change dramatically


            1917 Great October Revolution – need any expőlanation? Prior of it the Czar was a low risk borrower, after it the ROI became 0 🙂

            -Collapse of the EU

            -Change in the interest rate policy in China

            -Policy change toward stronger union and worker’s rights in Japan or Germany

            and so on.

            All of them or certain partial combination of them will bring the system toward a new eigenstate.





          • You’re assuming that the first moment of the wealth distribution converges. I don’t think you can make that assumption.

            You can calculate it with data, but if the structure of the underlying distribution doesn’t allow for convergence of the first moment of the wealth distribution or if the rate of convergence is too slow, none of what you said works.

            I’m very familiar with eigenvalues and eigenvectors (I’m doing my PhD in mathematics right now and got done with finals for the semester on Friday).

            These are the kinds of distributions which can give us problems to the methodology you’re talking about.
            a<1 means the mean of the distribution cannot converge
            Unless beta=0, the variance never converges either
            When they do converge via the CLT, the rate of convergence is too slow to be worth a damn

            "If someone try to correlate the average wealth of any individual in China with the average yearly interest then I’m 85% sure it will be highly correlated."

            This makes the assumption that, at any given time, the first moment of the wealth distribution (the mean), converges. Wealth is fat-tailed, which means the first moment may not have to converge.

          • I’m not saying inequality isn’t an issue either. Inequality is an issue, but wealth accumulation also occurs in winner-take-all circumstances. In other words, a majority of the populace at any given time are completely useless in terms of wealth accumulation. Wealth is accumulated by a small minority and the proportion of wealth that is generated by the small minority is highly liable to fluctuation. On top of this, the smaller amount of people that do generate that wealth, the disproportionately large the amount of wealth created will be.

            It may seem that what I’m saying is absolutely ludicrous, off-the-wall, crazy, revolutionary, and never occurs, but nothing could be further from the truth. In any complex system, you have winner take all effects (for lots of different reasons). In cases with fat-tailed probability distributions, everything I’m saying is pretty well understood. Most people find this sort of behavior to be extremely counter-intuitive and some find it to be morally wrong (particularly leftists, socialists, and statists).

            So the real question to ask is: are these domains fat-tailed and what is the alpha? When we look at markets, we see that a few specific days account for most of the variation and that the slightest perturbations create large deviations in tail effects. That’s all the evidence I need to tell me we’re dealing with fat-tailed processes. Now, with respect to what the alpha (tail exponent) is or how does it converge. The problem with detecting the alpha empirically is that any attempt to empirically determine it always chronically overestimates the alpha (or underestimates the size of the tail) because the tail exponent is so sensitive to the data we have available. Also note that in the calculation of the tail exponent, it’s rare events or outliers that dominate, and by definition, those events are rare which means we lack the data to actually calculate any sort of tail behavior effectively or accurately.

            I’ve actually done a good amount of research in these systems. I’m gonna be spending my entire summer and may even take next semester off to just spend towards research in these domains. Their behaviors are very, very strange to those not used to dealing with such systems. What they basically tell us is that the averages and the majority of the population matter little in these types of domains. It’s the extremes that matter.

          • Let analyse your arguments.
            First that you saying is “it is not possible to measure the wealth distribution, because any sub-sample from the population will not represent the wealth distribution of the whole population ”

            It is not about the observability and of the problem, and even if this statement is true on its own, it has no affect on my arguments.

            We don’t have to sample from the population, we can sample the wealth , and in that case the first moment of wealth distribution will converge fast, so a relatively small sample will have good correlation with the whole population.
            And the tax records of any country can give complete analysis about the wealth distribution 🙂

            Second:the wealth inequality has a negative correlation with the effectiveness (GDP) of any country.

            The reason is simple, if the workforce cheap there is no reason to improve the efficiency of the economy, so the GDP and the growth will be smaller than for a high wage economy.

