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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

Less is more? Employment rates and economic growth

Labour market participation, the proportion of a country’s population that is either working or actively looking for a job, seems like a boring statistical constant. In advanced economies it has hardly changed in recent decades.

But the latest IMF World Economic Outlook devotes a chapter to labour market participation, and it is a key to understanding current US monetary policy.

It is sometimes said that economic growth depends on the “three Ps”: productivity, population, and participation. The overall participation rate may not have changed much, but the combination of ageing populations, social change, higher educational attainments, the business cycle, and rapid technological development has substantially altered the components that make up the aggregate figure.

Men have been dropping out of the labour force, offset in the aggregate figures by increased participation by women. Variation between individual countries’ rates (shown by the shaded areas) has narrowed over time, especially for women’s participation.

This might seem to be a universal social trend, but in fact there are big differences between countries, with participation holding up for both men and women in Germany, Sweden, and South Korea, while rates for both fell in the US and Canada. Japan and Australia followed the more typical trend, with men’s participation falling and women’s rising.

Further disaggregation shows a drop in participation of the younger population (15–24 year-olds), with many spending more time in study. Participation by older workers (especially the 55–64 cohort), particularly women, has risen strongly.

The divergences between countries and characteristic differences at the two ends of the age spectrum suggest that outcomes are amenable to policy action. Greater participation by women, for example, reflects family-friendly policies, as well as social trends and wider educational attainment.

Those who are marginally attached to the labour force (usually the young and the old) are more likely to respond to financial incentives such as tax/benefits interaction.

Getting more of the population into the labour market (and into employment) is not only good for GDP, but also contributes to how satisfied people are with their lives. The dismal story of America’s falling longevity among older white men has multiple causes, but the absence of satisfactory work opportunities is one important factor in these “deaths of despair”.

In addition to influencing longer-term economic growth, participation is a key factor in current monetary-policy deliberations. The US debate illustrates the issues, and the same considerations are relevant in Europe.

How does the Federal Reserve know when to tighten policy to keep inflation in check? The headline rate of unemployment has fallen to 4.1%, which many would consider to be below “full employment”. Why is the Fed still on a gradual path to normalising policy if the economy is already running at full capacity?

The 2008 recession and subsequent slow recovery not only put people out of work, but discouraged some to the point that they dropped out of the labour force altogether – no longer actively looking for work, so no longer counted as unemployed. The recovery has, however, lured some of these discouraged workers back into the labour force.

If this process has further to go, the Fed should maintain its accomodative policy stance. But how can the Fed tell how much of the 3-percentage-points fall in participation since 2007 reflects changing age composition, as the baby boomers reached retirement age? These (and other compositional factors) are not responsive to monetary-policy action.

The graph below decomposes the fall in US participation since 2007 into two parts: the blue area shows the fall in participation that can be explained solely in terms of age-composition changes, assuming that 2007 participation rates for each of the component groups remained unchanged. The residual, the pink area, might be attributed to cyclical effects.

It looks like most of the cyclical fall in participation has been recovered, which would suggest that the labour market is tight, with little prospect of encouraging more non-participants into work. But steady GDP growth and appropriate policy measures could bring in more young workers (some have been studying because they can’t find a suitable job), encourage more older workers to stay in employment, and reverse the atypical fall in women’s participation in the US.

Women’s participation rose strongly after the Second World War. These additional workers added 14% to GDP in the three decades after 1970. But women’s participation peaked in 2000 and is now lower than in 1970: for 25–54 year-olds, it has fallen from 77.3% to 75.2%. Japan, usually associated with low female participation, has now overtaken the US.

 

Photo via Flickr user @mjb

Biding time: the G20 Eminent Persons Group on financial governance

Watchers of international financial markets have focused in recent months on the possible ramifications of an escalating trade war. The World Trade Organisation recently warned that rising trade tensions are impacting business confidence and investment decisions.

Against the background of rising protectionism, described by the International Monetary Fund (IMF) Managing Director as a “dark cloud” looming over the global economy, there is a touch of irony to G20 finance ministers meeting in Washington on Thursday to consider a status report from a G20 Eminent Persons Group (EPG) that largely revolves around proposals to promote greater international economic cooperation.

Is this a positive sign that may help counter the tit-for-tat tariff war unfolding currently, or another instance of the G20 increasingly becoming a talk shop divorced from reality?

The status report was authored by the EPG on Global Financial Governance that was established in April 2017. The EPG was tasked with reviewing challenges and opportunities confronting the global financial system, the optimal roles of the International Financial Institutions (IFIs), and to recommend practical reforms. Its final report is due in October 2018.

The EPG is chaired by Singapore’s Deputy Prime Minister, Tharman Shanmugaratnam, and its membership consists of distinguished academics. The group has not sought nor received much publicity.

Nancy Birdsall from the Center for Global Development (CDG) described it as a “relatively obscure and quiet group”. The meagre public attention may mean the group can have meaningful discussions with ministers on a wide range of issues without those ministers feeling pressure to immediately oppose anything controversial.

This status report will update relevant ministers on the group’s key findings and the direction of its thinking. The issues identified include an ever-growing multiplicity of international players; the increasing role of private capital flows and the challenge of harnessing these to promote growth; and threats to the “global commons” – climate change, pandemics, money-laundering, terrorism financing, tax evasion, and cyber-related risks.

