Baltimore police officer Edward Nero, one of six being tried separately in relation to the arrest and death of Freddie Gray, has been acquitted on all counts. The outcome for officer Nero was widely expected, but officials are nonetheless aware of the level of frustration and anger that remains in the city. Mayor Stephanie Rawlings Blake said: "We once again ask the citizens to be patient and to allow the entire process to come to a conclusion."

Since Baltimore came to national attention, Brookings scholars have probed the city’s challenges and opportunities, as well addressing broader questions of place, race and opportunity.

• In this podcast, Jennifer Vey describes how, for parts of Baltimore, economic growth has been largely a spectator sport: "1/5 people in Baltimore lives in a neighborhood of extreme poverty, and yet these communities are located in a relatively affluent metro area, in a city with many vibrant and growing neighborhoods."
• Vey and her colleague Alan Berube, in this piece on the "Two Baltimores," reinforce the point about the distribution of economic opportunity and resources in the city:
  

  In 2013, 40,000 Baltimore households earned at least $100,000. Compare that to Milwaukee, a similar-sized city where only half as many households have such high incomes. As our analysis uncovered, jobs in Baltimore pay about $7,000 more on average than those nationally. The increasing presence of high-earning households and good jobs in Baltimore City helps explain why, as the piece itself notes, the city’s bond rating has improved and property values are rising at a healthy clip."

• Groundbreaking work by Raj Chetty, which we summarized here, shows that Baltimore City is the worst place for a boy to grow up in the U.S. in terms of their likely adult earnings:

• Here Amy Liu offered some advice to the new mayor of the city: "I commend the much-needed focus on equity but…the mayoral candidates should not lose sight of another critical piece of the equity equation: economic growth."
• Following an event focused on race, place and opportunity, in this piece I drew out "Six policies to improve social mobility," including better targeting of housing vouchers, more incentives to build affordable homes in better-off neighborhoods, and looser zoning restrictions.
• Frederick C. Harris assessed President Obama’s initiative to help young men of color, "My Brother’s Keeper," praising many policy shifts and calling for a renewed focus on social capital and educational access. But Harris also warned that rhetoric counts and that a priority for policymakers is to "challenge some misconceptions about the shortcomings of black men, which have become a part of the negative public discourse."
• Malcolm Sparrow has a Brookings book on policing reform, "Handcuffed: What Holds Policing Back, and the Keys to Reform" (there is a selection here on Medium). Sparrow writes:
  

  Citizens of any mature democracy can expect and should demand police services that are responsive to their needs, tolerant of diversity, and skillful in unraveling and tackling crime and other community problems. They should expect and demand that police officers are decent, courteous, humane, sparing and skillful in the use of force, respectful of citizens’ rights, disciplined, and professional. These are ordinary, reasonable expectations."

Five more police officers await their verdicts. But the city of Baltimore should not have to wait much longer for stronger governance, and more inclusive growth.

      

The Horatio Alger ideal of upward mobility has a strong grip on the American imagination (Reeves 2014). But recent years have seen growing concern about the distance between the rhetoric of opportunity and the reality of intergenerational mobility trends and patterns.

The related issues of equal opportunity, intergenerational mobility, and inequality have all risen up the agenda, for both scholars and policymakers. A growing literature suggests that the United States has fairly low rates of relative income mobility, by comparison to other countries, but also wide variation within the country. President Barack Obama has described the lack of upward mobility, along with income inequality, as “the defining challenge of our time.” Speaker Paul Ryan believes that “the engines of upward mobility have stalled.”

But political debates about equality of opportunity and social and economic mobility often provide as much heat as light. Vitally important questions of definition and motivation are often left unanswered. To what extent can “equality of opportunity” be read across from patterns of intergenerational mobility, which measure only outcomes? Is the main concern with absolute mobility (how people fare compared to their parents)—or with relative mobility (how people fare with regard to their peers)? Should the metric for mobility be earnings, income, education, well-being, or some other yardstick? Is the primary concern with upward mobility from the bottom, or with mobility across the spectrum?

In this paper, we discuss the normative and definitional questions that guide the selection of measures intended to capture “equality of opportunity”; briefly summarize the state of knowledge on intergenerational mobility in the United States; describe a new microsimulation model designed to examine the process of mobility—the Social Genome Model (SGM); and how it can be used to frame and measure the process, as well as some preliminary estimates of the simulated impact of policy interventions across different life stages on rates of mobility.

The three steps being taken in mobility research can be described as the what, the why, and the how. First, it is important to establish what the existing patterns and trends in mobility are. Second, to understand why they exist—in other words, to uncover and describe the “transmission mechanisms” between the outcomes of one generation and the next. Third, to consider how to weaken those mechanisms—or, put differently, how to break the cycles of advantage and disadvantage.

Download "Modeling Equal Opportunity" »

Downloads

• Download "Modeling Equal Opportunity"

      

Paid leave for parents is likely to be an important issue on the campaign trail this year. Hillary Clinton, positioning herself as the candidate on the side of families, argues for all parents to be paid for 12 weeks of family leave, at two-thirds of their salary up to a (so far unspecified) cap. Donald Trump has not so far ruled it out, simply saying: “We have to keep our country very competitive, so you have to be careful of it.”

Polls routinely show high levels of general support for paid leave across the political spectrum. But there are many nuances here, including how to fund the leave entitlement, how long the leave should be, and whether fathers and mothers ought to get the same treatment.

Some light can be thrown on these questions by an analysis of the American Family Survey conducted earlier this year by Deseret News and the Center for the Study of Elections and Democracy (disclosure: I am an adviser to the pollsters). 

Americans of all stripes favor at least three months paid family leave

Views differ over the optimum length of leave depending on whether it is for the mother or father, and whether it is paid or unpaid:

But even Republicans are quite supportive, backing almost four months of paid leave for mothers and three months for fathers. So on the face of it, Clinton’s plan should be a vote winner even among moderate Republicans.

More for mom than dad? Depends how you ask the question

There are important implications about gender roles here. Encouraging men to take paid leave is important not only for the quality of family life, but also for gender equality more generally. Attitudes towards the role of fathers are shifting, although the primacy of motherhood remains. Among every ideological group there was greater support for longer maternity than paternity leave. It is worth noting, however, that half the respondents supported equal leave for mothers and fathers; the variation is driven by those in the other half, who drew a distinction by gender.

It turns out that the order in which the question is asked also makes a difference. For half the respondents, the question about maternity leave came before the one on paternity leave. For the other half, the questions were asked in the opposite order. (Because of the design of the survey, respondents could not change their previous answer.) The ordering of the question had an influence on responses:

Among those who gave an answer on paternity leave first, the gap between the preferred length of leave for mothers and fathers was much less. This was especially true for unpaid leave.

Breaking gender stereotypes

When people think about paid parental leave, many may think automatically of a mother, just as they think of a man when asked to picture a “strong leader.” Asking about maternity leave first goes with the traditional cultural grain, and results in more support for mothers compared to fathers. Asking about paternity leave first interrupts the normal gender framing, and narrows the gap.

There has been a slow revolution in attitudes towards the respective roles of mothers and fathers, reflected in the strongly symmetrical attitudes towards maternity and paternity leave in this survey. But there is more work to do. Mothers and fathers both need help balancing paid work and family life. Let’s hope this can be at least one area of agreement between Clinton and Trump.

       

British politics is starting to resemble a bowling alley. One after another, political figures are tumbling–including the leading lights of the Brexit campaign. They sowed the wind and now are reaping the whirlwind.

First to topple was the prime minister. After the referendum, David Cameron announced that he would step down. Last week fellow Conservative Boris Johnson, the leading light of the Brexit campaign, said he would not run to succeed Mr. Cameron after his ally Michael Gove, the justice secretary, concluded, in quintessentially British style, that Mr. Johnson lacked “the team captaincy” required. Then Nigel Farage stepped down as leader of the UK Independence Party, saying “I want my life back.” Labour Party leader Jeremy Corbyn has lost the support of his parliamentary colleagues and may be next to fall.

The exit of the leading Brexiteers is a relief. The skills required to run a populist, fact-averse campaign are not the same skills needed to lead a nation. For all his mercurial talents, on full display during his colorful stint as mayor of London, Boris Johnson would have been a disastrous prime minister. The alternatives–especially Mr. Gove and Home Secretary Theresa May–are steadier souls. Both are also better positioned to unite Conservative members of Parliament and hold on until the next scheduled general election, in 2020.

Mr. Corbyn is likely to go; the question really is when. It he doesn’t, the Labour Party will break apart. In his case the departure will be only slightly about the vote to remain in or leave the European Union. Broadly, his fellow Labour MPs didn’t want him as their leader in the first place; it was the votes of more left-wing party members that propelled him to the leadership, and many see him as an electoral liability. (He is.)

There is no direct connection between Brexit and Donald Trump. But a few things can still be deduced on this side of the pond. First, Mr. Trump may succeed in making the connection tighter. His immediate announcement that the vote was about “declaring independence” reflected his sharpening political instincts. The day after the vote, Mr. Trump said: “The people of the United Kingdom have exercised the sacred right of all free peoples. They have declared their independence from the European Union. … Come November, the American people will have the chance to re-declare their independence. Americans will have a chance to vote for trade, immigration and foreign policies that put our citizens first.”

Independence is a powerful populist theme, one Mr. Trump is likely to exploit it to its fullest.

Brexit and the economic and political chaos it has already sparked are proof that no matter how crazy or far-fetched an electoral outcome appears, it can happen. Right up to the last minute, many believed that even if the vote were close, it would be to remain in the EU. At some level we just couldn’t imagine the alternative. Maybe Mr. Cameron and Mr. Corybn felt the same, which is why they were so complacent. Not so, the other side.

All this suggests the wisdom of treating every poll with a fistful of salt. Electorates are becoming more volatile and more visceral. Pollsters are getting it wrong as often as they get it right. The last general election in the U.K. is another case in point. Populist sentiment wrecks standard political models. When people are angry, they don’t weigh the costs and benefits of their actions in the usual way; that’s true in life and it’s true in voting.