            The statistical tools has very limited usage , and every tool requiring a very precise definition about boundary conditions.
            So it should be better if you try to use dynamical system analysis instead of basic statistics 🙂

            The later is a bit more complex, but give a better understanding about the behaviour of the system.

          • “We don’t have to sample from the population, we can sample the wealth , and in that case the first moment of wealth distribution will converge fast, so a relatively small sample will have good correlation with the whole population.”

            What I’m saying is that the first moment of the wealth distribution is likely to not converge, and even if it does converge, the rate of convergence must be slow. And plus, it’s just a correlation.

            “First that you saying is “it is not possible to measure the wealth distribution, because any sub-sample from the population will not represent the wealth distribution of the whole population ””

            This is not what I’m saying at all. I’m saying that we can measure it, but we can’t fully understand the tail effects involved. I’m emphasizing that there’s a difference between being able to roughly understand the wealth distribution vs understanding the tail effects. It’s the tail effects that dominate.

            “So it should be better if you try to use dynamical system analysis instead of basic statistics”

            I’m not using statistics. I’m using the most recent developments in probability. Statistics is about communication and experimentation, which I have no interest in.

            I have plenty of experience in dealing with dynamical systems and I’m just using a micro-scale approach that’s mathematically equivalent to the macro-scale. You can use PDEs with boundary conditions and start with the macro-scale. Or you can study the way the particles interact, develop stochastic processes, and study the underlying distributions of the particles. Mathematically, they’re both equivalent and should lead to the same results if done properly.

          • “What I’m saying is that the first moment of the wealth distribution is likely to not converge, and even if it does converge, the rate of convergence must be slow. And plus, it’s just a correlation.” If you use the population as momentum space 🙂 .You have to follow the money, not the average person.

            Statistic past, probability future.

            I tried to recompile my argument few times, but it seems like you just repeat the same sentence with slight modifications. I think we have to stop here, and everyone can decide what he / she want to see.

          • “If you use the population as momentum space 🙂 .You have to follow the money, not the average person.”


            “Statistic past, probability future.”

            Exactly why normalization can’t just be assumed. This adds a layer of uncertainty.

          • When you’re saying I’m repeating the same things, you’re correct. The assumptions don’t satisfy the procedure you’re using. There’s a fundamental difference between statistics and probability and the use of past statistics increases tail effects when talking about the system as a whole. All of this stuff is well understood and pretty easily demonstrated with a few simulations on R.

          • Still don’t get the point.

            The statement: there is a wealth transfer from the poor to the wealthy in China.

            I is based on past observations, and this is the root cause of the collapsing consumption.

            This is the past, you can use statistics on it.

            Everything else is just a straw man argument from you based on that assumption you discussion partner want to continue calculate the future probability based on this .

            The probability of the future is chaotic.

            Al that we know is that the current situation is metastable now, but the future state will be on a random eigenstate, all that we can do is to calculate the probabilities (of course considering that it is a chaotic system any calculation is next to useless)

            The political situation in the US is unstable as well, 58% employment to population ratio lover than the Russian one, and historical low point.
            China has lot of flexibility due to the low consumption, it can afford 10-20% loss in GDP without any effect on the consumption.
            Every poor country has a customer’s job market.Every rich country has seller’s job market.

          • I agreed with everything in your last comment.

          • I apologize for my misunderstanding. If you’re saying a state change is coming, then you’re correct.

  32. Thank you for keeping a cool and logical head at a time when economic discussion is turning increasingly fantastical.

    Among many others, the idea that “China’s decision to use its reserves to boost Asian infrastructure investment was clearly welcome in Asia” is purely fantastical.

    Indeed, China’s monetary reserves accumulated through trade surpluses have already been used. Not once, but twice.

    One, they have been on-lent to the US (mainly) via the purchase of government bonds and the US Treasury has already spent the proceeds for its own purposes. And the U.S. Treasury is not in debt pay down mode. On the contrary, its debt has been rising exponentially faster than its revenues, so little chance of China’s seeing reserve release from the US (or any other debtors) anytime soon.