The breadth of these challenges brings into play many international organisations, particularly the United Nations, but in keeping with its terms of reference, the EPG has focused on the Multilateral Development Banks (MDBs) and the IMF.

The EPG has identified six areas for reform to strengthen the development impact of the MDBs: the development of a set of core principles to coordinate all MDB operations; country-owned platforms as the basis of the MDB country operations; MDB collaboration to support system-wide risk insurance; collaboration on securitisation to mobilise institutional investors; governance structures and internal incentive arrangements that reorient MDBs towards achieving a greater development impact; and transparency of responsibilities and complementarities between institutions.

Regarding the challenges of securing the benefits of open financial markets, the EPG emphasises the importance of developing a framework, managed by the IMF, for assessing and mitigating excess volatility of capital flows and exchange rates, which would guide national policies.

The group also asserts the need to achieve a resilient, predictable, and adequate Global Financial Safety Net, as well as more integrated financial surveillance and institutionalised early warning systems involving the IMF, Financial Stability Board, and Bank of International Settlements.

The direction of the reforms identified by the EPG are neither radical nor particularly novel. The IFIs are unlikely to disagree with the EPG’s thinking to date. Many will likely argue that they have been advancing various initiatives along these lines, although with mixed success. They would probably also say that the attitude of some shareholders has been the major hurdle in making greater progress.

At the core of the EPG’s approach is the need for greater collaboration between the IFIs based on a system-wide approach to governance. The aim is to ensure that they operate as coherent and complementary parts of a system, rather than as independent institutions. But this in turn requires shareholders to adopt a system-wide approach to their participation in each and all of the IFIs.

Birdsall described the EPG’s status report as “disappointing but still hopeful”. She supported the group’s broad approach, but was disappointed that it had not endorsed some proposals contained in the 2016 CDG report on the MDBs, such as the recasting of the World Bank with a specific mandate to advance global public goods, and the MDBs being given a mandate (and funding) to provide grant financing in support of investments with positive spillovers.

The problem with the CDG’s proposals was that they exceeded the MDBs’ shareholders’ appetite for reform. This is the challenge facing the EPG. As noted, many of the issues raised in the group’s status report have been discussed in various forums for many years.

The question the EPG should be focusing on is: what has impeded implementation of the reforms?

IFI governance is a problem, but reforms will not be achieved unless they are driven by major shareholders who would need to forgo their desire to control individual institutions and be more responsive to the advice offered by the IFIs.

There is currently little to suggest that shareholders have an appetite to advance significant IFI reforms, particularly if it involves having to convince their electorates of the merits of increased financial support for an IFI.

There is certainly no such appetite in the US. The US Treasury Secretary Steven Mnuchin recently defended proposals that would sharply cut or eliminate American support for the MDBs, and new National Security Advisor John Bolton previously advocated for the IMF to be shut down and the MDBs privatised.

Thankfully, the work of the EPG has flown under the radar, avoiding the build-up of unrealistic expectations that significant reform of global financial governance is near at hand. The EPG must play a long game. Rather than focusing on specific reform measures, its immediate task should be to convince a group of key shareholders to be the champions for reform.

This is easier said than done.

Global monetary policy returning to “normality”

Former US Federal Reserve chair Janet Yellen promised that unwinding quantitative easing would be “the policy equivalent of watching paint dry”. Not everyone agrees.

Jamie Dimon, head of JP Morgan, the most successful of the big American banks in the past decade, has voiced his concerns about the process of normalising US monetary policy:

Many people underestimate the possibility of higher inflation and wages, which means they might be underestimating the chance that the Federal Reserve may have to raise rates faster than we all think. While in the past, interest rates have been lower and for longer than people expected, they may go higher and faster than people expect.

Part of the widely expressed hand-wringing comes from a misunderstanding about the effects of quantitative easing. When US quantitative easing began in 2008, many were worried it involved “money creation” and inevitable inflation, based on half-understood recollections of the credit multiplier model and Milton Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon”.

These inflation fears were comprehensively refuted by the actual experience, with inflation below target everywhere. The extra liquidity quantitative easing provided to bank balance sheets did little to encourage them to lend more: some potential borrowers were still weighed down by legacy problems from the recession.

As well, the slow recovery discouraged others from borrowing to expand production capacity. Rather than expand output and push up wages and prices, credit flowed into asset markets, driving up equity and property prices.

Most of the quantitative easing expansion of base money simply sat unused in the balance sheets of banks, as excess reserves.

In its expansionary phase (2008–12), quantitative easing worked through two channels. First, via portfolio adjustments, with the Fed’s bond purchases causing investors to rejig their balance sheets, changing asset prices and interest rates in the process.

Second, quantitative easing provided some signalling messages about future Fed policy. Now that normalisation is underway, what is the likely impact?

The Fed has already begun unwinding its quantitative easing bond holdings, not by selling them in the market, but by allowing its bonds to mature over time – the least disruptive way of running down its bond holdings. Longer-term interest rates have started to move up, but are still lower than during the 2008 recession. The common view is that rates will not return to pre-crisis levels because the long-term equilibrium interest rate (the “neutral” or “natural” rate) has fallen, perhaps because of demographic shifts, low productivity performance, excessive saving, or a shortage of riskless government bonds in a risk-sensitive world.