It’s also why it’s risky to allow populist campaigners near the levers of power. I’ve written in this space before about the dangers of injecting direct democracy in a parliamentary political system. Think of referendums as akin to Ming vases: something rare, to be handled with great care. The British Parliament is now acting as a firebreak. The leading populists will not get the keys to 10 Downing Street.

But the United States holds direct elections for president. If Donald Trump wins in November, he will assume the most powerful office in the world. There is no firebreak, no buffer, no second chance.

---

Editor's note: This piece originally appeared on the Wall Street Journal's Washington Wire blog.

       

Politicians and scholars often lament the persistence of poverty across generations. But affluence persists, too. In the U.S. especially, the top of the income distribution is just as “sticky”, in intergenerational terms, as the bottom. The American upper middle class is reproducing itself quite effectively.

Good parenting, but also opportunity hoarding

Class reproduction is of course driven by a whole range of factors, from parenting and family structure through formal education, informal learning, the use of social networks, and so on. Some are unfair: playing the legacy card in college admissions, securing internships via closed social networks, zoning out lower-income families from our neighborhoods and school catchment areas. (These “opportunity hoarding” mechanisms are the focus of my forthcoming book, Dream Hoarders.)

Inequality incentivizes class persistence

It is natural and laudable for parents to want their children to prosper. It is also understandable that they’ll use the resources and means at their disposal to try to reduce the chances of their children being downwardly mobile. They are likely to try even harder if the drop looks big, in economic terms.

There is a significant earnings gap between those at the top and those in the middle. But this gap is much bigger in the U.S. than in other nations, and is getting bigger over time:

The cost of falling reflects the particular way in which income inequality has risen in recent years: namely, at the top of the distribution. The relationship between income inequality and intergenerational mobility is a much-disputed one, as regular readers of this blog know well. Overall, the evidence for a “Great Gatsby Curve” is quite weak.

But at the top of the distribution, there could be some incentive effects linking inequality and immobility. As the income gap has widened at the top, the consequences of falling out of the upper middle class have worsened. So the incentives of the upper middle class to keep themselves, and their children, up at the top have strengthened. It looks like a long drop, because it is.

Affluenza

Upper middle class Americans do seem worried. In 2011, while around half of American adults making less than $30,000 per year agreed that “today’s children will lead a better life than their parents,” only 37 percent of those making $75,000 or more were as optimistic.

The greater spending of upper middle class parents on “enrichment activities” is well known; recent evidence suggests the Great Recession did nothing to reduce it. American upper middle class parents are desperate to secure their children a high position on the earnings ladder. This makes sense, given the consequences of downward mobility for their economic fortunes. Inequality incentivizes opportunity hoarding, which reduces social mobility. Time, perhaps, to lower the stakes a little?

       

As a rhetorical ideal, greater opportunity is hard to beat. Just about all candidates for high elected office declare their commitments to promoting opportunity – who, after all, could be against it? But opportunity is, to borrow a term from the philosopher and political theorist Isaiah Berlin, a "protean" word, with different meanings for different people at different times.

Typically, opportunity is closely entwined with an idea of upward mobility, especially between generations. The American Dream is couched in terms of a daughter or son of bartenders or farm workers becoming a lawyer, or perhaps even a U.S. senator. But even here, there are competing definitions of upward mobility.

It might mean being better off than your parents were at a similar age. This is what researchers call "absolute mobility," and largely relies on economic growth – the proverbial rising tide that raises most boats.

Or it could mean moving to a higher rung of the ladder within society, and so ending up in a better relative position than one's parents.

Scholars label this movement "relative mobility." And while there are many ways to think about status or standard of living – education, wealth, health, occupation – the most common yardstick is household income at or near middle age (which, somewhat depressingly, tends to be defined as 40).

As a basic principle, we ought to care about both kinds of mobility as proxies for opportunity. We want children to have the chance to do absolutely and relatively well in comparison to their parents.

On the One Hand…

So how are we doing? The good news is that economic standards of living have improved over time. Most children are therefore better off than their parents. Among children born in the 1970s and 1980s, 84 percent had higher incomes (even after adjusting for inflation) than their parents did at a similar age, according to a Pew study. Absolute upward income mobility, then, has been strong, and has helped children from every income class, especially those nearer the bottom of the ladder. More than 9 in 10 of those born into families in the bottom fifth of the income distribution have been upwardly mobile in this absolute sense.

There's a catch, though. Strong absolute mobility goes hand in hand with strong economic growth. So it is quite likely that these rates of generational progress will slow, since the potential growth rate of the economy has probably diminished. This risk is heightened by an increasingly unequal division of the proceeds of growth in recent years. Today's parents are certainly worried. Surveys show that they are far less certain than earlier cohorts that their children will be better off than they are.

If the story on absolute mobility may be about to turn for the worse, the picture for relative mobility is already pretty bad. The basic message here: pick your parents carefully. If you are born to parents in the poorest fifth of the income distribution, your chance of remaining stuck in that income group is around 35 to 40 percent. If you manage to be born into a higher-income family, the chances are similarly good that you will remain there in adulthood.

It would be wrong, however, to say that class positions are fixed. There is still a fair amount of fluidity or social mobility in America – just not as much as most people seem to believe or want. Relative mobility is especially sticky in the tails at the high and low end of the distribution. Mobility is also considerably lower for blacks than for whites, with blacks much less likely to escape from the bottom rungs of the ladder. Equally ominously, they are much more likely to fall down from the middle quintile.

Relative mobility rates in the United States are lower than the rhetoric about equal opportunity might suggest and lower than people believe. But are they getting worse? Current evidence suggests not. In fact, the trend line for relative mobility has been quite flat for the past few decades, according to work by Raj Chetty of Stanford and his co-researchers. It is simply not the case that the amount of intergenerational relative mobility has declined over time.

Whether this will remain the case as the generations of children exposed to growing income inequality mature is not yet clear, though. As one of us (Sawhill) has noted, when the rungs on the ladder of opportunity grow further apart, it becomes more difficult to climb the ladder. To the same point, in his latest book, Our Kids – The American Dream in Crisis, Robert Putnam of Harvard argues that the growing gaps not just in income but also in neighborhood conditions, family structure, parenting styles and educational opportunities will almost inevitably lead to less social mobility in the future. Indeed, these multiple disadvantages or advantages are increasingly clustered, making it harder for children growing up in disadvantaged circumstances to achieve the dream of becoming middle class.

The Geography of Opportunity

Another way to assess the amount of mobility in the United States is to compare it to that found in other high-income nations. Mobility rates are highest in Scandinavia and lowest in the United States, Britain and Italy, with Australia, Western Europe and Canada lying somewhere in between, according to analyses by Jo Blanden, of the University of Surrey and Miles Corak of the University of Ottawa. Interestingly, the most recent research suggests that the United States stands out most for its lack of downward mobility from the top. Or, to paraphrase Billie Holiday, God blesses the child that's got his own.

Any differences among countries, while notable, are more than matched by differences within Pioneering work (again by Raj Chetty and his colleagues) shows that some cities have much higher rates of upward mobility than others. From a mobility perspective, it is better to grow up in San Francisco, Seattle or Boston than in Atlanta, Baltimore or Detroit. Families that move to these high-mobility communities when their children are still relatively young enhance the chances that the children will have more education and higher incomes in early adulthood. Greater mobility can be found in places with better schools, fewer single parents, greater social capital, lower income inequality and less residential segregation. However, the extent to which these factors are causes rather than simply correlates of higher or lower mobility is not yet known. Scholarly efforts to establish why it is that some children move up the ladder and others don't are still in their infancy.

Models of Mobility

What is it about their families, their communities and their own characteristics that determine why they do or do not achieve some measure of success later in life?

To help get at this vital question, the Brookings Institution has created a life-cycle model of children's trajectories, using data from the National Longitudinal Survey of Youth on about 5,000 children from birth to age 40. (The resulting Social Genome Model is now a partnership among three institutions: Brookings, the Urban Institute and Child Trends). Our model tracks children's progress through multiple life stages with a corresponding set of success measures at the end of each. For example, children are considered successful at the end of elementary school if they have mastered basic reading and math skills and have acquired the behavioral or non-cognitive competencies that have been shown to predict later success. At the end of adolescence, success is measured by whether the young person has completed high school with a GPA average of 2.5 or better and has not been convicted of a crime or had a baby as a teenager.

These metrics capture common-sense intuition about what drives success. But they are also aligned with the empirical evidence on life trajectories. Educational achievement, for example, has a strong effect on later earnings and income, and this well-known linkage is reflected in the model. We have worked hard to adjust for confounding variables but cannot be sure that all such effects are truly causal. We do know that the model does a good job of predicting or projecting later outcomes.

Three findings from the model stand out. First, it's clear that success is a cumulative process. According to our measures, a child who is ready for school at age 5 is almost twice as likely to be successful at the end of elementary school as one who is not.

This doesn't mean that a life course is set in stone this early, however.

Children who get off track at an early age frequently get back on track at a later age; it's just that their chances are not nearly as good. So this is a powerful argument for intervening early in life. But it is not an argument for giving up on older youth.

Second, the chances of clearing our last hurdle – being middle class by middle age (specifically, having an income of around $68,000 for a family of four by age 40) – vary quite significantly. A little over half of all children born in the 1980s and 1990s achieved this goal. But those who are black or born into low-income families were very much less likely than others to achieve this benchmark.

Third, the effect of a child's circumstances at birth is strong. We use a multidimensional measure here, including not just the family's income but also the mother's education, the marital status of the parents and the birth weight of the child. Together, these factors have substantial effects on a child's subsequent success. Maternal education seems especially important.

The Social Genome Model, then, is a useful tool for looking under the hood at why some children succeed and others don't. But it can also be used to assess the likely impact of a variety of interventions designed to improve upward mobility. For one illustrative simulation, we hand-picked a battery of programs shown to be effective at different life stages – a parenting program, a high-quality early-edcation program, a reading and socio-emotional learning program in elementary school, a comprehensive high school reform model – and assessed the possible impact for low-income children benefiting from each of them, or all of them.