    China’s reserves have then been used a second time when China decided to unleash a dramatic domestic credit expansion to cushion the impact on its economy of the international trade rebalancing forced by the crisis (thereby repeating the exact same mistake, for the exact same reasons, that Japan did in 1985 following the Plaza Accord, a mistake that Japan is still trying – increasingly desperately – to correct 30 years later and 250pts of Debt / GDP higher). China’s reserves have therefore been used as monetary base underpinning the huge domestic loan creation since 2009 (for an amount multiple times bigger than PBoC reserves) going into more fixed asset investments which are now struggling to generate the cash returns necessary to service that debt, hence little chance of reserve release anytime soon from here as well.

    At this stage, there has already been duplication of credit, China’s reserves having entered China money supply while having simultaneously remained part of the US money supply, for an aggregate amount far in excess of China’s reserves. Saying that China’s reserves will now be used a third time to fund Asian infrastructure projects can be more adequately referred to as “the further piling up of debt upon debt upon debt resting on each other in an ever more precarious balance”. That’s a fair description of the economic reality. Of course, the marketing impact is slightly different, hence the much preferred use of the fantastical formulation that passes these days for advanced economic thinking.

    Thank you for raising the bar.

    • “China’s (dollar) reserves have therefore been used as monetary base underpinning the huge domestic (rmb) loan creation since 2009” : (parentheses added) can you explain how this works; I think it don’t.

      • In the current system, a national central bank can issue currency not only against claims denominated in the national currency but also against claims denominated in foreign currency, like USD for instance.

        Generically, it works like this:

        1. Chinese companies in aggregate sell more goods to the US than they buy from the US, hence they have a trade surplus for which they receive the corresponding amount of USD balances as settlement.

        2. Chinese companies convert these USD balances to national currency (RMB) balances at the Chinese commercial banks.

        3. Chinese commercial banks convert these USD reserves to RMB reserves at the central bank. Said differently, the PBoC issues domestic currency as counterpart to the USD thus acquired. The equivalent of the USD balances enters China money supply. This is how Wikipedia describes it: “Foreign exchange reserves are assets held by central banks […] used to back its liabilities, eg. the local currency issued and the various bank reserves deposited with the central bank”. Note that this capacity of central banks to create domestic currency against foreign-exchange reserves is not new: if i’m not mistaken, it was instituted by the 1922 Genoa conference.

        4. The PBoC typically invests these USD balances in the US financial markets. Notice here the round trip of USD from the US to China back to the US, with the effect that the US trade deficit doesn’t result in any monetary contraction, hence doesn’t restrict purchasing power, hence doesn’t trigger any downward adjustment in internal demand to rebalance the external trade account. This is the secret of “the deficit without tears” as Jacques Rueff called it or the “exorbitant privilege” of the USD as it is sometimes referred to in the sense that the US can buy without paying or by always pushing the payment to later. In any case, the USD balances have entered China money supply without leaving the US money supply. This feedback of USD is repeated endlessly on a daily basis. It is the mechanism by which trade imbalances have been allowed to develop and balloon for so long unrestricted, accompanied of course by the corresponding rise in claims, ie. debt.

        5. The new RMB reserves of the Chinese banks can support new loans for a multiple amount of those reserves, for instance a 10x larger amount of loans if reserve requirements are 10%. This is what made China spectacular credit expansion possible from 2009-2010: by multiplication of the monetary reserves accumulated after years of trade surpluses. There is duplication of credit between China and the US as the USD balances enter China credit system while at the same time being on-lent back to the US, for instance being lent to the US Treasury if China buys US Treasury bonds. This exact same mechanism was also behind Japan’s credit boom of the late 1980’s after years of Japanese trade surpluses.

