Monday 27 Jan 2020 | 07:14 | SYDNEY
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About the project

The International Economy program aims to explain developments in the international economy, and influence policy. It does so by undertaking independent analytical research.

The International Economy program contributes to the Lowy Institute’s core publications: policy briefs and policy analyses. For example, the program contributed the Lowy Institute Paper, John Edwards’ Beyond the Boom, which argued that Australia’s transition away from the commodities boom will be quite smooth.

 

Latest publications

Stepping up on Pacific infrastructure

Australia has decided it is going to do a lot more infrastructure financing in the Pacific.

This is a welcome development. The Pacific faces some of the most difficult development conditions in the world and has huge financing needs, especially due to the effects of climate change. It is also important that the Australian response to Chinese development finance in the region move beyond criticism and towards something that looks more constructive to the developing countries it is trying to work with.

Ultimately, the Pacific is an aid dependent region and most countries need far more grant financing, not loans.

The recently announced Australian Infrastructure Financing Facility for the Pacific (AIFFP) will provide $2 billion in funding ($1.5 billion in loans and $0.5 billion in grants). There are still more questions than answers about how the AIFFP will work. Nonetheless, one can begin to frame the main issues and, more importantly, key choices at hand.

A common concern is that it may divert funding away from other worthy priorities besides infrastructure, such as health and education. This is possible but needn’t be the case, even without increasing the overall aid budget.

The advantage of using concessional loans is that the grant funding Australia currently provides can be leveraged into a much larger loan amount. That appears to be the intention by combining loans and grants in the facility. With Australia typically giving around $100 million each year in infrastructure grants to the Pacific, the entire $2 billion figure could theoretically be reached in five years just by leveraging this up to the maximum extent possible while still qualifying as aid (though more realistically it will probably take much longer to scale up).

A second criticism is that more loans will simply add to debt sustainability problems in the region. This is a valid concern. The Pacific is an aid dependent region and half of all Pacific countries are already at high risk of debt distress.

Yet, with some prudence, the AIFFP needn’t cause debt-related problems. The total $2 billion package would constitute about 5% of the region’s GDP – not insignificant but very manageable, especially as it is the largest Pacific economies (PNG and Fiji) that have more room to take on additional debt. Moreover, many infrastructure projects are intended to generate financial returns, making this more suitable for debt financing than other areas.

Perhaps the most critical question is whether the Department of Foreign Affairs and Trade (DFAT) has the capability to run the AIFFP effectively. The integration of the Australian aid program into DFAT generally weakened its aid management capabilities, especially in more specialised areas. Yet, even prior to this, Australia traditionally relied on channeling funds to the World Bank and Asian Development Bank when it came to major infrastructure projects, given their more technical capabilities.

One approach would be to basically continue this strategy by channeling most of the AIFFP funds to the multilateral development banks (MDBs), while retaining an ability to directly finance strategic projects. This would give Australia the improved tactical ability to compete with China directly on specific projects where needed while relying on working through the MDBs to do the heavy lifting on the longer term issue of sustainable infrastructure development.

Such an approach though would forfeit some of the (hoped for) broader ability of the facility to compete with China. While the MDBs are good at ensuring quality, this typically comes at the expense of speed and responsiveness – creating a key gap that China has been able to fill.

Equally though, it is not clear that a DFAT-managed facility would be able to do a better job than the MDBs (particularly at scale) while still maintaining the high standards that Australia and other Western donors hold as their comparative advantage over China (notably, regarding economic sustainability and environmental and social safeguards). Ultimately, if DFAT is to successfully manage the AIFFP in-house, it will have to not only rebuild lost capabilities but also develop significant new ones that not only match but even surpass that of the MDBs. Other parts of government might be able to assist, but the challenge would still remain.

Something in between this and out-sourcing to the MDBs might thus be the best way forward – with more funding shifting over time to projects managed directly by government as this capability is gradually built up and proven to work effectively.

The fundamental development task ahead should also not be underestimated, whether Australia works through the MDBs or not. In particular, it will require considerable upfront work to identify and prepare a sufficient pipeline of “bankable” infrastructure projects. In the Pacific, these are neither readily nor easily available due to a host of issues ranging from land acquisition problems to non-economic cost recovery and the fundamental difficulties imposed by the region’s remoteness, diseconomies of scale, and lack of economic dynamism. Yet, there will be a heightened need to ensure these projects are indeed economically sustainable, given loans will need to be repaid but also as the viability of these projects may well be increasingly marginal.