Chart

The second quantitative easing channel, policy-signalling, was probably more powerful during the confused period of the early recovery. Expansionary quantitative easing demonstrated to financial markets that the Federal Reserve was concerned about the slow recovery and would keep its short-term policy rate low for an extended period of time.

When markets received the correct message that short-term interest rates would stay “low for long”, this acted to keep longer-term interest rates low as well. The current signalling is pretty clear: the Fed funds rate is on the way up, with the only argument being whether there will be three increases this year or four – a relatively trivial issue of timing which will be settled as the Fed assesses the evolving economy. Thus, it’s hard to see any great surprises via the signalling channel.

The US recovery is more advanced than elsewhere, with the unemployment rate already quite low. Are the rest of us ready for any spillover tightening from the US?

If we are searching for things to worry about, then two possibilities come to mind. First, asset prices (particularly US equity prices) might have overshot the equilibrium, with the possibility of a sharp correction. If so, financial markets elsewhere will do the usual knee-jerk imitation.

Second, the low interest rates over the past decade might have tempted some borrowers to overextend their balance sheets. The main concern here is for borrowers in emerging economies who have borrowed in US dollars to fund activities in their domestic economies, leaving them at risk not only of higher interest rates, but also from adverse exchange rate movements.

As US interest rates rise, ours may too. It is not easy to explain exactly why there is a strong connection between US long-term interest rates and rates in other countries and currencies, but sentiment seems globally contagious and the long-term rate is influenced by the volatile term-premium – the difference between the short and long interest rates.

Longer-term rates everywhere appear to play follow the leader with the US. That said, countries seem to be able to set their own short-term policy interest rates, and there is no strong reason why floating-rate mortgage rates in Australia should respond to US interest rates.

Janet Yellen in no longer at the Federal Reserve to supervise the boring normalisation process she promised. But the new Federal Reserve Chairman, Jerome Powell, is a safe pair of hands, with six years of experience on the Fed board. He promises a continuation of the same gradual normalisation process which has already been underway, uneventfully, for three years.

American trade policy returns to “aggressive unilateralism”

America’s new haphazard and confrontational approach to trade policy under President Donald Trump is rapidly taking shape.

Risks of escalating protectionism and a damaging trade conflict between the US and China are rising. The two have already exchanged tit-for-tat moves with regard to Trump’s steel and aluminium tariffs. Now, following US allegations of Chinese technology theft, the focus has shifted to potential tariffs on US$50 billion of each other’s exports, with Trump threatening to raise this to US$150 billion if China retaliates. Tense negotiations are also ongoing with Canada, Mexico, the EU, and others.

Critics widely condemn Trump’s approach as inherently damaging, based on flawed economics, leading only to protectionism and a potential trade war, and otherwise undermining the rules-based system built around the World Trade Organisation (WTO). The 1930s descent into global protectionism provides the cautionary frame of reference.

Yet Trump’s unorthodox and unpredictable style make it difficult to take anything at face value. The hope remains that this is all just negotiation bluster and that a deal will be struck that limits the damage. Indeed, Trump walked back his steel and aluminium tariffs partially by granting (temporary) exemptions to most allies, though not all. And top administration officials have been publicly making this argument in an effort to calm financial markets. Trump’s threats of further escalation, however, have not helped.

But did such a strategy ever make sense? Rather than the 1930s, proponents often point to the 1980s and early 1990s as the relevant historical precedent, when the US engaged in what economist Jagdish Bhagwati dubbed “aggressive unilateralism”.

That period saw the US deploy similar tactics to those on display today to pursue its grievances with a rising Japan, and others, as well as to force through changes to the multilateral trading system. In particular, threats of unilateral sanctions were frequently deployed as a negotiating tactic to prise open foreign markets. The primary tool was the same Section 301 provisions in US trade law used to justify the current set of tariffs being considered against China.

So-called “voluntary export restraints” were also frequently negotiated, most famously to limit Japanese car exports to the US. That move is also being replicated today, with the US considering quotas as the price to pay for permanent country exemptions from Trump’s recent steel and aluminium tariffs. American requests that China reduce its bilateral trade surplus by US$100 billion (about a quarter) suggests similar tactics may also be employed in its negotiations with China.

Useful questions to ask about this past experience are whether or not it lends support to Trump’s current approach, and what insights it can provide for today.

According to one systematic study, Section 301 investigations, America’s primary unilateral tool, were somewhat effective in prising open foreign markets. Almost half of 72 cases were judged at least partially successful against their stated objectives, although the gains were modest overall. At the same time, there was no descent into escalating protectionism or full-blown trade wars, with only a few instances of countries actually retaliating against unilateral US actions.

Also in contrast to criticism at the time, American unilateralism did not ultimately undermine the multilateral system. Instead, it arguably played a key role in strengthening it. Previously stalled negotiations under the General Agreement on Tariffs and Trade (the WTO’s predecessor) were reinvigorated. This eventually led to the creation of the WTO in 1994, which helped address US concerns at the time and, from the perspective of others, provided the basis to contain future American unilateralism. New rules governing a broader range of areas were agreed on, and the dispute settlement mechanism was given more teeth.