        The combination of large trade imbalances with fractional reserve banking is the powerful engine that explains the staggering rise in global Debt-to-GDP for the past 35 years, ultimately pushing both debtor (US) and creditor (Japan, China) countries into excess debt situation. The fast increase in global debt relative to global production results from this double mortgaging of future production at each iteration of this duplicate credit structure. Until such time when debt is no longer serviceable from the cashflows generated by future production, even with interest rates at 0%. At that point, the global pyramid of financial claims will collapse, either nominally or in real terms. Such time is inevitably coming, the lowering of interest rates since 2008 is only buying time at the cost of making the global financial bubble bigger. This is why, if I understood correctly, Michael Pettis said a few years ago that we need “The Great Rebalancing”, whereby global trade imbalances are to be gradually reduced. It was already too late for him to be heard. Indeed, the country with excess supply (China) had already embarked on a massive addition of debt-financed fixed investment to boost capacity further while the country with excess demand (the US) had already embarked on a massive “wealth effect” to perpetuate that excess demand. In other words, policymakers were already implementing competitively the exact opposite of what had to be done cooperatively. “The courage to act” is worth nothing if you don’t act in the correct direction.

        • DvD: One of us is befuddled; in your paragraph 5. “The new reserves…”: what new reserves? Gizmo -> US-> $ to China which end up in PBoC -> US -> T bonds to China which now total approx $4T. These US bonds (or stock, bills, commercial paper etc) are NOT “new rmb reserves.” The PBoC created new rmb to buy these $$s from Gizmo Co; Gizmo deposited these rmb in some local bank, which PBoC “requested” they send back to PBoC in return for PBoC IOU; ie, a sterilization exercise to avoid a rapid increase in the money supply.
          The massive increase in new loans in 2008-9 had nothing to do with $$ reserves.
          “The combination of large trade imbalances with fractional reserve banking is the powerful engine…”: but debt in China is primarily SOEs (classic soft budget constraint mismanagement and corruption) and LGFVs (ditto). What has this to do with trade imbalances?

          • US 10 yr interest rates are approx 0 suggesting high world demand.

            Perhaps the problem is not enough debt.

          • DAn

            China has not but a bit more than a third of that near 4 trillion number in US treasuries, correct. Perhaps a 60-65% allocation to dollar denominated assets globally, and then 30-40% denominated in other currencies (from Yen to GBP, Euro, AUD, NZD, Swissie, etc)

          • Dan

            Of course what DvD is referring to is a process, that besides asset bloat more generally, enables Chinese money supply to be higher than normal, because of teh process of how dollars are moved through the Chinese financial system back to the US, which DvD is particularly concerned about, as he has been talking about this Double credit situation since around or before the MckinSey report.

            What enabled that was a lowering of the reserve rate at the bank, with the assets, bloated of the money supply expansion, both of the value of domestic assets (doesn’t matter what the land sells for because I will just get a loan x times the cost for building, so higher better), coupled to DvD’s pet peave, double credit, and the lowering of the rserve rate, allowed accumulation of debt to accelerate, as assets bloated of par and course, while surpluses enabled ever higher rates of money printing. One thing DvD has on his side of the argument, is that money printing on the case of the Chinese exploded during the loan expansion, your point it wasn’t the double, circular credit, it was the lowering of the reserve rate, which DvD will remind, perhaps, but of course a good portion of those supposed banking assets are of that money printing process, on the back of surpluses in the first place, which enabled asset bloat, and on, and on, an multi-circular process.

          • The new reserves of Chinese commercial banks created as per step 3.

            In the past 6 years from end 2008 to end 2014, the volume of new loans originated by Chinese banks has increased cumulatively by +180%, ie. by over 80 pts relative to nominal GDP. Such pace of credit expansion relative to income is simply not possible without the multiplier effect on reserves. If you think it is possible without this effect, then show me how. As an aside, it is rather telling that you think that the money supply should be constrained in the surplus country while seemingly finding it normal that it should not be constrained in the US despite the deficit.

            The combination of increased monetary reserves arising from trade imbalances and fractional reserve banking is the engine driving credit availability. That this available credit is disproportionately allocated to SOEs rather than to other potential borrowers in China has in itself nothing to do with trade imbalances. Not sure what point you are trying to make here.