Reflecting this, ensuring Australian loans are as concessional as possible is a higher priority than leveraging up our grants as much as possible (as more leverage reduces concessionality). This will also be necessary to compete effectively with China which, despite much criticism that its loans are more expensive than the MDBs, still provides quite concessional loan terms.

Even better would be simply providing more grants (something China itself may start to do more of) and a larger overall aid budget (especially after years of stagnation). Ultimately, the Pacific is an aid dependent region and most countries need far more grant financing, not loans. Without this, there will always be a pressing need for more development finance from somewhere.

US-China tensions: is this about economics or security?

The administration has recognised that the true challenge China presents is not fundamentally one of a rising power threatening to replace an established power. Instead it is the challenge that China poses to the fundamental principles embraced by market democracies globally: free trade and open markets, freedom of navigation, and good governance. Elisabeth C. Economy, Council of Foreign Affairs

With headlines dominated by President Donald Trump’s tariff war and bellicose rhetoric about “unfair” economics and stolen intellectual property, the challenge might seem to lie in China’s economic behaviour rather than old-fashioned power rivalry. But closer examination suggests otherwise.

Just how different – and incompatible – are the two economies?

Beginning with Deng Xiaoping’s “Southern journey” in 1992, the Chinese economy has been guided by market forces. Without this market-driven dynamic, China would not have achieved its decades of spectacular growth and produced a world-beating crop of billionaires. Instead, it would have been weighed down by the plodding inefficiencies of a planned economy. China is now a mixed economy, with two-thirds of output produced by the private sector.

Just as China is far different from the sort of centrally planned system seen in the USSR, America is far from the free-market paradigm.

China has its “Made in China 2025” industry policy; America had John F. Kennedy’s moon-landing commitment in the 1960s, and now Trump’s adviser Peter Navarro’s plan to make America self-sufficient in security-related production. Anyone doubting the extent of government intervention in the American economy might examine the policy response to the 2008 financial crisis.

In China’s state-capitalism system, Beijing directs industry; in America’s economic model, industry directs Washington through lobbying and political pressures. The interplay is different, but both countries have a symbiotic relationship between state and industry.

China’s development strategy doesn’t differ in principle from the successful development model of Japan, South Korea, and Taiwan. Competitive exchange rates and industry protection were used to establish viable scale in manufacturing, disciplined by a strong export sector. Singapore might be seen as a small-scale prototype for China, and who disputes its success or claims unfairness?

What, then, is the basis of Trump’s complaints about China’s economic rule-breaking?

The danger in Trump’s rantings lies in the confounding of economic issues with the real and serious security issues that should be at the heart of the debate.

The most straightforward explanation is that he hopes his arm-wrestling can achieve a better international deal for America. This involves repeating his NAFTA renegotiation with other trade deals. With China, he hopes to increase imports from America, allow more American investment, and encourage China to pay more for intellectual property (they paid US $26 billion in 2017).

He misunderstands the advantage of multilateral trade and the irrelevance of bilateral trade balances. His objective, however, is rational enough: to reset America’s trade relations more favourably. We might even take him at his word that he wants zero tariffs, eventually.

In this, he may be cruder than his predecessors and more confused: but the objective is not so different. Each American president has, understandably, tried to shift the rules in America’s favour. Whoever won in 2016 was going to move towards protection.

There will be some damage from Trump’s behaviour, mainly to America, but the tariff war is less harmful than the headlines imply. If “decoupling” means a return to pre-Nixon isolation of China, this is infeasible. Globalisation is robust and can operate with imperfect rules. When the arm-wrestling is over, the “fundamental principles” of free trade and open markets will remain a utopian ideal, observed by none, but good-enough general guidance for all countries to benefit.

The danger in Trump’s rantings lies in the confounding of economic issues with the real and serious security issues that should be at the heart of the debate.

We see this confusion in the intellectual property discussion. The commercial imperative to maximise IP earnings is incompatible with the security imperative to keep secrets. Security-critical technology (including dual-use technology) shouldn’t be part of the IP discussion. It has to be kept secret, not sold under license in the futile hope that it won’t be copied. When national security is misused to justify steel tariffs against allies, this muddle makes it harder to identify true security risks such as Chinese investment in Silicon Valley’s high tech.

At the heart of the security debate is some simple but uncomfortable arithmetic. China’s population is four times America’s. Even if China gets only half-way to matching America’s per-capita income, China would by then have twice the US gross domestic product.

Leaving GDP to one side, China’s military capabilities will remain far behind America’s for many years, but already, in this inferior position, China has been able to effectively seize the South China Sea, with no viable retaliation from more powerful forces. This was not about economics: it was about the crude exercise of power.