So far, so good. Yet several other factors suggest things are much more concerning this time around.

First, retaliation and tit-for-tat protectionism looks very likely and is already happening. That will magnify the damage of any unilateral actions and create risks of further escalation, of which there are already worrying signs. Global supply chains are also now distributed across many countries, so tariffs aimed at China will invariably hit others along the way, including the US. That will not only reduce their effectiveness as a threat but also set other trading partners offside.

Second, while both periods involved a misguided belief that trade deficits reflect unfair trading practices (rather than macroeconomic factors), the policy response has been very different. In the 1980s, the Plaza Accord was used to correct the real source of the US trade deficit at that time – an overvalued US dollar – and thus head-off protectionist pressures primarily emanating from Congress. US protectionism was thus partly only an outlet for blowing-off political steam.

Today, by contrast, it is the president who is leading the charge on trade deficits and protectionism. Yet he is also delivering a large fiscal stimulus that will further widen the trade deficit significantly, potentially fuelling additional protectionist pressures.

Third, the US seems more interested this time around in paring back the multilateral trading system rather than strengthening it. In particular, it sees the WTO dispute settlement body as engaging in judicial activism and has been blocking the appointment of new appellate judges.

The US essentially wants the WTO to limit itself to areas where the existing rules are clear-cut. But with negotiations to update those rules stalled, the WTO’s ability to mediate disputes and keep a lid on protectionism is at risk. America’s steel and aluminium tariffs are a case in point, utilising what it sees as a loophole in WTO rules to self-declare an issue of national security, no matter how spurious the argument.

Concerns about China are of course central to US complaints about both trade deficits and the WTO, particularly over its ability to deal with China’s unique party-state capitalist model. There are strong parallels with Japan in the 1980s, reflecting similar US concerns about a large bilateral trade deficit and Japan’s state-guided keiretsu (conglomerate) economy, as well as fears that America might be eclipsed both economically and technologically by a rising power.

Of course, the situation with China is likely to be far more difficult. Most obviously, China is not an American ally, which will make a meaningful compromise more difficult to reach. More importantly, Japan’s financial crisis in the early 1990s and ensuing economic stagnation meant the challenge it posed to American economic primacy never really played out. Although China’s economy faces some short-term risks, it is unlikely to fade into the background so easily.

 

Photo: via Flickr user A.Davey

Profit shifting: digital fat cats in national tax gaps

Company tax is in the news again. While the Australian Government attempts to garner Senate approval for its corporate tax-cut proposals, the EU is moving in the opposite direction, searching for ways to raise corporate taxes. What’s driving these two diametrically opposite policies?

Since 2000, multilateral company tax has fallen from 34% of profits to 24%. This reflects a variety of factors. Some countries have reduced their corporate tax rate to attract enterprises, and others have responded competitively. The extreme examples are the zero-tax havens, but Singapore, Switzerland, the Netherlands, Ireland, and many others offer very low tax rates. Ireland has been so successful that these footloose profits now make up 23% of its GDP, mostly from companies with no substantial presence in the country.

Companies have become much more adept at shifting profits to these low-tax* jurisdictions. While globalisation, the greater importance of intellectual property, and the burgeoning digital economy have all facilitated such shifting for digital companies, more conventional companies may be able to achieve similar outcomes through inter-company borrowing, tax deferral, and transfer pricing.

The OECD has long recognised these issues. The Base Erosion and Profit Shifting (BEPS) initiative has laboured to find a solution which can be applied globally, or at least uniformly in the OECD, with a further report to be published in April. Unsurprisingly, achieving consensus among OECD members, with so many varied and vested interests not only between countries but also within them, is proving very challenging.

Without globally uniform solutions, various countries, including Australia, are taking their own measures. This option is clearly second-best, but understandable. Perhaps hoping to head off the complexity that would come from these disparate and inconsistent national solutions, EU bureaucrats in Brussels have been working on their own Common Consolidated Corporate Tax Base (CCCTB) for some years, with prospective application in the EU only.

But the CCCTB is on a slow track, held back by the same factors that constrain the BEPS initiative. Thus, the EU Commission has developed a proposal to tackle just one aspect of this problem: the difficulty of taxing the burgeoning digital economy.

Companies such as Facebook, Apple, Netscape, Uber, eBay, Airbnb, and Amazon accrue large revenues from advertising, sale of data, platform revenues, and subscriptions which are readily channelled to low-tax jurisdictions. Tech-based companies are the fast-growing sector. In Europe they pay less than 10% company tax, compared with 23% for conventional companies. Value-creation through interaction with customers takes place in one country, while profits accrue in another.

The EU proposal is to impose a 3% tax on total revenue (rather than profits), distributing this to the countries where the product earns revenue. This is seen as a temporary measure pending the arrival of the CCCTB.

Recognising the likely long wait for CCCTB, the alternative view is that the EU proposal might prevent similar proposals being developed among individual EU countries (France and Germany in particular), in the hope of at least getting some intra-EU consistency in taxing the digital economy. Even this lesser objective seems beyond reach as it needs agreement from the 28 EU members, including some (for example, Ireland and Luxembourg) that do very nicely out of the existing defective system.