            US 10yr interest rates are about 2% in nominal terms and also 2% in real terms. Not sure where you get your 0% from. Yes, there has been strong demand for US bonds from the Fed in recent years ($ 3.6 Tr to be precise) to try to debase the USD. Since mid-2024, there is strong demand for dollar-denominated assets as the rest of the world tries to debase its currency vs. USD to shift all the burden of the worldwide adjustment onto the US. With some success, judging by the latest US trade deficit statistics. So the US is again placed in a situation where it needs to choose between going back into recession or keeping up growth by releveraging and reflating further its balloon economy. Your comment that the problem is perhaps not enough debt – while denoting your keen sense of observation of the events of 2008-2009 – suggests that you find the latter possibility more appealing. For sure, interest rates dropping from 4.5% in 2007 to 2% now creates some headroom for extra debt, which the US will most likely use as it makes the “exorbitant burden” that much lighter. Whether that’s good or bad long term remains to be seen, but the experience is not very encouraging in that regards. The effect of interest rates on the sustainable level of relative debt – “not enough” or “too much” – is really not that great, especially when interest rates are already relatively low. What matters is the debt servicing cashflows (interest + principal) relative to the stream of operating cashflows generated by future production, so that it remains credible that debt can be repaid out of future cash generation. For illustration purposes, if relative debt is 300% of income, interest rate 4.5% and debt amortization period 10 years, debt service absorbs 34% of future income on average over the period assuming income grows at 2% while debt service remains fixed. If interest rates are 2%, debt service absorbs 30% of future cashflows, all else equal. If lending rates were to drop to 0%, debt service would still absorb 27% of future cashflows, all else equal. To max out debt so that debt servicing cashflows are also maxed out at 0% interest rates poses obvious risks, with which Japan are currently struggling. Please refer to Michael Pettis’s article “Will debt derail Abenomics?”

          • Dan Berg wanted me to post this because this comment of his wasn’t apparently showing up, so here it is.

            “DvD and Csteven: Let’s try this again, because I think the central point of our disagreement is important. In para. 3: “this capacity of central banks to create domestic currency against foreign-exchange reserves . . .” I’m arguing that this is NOT the case. You correctly point out that China increased “new loans” by 180%. Zimbabwe increased “new loans” by much more than that with zero US dollar reserves. How? Banks create domestic currency loans with or without US dollar reserves.
            Ref. interest rates you are correct; should have read 1 year, which have been 0 (approx) since 2008; source: FRED, stlouisfed.org”

            Here’s the link on my blog:

          • “Banks create domestic currency loans with or without US dollar reserves”.

            In “Syriza and the French indemnity of 1871-1873”, we discussed how banks can create money out of nothing but mere accounting entries. At least during good times, while they tend to destroy money by deleveraging during bad times, thus greatly amplifying fluctuations in the economy. If a bank has a 12% capital ratio vs. an 8% regulatory requirement, it can just extend a loan and credit a customer’s account with the corresponding amount. Just like that, by a mere accounting entry, it has created new money, ie. new purchasing power, for an amount equal to the new loan. If i remember correctly, Dan Berg was challenging this view in the “Syriza and the French indemnity” discussion. Now, he’s using that same argument. We are progressing.

