Bretton Woods III or bust

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CHINA is going to export capital, and either the US puts it to good infrastructure use in a “Bretton Woods III” system or the world will face continued poor growth and high asset prices.

Sanjeev Sanyal, global strategist at Deutsche Bank, calls it the Age of Chinese Capital, one in which the world’s largest economy transitions to a consumer-driven model and starts to pump out its massive savings to the rest of the world.

The US, with its woeful infrastructure, is the best candidate to usefully absorb capital on the scale China will shortly be throwing off, Sanyal argues.

While economists tend to fret and tut at the idea of these kinds of ongoing structural imbalances, we should remember that the world is always changing and it is harder to find a state of balance in nature than create one on paper with an equation.

The original Bretton Woods system, which lasted in some form from 1944 to 1971, was a formally negotiated system with a series of fixed exchange rates.

Bretton Woods II, some argued, was based around a Chinese peg of the yuan, shadowed by many of its Asian trading competitors, and adjusted by recycling export revenues into dollar reserves mostly in the form of Treasuries.

While some argue that this had the effect of force-feeding cheap credit to the US, contributing to the sub-prime bubble and financial crisis, one thing Bretton Woods II definitely did was form the backdrop for a massive rise in Chinese output and wealth.

While everyone complains that investment is too low, as in the International Monetary Fund’s (IMF) call for infrastructure investment, the fact is that at 24.5% of global gross domestic product (GDP) in 2013, investment is at just about its long-term average.

The issue instead has been that investment has been rising, until possibly recently, in China, and going into lower-quality projects which are often unneeded.

That era may now be ending, but with China saving more than half of its annual GDP, accounting for more than a quarter of global savings, that money is going to have to find a new destination.

Opportunities and demographics in China are not favourable, so abroad the money will likely go, but where?

While India might seem to be a prime candidate, as it is sorely lacking infrastructure and Prime Minister Modi seems bent on following China’s investment-driven model, the fact is that India simply isn’t big enough, at least yet, to take these kinds of flows.

As for the rest of emerging markets, the IMF itself argues that while public infrastructure investment can be self-financing in developed countries, in developing ones it is likely to simply lead to higher levels of debt.

No free lunch in Africa or Latin America, apparently.

And while much attention is currently focused on Europe, in hopes that austerity can be eased, the medium-term scope for infrastructure is limited.

For example, ageing in Germany, Sanyal argues, means that the most we might hope for is that Germany doesn’t add to the global glut of savings.

That leaves the US, where a particular brand of politics has led to decades of underinvestment in infrastructure.

Deutsch Bank estimates that the 25-year investment deficit in everything from airports to roads to schools is almost US$4 trillion (RM13.08 trillion), and a yearly funding shortfall of more than US$200 billion.

Now remember, when you have a glut of capital a few things reliably happen. Asset prices rise, because capital seeks a return, interest rates stay low, for the same reason, and you have a tendency for bubbles to develop.

That means that even if western central banks were able to raise interest rates, flows of capital from China might keep rates low and give rise to bubbles anyway.

If, as seems the case now, those rate rises are delayed, the effect might be stronger.

If Chinese capital can be put into self-financing infrastructure in the US, and, where possible, elsewhere, global growth would rise.

But this requires the US to decide to borrow money, effectively from the Chinese, and use it for public investment. Hardly seems a sure thing, as political propositions go.

“If Bretton Woods Three fails to take off for whatever reason, we should reconcile ourselves to a long period of mediocre growth,” Deutsche’s Sanyal writes in a note to clients.

“Cheap capital, however, will continue to support asset prices and depress yields. If history is any indication, trophy assets may do especially well.”

It may be a choice between bridges and bubbles. — Reuters

This article first appeared in The Edge Financial Daily, on October 14, 2014.