China’s dominant scale seems almost inevitable: growth at double the American rate seems likely for a decade or more. Attempting to delay this through “decoupling” makes no sense. The critical issue, then, is intent: what will China do with this power? This is an old-fashioned security issue, akin to Russia’s current clashes with Ukraine.

The starting point for sensible policy is to distinguish between security and economics, and between objectives and instruments. The response to a security threat may well involve economic instruments, such as sanctions. But let’s keep this analytically separate from sensible economic objectives, which include a multilateral trading framework with minimal trade distortions and enough well-functioning international institutions such as the World Trade Organisation to make globalisation work for the benefit of all.

“America First” and global economic governance

President Donald Trump’s stated objective is “America first”. What might this isolationist mantra mean for global economic governance, which is the economic component of the “rules-based order”?
 


Trump might have left the Paris climate-change accord and the Trans-Pacific Partnership, but there has been no blanket departure from the international institutions that are still useful in the pursuit of American interests. America retains membership of the UN, the World Bank, and the International Monetary Fund. Even within the World Trade Organisation, Trump’s disruptions are best interpreted as bullying efforts at reform rather than an attempt to pull down the temple.

That said, something has changed since the halcyon days when the US was constructively building international institutions that would benefit all and foster globalisation.

At Bretton Woods in 1944, America was prepared to give others a role in global institution-building, even if it retained a veto and a loud voice. Contrast this with the first great period of globalisation ­– the century before the First World War – when the colonial powers forced their presence on weaker nations for their own narrow economic advantage. Bretton Woods brought a different vision of globalisation, in which the preeminent economy asserted its position in a more refined manner.

Based on their own market-oriented beliefs, America established global guidelines that came to be called the Washington Consensus. Its core elements – free international trade, reliance on markets, fiscal rectitude – were conducive to international integration and enabled the outstanding period of global growth following the Second World War.

The success demonstrates how little global governance is needed to foster international trade and integration.

Of course, this rule-lite free-market orientation suited America: opening up new markets for trade and capital flows provided the incumbent industrial superpower with profitable opportunities. It also made good sense for the rest of the world, including the emerging economies (Taiwan, South Korea, Singapore and, in due course, China all did well).

The success demonstrates how little global governance is needed to foster international trade and integration. Global rules can be light-touch, with national rules often sufficing. Where global coordination is needed, it is often provided by ad hoc agreements covering the practical details: in aviation, shipping, telecommunications, financial stability, and taxation.

The WTO has laboured largely in vain since 1995 to improve the rules. Where progress was made, it was in smaller plurilateral or bilateral agreements that were, in principle, inferior to multilateral deals. Much production remains isolated from international competition – for example, the European Common Agricultural Policy. Perhaps no country (certainly not the US) has done away with protectionists policies.

There have been sporadic attempts at international policy coordination, with debatable success: the Plaza and Louvre accords in the mid-1980s addressed exchange-rate misalignments. It is hard to point to much governance rule-making coming out of ten years of G20 meetings. The continued presence of the G7 reflects the realities of power; it maintains its own interests and priorities.

There is little capacity to address the various global “tragedies of the commons” such as climate change and biosecurity or to provide global public goods in the form of effective international dispute-settlement, sovereign insolvency or equitable company tax. Sensitive sovereignty and vested interests get in the way of a more complete set of rules.

Despite these gaps in governance, the current structure is robust, with a great capacity to deliver widespread benefits. Even when the optimal rules are not observed by all – or any – of the participants. Globalisation has continued apace (some would say too fast) even in this rules-lite environment.

In part, this reflects other factors driving world integration. Technology boosted growth in general, and boosted globalisation in particular – the fall in transport costs (containerisation) and communications produced an almost “flat world”.

In short, Trump arrives on a world stage of highly-integrated economies operating an imperfect but “good enough” system of rules and understandings, loosely held together by talk-shops such as G20 and deeper networks of ad hoc technical agreements.

If Trump’s presence prevents these meetings from issuing a joint communique, not much is lost.

Trump’s rhetoric is a departure from the Bretton Woods ideals and his America First could do some damage at the margin. It is one thing to take America out of the TPP; it is another to use America’s heft to curtail other countries’ trade deals with third countries. If he collapses the WTO, by design or accident, a constraint on protectionism will be removed. With global financial fragility still an issue, the US Federal Reserve may not be able to repeat its crisis-averting injection of US $500 billion into a collapsing global banking system in 2008. But none of these adverse prospects seems likely to derail the powerful self-generating momentum of integration.

As usual, history provides a note of caution.