            Now, the banks ability to create money out of nothing but accounting entries is subject to minimum reserve and capital rules. At the end of the day, money is fungible and when a Chinese borrower receives a new RMB loan, it is in practise impossible to determine whether the reserves partially backing that loan are RMB or USD-denominated in the first place. One thing is sure though: each monthly trade surplus brings new USD reserves to China credit system, which enhances and magnifies its ability to extend new loans. Just consider the orders of magnitude: PBoC foreign assets amount to RMB 27 Tr or 80% of its total assets of RMB 34 Tr. These are the central bank assets backing banks reserve on the liabilities side of the PBoC balance sheet. From these RMB 34 Tr of reserves, banks have total loans outstanding of about RMB 130 Tr. If i understand Dan correctly, the RMB 130 Tr of Chinese loans are backed only by the RMB 7 Tr (34 – 27) of domestic reserves, not by the RMB 27 Tr of foreign exchanges reserves. But that would be a reserve ratio of 5.4% (7 / 130) whereas a 18.5% reserve ratio is officially required for Chinese banks. If the RMB 130 Tr loans are backed by RMB 34 Tr of reserves (of which 80% foreign assets), that’s a reserve ratio of 26.2% and Chinese banks are compliant with the 18.5% reserve requirement. Conclusion: the USD reserves are backing RMB loans in the Chinese credit system while being simultaneously recycled into the US credit system. There is duplication of credit within the debtor and creditor countries arising from trade imbalances. This is the key reason why global debt is growing much faster than global production and income. Which is something that should preferably be stopped before it triggers a global solvency crisis and the collapse of this fragile debt pyramid.

          • When Dan writes: “Debt in China is primarily SOEs (classic soft budget constraint mismanagement and corruption)”, he’s right in a certain sense. To exercise on production a purchasing power arising in part from mere accounting entries rather than earned by providing a useful service is corruption in the original sense of the word that something is altered, wasted. When the banking system is under the control or the dominant influence of the Government, it is not too surprising that the beneficiaries of this unearned purchasing power are related parties. For sure, they pay a cost for this artificially created purchasing power in the form of interest rate, but then this cost is subsidized by savers in the form of lower than otherwise interest rates and / or by society at large in the form of higher than otherwise overall price level. The same corruption happens in financial markets when they are under the dominant influence of central banks. For instance, when the central bank creates money ex-nihilo to the benefit, among others, of related parties who then hire the former head of the central bank, it is blatant corruption. Legal corruption, certainly, but corruption nevertheless. For the broad public to see so plainly how the powerful literally print their own money can only deeply undermine their support for the free market economy and deeply alter the incentive structure underpinning sustainable wealth creation. In that sense, it leads to a corruption of the system.

        • biggestbrotherofthe mall

          great blog answer to great question in great blog

  33. natural inclination, at present, is to view anything and all developments regarding
    Chinese economy as boom,boom,boom.
    Particularly right now with the Chinese stock market currently on a roll for past 12 months.

    this article should be useful for those of us who like to counter this natural trends towards “Confirmation Bias”.

    • chinese stock market is on a roll bcz money is desperately fleeing the housing market, setting up the next implosion in the process. it’s not bcz business profits or expectations are soaring, that’s for sure

  34. “…because all transaction involve two currencies, I think a 50% share is the limit any currency can have)…”

    Oops… the author has no idea what the SWIFT system does or how it works… too bad

  35. http://www.nber.org/macroannualconference/macroannual_2015.html More empirical confirmation of Michael’s basic arguments ref. china

  36. Gao Xiqing, former president of China Investment Corporation, outlined in an article in AsianInvestor.net from 2013 that CIC is not allowed to take more than a 10% stake in a given project or company, and wants to write tickets of at least $100 million. Its portfolio of direct investments and alternatives (private equity, infrastructure and real estate) comprises more than 50% of its $650 billion of assets. That means for the majority of its allocations (not counting what Central Huijin does domestically) it is looking to write tickets of $100 million and above, meaning CIC continually searches for projects valued at $1 billion and above. In smaller countries and emerging markets, where CIC wants to go for political reasons as much as for returns on investment, such projects are rare. CIC engages in negotiations with mulitple governments about financing cross-border infrastructure: not easy. The AIIB’s CEO-in-waiting, Jin Liqun, has said AIIB will coordinate its activities with other Chinese agencies. The AIIB seems like a tool designed to convince recipient governments to work together to create cross-border projects that are big enough for CIC to invest in. CIC can take 10%, AIIB can take another, larger, tranche, and the rest will be left to other Chinese SOEs or perhaps some likeminded sovereign wealth funds or large private-equity funds. So China can find politically acceptable allocations for its excess reserves, although whether they ultimately provide better risk-adjusted returns than US Treasuries remains to be seen, at least assuming basic environmental and local-community standards are respected – which also remains to be seen.

