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.…According to Pettis, much ado about nothing.
These issues are important politically (geopolitically) but less important economically, if at all.
Some good lessons from history, too.
China Financial Markets
Will the AIIB one day matter?
Michael Pettis | Professor of Finance at Peking University’s Guanghua School of Management
4 comments:
Good article, but here is a part of the analysis that doesn't quite make sense to me:
3. 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.
Banks don't satisfy the demand for capital. They satisfy the demand for credit. If, as Pettis believes, there is a global glut of inefficiently invested savings, then there is clearly an opportunity there for the creation of new financial mechanisms to channel savings into investment.
Right. I think that a good deal of the problematic is semantic, involving the use of terms like "saving," investment," and "capital."
Pettis is using an accounting model, which is the correct approach. But that needs some unpacking to be clear, unless one is used to thinking in terms of accounting reports and balance sheets in particular. Even most economists aren't, as Pettis points out as a source of problems in understanding what is actually happening.
In his defense, he only has so many words in this format. Perhaps he goes into it in greater detail in his books, which I have not read. Otherwise, he presumes that one has the accounting background to understand the technical meaning of terms.
The short answer is that what counts as "capital" is what shows up in the capital account as an accounting convention.
Here is short explanation from Investopedia for those unfamiliar with the jargon:
Understanding Capital And Financial Accounts In The Balance Of Payments by Reem Heakal
Yes, Tom, there are many different ways of defining the term "capital", although they all have a rough similarity in meaning..
But I think the main flaw in Pettis's discussion is that, however one defines "capital", he think that the world has too much of it. He believes in some version of the savings glut thesis. And he also seems to think of investment banks as institutions that somehow manufacture capital. And clearly if there is too much capital, there is no need to manufacture more of it.
But banks don't manufacture capital. They swap one form of capital (their own liabilities, or the liabilities of governments or other banks) for another kind (the promissory notes of the borrowers). The point of all this this is to deliver more liquid financial capital into the hands of those who know how to use it mobilize productive real capital development, in exchange for a share of the returns from that development.
There are billions of people across Asia with a continuing hunger and untapped real potential for economic improvement. Under the circumstances, it is hard to see what it could mean to say there is "too much capital" in the world. If existing capital isn't finding its way into those projects, that bespeaks a financial breakdown.
I understand him to mean that supply is not the issue but rather demand. Net exporters should be reducing their financial capital saved in net importers securities by investing in and consuming more on the world stage. They are over producing/saving and under consuming/investing abroad.
The "savings glut" results from countries borrowing domestically (increasing the fiscal deficit) to fund net imports increasing the (trade deficit), with the result that global savings are generated in the currency of the net importer than sit on the books of the net exporters as a capital surplus.
The problem is that the capital surpluses are too big owing to the desire to save in a foreign currency instead of to spend that surplus down through FDI and reciprocal trade.
This has nothing to do with a country having a so-called reserve currency per se but rather with countries being willing to save in that currency.
He is not talking about domestic capital, either real or financial, but rather balance of payments and associated current, capital and financial accounts, as I read it anyway.
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