No single program does very much to close the gap between children from lower- and higher-income families. But the combined effects of multiple programs – that is, from intervening early and often in a child's life – has a surprisingly big impact. The gap of almost 20 percentage points in the chances of low-income and high-income children reaching the middle class shrinks to six percentage points. In other words, we are able to close about two-thirds of the initial gap in the life chances of these two groups of children. The black-white gap narrows, too.

Looking at the cumulative impact on adult incomes over a working life (all appropriately discounted with time) and comparing these lifetime income benefits to the costs of the programs, we believe that such investments would pass a cost-benefit test from the perspective of society as a whole and even from the narrower prospective of the taxpayers who fund the programs.

What Now?

Understanding the processes that lie beneath the patterns of social mobility is critical. It is not enough to know how good the odds of escaping are for a child born into poverty. We want to know why. We can never eliminate the effects of family background on an individual's life chances. But the wide variation among countries and among cities in the U.S. suggests that we could do better – and that public policy may have an important role to play. Models like the Social Genome are intended to assist in that endeavor, in part by allowing policymakers to bench- test competing initiatives based on the statistical evidence.

America's presumed exceptionalism is rooted in part on a belief that class-based distinctions are less important than in Western Europe. From this perspective, it is distressing to learn that American children do not have exceptional opportunities to get ahead – and that the consequences of gaps in children's initial circumstances might embed themselves in the social fabric over time, leading to even less social mobility in the future.

But there is also some cause for optimism. Programs that compensate at least to some degree for disadvantages earlier in life really can close opportunity gaps and increase rates of social mobility. Moreover, by most any reasonable reckoning, the return on the public investment is high.

---

Editor's note: This piece originally appeared in the Milken Institute Review.

       

The Chinese currency, or renminbi (RMB), has been a contentious issue for the past several years. Most recently, members of Congress have suggested tying China currency legislation to the upcoming votes on the free trade agreements with South Korea, Colombia and Panama. While not going that far, the Senate Majority Leader, Harry Reid, and Senator Charles Schumer have promised a vote on the issue some time this year.

The root of the conflict for the United States—and other countries—is complaints that China keeps the value of the RMB artificially low, boosting its exports and trade surplus at the expense of trading partners. Recent government data show that the bilateral trade deficit between the U.S. and China grew nearly 12 percent in the first half of 2011—fueling efforts to boost job creation domestically by authorizing import tariffs and other restrictions on countries that manipulate their currencies.

Although the U.S. Treasury has repeatedly stopped short of labeling China a “currency manipulator” in its twice-yearly reports to Congress, it has consistently pressured China to allow the RMB to appreciate at a faster pace, and to let the currency fluctuate more freely in line with market forces. The International Monetary Fund (IMF), the World Bank and many economists have also argued for faster appreciation and a more flexible exchange rate policy as part of a broader program of “rebalancing” the Chinese economy away from its traditional reliance on exports and investment, and towards a more consumer-driven growth model. Partly in response to these pressures, but more because of domestic considerations, China has allowed the RMB to rise by about 25 percent against the U.S. dollar since mid-2005. Yet the pace of appreciation remains agonizingly slow for the United States and other countries in Europe and Latin America whose manufacturing sectors face increasing competition from low-priced Chinese goods.

The international conversation over the RMB remains perennially vexed because China and its trade partners have fundamentally divergent ideas on the function of exchange rates. The United States and other major developed economies, as well as the IMF, view an exchange rate simply as a price. Consistent intervention by China to keep its exchange rate substantially below the level the market would set is, in this view, a distortion that prevents international markets from functioning as well as they could. This price distortion also affects China’s own economy, by encouraging large-scale investment in export manufacturing, and discouraging investment in the domestic consumer market. Thus it is in the interest both of China itself and the international economy as a whole for China to allow its exchange rate to rise more rapidly.

Chinese officials take a very different view. They see the exchange rate—and prices and market mechanisms in general—as tools in a broader development strategy. The goal of this development strategy is not to create a market economy, but to make China a rich and powerful modern country. Market mechanisms are simply means, not ends in themselves. Chinese leaders observe that all countries that have raised themselves from poverty to wealth in the industrial era, without exception, have done so through export-led growth. Thus they manage the exchange rate to broadly favor exports, just as they manage other markets and prices in the domestic economy to meet development objectives such as the creation of basic industries and infrastructure. These policies do not differ materially from those pursued by Japan, South Korea and Taiwan since World War II, or by Britain, the United States and Germany in the 19th century. Since the Chinese leaders perceive that an export-led strategy is the only proven route to rich-country status, they view with profound suspicion arguments that rapid currency appreciation and markedly slower export growth are “in China’s interest.” And because China—unlike Japan in the 1970s and 1980s—is an independent geopolitical power, it is fully able to resist international pressure to change its exchange-rate policy.

A second issue raised by China’s currency and trade policies is the persistent trade surplus since 2004 which has contributed about three-quarters of the nearly US$3 trillion increase in China’s foreign exchange reserves over the past eight years. Close to two-thirds of these reserves are invested in U.S. treasury debt. Some fear that China has become the United States’ banker, and could cause a collapse in the U.S. dollar and the U.S. economy by dumping its dollar holdings. Others suggest that China’s recent moves to increase the international use of the RMB through an offshore market in Hong Kong signal China’s intent to build up the RMB as an international reserve currency to rival or eventually supplant the dollar. All of these concerns are based on serious misunderstandings of both international financial markets and China’s domestic political economy. China is not in any practical sense “America’s banker;” it is more a depositor than a lender, and its economic leverage over the United States is very modest.

And while China’s leading position in global trade makes it quite sensible to increase the use of the RMB for invoicing and settling trade, it is a huge leap from making the RMB more internationally traded to making it an attractive reserve currency. China does not now meet the basic conditions required for the issuer of a major reserve currency, and may never meet them. Most importantly, the RMB is unlikely to become more than a second-tier reserve currency so long as Chinese leaders cling to their deep reluctance to allow foreigners a significant role in China’s domestic financial markets.

China’s Currency Policies

China’s exchange-rate policy must be understood within the context of two political-economic factors: first, China’s overall development strategy which aims to build up the nation’s economic and political power with market mechanisms being tools to that end rather than ends in themselves; and second, China’s geopolitical position.

The Chinese development strategy, which emerged gradually after Deng Xiaoping began the process of “reform and opening” in 1978, is based on a careful study of how other industrial nations got rich—and in particular, the catch-up growth strategies of its east Asian neighbors Japan, South Korea and Taiwan after World War II. A key lesson of that study is that every rich nation, in the early stages of its development, used export-friendly policies to promote domestic industry and to accelerate technology acquisition. In earlier eras, when the use of the gold standard made it impossible to maintain permanently undervalued exchange rates, countries used administrative coercion and high tariffs to achieve the same effect of favoring domestic manufacturers over foreign ones. Britain’s policies of using colonies as captive markets for its manufactured exports, and prohibiting the colonies from exporting manufactures back to Britain, were important components of that nation’s rise as the world’s leading industrial power in the late 18th and 19th centuries. Resentment of those policies was one cause of the American Revolution; once independent, the United States spurred its economic development through the “American system,” which featured high tariff walls (often 40 percent or more) through the 19th and into the early 20th century. Germany used similar protective policies to foster its industries in the late 19th century. Countries did not become advocates for free trade until their firms were secure in global technological leadership and the need for protection waned for Britain, this occurred in the mid-19th century; for the United States, the mid-20th.

After World War II, undervalued exchange rates became an important tool of export promotion, partly because new global trading rules under the General Agreement on Tariffs and Trade (GATT, which morphed into the World Trade Organization in 1995) made it more difficult to maintain extremely high levels of tariff protection. The testimony of post-war economic history is quite clear. Countries that maintained undervalued exchange rates and pursued export markets enjoyed sustained high-speed economic growth and became rich. These countries include Germany, Japan, South Korea and Taiwan. Countries that used other mechanisms to block imports and encouraged their industrial firms to cater exclusively to domestic demand—so-called “import substitution industrialization,” or ISI, which usually involved an overvalued exchange rate—in some cases grew quite rapidly for 10 years or more. But this growth could not be sustained because the ISI strategy includes no mechanism for keeping pace with advances in global technology. Most ISI countries, including much of Latin America and the whole of the Communist bloc, experienced severe financial crisis and fell into long periods of stagnation.

As it tried to accelerate growth by moving from a planned to a more market-driven economy in the 1980s, China gradually depreciated the RMB by a cumulative 80 percent, from 1.8 to the dollar in 1978 to 8.7 in 1995. Since then, however, the RMB has only appreciated against the dollar, moving up to a rate of 8.3 by 1997, and holding steady at that rate until mid-2005 after which gradual appreciation resumed. Since 2006 the RMB has appreciated at an average annual rate of about 5 percent against the dollar, to its current rate of about 6.4, and it is likely that this average rate of appreciation will be sustained for the next several years. This history demonstrates that supporting export growth, while important, is not the sole determinant of China’s exchange-rate policy. During the Asian financial crisis of 1997-1998, the consensus of most economists held that the RMB was overvalued; despite this, Beijing kept the value of the RMB steady, on the grounds that devaluation would further destabilize the battered Asian regional economy. As a consequence, China endured a few years of relatively anemic growth in exports and GDP, and persistent deflation. The leadership decided that this was a price worth paying for regional economic stability.

Conversely, the appreciation since 2005 reflects Beijing’s understanding that clinging to a seriously undervalued exchange rate for too long risks sparking inflation. This occurred in many oil-rich Persian Gulf countries in 2005-2007, which held fast to unrealistically low pegged exchange rates and suffered annual inflation rates of 20 percent to 40 percent. For Chinese leaders, an inflation rate above 5 percent is considered dangerously high, and the most rapid currency appreciation in the last few years has occurred when inflationary pressure was relatively strong. A second reason for switching to a policy of gradual appreciation was the view that an ultra-cheap exchange rate disproportionately benefited manufacturers of ultra-cheap goods, whose technology content and profit margins were low. While these industries provided employment for millions, they did not contribute much to the nation’s technological upgrading. A gradual currency appreciation, economic policymakers believed, would eventually force Chinese manufacturers to move up the value chain and start producing more sophisticated and profitable goods. This strategy appears to be bearing fruit: China is rapidly gaining global market share in more advanced goods such as power generation equipment and telecoms network switches. Meanwhile, it has begun to lose market share in low-end goods like clothing and toys, to countries like Vietnam, Cambodia, Indonesia and Bangladesh.