  37. I think the future of the AIIB looks very bright. Everyone from the United Kingdom to Australia is joining it – they know where the future is, and are building connections to take advantage of it regardless of what the US thinks, It’s about time that there’s a system that can respond to the needs of the majority of the world’s population, and not just primarily western interests – this is all coming from an American.

    • It just seems to illustrate how much confusion exists in the seem at the present point.
      Of course the AIIB is largely a rationalization for what china has done internally, externally, to use the resources existent (they paved parking paradise and put up a parking lot; 4 years of cement during recent expansion, more than the entire 20th century in US). So they have a great deal of capital resources able to do this more broadly, plus elites control these sectors of the economy, so…

      Of course, the piper will be paid in China, and all that we have discussed here and on FTM this last decade has come true, in degrees, and increasingly, so…

      It is just ironic, in this era of confusion, how some who barked the loudest over transparency and governance, these last several decades, in this era of disruption, how much of their tones have been modulated by their acquiescence at participation. Frankly, they had nothing to lose, but their credibility were they to hype those issues again, in the aftermath of this trouble, in their revitalization. Perhaps, this again is born of the confusion resultant of success of the system, that requires a doubling down, and further understanding of the mechanics (thanks Michael), or there will be retrenchment. So in this current trial, let us support a bright spot somewhere, they have jettisoned decades of a morally higher ground, just because things are shaky. It undermines progress globally, in a way on the governance and transparency issues, but then without greater cooperation and understanding, there is a retrenchment, so….

      • Doubling down…. That’s the key point. We have these imbalances that were being driven by some people in power. When these imbalances started to create issues, the guys in charge just did what had always worked for them: double down. Doubling down allows these guys to hold power for longer while worsening the underlying imbalances, making the transition far more difficult than it has to be, increasing the costs if something does go wrong in a disproportionate manner while the probability of failure drops, and thus increases the risk on the tails. When you just keep doubling down, there’s no way to reduce the scale of the impact, so the probability of failure in the near term falls while the scale of the possible impact IF something does go wrong starts shooting upward. This usually continues until you hit sustainability constraints. Then BAM! Sure enough, the peoples these guys rule end up getting fucked over.

        • biggestbrotherofthe mall

          Its the military stuff that is truly scary. Bigger GDP than the US. No free press. No truth. Truthiness, doublespeak, doubledown, 2000 year chip on shoulder.

          The amazing thing about inbalances is how long they endure! I mean a tyrant is an imbalance of sorts and they can survive a lifetime, or a dynasty! A bit of Ghengis in us all.

          • The history of China is deeper than that .

            The complete freedom at the moment will spawn complete anarchy, and complete collapse, that should be good for the US and Japan (who cares about a couple of 100 million death).

            Just see the change of the Soviet block, that killed tens of millions and devastated more than half billion people live .
            All that reached was an opportunity for a few to grab huge amount of money.

            China just recovering from the shock of the XIX century. This is the end of Mao’s reform 🙂

        • Suvy

          See how large Michaels fonts are, your blog should be similarly sized.

  38. short video of N.Lardy who maintains China will grow “in the 8% range” for the next 5-10 years;

  39. Professor: I believe that–
    AIIB is part of Globalist Agenda
    China: Building up the False Savior
    The Rockefeller Plan for the BRICS New World Order, in their own words

  40. Professor Pettis, it would be great to get your thoughts on the latest set of national accounts (primarily the drop in imports and exports) and the debt swap the banks are doing with the Local Government Financing Vehicles. It seems like the hard landing scenario is starting to play out right now.

    I was fortunate enough to participate in some financial due diligence on a Chinese based entity and the manufacturer gate deflation is quite concerning at the moment.

    • Professor Pettis, it would be great to get your thoughts on the following from Tyler Cowen (George Mason University, currently visiting China) regarding the municipal bond swap; http://marginalrevolution.com/marginalrevolution/2015/05/the-chinese-bailout-has-started.html.