Charles Kindleberger, a masterly chronicler of business cycles and recessions, attributes the trade contraction of the between-wars period to America’s unwillingness to assume its leadership responsibilities during the Great Depression. Britain was too weakened by war, while America was too new in its role as the global superpower. The world economy was left without mechanisms to constrain competitive protectionism.

Will geopolitics trump trade?

Geopolitics may be rapidly moving to the forefront in deciding how the US-China trade war will play out. If so, the odds of a rapprochement are dwindling fast.

The trade conflict has always been about many things, clouding how different analysts understood it. Initially, it seemed best understood as part of the populist backlash against globalisation. According to Donald Trump, China was “raping” the American economy and stealing its manufacturing jobs. On the campaign trail, he promised to impose 45% tariffs on all Chinese imports. Protectionism was the name of the game.

Once in office, however, the agenda morphed to paradoxically reflect the concerns of America’s policy and business establishment (the very globalists seen by populists as complicit in offshoring US jobs). The chief complaints against China came to focus on its investment restrictions, abuse of intellectual property rights, industrial policies, and nationalist technology ambitions. Such “unfair” practices undermined US commercial interests and, it was argued, America’s national interest as well.

This created an internal inconsistency, clouding how the trade conflict might play out. If Trump “won” the trade war by forcing China to open up its economy, it would only increase trade and investment between the two countries. If anything, this would reinforce the offshoring of manufacturing jobs even if it boosted US profits and created jobs elsewhere, such as in services. The US-China trade deficit (a key complaint of Trump’s) may not necessarily even go down, particularly as the overall US trade deficit is set to widen anyway.

Trump’s ability to sell nearly anything to his political base, however, provided the key path to a deal. Take the revisions to both the US-Korea Free Trade Agreement and the North American Free Trade Agreement. The US forced through a few protectionist changes to each but largely left both agreements intact. The changes won’t do much for US prosperity or shift its distribution towards the working class. But Trump can claim the wins and everyone else can largely move on.

A rapidly deteriorating geopolitical narrative in the US might stand in the way.

The situation with China was always more complicated. Still, one can envision a deal where China liberalises its economy in some important ways and perhaps forcibly buys more US goods to help reduce its trade surplus with America. China has previously offered to do this to no avail. But perhaps more favourable timing (e.g. after the US mid-term elections) and/or a more substantial offer would do the trick.

Getting allies such as Europe and Japan to help pressure China has also been seen as key to achieving a meaningful deal. And very slowly, the Trump administration has been coming around to this as it dials down (though doesn’t necessarily drop) its various trade grievances with key allies.

This is the basic scenario for an eventual solution to the trade war. Yet, this view sets aside how a rapidly deteriorating geopolitical narrative in the US might stand in the way.

Signs of this have now mounted significantly. In a bluntly worded speech last week, US Vice President Mike Pence articulated what can only be seen as a clear reset of US policy towards China, essentially moving towards an overtly adversarial strategy. A similar message was also conveyed directly at a Chinese embassy event by a top US national security official.

The week also saw two unsettling developments, including a dangerously close encounter in the South China Sea and a Bloomberg report that the Chinese military had installed hidden microchips in hardware destined for major US tech companies, whose clients include the US government. The first provided a vivid example of how China is now challenging US power. The second brought into the public domain deep anxieties about the national security vulnerabilities created by today’s complex global supply chains and China’s central role within them, reinforcing a Pentagon report making similar warnings.

Pence’s remarks left the door open to a trade deal, saying: “we continue to demand an economic relationship with China that is free and fair and reciprocal”. This suggests that the Trump administration’s goals in this domain might still be on the core issues of concern to US commercial interests.

But another deep policy inconsistency has now emerged, this time with the rest of the national security agenda as it is now being articulated.

Chinese liberalisation would only enmesh the two economies further together – reinforcing vulnerabilities in US supply chains and creating broader opportunities for China to use economic leverage with US business interests in its political influencing activities, which the Trump administration has also identified as a major concern. It would also ultimately aid China’s economic and technological rise, without necessarily spurring the kind of political liberalisation many in the US seem to need in order to be comfortable with this. For them, economic “decoupling” is the objective not a mutually prosperous economic relationship. 

Thus, when it comes to the US-China trade war, there is an increasing alignment between the populists and the national security establishment. Free traders and businesses appear to be the odd ones out.

NAFTA to USMCA – what’s in a name?