In short, China’s exchange-rate policy is mainly driven by the aim of enhancing the nation’s export competitiveness. But other factors play a role, namely a desire to maintain domestic and regional macro-economic stability, keep inflationary pressures at bay, and force a gradual upgrading of the industrial structure. From the point of view of Chinese policy makers, all of these objectives suggest that the exchange rate should be carefully managed, rather than left to unpredictable market forces. While economists may argue that long-run economic stability is better served by a more flexible exchange rate, Chinese officials can point to the excellent track record their policies have produced: consistent GDP growth of around 10 percent a year since the late 1990s, inflation consistently at or below 5 percent, export growth of more than 20 percent a year, and a steady increase in the sophistication of Chinese exports. Until some kind of crisis convinces them that their economic policies require major adjustment, China’s economic planners are likely to stick with their current formula.

International pressure to accelerate the pace of RMB appreciation is unlikely to have much impact. The basic reason is that other countries have very little leverage that they can bring to bear. In the 1970s, the United States was able to pressure Germany and Japan to appreciate their currencies because those countries were militarily dependent on America. (Moreover, the United States was able unilaterally to engineer a devaluation of the dollar by going off the gold standard in 1971.) Japan’s position of dependency forced it to accede to the Plaza Accord of 1985, which resulted in a doubling of the value of the yen over the next two years. China, being, geopolitically independent, has no incentive to bow to pressure on the exchange rate from the United States, let alone Europe or other nations such as Brazil. The only plausible threat is that failure to appreciate the RMB could lead to a protectionist backlash that would shut the world’s doors to Chinese exports. Yet this threat has so far proved empty: even after three years of the worst global recession since the Great Depression, trade protectionism has failed to emerge in the United States or Europe.

Other considerations further strengthen the Chinese determination not to give in to foreign pressure on the exchange rate. One is the Japanese experience after the Plaza Accord. The generally accepted view in China is that the dramatic appreciation of the yen in the late 1980s was a crucial contributor to Japan’s dramatic asset-price bubble whose collapse after 1990 set the former world-beating economy on a two-decade course of economic stagnation. Chinese officials are adamant that they will not repeat the Japanese mistake. This resolve was strengthened by the global financial crisis of 2008, which in China thoroughly discredited the idea—already held in deep suspicion by Chinese leaders—that lightly regulated financial markets and free movements of capital and exchange rates are the best way to run a modern economy. China’s rapid recovery and strong growth after the crisis are deemed to vindicate the nation’s strategy of a managing the exchange rate, controlling capital flows, and keeping market forces on a tight leash.

The Internationalization of the RMB

Despite this generally self-confident view of the merit of its exchange-rate and other economic policies, Chinese leaders are troubled by one headache caused by the export-led growth strategy: the accumulation of a vast stockpile of foreign exchange reserves, most of which are parked in very low-yielding dollar assets, principally U.S. treasury bonds and bills. For a while, the accumulation of foreign reserves was viewed as a good thing. But after the 2008 financial crisis, the perils of holding enormous amounts of dollars became evident: a serious deterioration of the US economy leading to a sharp decline in the value of the dollar could severely reduce the worth of those holdings. Moreover, the pervasive use of the dollar to finance global trade proved to have hidden risks: when United States credit markets seized up in late 2008, trade finance evaporated and exporting nations such as China were particularly hard hit. The view that excessive reliance on the dollar posed economic risks led Chinese policy makers to undertake big efforts to internationalize the RMB, beginning in 2009, through the creation of an offshore RMB market in Hong Kong.

Before considering the significance of RMB internationalization, it is worth addressing some misconceptions about China’s large-scale reserve holdings and investments in U.S. treasury bonds. Because China’s central bank is the biggest single foreign holder of U.S. government debt, it is often said that China is “America’s banker,” and that, if it wanted to, it could undermine the U.S. economy by selling all of its dollar holdings, thereby causing a collapse of the U.S. dollar and perhaps the U.S. economy. These fears are misguided. First of all, it is by no means in China’s interest to cause chaos in the global economy by prompting a run on the dollar. As a major exporting nation, China would be among the biggest victims of such chaos. Second, if China sells U.S. treasury bonds, it must find some other safe foreign asset to buy, to replace the dollar assets it is selling. The reality is that no other such assets exist on the scale necessary for China to engineer a significant shift out of the dollar. China accumulates foreign reserves at an annual rate of about US$400 billion a year; there is simply no combination of markets in the world capable of absorbing such large amounts as the U.S. treasury market. It is true that China is trying to diversify its reserve holdings into other currencies, but at the end of 2010 it still held 65 percent of its reserves in dollars, well above the average for other countries (60 percent). From 2008 to 2010, when newspapers were filled with stories about China “dumping dollars,” China actually doubled its holdings of U.S. Treasury securities, to US$1.3 trillion.

The other crucial point is that China is not in any meaningful sense “America’s banker,” and its economic leverage is modest. China owns just 8% of the total outstanding stock of US Treasury debt; 69% of Treasury debt is owned by American individuals and institutions. Measured by Treasury debt holdings, America is America’s banker—not China. And China’s holdings of all US financial assets – equities, federal, municipal and corporate debt, and so on – is a trivial 1%. Chinese commercial banks lend almost nothing to American firms or consumers. The gross financing of American companies and consumers comes principally from U.S. banks, and secondarily from European ones. It is more apt to think of China as a depositor at the “Bank of the United States”: its treasury bond holdings are super-safe, liquid holdings that can be easily redeemed at short notice, just like bank deposits. Far from holding the United States hostage, China is a hostage of the United States, since it has little ability to move those deposits elsewhere -- no other bank in the world is big enough.

It is precisely this dependency that has prompted Beijing to start promoting the RMB as an international currency. By getting more companies to invoice and settle their imports and exports in RMB, China can gradually reduce its need to put its export earnings on deposit at the “Bank of the United States.” But again, headlines suggesting that internationalization of the RMB heralds the imminent demise of the current dollar-based international monetary system are premature.

The simplest reason is that the RMB’s starting point is so low that many years will be required before it becomes one of the world’s major traded currencies. In 2010, according to the Bank for International Settlements, the RMB figured in under 1 percent of the world’s foreign exchange transactions, less than the Polish zloty; the dollar figured in 85 percent and the euro in 40 percent. There is no question that use of the RMB will increase rapidly. Since Beijing started promoting the use of RMB in trade settlement (via Hong Kong) in 2009, RMB-denominated trade transactions have soared: around 10 percent of China’s imports are now invoiced in RMB. The figure for exports is lower, which makes sense. Outside China, people sending imports to China are happy to be paid in RMB, since they can reasonably expect that the currency will increase in value over time. But Chinese exporters wanting to get paid in RMB will have a difficult time finding buyers with enough RMB to pay for their shipments. Over time, however, foreign companies buying and selling goods from China will become increasingly accustomed to both receiving and making payments in RMB – just as they grew accustomed to receiving and making payments in Japanese yen in the 1970s and 1980s.

Since China is already the world’s leading exporter, and is likely to surpass the United States as the world’s leading importer within three or four years, it is quite natural that the RMB should become a significant currency for settling trade transactions. Yet the leap from that role to a major reserve currency is a very large one, and the prospect of the RMB becoming a reserve currency on the order of the euro—let alone replacing the dollar as the world’s dominant reserve currency—is remote. The reason for this is simple: to be a reserve currency, you need to have safe, liquid, low-risk assets for foreign investors to buy; these assets must trade on markets that are transparent, open to foreign investors and free from manipulation. Central banks holding dollars and euros can easily buy lots of U.S. treasury securities and euro-denominated sovereign bonds; foreign investors holding RMB basically have no choice but to put their cash into bank deposits. The domestic Chinese bond market is off-limits to foreigners, and the newly-created RMB bond market in Hong Kong (the so-called “Dim Sum” bond market) is tiny and consists mainly of junk-bond issuances by mainland property developers.

Again, we can reasonably expect rapid growth in the Hong Kong RMB bond market. But the growth of that market, and granting foreigners access to the domestic Chinese government bond market, remain severely constrained by political considerations. Just as Chinese officials do not trust markets to set the exchange rate for their currency, they do not trust markets to set the interest rate at which the government can borrow. Over the last decade Beijing has retired virtually all of its foreign borrowing; more than 95 percent of Chinese government debt is issued on the domestic market, where the principal buyers are state-owned banks that are essentially forced to accept whatever interest rate the government dictates. There is absolutely no reason to believe that the Chinese government will at any point in the near future surrender the privilege of setting the interest rate on its own borrowings to foreign bond traders over whom it has no control. As a result, it is likely to be many years before there is a large enough pool of internationally-available safe RMB assets to make the RMB a substantial international reserve currency.

In this connection the example of Japan provides an instructive example. In the 1970s and 1980s Japan occupied a position in the global economy similar to China’s today: it had surpassed Germany to become the world’s second biggest economy, and it was accumulating trade surpluses and foreign-exchange reserves at a dizzying rate. It seemed a foregone conclusion that Japan would become a central global financial power, and the yen a dominant currency. Yet this never occurred. The yen internationalized – nearly half of Japanese exports were denominated in yen, Japanese firms began to issue yen-denominated “Samurai bonds” on international markets, and the yen became an actively traded currency. Yet at its peak the yen never accounted for more than 9 percent of global reserve currency holdings, and the figure today is around 3 percent. The reason is that the Japanese government was never willing to allow foreigners meaningful access to Japanese financial markets, and in particular the Japanese government bond market. Even today, about 95 percent of Japanese government bonds are held by domestic investors, compared to 69 percent percent for US Treasury securities. China is not Japan, of course, and its trajectory could well be different. But the bias against allowing foreigners meaningful participation in domestic financial markets is at least as strong in China as in Japan, and so long as this remains the case it is unlikely that the RMB will become anything more than a regional reserve currency.

