New Development Bank-The Elephant in the Room.

Next month, the five BRICS governments will begin to erect the New Developing Bank (NDB), focused on infrastructure development and structural changes focused on the developing world. Amidst the gossip of the NDB challenging the World Bank, what is important to note, is that this initiative offers a step towards a globally cohesive future.

Let’s analyse the two banks, as they do share some commonalities: While the World Bank’s two missions are to reduce extreme poverty to 3% and promote shared prosperity on a global scale, the two missions of the NDB are to finance investment in infrastructure, and ensure sustainable development in BRICS and other emerging and developing countries.

Herein lies the first difference. While the main objective of the NDB is focused on sustainable infrastructure development, the World Bank has much more all-encompassing view that focuses on a number of issues, ranging from medical aid to education.

The second difference is with the NDB’s contingency fund. Named the Contingency Reserve Arrangement (CRA), this $100 billion nest egg is the BRICS version of saving for a rainy day. The CRA is to provide member countries with a bail out option in case any one of them has a Balance of Payments deficit. (Although, the IMF already exists to provide short term balance of payments, their funding is often insufficient and comes attached with inappropriate conditions.)

The tertiary difference will be in the structure of the NDB. The World Bank is renowned to be a cumbersome beast and securing a loan from them often proves to be a costly affair owing to its inflexible administrative structure. In the words of Amar Bhattacharya, the Head of the G24 Secretariat, “The governance structure of the (World) Bank is still 19th century, not even 20th century.” The NDB on the other hand has the possibility of creating a modern, efficient and transparent financial institution with a high standard of accountability.

The resonating question that one may ask is, why create a new bank when institutions like the IMF and the World Bank already exist?

Infrastructure & the need for the NDB

Following the 2008 financial crisis, global financial markets began to sell their emerging market assets. This trend was further accelerated by the Federal Reserve’s decision to begin tapering its QE initiative and the slow recovery of EU economies after the crisis. This pessimistic scenario made investors question the sustainability of the high growth rates that were enjoyed by the BRICS economies over the last decade.

In order to regain investor confidence, it became increasingly necessary for emerging economies to ensure steady long-term growth. To achieve this feat, they required structural changes that were laid on the foundations of a strong infrastructure.

But it wasn’t just foreign investment that was the key motivator to the creation of the NDB. Studies have shown that a more robust infrastructure ensures economic growth and a reduction in income inequality. This point coupled with the fact that currently 0.9 billion people in developing countries live without access to clean water, another 1.5 billion without electricity and a whopping 2.5 billion without access to hygienic sanitation, makes infrastructure development a salient feature of the NDB.

The future scenario further epitomizes this need. In the next 30 years, the world population is set to expand by two billion people. A vast majority of this population will be born in the developing countries and most of them will live in cities. Hence urbanization projects addressing transportation modes and energy grids are essential if prosperity and equality are to reign in these countries.

The sheer scale and quantity of these future projects is only surpassed by their quality requirements. In order to ensure that future generations have a healthy environment, these countries need to pilot green-field projects that are not overly capital intensive. This also includes reducing the environmental impacts of existing infrastructure, adapting it to an altering climate, and designing an infrastructure that promotes an environmentally sustainable lifestyles. Hence, efficiency gains and environmental protection will share the center stage for these projects.

The achievement of these ambitions requires an increase in the amount spent on infrastructure in the developing world from its current $800 billion a year, to $2.4 trillion a year by 2020. Also the source of these funds needs rethinking. Currently, the bulk of the $800 billion comes from public budgets and private finance. Official multilateral development banks (MDB), like the World Bank, contribute about $3 billion to this initiative…not much when compared to $800 billion.

Coupled with the fact that loans from MDB’s are costly, it makes less economic sense to ask a poor present generation to incur debt for a richer future generation. Hence the creation of the NDB allows for the creation of an independent infrastructure platform and allows the BRICS to play a direct, as well as a catalytic role in the development of sustainable infrastructure models in emerging economies. It should be emphasized that whilst doing so, the NDB is not an alternative to the MDB’s. Rather it is a complement to them.

A deeper look at the CRA

The CRA was first conceived in 2012 and was approved at the 2013 Durban BRICS summit. A point to be remembered, is that the CAR is not a contribution but a promise to contribute. Secondly, the 5 countries have not promised to contribute equally to the CRA.

While China is the dominant contributor willing to donate $41 billion to the CRA, India, Russia and Brazil have made equal promissory engagements of approximately $18 billion each, and South Africa fills up the gap with a $5 billion contribution, rounding up the up the figure to a cool $100 billion. The money that each country is willing to contribute will stay with the member countries until the time that one or more of them faces a balance of payments crisis.