What’s in a name? According to US President Donald Trump, it is the difference between the “worst trade deal ever made” – as he called the North American Free Trade Agreement (NAFTA) – and a “wonderful new trade deal” – his reference to the United States-Mexico-Canada Agreement (USMCA) – which has been agreed to replace NAFTA. After a lengthy period of Trump lambasting NAFTA, threatening to walk away, and intimidating Canada and Mexico with the threat of higher tariffs if they did not agree to US demands, the three countries came to a “last minute” (the deadline imposed by the US) agreement on 30 September to replace NAFTA with USMCA.

If a member of the USMCA negotiates a trade deal with a non-market country – read China – it can be kicked out of the USMCA.

Irrespective of the merits of the new agreement, when it comes to names, the acronym USMCA does not flow off the tongue as easily as NAFTA (it is even worse for French-speaking Canadians who would refer to it as AEUMC). But Trump does like renaming things and the main attribute of the new trade deal as far as Trump is concerned is that it is not called NAFTA.

Was the renegotiation of NAFTA worth the effort? Following the announcement of the USMCA, CNBC reported “New Trump trade deal leaves NAFTA largely intact”. It was noted that there were some technical changes to such things as rules about manufactured cars and trucks, opening up the Canadian dairy industry, the length of copyrights and rules governing disputes, but overall North American “free trade” will continue, more or less, as it has done for many years. The Washington Post observed: “The only truly radical difference is that Trump’s negative angry language [against NAFTA] has been replaced by happy, enthusiastic language [in support of USMCA]”.

But these assessments underplay the significance of the new USMCA and what it conveys in terms of the US approach to trade deals.

As is common with such deals, the focus turns to identifying winners and losers, in other words, which country made the biggest concessions. It stems from the entrenched mercantilist view that exports are good and imports are bad, and a country’s measure of a successful trade deal is the extent of the concessions it has extracted from other partners. In assessing winners and losers, no account is normally given to the trade distorting impacts that may flow from such agreements and the impact they may have on consumers.

In terms of the three members of the USMCA, however, the US has come out on top, but this does not make it a “good” trade agreement for the US. The main gain for Canada and Mexico is relief that NAFTA was not abandoned altogether, and that trade in North America will largely continue as it has done. However, while Canada and Mexico have avoided the US threat of large tariffs on automobiles (they will receive a tariff free quota), the USMCA does not remove the threat to Canada and Mexico of US tariffs on steel and aluminium on national security grounds.

Canada does have to open its long-protected dairy market to US competition. While Canadian dairy farmers are complaining, it is a good outcome for Canadian consumers and the Canadian economy. As to other changes under the USMCA, cars will qualify for tariff-free treatment only if 75% is produced in North America, up from 62.5% in NAFTA.

In addition, 30% of the content must be produced by workers earning at least US $16 per hour, and this will rise to 40% in 2023. This is more than three times what the average Mexican automotive worker earns. While the auto workers in the US may welcome these changes, it will raise the cost of cars produced in North America, which will be felt by consumers and provide an incentive for American and Canadian car manufacturers to relocate elsewhere.

Other “gains” to the US include lengthening patents for US pharmaceuticals and strengthened intellectual property rights. Canada sought, but failed, to remove “Buy American” and open up subnational procurement in the US. Canada’s CBS News summed up the impact of USMCA as: “higher drug prices, longer copyright terms and no reprieve from ‘Buy American’”.

The new deal also contains a provision deterring members from manipulating their currencies. This US inspired provision is not aimed at Canada or Mexico, who have floating exchange rates, but is clearly a signal directed at China.

A particularly significant feature of the USMCA is that it does not just cover trade among the three members of the agreement, but impacts on their ability to enter into trade deals with other countries. If a member of the USMCA negotiates a trade deal with a non-market country – read China – it can be kicked out of the USMCA. Blayne Haaggart from Canada’s Brock University concluded:

It’s hard to read this as anything but a way to further lock Canada and Mexico into the US orbit, restricting their ability to counterbalance overwhelming American influence.

The USMCA may be Trump’s biggest trade deal to date and it may have removed uncertainty over the future of NAFTA, but it is hardly a positive for the global economy. It has demonstrated the US “take no prisoners” approach to trade negotiations, even when dealing with its allies.

Moreover, it demonstrates yet again Trump’s obsession with China.

Sliding rupiah causes Jakarta jitters

Capital has been flowing out of emerging economies around the world, causing currencies and financial markets to fall. While tightening global liquidity was the initial catalyst, the threat from Donald Trump’s trade war and fear that "contagion" might spread from Turkey and Argentina have added fuel to the fire.