Australia’s proposed tax reductions have a different motivation: the fear that the global tax reductions noted above will adversely affect capital inflow. These fears seem grossly exaggerated, but the business lobby is campaigning strongly.

The proposed modest cut to 25% doesn’t mean that we are leading the charge in the “race to the bottom” to attract footloose global capital. If tax was the dominant investment determinant, companies would still have an incentive to go to lower-tax jurisdictions (for an anecdote on Singapore’s use of low tax to attract enterprise, see here).

Nevertheless, BEPS and the EU objectives seem a far more worthwhile goal: to put in place a tax system which requires companies to make a fair contribution to running the countries in which they create their value and earn their profits.

 

* An earlier version of this article referred to “low income”.

 

Photo by Flickr user Mr Thinktank.

Intellectual property: the big risk in US–China ties

It may be chaotic and confused, but the Trump administration is not entirely nuts. Expected to slam China with heavy penalties for appropriating the intellectual property of US businesses, the administration instead appears to be stopping short of a fundamental injury to the world’s biggest bilateral trading relationship.

Even so, the developing dispute over intellectual property is now a big risk to US–China economic ties, one that if mishandled has the capacity to hurt the growth of world trade.

According to background briefings given by administration officials to the media last week, President Donald Trump will soon announce a US $30-billion penalty on China’s exports to the US in reprisal for what the administration will claim is the cost of Chinese appropriation of US businesses’ intellectual property.

In most contexts, $30 billion is a very large amount; however, it is less than 6% of China’s annual exports to the US. Depending on the time frame and method of application, the actual cost may be mitigated. Imposed as, say, a 20% tariff on $30 billion of China’s US exports, the cost could come down to something closer to $6 billion, shared between Chinese exporters and US consumers.

The action will be proposed in response to an adverse finding in an investigation under Section 301 of the US Trade Act, initiated in August by the US Special Trade Representative Robert Lighthizer. Much depends on the plausibility of the 301 report, which is delivered as an outcome of the investigation.

The official brief for the USTR investigation was to examine:

any of China’s laws, policies, practices, or actions that may be unreasonable or discriminatory and that may be harming American intellectual property rights, innovation, or technology development.

It was, to say the least, a very wide brief. The further the report goes beyond actual offences to World Trade Organization rules, the less support the US will receive from the rest of the world.

The 301 report will likely argue that China has engaged in deliberate, large-scale appropriation of intellectual property from the US. It will allege that Chinese Government authorities, private businesses, and state-owned enterprises have participated in co-option of intellectual property. It will claim that there has been a systematic campaign to target technologies, including robotics, artificial intelligence, and advanced communications. And it will assert that some of these technologies have defence applications, so their importance is not only commercial but also strategic.

The 301 report will probably claim that Chinese corporations and government authorities have used standard commercial means to transfer technology, including commercial licensing agreements, but also less legitimate and less obvious means to which US and other advanced economies should be more alert. These include direct offshore investment in early-stage Western technology businesses; direct offshore investment in mature Western technology businesses; and “involuntary” knowledge transfers required by Chinese authorities as part of the price of access to China’s vast and rapidly growing consumption and investment market.

The 301 document may also accuse Chinese authorities of engaging in cybertheft of intellectual secrets and actual commercial espionage, citing cases that arose during previous administrations.

Most of this is old stuff. With varying levels of annoyance and plausibility, the US has been complaining of theft of intellectual property by China for three decades. It was once an argument over DVDs and fake designer handbags, watches, and jeans. Under successive administrations the argument moved on as China moved up the technology curve.

Nor is the US complaint unique to China. Further back, the US was accustomed to similar disputes with Japan and South Korea. Even today, US officials sometimes portray France as a close second to China in intellectual property wickedness. As recently as May 2014, former US Secretary of Defense Robert Gates said:  

[there] are probably a dozen or 15 countries that steal our technology ... in terms of the most capable, next to the Chinese, are the French – and they’ve been doing it a long time.

Rhetorically enlivened by the Trump administration, the US stance on intellectual property will meet very little dissent in Washington. It will be backed by Republicans and Democrats alike, free-traders and protectionists. Once upon a time, US corporations would have lobbied against strong action on China. Perhaps disappointed by their experience in China, perhaps cowed by greater anti-China sentiment as that country has asserted itself in the world, US business is now on the side of sterner action – particularly regarding intellectual property transfers.

China will certainly respond with sanctions on US exports to China, which over the last decade have grown twice as fast as China’s exports to the US. But China, like Europe, will be wary of escalating the dispute with the US. It will continue to look to the long game.

Tangled in this coming dispute are much bigger issues for the US, China, and the rest of the world. One is the extent to which the US may wish to obstruct China’s declared intention of becoming a leading competitor in high-technology industries. Another is the extent to which the US wishes to frame trade disputes with China as those between a “liberal international order” created and sustained by the US and a state-directed transactional and opportunistic challenge by China.