This is not the first time that an initiative of this nature has been conceived. In 2010, the ten members of the Association of Southeast Asian Nations (ASEAN) launched the Chiang Mai Initiative (CMI), which was a multilateral currency swap arrangement. This foreign exchange reserves pool, which was initially set at a $120 billion was expanded to $240 billion in 2012.

Like the CMI, the CRA is also closely tied up to the IMF. Only 30% of the funds demanded by the country in need will be provided by upfront. The remaining 70% of the funds will be ‘linked’ to the IMF. The reason for this juxtaposition of payment systems is because the IMF is currently the only institution with structure to monitor and aid these kinds of payments.

Hence, it would be prudent to question the originality of the scheme. The main difference lies in the currency. The NDB has the objective of facilitating non-dollar trade. By initiating a lending mechanism based on the 5 R’s (Rupee, Rouble, Renminbi, Real, Rand), the NDB aims to provide an alternative to the dollar dominated trade framework. However at this point of time how this objective will be achieved remains unclear with no comprehensive architecture in sight. What is clear though, is that the NDB provides a visionary platform on which non-dollar trade can begin to be experimented upon.

The elephant in the room

With China willing to contribute close to 50% of the $100 billion, it is fundamental to analyse the Chinese economy. As China’s economy accounts for approximately 12.5% of the world’s nominal GDP, the trade impact would touch virtually every product and country.

The elephant in the room is the current housing bubble in China. Cheap credit from formal banks and the ever growing shadow banking sector have led to an upswing in lending within the Chinese economy.

As a result, the residential real estate market and the construction sector have seen a boom period. However, the initial warning signs of the collapse of this bubble have already begun to emerge. As the Chinese economy began to slowdown in 2013, steep price discounts were seen in the residential real estate market. This has been followed by an increasing number of vacant spaces and defaults by small property developers. One could almost draw parallels of this phenomenon with the negative effects of rent control seen in New York in the early 70’s (eloquently explained by Thomas Sowell in his book simply titled, ‘Basic Economics’).

What does this mean to the NDB? Well the question cannot be limited uniquely to this institution. China is bigger than all the other members of the BRICS put together. Although there is very little trade between the BRICS countries, they all trade with China, just like almost every country in the world today.

If the bubble were to burst, Chinese banks would reduce credit injections into their economy. This would lead to less investment, followed by reduced household consumption. The increased tendency to save would not only reduce industrial production but also effect exports and global commodity prices. The deprecating Yuan will also result in reduced imports.

Although the devaluation of the Yuan would result in increased exports for China, it would not paint emerging markets in a positive light. Consequentially, the exchange rates of those countries who are dependent on foreign inflows (like India, Indonesia and Turkey) will be negatively affected, resulting in a slowing of their economies as well.
Thus, the ramifications of a bubble bursting in the Chinese economy will not be limited to her borders. Sovereign interest rates, foreign exchange markets, trade agreements, capital investment arrangements, consumer demand and commodity prices will all face short term consequences as a result of this calamity.

But would it be too opportunistic to see a silver lining in this scenario? The Chinese economy has dominated the manufacturing sector for over two decades. A threat to her economy offers the incentive to other developing countries to bolster their efforts to become the next manufacturing powerhouse. Infrastructure developments with this ambition in foresight could help developing economies with an ambitious goal to ignite their projects.

The second silver lining is that a catastrophe of this scale, would further encourage the BRICS countries to initiate partnerships with other regional institutions like ASEAN, the African Union and MIST. Apart from instigating trade and technology transfers, this will also help developing economies buffer the middle-income trap (the failure to carry out reforms needed to help the transition to higher-value production after the country’s lower-value-added sectors start losing market share to countries with cheaper labor costs).

Closing thoughts:

Although the above mentioned silver lining objectives could be achieved without the need for a collapse of the Chinese economy, market competition forces will play a role in judging the sway of opportunity. Apart from offering developing economies with independence, the NDB also offers the opportunity to better invest their capital.

The leading force behind the rise of the BRICS economies is their propensity to save. However the current status quo promotes the usage of the wealth that has been created by these savings to finance the US budget deficit and to invest in Wall Street. By doing so developing economies are trading safe capital for risky capital which is then used for development.

The challenge faced by the NDB will be to directly use these savings for development services. In order to do so, the NDB needs to aspire to a higher standard and recycle its savings into its own economy thus adding greater value.

By doing so the NDB could create the next elephant in the room in the form of a new BRICS currency that might one day be on an equal standing with the US dollar and the Euro.

Suggested further reading:
http://blogs.ft.com/beyond-brics/2014/07/18/guest-post-using-the-brics-bank-to-dilute-the-us-dollar-zone/

http://www.cepal.org/ues/noticias/noticias/4/50164/4._Amar_Bhattacharya_and_Mattia_Romani.pdf

http://www.bloomberg.com/news/2014-07-22/chinese-banks-seen-discounting-mortgage-rates-survey-shows.html

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s