Indonesia has found itself at the centre of such concerns in Asia. The rupiah has fallen about 10% since the start of the year and is now plumbing lows not seen since the Asian financial crisis. This has prompted much concern in Jakarta, where the scars from that crisis still run deep and many know all too well that "contagion" is a real thing. Policymakers have thus reacted strongly, happy to crimp economic growth for the sake of greater stability.

But is Indonesia really at risk of "contagion"? The rupiah’s fall to date has not really been that large. Nonetheless, Indonesia has been among those economies most significantly affected by capital outflows this year. A simple extrapolation, then, might suggest that if true contagion were to spread due to a more significant global shock, it would spread to Indonesia.

Yet such thinking ignores any meaningful analysis of Indonesia’s economic situation or indeed how a contagion might be transmitted.

The starting point is recognising that Indonesia’s fundamentals remain sound. Economic growth has been very consistent at 5% a year, inflation is subdued, public finances strong, and the banking system in broadly good health.

The current account deficit is the key weak point, but concerns are overblown. Presently it is only at 2.3% of GDP (on a rolling four-quarter basis). This exposes Indonesia to short term swings in capital flows, but it is hard to imagine investors would be permanently unwilling to finance such a moderate deficit given Indonesia’s comparatively strong growth prospects. Indeed, even this year, capital flows have quickly returned whenever global volatility has receded, suggesting investors, on net, tend to agree.

Economists liken this kind of situation to the difference between a solvent firm experiencing liquidity problems and one that is insolvent. Illiquidity can however quickly turn into insolvency. So the key thing to ask is: how easily could things tip over and undermine Indonesia’s good fundamentals?

One possibility is if investors see eerie similarities with other economies experiencing difficulties and simply reassess a country’s economic health. That was the case in 1997 when the collapse of the Thai baht set off a sharp reassessment of Indonesia’s economy and others in the region. Today, however, is much different. Indonesia shares neither the extent of economic problems in Turkey and Argentina nor the political drivers underpinning them. There is little reason for investors to suddenly reassess Indonesia’s fundamentals on this basis.

Another potential source of contagion is the dreaded risk of a ‘sudden stop’ (a prolonged cessation of capital inflows) if markets become unnerved or seize up for whatever reason. That would leave Indonesia unable to finance its current account deficit, or rollover maturing external debt, and potentially facing a painful and disorderly economic adjustment.

Yet this is precisely why Indonesia, and many other Asian economies, hold such substantial foreign exchange reserves. In the event of a ‘sudden stop’, Indonesia can use its reserves as emergency liquidity financing until markets normalise. Indonesia’s reserves are enough to cover its gross external financing needs for almost 18 months. Turkey and Argentina would only get by for several months.

Another risk is that a falling currency increases the burden of debt denominated in foreign currencies, potentially creating insolvency problems. Indonesia’s foreign currency debt is somewhat elevated at 28% of GDP. But half is owed by the government, which remains in a strong fiscal position, while half of the remainder is held by mining and manufacturing firms which tend to enjoy some natural hedging of currency risk. Nor does the banking system look obviously vulnerable. It remains well capitalised, not overly reliant on foreign funding, and mostly lends on rupiah terms.

What about America’s escalating trade war with China? This is certainly a threat. Indonesia however is less exposed than many other Asian economies. It is less trade dependent and it mostly exports basic commodities primarily used domestically by importing countries rather than as inputs into their own exports. The trade war would thus need to significantly reduce economic growth in Indonesia’s major trading partners to cause serious knock-on effects. A financial crisis in China is also a key risk in that regard. But that has been a tail risk for some time.

So where does all this leave Indonesia? The rupiah is likely to stay under pressure as global liquidity and interest rates tighten, particularly against a generally strengthening US dollar. Rising oil prices will add further pressure. Continued volatility and further depreciation thus seem more likely than not. But Indonesia’s solvency does not look especially sensitive to the major risks on the horizon. Global difficulties would thus have to escalate very severely to tip Indonesia over into a situation that looks anything like Turkey’s or Argentina’s problems today.

An emerging Indo-Pacific infrastructure strategy

The reaction to this week’s announcement by US Secretary of State Mike Pompeo of a US$113 million infrastructure fund is that it was more than a tad underwhelming.

When set against potentially upwards of US$1 trillion in financing for China’s Belt and Road Initiative (BRI) – to which the new US fund is a thinly veiled response – that certainly seems the case. Yet the outlines of an Indo-Pacific infrastructure strategy that looks potentially more promising can also be seen. 
 

A four-pronged strategy

First, it’s important to note that the US$113 million isn’t aimed at financing new infrastructure projects. Instead, it appears primarily intended to provide technical support to help governments develop and manage their own investments, particularly by attracting private capital. Viewed in this light, it is a more substantive amount, although still not a lot once spread across numerous countries.