In its disputes over intellectual property and China’s adherence to WTO undertakings in 2001, the US will be seeking allies. These include Australia, but the major ally the US needs is Europe. The administration appears prepared to refer some aspects of the intellectual property case to the WTO, long portrayed by Trump as the centre of anti-US iniquity in global trade disputes.

To find allies, the administration is evidently now prepared to do what was previously unthinkable. But European support will not be forthcoming unless the US gives ground on its steel and aluminium tariffs due to become effective on Friday. 

The sky is not falling on Asia’s central banks

The nature of financial-markets commentary is that every tiny blip and ephemeral piece of news is presented as a narrative of impending doom: who wants to read a story about how everything is jogging along normally?

Headlines such as “Asian central banks face white-knuckle steering as Fed tightens” are hardly surprising; others describe the minor correction to equity markets last month as a “global rout”.

But it’s a stretch to say that “you can almost hear the echoes of the Asian financial crisis which battered emerging economies twenty years ago”. The facts are more boring – and reassuring.

The US Federal Reserve will do what it has been talking about doing for some years: gradually lifting interest rates from the historically low levels of the past decade and (equally gradually) unwinding quantitative easing (QE). In doing so, it will assess the impact of every small policy move, raising rates to counterbalance the now-sustained expansion.

Unwinding the Fed’s QE bond holdings will not be achieved by dumping bonds on the open market, but by letting them mature on the Fed’s balance sheet. Former Fed chair Janet Yellen promised that unwinding QE would be “the policy equivalent of watching paint dry”.

All this has been so well signalled by the Fed that investors should have fully adjusted their portfolios in advance. Any investor who is uncomfortable with the uncertainty of emerging markets should have retreated already.

Minor portfolio tweaks might be necessary as investors respond to the precise profile of the unfolding Fed “normalisation”, but no single policy change will be important enough to significantly change the outlook. Why should this cause any drama?

Rather than a wholesale global retreat of capital from emerging economies, what seems more likely is that individual countries might come under pressure because of idiosyncratic vulnerabilities: governments or companies that have borrowed too much in foreign currency in a world of shifting exchange rates; a country that is running big account deficits, or is mired in sluggish growth and big budget debt (for example, Brazil), for which even modestly higher interest rates raise issues of sustainability.

The interesting issue is not the prospect of global panic, but which among the emerging economies might get into trouble.

Our region looks pretty secure. India and Indonesia, members of the 2013 “Fragile Five”, are both in better shape than five years ago (and even then, the so-called “taper tantrum” was only a short-lived scare).

Taking Indonesia as an example, the Nervous Nellies among foreign holders of government rupiah–denominated bonds have already pulled back (foreigners’ share of these bonds has fallen from 41% to 38%). The current account deficit (around 3% of GDP in 2013) was less than 2% in 2017 and won’t be much more than 2% this year. The budget has been straightened out, and inflation is low. Foreign exchange reserves are $US130 billion. The exchange rate has already depreciated a few per cent this year, ensuring that it won’t be seen as grossly overvalued.

Elsewhere in the region, China has its congenital doomsayers. The Bank for International Settlements is promoting a crisis early-warning measure, comparing the credit/GDP ratio with its trend. On this measure, China’s credit/GDP is way over trend. But it’s much less above-trend than it was a year or two ago (now 13%  compared with 29%  in 2016), so there seems a good chance China will sneak through, gradually bringing financial excesses under control through case-by-case restructuring of over-leveraged entities.

Neither the doom-laden headlines nor the Bank for International Settlements’s one-size-fits-all early-warning indicators are subtle enough to help in foretelling the next crisis. Market analysts should keep calm and carry on with the tedious task of analysing the detailed national data, recalling that “unhappy countries are all unhappy in their own way”.

CPTPP wobbles over foreign investor rights

With the Comprehensive and Progressive Agreement for the Trans-Pacific Partnership (CPTPP) now signed and awaiting ratification by the member states, the issue of investor-state dispute settlement (ISDS) is again being debated. The high-profile opinion-catalysing group GetUp is encouraging opposition to ISDS, and the Labor Party has long-standing concerns about the system which will likely be rehearsed during the ratification process.

Should this esoteric issue be a deal-breaker for Australia’s membership of the CPTPP?

Defenders of ISDS can argue that the current clauses (redrafted as the TPP morphed into the CPTPP) embody protection against misuse: ISDS could not be used for a repeat of Philip Morris’s egregious attempt to overturn Australia’s cigarette plain-packaging laws. The CPTPP clauses are doubtless an improvement over the ISDS clauses in many bilateral investment treaties that remain in force. And, of course, there are many other international agreements which constrain or override national sovereignty.

Opponents of ISDS argue that countries should be entitled to decide how they treat foreign investors in their own country. History, circumstances, and domestic public opinion differ from country to country, and there is no good reason why foreigners should be given the advantage, over domestic investors, of appealing to foreign arbitration less cognisant of domestic factors than the local judicial system. Foreigners who don’t like the laws or the judicial system should simply stay away.

There is a more rarely articulated foreign-policy argument for moving away from ISDS in international agreements. In the past, foreign investors have used ISDS to strengthen their position in sensitive investment areas, such as mining, which often involve vexed issues of land ownership, environment, and perceived exploitation. Australian company Newcrest has used ISDS to oppose public-policy changes in Indonesian law, as has Newmont (American, but often thought of as Australian).