Implications for U.S. Policy

The above analysis suggests two broad conclusions of relevance to United States policymakers. First, China’s exchange-rate policy is deeply linked to long-term development goals and there is very little that the United States, or any other outside actor, can do to influence this policy. Second, the same suspicion of market forces that leads Beijing to pursue an export-led growth policy that generates large foreign reserve holdings also means that Beijing is unlikely to be willing to permit the financial market opening required to make the RMB a serious rival to the dollar as an international reserve currency. A related observation is that an average annual appreciation of the RMB against the dollar of about 5 percent now seems to be firmly embedded in Chinese policy. An appreciation of this magnitude enables China to maintain export competitiveness while achieving two other objectives: keeping domestic consumer-price inflation under control, and gradually forcing an upgrade of China’s industrial structure.

Generally speaking, these trends are quite benign from a U.S. perspective. In substantive terms, there is little to be gained from high-profile pressure on China to accelerate the pace of RMB appreciation, since the United States possesses no leverage that can be plausibly brought to bear. While the persistent undervaluation of the RMB will present increasing difficulties for American manufacturers of high-end equipment, as Chinese manufacturers gradually become more competitive in these sectors, the steady appreciation of the currency will increase the purchasing power of the average Chinese consumer and the total size of the Chinese consumer market. United States policy should therefore de-emphasize the exchange rate, where the potential for success is limited, and instead focus on keeping the pressure on China to maintain and expand market access for American firms in the domestic Chinese market, which in principle is provided for under the terms of China’s accession to the World Trade Organization.

This paper is part of a series of in-depth policy papers, Shaping the Emerging Global Order, in collaboration with ForeignPolicy.com. Visit ForeignPolicy.com's Deep Dive section for discussion on this paper.

      

Editor's Note: In the coming decade, China’s economic growth is projected to slow from its long-run average annual rate of 10 percent, sustained over the past three decades. The imminent slowdown also reflects a variety of specific structural challenges. Arthur Kroeber argues that responding effectively to these challenges requires a broad set of reforms in the financial sector, fiscal policy, pricing of key factors such as land and energy which are now subject to extensive government manipulation, and the structure of markets.

In the coming decade, China’s economic growth will certainly slow from the long-run average annual rate of 10% sustained over the past three decades. In part this is a natural slowdown in an economy that is now quite large (around US$7 trillion at market exchange rates) and solidly middle-income (per capita GDP of about US$7,500, at purchasing power parity). Despite the certainty of this slowdown, China’s potential growth rate remains high: per-capita income is still far below the level at which incomes in the other major northeast Asian economies (Japan, South Korea and Taiwan) stopped converging with the US level; the per-capita capital stock remains low, suggesting the need for substantial more investment; and the supply of low-cost labor from the traditional agricultural sector has not yet been exhausted. All these factors suggest it should be quite possible for China to achieve average annual real GDP growth of at least 7% a year through 2020.[1]

But the imminent slowdown also reflects a variety of specific structural challenges which require active policy response. Inadequate policies could result in a failure of China to achieve its potential growth rate. Three of the most prominent structural challenges are a reversal of demographic trends from positive to negative; a substantial secular decline in the contribution of exports to growth; and the very rapid increase in credit created by the 2009-10 stimulus program, which almost certainly led to a substantial reduction of the return on capital. Responding effectively to these challenges requires a broad set of reforms in the financial sector, fiscal policy, pricing of key factors such as land and energy which are now subject to extensive government manipulation, and the structure of markets. This paper will argue that financial sector reform is the best and most direct way to overcome these three major structural challenges.

1. China’s growth potential

There are several strong reasons to believe that China has the potential to sustain a fairly rapid rate of GDP growth for at least another decade. We define “fairly rapid” as real growth of 7% a year, which is a very high rate for an economy of China’s size (US$7 trillion), but substantially below the average growth rate since 1980, which has been approximately 10%.

The most general reason for this belief is that China’s economic growth model most closely approximates the successful “catch-up” growth model employed by its northeast Asian neighbors Japan, South Korea and Taiwan in the decades after World War II. The theory behind “catch-up” growth is simply that poor countries whose technological level is far from the global technological frontier can achieve substantial convergence with rich-country income levels by copying and diffusing imported technology. Achieving this catch-up growth requires extensive investments in enabling infrastructure and basic industry, and an industrial policy that focuses on promoting exports. The latter condition is important because a disciplined focus on exports forces companies to keep up with improvements in global technology; in effect, a vibrant export sector is one (and probably the most efficient) mechanism for importing technology.

A survey of 96 major economies from 1970 to 2008 shows that 14 achieved significant convergence growth, defined as an increase of at least 10 percentage points in per capita GDP relative to the United States (at purchasing power parity). Eight of these countries were on the periphery of Europe and so presumably benefited from the spillover effects of western Europe’s rapid growth after World War II, and from the integration of eastern and western Europe after 1990. The other six were Asian export-oriented economies: Japan, South Korea, Taiwan, Malaysia, Thailand and China. Most of these countries experienced a period of very rapid convergence with US income levels and then a sharp slowdown or leveling off. On average, rapid convergence growth ended when the country’s per capita GDP reached 55% of the US level. The northeast Asian economies that China most closely resembles were among the most successful: convergence growth in Japan, Taiwan and South Korea slowed at 90%, 60% and 50% of US per capita income respectively. In 2010 China’s per capita income was only 20% of the US level. Based on this comparative historical experience, it seems plausible that China could enjoy at least one more decade of relatively rapid growth, until its per capita income reaches 40% or more of the US level.[2]

So China’s growth potential is fairly clear. But realizing this potential is not automatic: it requires a constant process of structural reform to unlock labor productivity gains and improve the return on capital. The urgency of structural reform is particularly acute now. To understand why, we now examine three structural factors that are likely to exert a substantially negative effect on economic growth in coming years.

2. Challenges to growth

When considering China’s structural growth prospects, it is necessary to take account of at least three major challenges to growth. Over the past three decades, rapid economic growth has been supported by favorable demographics, a very strong contribution from exports, and a large increase in the stock of credit. The demographic trend is now starting to go into reverse, the export contribution to growth has slowed dramatically in the last few years, and the expansion of credit cannot be safely sustained for more than another year or two at most.

Demographics. From 1975 to 2010, China’s “dependency ratio”—the ratio of the presumably non-working (young people under the age of 15 and old people above the age of 64) to the presumably working (those aged 15-64) fell from approximately 0.8 to 0.4. Over the same period the “prime worker ratio”—the ratio of people aged 20-59 to those 60 and above—stayed roughly stable at above 5. Both of these ratios indicate that China’s economy enjoyed a very high ratio of workers to non-workers. This situation is favorable for economic growth, because it implies that with a relatively small number of dependent mouths to feed, workers can save a higher proportion of their incomes, and the resulting increase in aggregate national saving becomes available for investment in infrastructure and basic industry.

Over the next two decades, however, these demographic trends will reverse. The dependency ratio will rise, albeit slowly at first, and the prime worker ratio will decline sharply from 5 today to 2 in the early 2030s. These demographic shifts are likely to exert a drag on economic growth, for two reasons.

The first impact, which is already being felt, is a reduction in the supply of new entrants into the labor force—those aged 15-24. This cohort has fluctuated between 200m and 230m since the early 1990s, and in 2010 it stood at the upper end of that range. By 2023 it will have fallen by one-third, to 150m, a far lower figure than at any point since China began economic reforms in 1978. Because the supply of new workers is falling relative to demand for labor, wage growth is likely to accelerate above the rate of labor productivity growth, which appears to be in decline from the very high levels achieved in 2000-2010. As a result, unit labor costs will start to rise (a trend already in evidence in the manufacturing sector since 2004) and inflationary pressures will build. In order to keep inflation at a socially acceptable level, the government will be forced to tighten monetary policy and reduce the trend rate of economic growth.

The second impact will be the large increase in the population of retirees relative to the number of workers available to support them. This is the effect described by the prime worker ratio, which currently shows that there are five people of prime working age for every person of likely retirement age. As this ratio declines, the overall productivity of the economy slows, and the health and pension costs of supporting an aging population rise. The combination of these two effects can contribute to a dramatic slowdown in economic growth: during the period when Japan’s prime worker ratio fell from 5 to 2 (1970-2005), the trend GDP growth rate fell from 8% to under 2% (though demographics, of course, does not explain all of this decline). Over the next 20 years China’s prime worker ratio will decline by exactly the same amount as Japan’s did from 1970-2005.

Export challenge. Another element of China’s extraordinary growth was its rapidly growing export sector. Exports are a crucial component of catch-up growth in poor economies because, as explained above, they act as a vector of technology transfer: in order to remain globally competitive, exporters must continually upgrade their technology (including their processes and management systems) to keep up with the continuous advance of the global technological frontier.

Precisely measuring the impact of exports on economic growth is tricky, because what matters is not headline export value (which contains contributions from imported components and materials), but the domestic value added content of exports. In addition, a dynamic export sector is likely to have indirect impacts on the domestic economy through the wages paid to workers, the long-run effect of technological upgrading and so on. If we ignore these second-round impacts and focus simply on the direct contribution to GDP growth of domestic value added in exports, we find that exports contributed 4.6 percentage points to GDP growth on average in 2003-07. In other words, exports accounted for about 40% of economic growth during that period.[3]

Such a high export contribution to growth is on its face unsustainable for a large continental economy like China’s, and in fact the export contribution has slowed substantially since the 2008 global financial crisis. In 2008-11 the average contribution of export value added to GDP growth was just 1.5 percentage points – about one-third the 2003-07 average. It is likely that the export contribution to growth will fall even further in coming years.