Second, this is only the first step. A more significant next step is the BUILD Act, which is currently working its way through Congress. This would revamp the existing Overseas Private Investment Corporation into a new International Development Finance Corporation with modernised financing capabilities, including a doubling of its contingent liability ceiling to US$60 billion. 

Even a modest amount of new funding is welcome given the region’s infrastructure financing needs.

Third, a new trilateral framework is being established between the US, Australia, and Japan. Whether additional funds might come from Australia and Japan is not yet clear, although the latter did move earlier in 2016 to earmark US$200 billion over five years for its “quality infrastructure” initiative.

Fourth is an emphasis on “high standards” (or similar euphemisms) aimed at distinguishing its appeal compared to Beijing’s offering, which Washington paints as lower quality, self-serving, and a potential debt trap. High standards, by contrast, is intended to mean better built projects, transparency, competitive tendering, strong environmental and social safeguards, and, most importantly, economic sustainability.

Hence, the outlines of a four-pronged strategy appear to be emerging, consisting of a modest increase in funding, mobilising private capital, cooperation among financiers, and an emphasis on high standards.
 

A preliminary assessment

Even a modest amount of new funding is welcome, given the region’s infrastructure financing needs to 2030 are as high as US$26 trillion. The focus on mobilising private capital also makes plenty of sense, as official capital could never plug the gap and there is plenty of market interest. 

All this, however, is much easier said than done. The World Bank and Asian Development Bank have been doing this for years with limited success, at least at the kind of scale required, and in more difficult environments.

The problem is the limited pool of “bankable” projects. Critically, the main blockages lie in the recipient countries themselves – including pernicious problems of land acquisition, non-economic cost recovery, inept and corrupt bureaucracies and state-owned firms, poor project selection, and legal and regulatory frameworks that deter private participation.

Providing technical support can help, as most developing countries’ governments lack the expertise required across many areas. But deeper political and institutional problems are rarely easily overcome.

This leads to one clear difficulty in seeking to compete with BRI – bankability is much less constraining for China as it has been willing to take on much higher risks. Partly this is because it has at times misread the potential problems of working in many countries. This may eventually see it tighten its approach. Even so, as long as China retains a higher risk tolerance than other potential financiers, it will continue to find plenty of willing takers. 

The focus on “high standards” presents similar issues. For Western donors, this means good-quality investments. But for developing country governments, it usually means excruciatingly slow approvals, interference in domestic policies, preferred projects that go unfinanced, and, often, less overall investment.

China, on the other hand, is seen as faster, less burdensome, and more responsive. Even an emphasis by the trilateral partners on debt sustainability, while sensible and necessary, will do little to deter governments unperturbed about their own fiscal profligacy from seeking alternative financing options.
 

Of good development and good geopolitics

A race to the bottom is undesirable. The emphasis should instead be on encouraging China to converge over time towards something that looks more like existing global practices.

China, for its part, seems interested in doing this anyway. For instance, it has set up the Asian Infrastructure Investment Bank, its own International Development Cooperation Agency, and funded an International Monetary Fund facility to help governments receiving Chinese money better assess debt sustainability risks.

The trilateral framework could encourage this direction by setting a clear basis for potential cooperation with China (and others), where a commitment to broadly similar standards can be made.

But the trilateral partners should also not ignore serious shortcomings in their own existing approaches, which not only limit their impact but also make it harder to compete with Chinese finance. 

China’s willingness to engage in difficult environments should not simply be dismissed as uneconomic, but rather taken as a challenge to think harder about how to better support fragile states and least developed countries. External assistance here is most costly and difficult, but also greatly needed for both developmental and security reasons. 

Similarly, slow and burdensome processes need an overhaul, particularly at the World Bank and ADB which deliver the bulk of infrastructure development finance (including substantial co-financing from the trilateral partners). Much of this could potentially be greatly streamlined in ways that either retain the quality of the projects financed or achieve a better balance between managing risks and delivering results. 

A final area for reflection is the amount of financing itself. It is frequently said that it is impossible to compete with the scale of Chinese finance. Leaving aside much uncertainty about how large that is, the trilateral partners have plenty of firepower they are not using. All three only commit about 0.2% of their gross national income to official development assistance, compared to an average 0.5% among Western European countries. 

In Australia’s case, consideration might also be given to using bilateral loans (as Japan already does and the US seems to be moving towards) rather than only    providing grant financing. This would greatly magnify the amount of resources available. It makes particular sense for infrastructure projects, where financial returns should be expected.