Do we want our diplomatic relationship, including public opinion of Australia in the host country, burdened by disputes in which the foreigner has the advantage of being supported by ISDS clauses in international treaties? When Australians get themselves into trouble in foreign countries, the usual consular response is that domestic laws and procedures apply, no matter how much these might differ from Australian norms. Why isn’t the same for companies? Retaining ISDS provisions in CPTTP makes it less likely that countries such as Indonesia will join the group later.

The inclusion of ISDS in the CPTTP does raise an interesting, if peripheral, issue. Who among the 11 members of the CPTTP wanted to keep ISDS provisions in the agreement? Both Japan and Canada have had recent experience of the groundswell against ISDS provisions in their trade negotiations with the EU. Why not put the issue into suspension, as happened to some other American-inspired clauses?

Whatever the doubts about ISDS, this text is now agreed and signed, with no opportunity for revision. We either sign up, or don’t join the CPTPP. After years of negotiation and the drama of America’s withdrawal from the TPP, followed by Canada’s doubts-at-the-altar, a last-ditch effort has succeeded in reviving an agreement which on balance is probably advantageous for global trade, even if it offends some multilateral desiderata.

For Australia, the CPTPP, with its less far-reaching intellectual property protection, it is probably better than the TPP. We retain the benefits of our bilateral trade agreement with America while obtaining some new trade advantages (for example, beef to Japan, where American competition is disadvantaged).

Let’s hope the CPTPP gets the stamp of approval from the Australian Parliament without too much political posturing.

Trump’s tariff antics as the TPP-11 is signed

The symbolism of last Thursday for the future of the global trading system was hard to miss. In Washington, Donald Trump authorised new tariffs on steel and aluminium imports of 25% and 10% respectively in one of the clearest signs yet that he plans on following through on his protectionist agenda. In Santiago, eleven countries, including Australia, gathered to sign the Comprehensive and Progressive Partnership for Trans Pacific Partnership (CPTPP or TPP-11), voicing their support for the opposite – a desire to open markets further and work constructively to modernise the rules of international commerce.

Trump’s new tariffs were always poorly conceived (by one estimate it will destroy 146,000 American jobs on net). Ostensibly, the policy is aimed at protecting national security and curbing Chinese imports in particular. In practice, it serves neither purpose well and will instead primarily hit US allies. Canada and Mexico got exemptions and the door was left open for others with a US “security relationship” to also seek exemptions, with Australia already securing this after intense government lobbying.

Yet sighs of relief should still be tempered for now. Although we are still some way from an actual “trade war”, the risks of escalating tit-for-tat protectionism remains high.  

After Canada, the EU is the second most important source of US steel and aluminium imports, at about US$7.3 billion a year. The EU is yet to get an exemption and has already drawn up a “hit list” of some US$3.5 billion in US exports for retaliatory measures. Trump said he would retaliate to their retaliation with tariffs of 25% on EU car exports. If this actually happened, it would be a big escalation – these exports are worth some US$40 billion a year.

The EU is of course hoping its status as a close ally will eventually earn it an exemption, though America’s trade deficit with the EU could be a sticking point (the US, by contrast, runs a trade surplus with Australia).

Meanwhile China will be little affected by the latest tariffs, so is likely to be more restrained in response. But the real risk emanates from the ongoing US investigation into technology theft by China. This will soon be completed and could lead to wide-ranging protectionist measures. Risks of a more damaging protectionist cycle following such a move are much higher, especially as China is unlikely to give in easily to US demands. Compromise will need to be found on both sides.

Trump’s antics also risk undermining the ability of the World Trade Organisation to play its role in keeping a lid on protectionism. The claimed national security foundations were always flimsy and risked setting a damaging precedent. But by linking exemptions for Canada and Mexico to a favourable outcome in ongoing North America Free Trade Agreement negotiations (favourable, that is, according to the flawed logic that trade deficits are inherently bad) it is now even more obvious that national security was never anything other than a convenient loophole.

The WTO itself would also be put in a precarious position should the case be referred to it. If it finds in favour of the US, it risks opening the protectionist flood gates on similar flimsy grounds. If it finds against, the WTO risks further aggravating the US, which is already putting significant pressure on its dispute settlement body by blocking the appointment of new appellate judges. Making matters worse, the planned retaliation by the EU may also violate WTO rules.

In this context, what should we make of the signing of the TPP-11 last week?

While the TPP-11 clearly lost the battle for the headlines, it is by far the bigger deal on the pure economics (that is, as long as a full-blown trade war is avoided). Lost exports amongst those affected by Trump’s new tariffs might amount to about US$10 billion a year, compared to around US$300 billion in estimated additional annual exports by 2030 for the TPP-11. Even this comparison overstates the relative importance of Trump’s tariffs, as a large share of lost exports to the US will likely be diverted to other markets.

More important, however, will be what impact the TPP-11 can have in keeping the agenda of open markets, international cooperation and a rules-based system alive, even as Trump’s America pulls back.