Credit challenge. China responded to the global financial crisis with a very large economic stimulus program which was financed by a large increase in the credit stock. The ratio of non-financial credit (borrowing by government, households and non-financial corporations) rose from 160% in 2008 to over 200% in 2011. While the overall credit/GDP ratio remains lower than the 250% that is typical for OECD nations, a rapid increase in the credit stock in a short period of time, regardless of the level, is frequently associated with financial crisis. In China’s case, it is evident that the majority of the increase in the credit stock reflects borrowing by local governments to finance infrastructure projects which are likely to produce economic benefit in the long run but which in many cases will result in immediate financial losses.[4] To avert a potential banking sector crisis, therefore, it would be prudent for government policy to target first a stabilization and then a decline in the credit/GDP ratio.

The good news is that China has recent experience of deflating a credit bubble. In the five years after the Asian financial crisis (1998-2003), the credit/GDP ratio rose by 40 percentage points (the same amount as in 2008-11) as the government financed infrastructure spending to offset the impact of the crisis. Over the next five years (2003-08), the credit/GDP ratio fell by 20 points, as nominal GDP growth (17% a year on average) outstripped the annual growth in credit (15%). This experience suggests that, in principle, it should be possible to reduce the annual growth in credit significantly without torpedoing economic growth.

The bad news is that the 2003-08 deleveraging occurred within the context of the extremely favorable demographics, and unusually robust export growth that we have just described. Not only are these conditions unlikely to be repeated in the coming decade, both these factors are likely to exert a drag on GDP growth. Given this backdrop, any reduction in the rate of credit growth must be accompanied by extensive measures to ensure that the productivity of each yuan of credit issued is far higher than in the past.

3. The role of financial sector reform

The three growth challenges described above are diverse, but they are reflections of a single broader issue which is that China’s ability to maintain rapid growth mainly through the mobilization of factors (labor and capital) is decreasing. Much of the high-speed growth of the last decade derived from a rapid increase in labor productivity which was in turn a function of an extremely high investment rate: as the amount of capital per worker grew, the potential output of each worker grew correspondingly (“capital deepening”). But the investment rate, at nearly 49% of GDP in 2011, must surely be close to its peak, since it is already 10 percentage points higher than the maximum rates ever reached by Japan or South Korea. So the amount of labor productivity gain that can be achieved in future by simply adding volume to the capital stock must be far less than during the last decade, when the investment/GDP ratio rose by 10 percentage points.

The obvious corollary is that if China’s ability to achieve rapid gains in labor productivity and economic growth through mobilization of capital is declining, these gains must increasingly be achieved by improved capital efficiency. More specifically, the tightening of the labor supply implied by the demographic transition means that unit labor cost growth will accelerate; all things being equal this means that consumer price inflation will be structurally higher in the next decade than it was for most of the last. This in turn means that nominal interest rates will need to be higher. As the cost of capital rises, the average rate of return on capital must also increase; otherwise a larger share of projects will be loss-making and the drag on economic growth will become pronounced.

On the export side, the dramatic slowdown in the contribution to economic growth from exports means the loss of a certain amount of “easy” productivity gains. Greater productivity of domestic capital could help offset the deceleration in productivity growth from the external sector. Finally, as just noted, the need to arrest or reverse the rapid rise in the credit/GDP ratio means that over the next several years, a given amount of economic growth must be achieved with a smaller amount of credit than in the past—in other words, the average return on capital (for which credit here serves as a proxy) must rise.

Conceptually this is all fairly straightforward. The problem for policy makers is that measuring the “productivity of capital” on an economy-wide basis is not at all straightforward. In principle, one could measure the amount of new GDP created for each incremental increase in the capital stock (the incremental capital output ratio or ICOR). But in practice calculating ICOR is cumbersome, and depends heavily on various assumptions, such as the proper depreciation rate. Moreover, in an industrializing economy like China’s, the ratio of capital stock to GDP tends to rise over time and therefore the ICOR falls; this does not mean that the economy misallocates capital but simply that it experiences capital deepening. Sorting out efficiency effects from capital deepening effects is a vexing task.[5]

A more practical approach is simply to examine the ratio of credit to GDP. There is no one “right” level of credit to GDP, since different economies use different proportions of debt and equity finance. But the trends in the credit to GDP ratio in a single country (assuming there is no major shift in the relative importance of debt and equity finance), which are easily measured, can serve as a useful proxy for trends in the productivity of capital, and provide some broad guidelines for policy.

Figure 1 shows the ratio of total non-financial credit to GDP in China since 1998 (all figures are nominal). Total non-financial credit comprises bank loans, bonds, external foreign currency borrowing, and so-called “shadow financing” extended to the government, households and non-financial corporations; it excludes fund-raising by banks and other financial institutions. This measure is similar to the measure of “total social financing” recently introduced by the People’s Bank of China. 

This shows, as noted previously, that the credit to GDP ratio rose sharply from 160% of GDP in 2008 to 200% in 2010. The current ratio is not abnormally high: many OECD countries have credit/GDP ratios of 250% or so, and Japan’s is around 350%. But it is obvious that the trend increase is worrying: if credit/GDP continues to rise at 20 percentage points a year then by 2015 it would hit 300%, a level much higher than is normal in healthy economies. It seems intuitively clear that to ensure financial stability, policy should target a stabilization or decline in the credit/GDP ratio. Success in this policy would imply that the productivity of credit, and capital more generally, improves.

The large increase in the credit/GDP ratio in 2008-10 is not unprecedented. Following the Asian financial crisis of 1997-98, the total credit stock rose from 143% of GDP in 1998 to 186% in 2003, an increase of 43 percentage points in five years, as a result of government spending on infrastructure and the creation of new consumer lending markets (notably home mortgages). During this period the credit stock grew at an average annual rate of 15.9%, but nominal GDP grew at just 10% a year.

Over the next five years, 2004-08, the average annual growth in total credit decelerated only slightly, to 14.8%. But thanks to a gigantic surge in productivity growth—caused by a combination of the delayed effect of infrastructure spending, deep market reforms (such as the restructuring of the state owned enterprise sector), and a boom in exports—nominal GDP growth surged to an average rate of 18.3%. As a consequence, the credit/GDP ratio declined to 160% in 2008, a decline of 26 percentage points from the peak five years earlier.

This experience shows that, in a developing country like China, it is quite possible to deflate a credit bubble relatively quickly and painlessly. To do so, however, two conditions must be met: the projects financed during the credit bubble must, in the main, be economically productive in the long run even if they cause financial losses in the short run; and structural reforms must accompany or quickly follow the credit expansion, in order to unlock the productivity growth that will enable deleveraging through rapid economic growth rather than through a painful recession. These conditions were clearly met during the 1998-2008 period: the expanded credit of the first five years mainly went to economically useful infrastructure such as highways, telecoms networks and port facilities; and deep structural reforms improved the efficiency of the state sector, expanded opportunities for the private sector, and created a new private housing market. This combination of infrastructure and reforms helped lay the groundwork for the turbo-charged growth of 2004-08.

The credit expansion of 2008-10, following the global financial crisis, was about the same magnitude as the credit expansion of a decade earlier: the credit/GDP ratio rose 40 percentage points, from 160% to 200%. But the expansion was much more rapid (occurring over two years instead of five), and while the bulk of credit probably did finance economically productive infrastructure, there is evidence that the sheer speed of the credit expansion led to far greater financial losses. A large proportion of the new borrowing was done by local government window corporations, often with little or no collateral and in many cases with no likelihood of project cash flows ever being large enough to service the loans. A plausible estimate of eventual losses on these loans to local governments is Rmb2-3 trn, or 4-7% of 2011 GDP.

Furthermore, whereas in the late 1990s restructuring of the state enterprise sector and creation of the private housing market took off at the same time the government began to expand credit, the 2008-10 credit expansion occurred without any significant accompanying structural reforms. In sum we have significantly less reason to be confident about the foundations for economic growth over the next five years than would have been the case in 2003.

On the assumption that the trend rate of nominal GDP growth over the next five years is likely be quite a bit less than in 2003-08, just how difficult will it be for China to stabilize or better yet reduce the credit to GDP ratio? For the purposes of analysis, Figure 1 proposes two scenarios. Both assume that nominal GDP will grow at an average rate of 13% in 2012-2015 (combining real growth of 7.5% a year with economy-wide inflation of 5.5%). The “stabilization” scenario assumes that total credit grows at the same 13% rate, stabilizing the credit/GDP ratio at around 200%. The “deleveraging” scenario assumes that credit growth falls to 9.5% a year, enabling a reduction in the credit/GDP ratio of 25 percentage points to 175%--about the same magnitude as the reduction of 2003-08.

A quick glance suggests that achieving either of these two outcomes will be far more difficult than in the previous deleveraging episode. In 2003-08, the average annual rate of credit growth was just one percentage point lower than during the credit bubble of 1998-2003. In other words, the work of deleveraging was accomplished almost entirely through economic growth, rather than through any material constraint on credit.

In the three years following the global financial crisis, by contrast, total credit expanded by 22.7% a year, generating nominal GDP growth of 14.1% on average. The required drop in average annual credit growth is 10 percentage points under the stabilization scenario and 13 points under the deleveraging scenario, while nominal GDP growth declines by only a point. In other words, this episode is likely to be the reverse of the 2003-08 episode: deleveraging will need to come almost entirely from a constraint on credit, rather than from economic growth.



Another way of looking at this is to examine the relationship between incremental credit and incremental GDP—that is, how many yuan of new GDP arise with each new yuan of credit. This calculation is presented in Figure 2. This shows that in 1998-2003 each Rmb1 of new credit generated Rmb0.39 of new GDP; this figure rose to 0.72 in 2003-08, an 84% increase in the productivity of credit. The GDP payoff from new credit in 2008-10 was far worse than in 1998-2003. Simply to stabilize the credit/GDP ratio at its current level will require a 73% increase in credit productivity. To achieve the deleveraging scenario, a 150% improvement will be required.