Trade: the US should be isolated, not accommodated

Prior to leaving for the latest G20 Finance Ministers Meeting, held at the weekend in Buenos Aires, Australian Treasurer Scott Morrison said “the trade war cannot be ignored”. He has never said truer words. Unfortunately, it seems that the G20 ministers largely ignored the trade war.

While the communiqué released following the meeting acknowledged that “heightened trade and geopolitical tensions” pose risks to global growth, there was only one reference to doing something about reducing the risk:

We reaffirm our Leaders’ conclusions on trade at the Hamburg Summit and recognise the need to step up dialogue and actions to mitigate risks and enhance confidence.

This statement isn’t going to do much to ease concerns over a trade war.

Why isn’t the threat of a trade war being treated seriously? During Donald Trump’s campaign for the US presidency, concern was expressed about his views on trade. In 2016, USA Today ran the story “Trump’s trade policies worry economists”.

Yet despite a strident protectionist line both throughout his campaign and when he came into office, there seemed to be a view that Trump’s bark would be worse than his bite.

While Trump’s trade policies are not positive for the world economy, they are manageable if countries don’t retaliate.

Even after Trump ordered steep tariffs on steel and aluminium imports, of 25% and 10% respectively, earlier this year, there was a view that it would be alarmist to talk about a trade war. Prominent economist Dani Rodick said in March that “the reality is that Trump’s trade measures to date amount to small potatoes”.

This tendency to play down the seriousness of a Trump-inspired trade war seemed to reflect a view that it is only a concern if the restrictive measures he has announced are likely to result in a full-blown crisis. For example, in March Kristian Kolding and Chris Richardson implied that we should not be too concerned because Trump’s tariffs on steel and aluminium wouldn’t spell a recession for the world or for Australia.

What was not taken into account sufficiently is how a trade war can escalate with tit-for-tat restrictive measures. And a recession should not be the benchmark for escalating concern over Trump’s trade policies. In a world that is only starting to throw off the constraints of the global financial crisis, we should take any policies that are likely to restrain growth very seriously, even if they do not result in a recession.

The trade war has escalated. While Trump may have flip-flopped on other issues, he has consistently implemented his threats to address “unfair trade”, at least in his eyes.

On 6 July, Trump ordered 25% tariffs on approximately US$34 billion of Chinese imports, which were promptly met by retaliatory tariffs on an equivalent volume of US exports to China. On 20 July, Trump was “ready to go” and impose tariffs on US$500 billion of imports from China, and he has threatened sweeping tariffs on automobile imports from the European Union.

In the lead-up to the G20 Finance Minister’s Meeting on weekend, the International Monetary Fund issued a Surveillance Note warning that:

the likelihood of escalating and sustained trade actions has risen, threatening a serious adverse impact on global growth.

The note contained four hypothetical trade scenarios for the global economy. If all currently announced tariffs go into effect, global output would be reduced by 0.1% by 2020. It does not sound much. But the IMF points out that if global confidence is shaken by these tariffs, which is likely, global GDP could decrease by 0.5% – or around US$430 billion – below the current projection for 2020. Such an outcome would make a serious dent in global growth.

It was only four years ago, under the Australian G20 presidency, that the objective was to increase global growth by an additional 2% over five years, and the measure of success for the G20 was the extent to which additional growth was achieved. The G20 cannot now take any comfort in the extent to which their restrictive trade policies will “only” result in a decline in growth that would otherwise be achieved.

If the G20 members took the Trump-inspired trade war seriously, what could they do about it? The finance ministers could at a minimum signal to the rest of the world that they discussed it at their recent meeting rather than releasing a communiqué featuring such bland words as “we are working to strengthen the contribution of trade to our economies”. What happened to previous commitments to resisting protectionism, even if they did not follow through with them?

G20 finance ministers need to get real and signal that a tit-for-tat trade war will seriously damage growth, even if the US will not sign up to such a message. The US needs to be isolated and not accommodated. Moreover, the best thing G20 members could do to avoid a trade war is signal that they will “do nothing”. That is, they should commit to not engage in retaliation.

In March, the Reserve Bank of Australia Governor Philip Lowe said that while Trump’s trade policies are not positive for the world economy, they are manageable if countries don’t retaliate. Dani Rodick recently observed that if Europe, China, and other countries want to uphold a rules-based multilateral system, they should not mirror Trump’s unilateralism and take matters into their own hands by retaliating. They should work through the World Trade Organisation.

If one member of the G20 issues trade barriers, the rest of the G20 members should condemn the move, but commit to maintaining their open borders and avoiding a trade war.

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