      Professor Cowen thinks the government bailout has already started. This seems to be more evidence that the PBOC are avoiding reform and are doubling down on capital investment.

      To me this seems reminiscent of Bear Stearns getting bailed out in May 2008 and then the market jumping up again under the false belief that the Fed would continue to bail out all institutions. The cost of the bailouts start to increase and this just makes things worse. As an Australian whose economy is heavily reliant on Chinese capital investment, this is going to hurt when it hits. Our banking sector is highly leveraged and appear to be ignoring the risks from a hard landing in China.

      Not good.

      • Everywhere you look, you see central banks trapped into their initial error of diagnostic – that economic stagnation is due to money being too tight – with no possibility to normalize monetary policy. The mere stopping of easing appreciates their currency and sends their economy back into recession. On the contrary, central banks are being forced to increase their intervention in an exponential manner. The Fed has done several iterations of QE just to find itself stuck after barely two quarters of semi-strong dollar. The ECB is now doing QE after having done LTROs. The BoJ is at it for nearly 30 years now, still running – increasingly faster – after its 1985 policy mistake. Now, China is also easing monetary conditions to lighten up the debt burden it has itself decided to unleash 6 years ago as a matter of policy. The problem with policy mistakes is that they have the tenacious habit of calling for corrective measures. Again and again and again, as long as the diagnostic is incorrect. Now that all major economies have made the exact same mistake as Japan, one wonders how long the current global balance of monetary terror can last and where it could be taking us. Would have been far easier to listen to Keynes in 1944, Triffin in the early 1960’s, Allais in the early 1990’s and others along the way who have all tried – in vain – to make the blind see and the deaf hear.

        • Japan did monetary intervention far too late and the scale of the intervention was noticeable only recently, but it’s scale was massive. I don’t think it’s fair to compare the position of countries like the US or Europe to Japan; the supply-side economic structures between the economies are completely different which means monetary policy also has different impacts.

          I do agree with you on the global imbalance issues and the necessity for a new monetary system though.

        • It is not mistake.I mean that the central banks did.

          Now the main problem is the “Globalisation”, and the solution will be the same.
          Closing down the borders, and scaling back the international trade.

          Like in the 30s.

        • It was a bit short . So, the globalisation opened up the borders for the flow of goods and same cases for the flow of workforce, and it made a buyers market for workforce.

          Due to that the demand for workforce low, and the price of work is low as well.
          Meaning high unemployment,and stagnant/falling wages.

          • And how is domestic credit easing by national central banks a relevant solution to that problem?

            What if it is worsening the situation by leaving the initial problem identical while increasing debt level? That would be a mistake, no?

            That’s exactly what happened. The policy response to that problem via domestic monetary easing has been and still is a gigantic mistake for the simple reason that it is not a problem of a domestic monetary nature. This problem doesn’t occur because interest rates are too high, so it is a mistake to believe that lower interest rates will solve that problem.

          • The international trade is already being scaled back. Currency wars are, in many ways, the same as tariffs (and worse in some respects).

            In The Volatility Machine, Prof. Pettis talks about how globalization is just liquidity. It makes sense if you think about it from a geopolitical finance perspective because why would it help someone in power to hold it if they were anti-globalization when liquidity was expanding and thus credit was cheap? Similarly, how would some guy who was pro-globalization hold power in a time when liquidity is contracting?

  41. May I ask are you Pro America?

  42. I don’t write a leave a response, however after looking at
    through a great deal of comments on this page Will the AIIB one day
    matter? | Michael Pettis' CHINA FINANCIAL MARKETS.
    I actually do have a couple of questions for you if you do not mind.
    Could it be just me or do a few of these responses look like they are left by brain dead people?

    😛 And, if you are posting at additional social sites,
    I’d like to follow anything new you have to post. Could you make a list of
    every one of all your social sites like your Facebook page, twitter feed, or linkedin profile?

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