The good news is that under the deleveraging scenario, the average productivity of credit in 2011-2015 only needs to be the same as it was in 2003-08. In principle, this should be achievable. But as previously noted, the mechanism of improvement needs to be quite different this time round. In 2003-08, the productivity of credit rose because credit growth remained roughly constant while GDP growth surged, thanks to structural reforms that accelerated returns to both capital and labor. Over the next several years, by contrast, the best that can be hoped for is that GDP growth will remain roughly constant. Consequently any improvement in credit productivity must come from constraining the issuance of new credit, while substantially raising the efficiency of credit allocation and hence the returns to credit.

What are the main mechanisms for improving the efficiency of credit, and of financial capital more generally? Broadly speaking, there are two: diversification of credit channels, and more market-based pricing of credit. Historically most credit has been issued by large state-owned banks, which are subject to political pressure in their lending decisions, and the majority of credit has gone to state-owned enterprises. Diversifying the channels of credit to include a broader range of financial institutions, a more vigorous bond market, and even by encouraging the creation of dedicated small- and medium-size enterprise lending units within the big banks, should improve credit allocation by giving greater credit access to borrowers who were previously shut out simply by virtue of a lack of political connections. Over the past decade government policy has been broadly supportive of the diversification of credit channels: specialized consumer credit, leasing and trust companies have been allowed to flourish, and there is some anecdotal evidence that SME lending at the state owned banks has begun to pick up steam.

The government has been far more reluctant, however, to embrace systematic measures for improving the pricing of credit. Bank interest rates remain captive to the policy of regulated deposit rates. Guaranteed low deposit rates means that banks have little incentive to seek out and properly price riskier assets, and are content to earn a fat spread on relatively conservative loan books. Bond markets, which in more developed economies form the basis for pricing of financial risk, are in China large in primary issuance, but small in trading volumes. The majority of bonds are purchased by banks and other financial institutions and held to maturity, make them indistinguishable from bank loans. Active secondary market trading by a wide range of participants is the essential mechanism by which bond prices become the basis for financial risk pricing.

4. Conclusions and recommendations

China still has potential for another decade of relatively high speed growth, but a combination of structural factors means that “high speed” in future likely means a trend GDP growth rate of around 7%, well below the historic average of 10%. Moreover, a combination of negative trends in demographics and the external sector, and the need to constrain credit growth after the enormous credit expansion of 2008-2010, mean the obstacles to realizing this potential growth rate are quite large. In order to overcome these obstacles, the efficiency of credit, and of capital more generally, must be improved. A large increase in credit efficiency was achieved in the previous economic deleveraging episode of 2003-08, but that increase in efficiency resulted mainly from an acceleration in GDP growth due to capital deepening, rather than from a constraint on credit. Over the next several years, the best that can plausibly be achieved is a stabilization of nominal GDP growth at approximately the current level. Any increase in credit efficiency must therefore come from a constraint on credit growth and direct improvements in credit allocation, rather than from capital-intensive economic growth.

In order to achieve this improvement in credit efficiency, three improvements to China’s financial architecture are urgently needed. First, the diversification of financial channels should continue to be expanded, notably through the acceptance and proper regulation of so-called “shadow financing” activities, which reflect market pressure for higher returns to depositors and greater credit availability (at appropriate prices) for riskier borrowers. Second, the ceiling on bank deposit rates should gradually be lifted and ultimately abolished, in order to give banks incentives for increased lending at appropriate prices to riskier borrowers who (it is to be hoped) will deliver a higher risk-adjusted rate of return than current borrowers. Third, steps should be taken to increase secondary trading on bond markets, in order to enable these markets to assume their appropriate role as the basis of financial risk pricing. Particular stress should be laid on diversifying the universe of financial institutions permitted to trade on bond markets, to include pension funds, specialized fixed-income mutual funds and other institutional investors with a vested interest in active trading to maximize both short- and long-term returns.

 

---

 

      

Following the global financial crisis of 2008, China’s authorities took a number of steps to internationalize the use of the Chinese currency, the renminbi. These included the establishment of currency swap lines with foreign central banks, encouragement of Chinese importers and exporters to settle their trade transactions in renminbi, and rapid expansion in the ability of corporations to hold renminbi deposits and issue renminbi bonds in the offshore renminbi market in Hong Kong.

These moves, combined with public statements of concern by Chinese officials about the long-term value of the central bank’s large holdings of U.S. Treasury securities, and the role of the U.S. dollar’s global dominance in contributing to the financial crisis, gave rise to widespread speculation that China hoped to position the renminbi as an alternative to the dollar, initially as a trading currency and eventually as a reserve currency.

This paper contends that, on the contrary, the purposes of the renminbi internationalization program are mainly tied to domestic development objectives, namely the gradual opening of the capital account and liberalization of the domestic financial system. Secondary considerations include reducing costs and exchange-rate risks for Chinese exporters, and facilitating outward direct and portfolio investment flows. The potential for the currency to be used as a vehicle for international finance, or as a reserve asset, is severely constrained by Chinese government’s reluctance to accept the fundamental changes in its economic growth model that such uses would entail, notably the loss of control over domestic capital allocation, the exchange rate, capital flows and its own borrowing costs.

This paper attempts to understand the renminbi internationalization program by addressing the following issues:

1. Definition of currency internationalization

2. Specific steps taken since 2008 to internationalize the renminbi

3. General rationale for renminbi internationalization

4. Comparison with prior instances of currency internationalization, notably the U.S. dollar after 1913, the development of the Eurodollar market in the 1960s and 1970s; and the deutsche mark and yen in 1970-1990

5. Understanding the linkage between currency internationalization and domestic financial liberalization

6. Prospects for and constraints on the renminbi as an international trading currency and reserve currency

Downloads

• China’s Global Currency: Lever for Financial Reform

      

       

       

       

Event Information

Register for the Event

Prime Minister Shinzo Abe has been promoting the increased participation of women in the Japanese economy, a policy popularly known as womenomics, as a pillar of his campaign for economic revitalization. While significant strides have been made with regard to increasing female workforce participation, corporate efforts to introduce flexible working practices, and spurring the promotion of women on the corporate ladder, womenomics will be incomplete if it remains confined to the established corporate structure. Unleashing the creative potential of half of Japan’s population will require an equally sustained effort to promote female entrepreneurship. This is a tall order for Japan where female entrepreneurs face a two-fold challenge: the modest development of venture capital and a host of legal and cultural hurdles to individual entrepreneurship; plus the additional hurdles for women in gaining access to the assets widely perceived as essential to success such as business networks, financing, technology, and access to markets at home and abroad. However, entrepreneurship offers Japanese women significant benefits through the opportunity to bypass rigid corporate hierarchies, custom tailor their workloads to better achieve work-life balance, and offer new and innovative products and services to the Japanese consumer.

On February 8, the Center for East Asia Policy Studies at Brookings hosted a distinguished group of policy experts and entrepreneurs for a discussion on the current state of female entrepreneurship in Japan and concrete strategies to promote female-run businesses in the country. They compared Japan and the United States, both in terms in differing results but also on-going common challenges, and discussed their own personal experiences.

Join the conversation on Twitter using #Womenomics

Video

• Womenomics 2.0: The potential of female entrepreneurs in Japan
• The importance of mentors for female entrepreneurs
• Female entrepreneurs: Different options and different styles
• Female leadership creates opportunities

Audio

• Womenomics 2.0: The potential of female entrepreneurs in Japan

Transcript

• Uncorrected Transcript (.pdf)

Event Materials

• Kurihara Presentation for website
• 20160208_womenomics_japan_transcript

       

As part of his economic revitalization plan, Japan’s Prime Minister Shinzo Abe has been touting “womenomics,” a plan to increase the number of women in the labor force. One way for women to enter the workforce but bypass the conventional corporate structure is through entrepreneurship.

Four questions for three female entrepreneurs

At a recent Center for East Asia Policy Studies event on womenomics and female entrepreneurship in Japan, we brought together three successful female entrepreneurs to discuss their experiences both in the United States and Japan. Prior to their panel discussion, we asked each of the speakers four questions about their careers.

1. What was the trigger that made you decide to start your own business?
2. What was the biggest hurdle in starting and/or running your business?
3. How or when was being a woman an asset to you as an entrepreneur and/or running your business?
4. How has the climate for female entrepreneurs changed compared to when you started your business?

Despite the differing environments for entrepreneurs and working women in the two countries, the speakers raised many of the same issues and offered similar advice. Access to funding or financing was an issue in both countries, as was the necessity to overcome fears about running a business or being in male-dominated fields. All of the speakers noted the positive changes in the business environment for female entrepreneurs since they had started their own businesses, as well as the impact this has had in creating more opportunities for women.

Donna Fujimoto Cole

Donna Fujimoto Cole is the president and CEO of Cole Chemical and Distributing Inc. in Houston, Texas. She started her company in 1980 at the urging of her clients. Today Cole Chemical is ranked 131 among chemical distributors globally by ICIS (Independent Chemical Information Service) and its customers include Bayer Material Scientific, BP America, Chevron, ExxonMobil, Lockheed Martin, Procter & Gamble, Shell, Spectra Energy, and Toyota. Cole is also an active member of her community and serves on the boards of a variety of national and regional organizations.

Fujiyo Ishiguro

A founding member for the Netyear Group, Fujiyo Ishiguro is now the president and CEO of the Netyear Group Corporation based in Tokyo, Japan. The firm, which was established in 1999, devises comprehensive digital marketing solutions for corporate clients. The Netyear Group was listed on the Mothers section of the Tokyo Stock Exchange in 2008. Recently, Ishiguro has served on a number of Japanese government committees including the Cabinet Office’s “The Future to Choose” Committee and the Ministry of Economy, Trade and Industry’s “Internet of Things” Committee. 

Sachiko Kuno

Sachiko Kuno is the co-founder, president, and CEO of the S&R Foundation in Washington, D.C., a non-profit organization that supports talented individuals in the fields of science, art, and social entrepreneurship. A biochemist by training, Kuno and her research partner and husband Ryuji Ueno have established a number pharmaceutical companies and philanthropic foundations including R-Tech Ueno in Japan and Sucampo Pharmaceuticals in Bethesda, Maryland. Together, Kuno and Ueno hold over 900 patents. Kuno is active in the greater Washington community and serves on the boards of numerous regional organizations.