At the margins, fear of losing out through trade diversion may give others an incentive to join the pact and/or catalyse “competitive liberalisation”, in particular ongoing negotiations for the Regional Comprehensive Economic Partnership. However, the latter continues to move at a snail’s pace. Meanwhile, a number of countries at various points have said they are interested to join the TPP. But the agreement has also become far less attractive now that better access to the US is not on offer, while the political cost in terms of the deep and wide-ranging reforms required to join remain largely the same.

Without expanding membership and eventually bringing the US back into the fold, it will be difficult for the TPP to fulfil its other strategic objectives. Hopes of using the TPP to write the rules of international commerce for the region and using this to influence broader negotiations at the WTO are, for now, significantly diminished.

There is also little the TPP-11 can do to anchor US economic engagement in Asia and reassure Asian partners of American reliability, key overarching objectives of the original TPP. For that, Washington would need to rethink its protectionist and unilateralist agenda.

No urgency in cutting Australian corporate tax

Prime Minister Malcolm Turnbull returned from Washington last month even more convinced of the need for deep cuts in Australia’s 30% corporate tax rate, which is well above that in the US. Given the numbers in the Australian Senate, however, it is unlikely the proposed tax cut will pass.

How serious an issue is this for the future of the Australian economy? How long can any middle-sized economy hold out against a trend to lower corporate rates among its competitors?

As my Lowy Institute colleague Steven Grenville recently reminded us, because of the imputation system, corporate taxation functions very differently in Australia than in all other countries, except New Zealand.

The relevant issue is the impact company tax cuts will have on foreign investment in Australia. This is readily conceded in Treasury modelling, and has been pointed out several times by the Reserve Bank.

Somewhat surprisingly, given the rhetoric of the Australian Government and the Business Council of Australia (BCA), the numbers show that the relatively high nominal tax rate appears to have had no discernible impact on foreign direct investment in Australia. In the 12 months to the September quarter of 2017, the most recent quarter for which we have data, the flow of foreign direct investment into Australia was higher than it had ever been, and by a considerable margin.

At $79 billion, the inward flow was more than a tenth higher than the next highest 12-month rolling total, back in 2012. This is transactions data and comes closest to measuring the inward flow.

The stock of foreign direct investment in Australia has been similarly firm. At just short of $900 billion, in the September quarter 2017 the stock of foreign direct investment was 50% higher than it had been five years earlier, at a time widely regarded as the peak of the mining investment boom.

Throughout the period in which Australia has been discussing cuts to the corporate tax rate, and the government and the BCA have been warning of a sharp loss of international competitiveness, foreign direct investment in Australia has boomed.

If the corporate tax rate was such a disincentive to investment, one might expect Australian businesses to be eagerly putting their money into other economies with lower tax rates. Attracting foreign investment is, after all, said to be the motive for lowering corporate tax rates. But recently, outward direct investment has been unusually feeble.

The stock of Australian direct investment abroad in the September quarter 2017 was much the same as it had been two years earlier, and would have been markedly less were it not for the valuation effect of the cheaper Australian dollar. The flow of outward direct investment in the same period was $5 billion, or one sixteenth of the inward flow of direct investment.

It may be that Australia’s corporate tax rate is not as uncompetitive for foreign investors as the headline rate suggests. What really matters are the provisions for capital depreciation and other deductions. These account for a large part of the difference between the nominal tax rate and the effective rate, which is the actual rate paid.

In his Interpreter article, Grenville used Congressional Budget Office estimates of comparative rates to show that Australia’s effective rate is more competitive than the nominal rate suggests. Finance Minister Mathias Cormann prefers the corporate tax database of the Oxford University Centre for Business Taxation. In this database, Australia’s effective average corporate tax rate was 26.6% in 2017.

Of advanced economies, Japan, Germany, Spain, Belgium, and a number of others have somewhat higher corporate tax rates than Australia. New Zealand’s was a little more than one percentage point lower, and Canada three percentage points lower. The US effective rate was an enormous seven percentage points higher, but is now lower. The UK effective tax rate was far lower, at 18.5%.

On these numbers, the effective rate facing a foreign investor in Australia is a little higher than in New Zealand, Canada, and the UK, and a little lower than in a number of other countries.

But it is quite difficult to link the corporate tax rate with investment – either foreign or domestic. On World Bank data for the year 2016, Australia’s investment as a share of GDP was 25.5%, compared to 17% for the UK. Investment in Canada and New Zealand as a share of GDP was also below Australia’s, though both countries have somewhat lower effective corporate tax rates. The US, with a stellar effective corporate tax rate of 34%, nearly twice the UK’s effective rate, also had higher investment as a share of GDP than the UK in 2016.

It is true that tax rates are one of the issues affecting the level of foreign investment, and if corporate tax rates in competing economies continue to erode, Australia may someday have to cut its rates as well. But foreign direct investment, as well as overall investment, in Australia is actually very strong compared to economies with lower corporate tax rates. And we are yet to see the long-term consequences of financing corporate tax cuts by adding to fiscal deficits, which is what the US is doing.

At the very least, the strength of inward flows suggests there is no urgency in cutting Australian corporate tax. We could well wait and see, and in the meantime repair the Federal Government budget faster than we could otherwise. This might also give Australian policymakers time to think up cleverer and more discriminating ways to attract mobile foreign capital in its most useful forms.

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