Full video of the event featuring these speakers can be found here.

Video

• The importance of mentors for female entrepreneurs
• Female entrepreneurs: Different options and different styles
• Female leadership creates opportunities

       

Event Information

Earlier this month, the Trans-Pacific Partnership Agreement was signed by its 12 member states in New Zealand, bringing the trade deal one step closer to fruition. The member states must now work on resolving their respective domestic issues tied to TPP. For Japan, one of the major issue areas involving TPP is agriculture.

On February 24, the Center for East Asia Policy Studies hosted Kazuhito Yamashita for a presentation in which he discussed the impact of Japan’s market access commitment on agriculture, the TPP countermeasures that the Japanese government announced for agriculture, and the types of agricultural policy reform that are being considered in Japan.

Transcript

• Transcript of Kazuhito Yamashita Presentation (.pdf)

Event Materials

• Yamashita Brookings presentation for website 022416
• Transcript Kazuhito Yamashita Presentation

       

The Brexit vote has stunned us. It has shaken us. It has forced upon us a set of dreadful questions none of us ever wished answers were required for:

• How do you disarticulate deeply integrated economies? How do you prevent the rancor of the U.K.'s divorce from the EU wreaking more havoc, not only in Europe but in the rest of the world? The divorce metaphor is apt here as it signals the treacherous waters ahead when the feeling of betrayal and the temptation of revenge may result in a misguided punitive approach to separation. Let's not forget that almost half of U.K.'s referendum voters chose "remain." Let's not forget that the youth in the U.K. overwhelmingly chose the EU for their future. EU leaders therefore face the ultimate test of leadership. In negotiating exit terms they must strengthen this constituency for internationalism. The U.K. needs committed internationalists. We all need them.
• How do you prevent rising nationalism from dialing back globalization? Is the "Great Convergence" at risk? In the past few decades, developing countries have emerged into the international trading system, and in opening their economies they have lifted millions from abject poverty. Will this future be off-limits to the next round of poor nations seeking to avail themselves of the opportunities of the international marketplace? Has globalization already peaked and are we to be the unlucky generation that lives through the tumultuous process of retrenchment? Are we to feel firsthand the dread that the generation of a century ago experienced when they all suffered from beggar-thy-neighbor policies?
• Are we next? Are the forces of economic nationalism and nativism that drove the referendum outcome in the U.K. unstoppable elsewhere? Will they decide the outcome of the American presidential election this fall? And if so, what happens to the international economic order?

These are still imponderable questions, but I would venture two answers: Brexit is not the final indictment of globalization, and our futures are not yet destined to be ruled by the politics of grievance.

The United States need not become the next domino to succumb to the harmful influence of populism. The parallels in the anti-globalization campaign on both sides of the Atlantic are of course unnerving:

• Anti-elitism: Fueled by the sense of economic disenfranchisement of older white voters who feel that a future of "splendid isolation" is possible.
• Nationalism: Driven by a desire to "take back" our country.
• Nativism: Spurred by strong anti-immigration feelings and rejection of a multicultural polity.

But the differences are also striking, especially when it comes to the issue of trade which commanded so much attention during both the Brexit campaign and the American presidential nomination debates. In reading the "Leave" campaign's statement on trade policy, you will not find:

• The rejection of trade deals for "killing jobs" with special blame placed on developing countries (aka China) for inflicting a mortal wound on manufacturing prowess;
• The promise to impose punitive tariffs on major trading partners even at the risk of initiating a trade war;
• The call for a boycott of firms that relocate part of their production overseas.

Brexit then is not an endorsement of the Trump brand of predatory protectionism.

Instead, what the Leave campaign offered on trade policy are heaps of wishful thinking and hidden truths. It sought to downplay the importance of the EU market to U.K. producers in order to justify setting its sights on other horizons. It promised to open up trade opportunities and job growth by negotiating trade deals with emerging economies such as China and India. And it confidently stated that trade links with the EU could be restored through a U.K.-EU trade deal that would mirror what countries like Norway have done. But this optimistic prognosis left out a lot. For starters, a future U.K.-EU free trade agreement will most likely yield pared-down benefits. Norway gained access to the single market by agreeing to free movement of labor that Brexiters vehemently reject. Moreover, the U.K. cannot chart its own course on trade policy until its separation from the EU is complete. Restructuring U.K.'s trading relations will take years and the results are hard to predict. But the costs of uncertainty are immediate as companies and investors will recalibrate their strategies without waiting for a protracted process of trade negotiations.

Brexiters struck a xenophobic note, but did not produce an overtly protectionist manifesto. Yet, their success at the ballot did deliver a major blow to economic internationalism. Trumpism is both xenophobic and protectionist, and were it to prevail in the November election, its negative impact on globalization will be vastly more profound. But the die has not been cast, and there are sound reasons to doubt a Trump victory.

If we are to prevail in overcoming the politics of grievance, we must first reckon that populism did not materialize from thin air. It is based on a fact: As globalization intensified during the past two decades, the middle classes in the industrialized world experienced stagnant incomes. The inward push is enabled by the manipulation of this fact: Offering trade as an easy scapegoat for a vastly more complex set of factors producing economic disparities (such as technological change and political decisions on taxation, education, and safety nets). And this populism is based on a false promise—that "taking control," i.e., taking our countries out of the existing trading regime will make those left behind better off. Its one unmistakable deliverable will be to make all of us worse off.

       

       

       

       

       

       

       

       

       

       

       

Downloads

• Download the policy recommendations
• The potential and limitations of impact bonds: Lessons from the first five years of experience worldwide (PDF)

      

Editor’s Note: This blog post is one in a series of posts in which guest bloggers respond to the Brookings paper, “The potential and limitations of impact bonds: Lessons from the first five years of experience worldwide."

Constitutional mandate for ECD in Kenya

In 2014, clause 5 (1) of the County Early Childhood Education Bill 2014 declared free and compulsory early childhood education a right for all children in Kenya. Early childhood education (ECE) in Kenya has historically been located outside of the realm of government and placed under the purview of the community, religious institutions, and the private sector. The disparate and unstructured nature of ECE in the country has led to a proliferation of unregistered informal schools particularly in underprivileged communities. Most of these schools still charge relatively high fees and ancillary costs yet largely offer poor quality of education. Children from these preschools have poor cognitive development and inadequate school readiness upon entry into primary school.

Task to the county government

The Kenyan constitution places the responsibility and mandate of providing free, compulsory, and quality ECE on the county governments. It is an onerous challenge for these sub-national governments in taking on a large-scale critical function that has until now principally existed outside of government.

In Nairobi City County, out of over 250,000 ECE eligible children, only about 12,000 attend public preschools. Except for one or two notable public preschools, most have a poor reputation with parents. Due to limited access and demand for quality, the majority of Nairobi’s preschool eligible children are enrolled in private and informal schools. A recent study of the Mukuru slum of Nairobi shows that over 80 percent of 4- and 5-year-olds in this large slum area are enrolled in preschool, with 94 percent of them attending informal private schools.

In early 2015, the Governor of Nairobi City County, Dr. Evans Kidero, commissioned a taskforce to look into factors affecting access, equity, and quality of education in the county. The taskforce identified significant constraints including human capital and capacity gaps, material and infrastructure deficiencies, management and systemic inefficiencies that have led to a steady deterioration of education in the city to a point where the county consistently underperforms relative to other less resourced counties. 

Potential role of impact bonds

Nairobi City County now faces the challenge of designing and implementing a scalable model that will ensure access to quality early childhood education for all eligible children in the city by 2030. The sub-national government’s resources and implementation capacity are woefully inadequate to attain universal access in the near term, nor by the Sustainable Development Goal (SDG) deadline of 2030. However, there are potential opportunities to leverage emerging mechanisms for development financing to provide requisite resource additionality, private sector rigor, and performance management that will enable Nairobi to significantly advance the objective of ensuring ECE is available to all children in the county.

Social impact bonds (SIBs) are one form of innovative financing mechanism that have been used in developed countries to tap external resources to facilitate early childhood initiatives. This mechanism seeks to harness private finance to enable and support the implementation of social services. Government repays the investor contingent on the attainment of targeted outcomes. Where a donor agency is the outcomes funder instead of government, the mechanism is referred to as a development impact bond (DIB).

The recent Brookings study highlights some of the potential and limitations of impact bonds by researching in-depth the 38 impact bonds that had been contracted globally as of March, 2015. On the upside, the study shows that impact bonds have been successful in achieving a shift of government and service providers to outcomes. In addition, impact bonds have been able to foster collaboration among stakeholders including across levels of government, government agencies, and between the public and private sector. Another strength of impact bonds is their ability to build systems of monitoring and evaluation and establish processes of adaptive learning, both critical to achieving desirable ECD outcomes. On the downside, the report highlights some particular challenges and limitations of the impact bonds to date. These include the cost and complexity of putting the deals together, the need for appropriate legal and political environments and impact bonds’ inability thus far to demonstrate a large dent in the ever present challenge of achieving scale.

Challenges in implementing social impact bonds in Kenya

In the Kenyan context, especially at the sub-national level, there are two key challenges in implementing impact bonds.

To begin with, in the Kenyan context, the use of a SIB would invoke public-private partnership legislation, which prescribes highly stringent measures and extensive pre-qualification processes that are administered by the National Treasury and not at the county level. The complexity arises from the fact that SIBs constitute an inherent contingent liability to government as they expose it to fiscal risk resulting from a potential future public payment obligation to the private party in the project.

Another key challenge in a SIB is the fact that Government must pay for outcomes achieved and for often significant transaction costs, yet the SIB does not explicitly encompass financial additionality. Since government pays for outcomes in the end, the transaction costs and obligation to pay for outcomes could reduce interest from key decision-makers in government.

A modified model to deliver ECE in Nairobi City County

The above challenges notwithstanding, a combined approach of results-based financing and impact investing has high potential to mobilize both requisite resources and efficient capacity to deliver quality ECE in Nairobi City County. To establish an enabling foundation for the future inclusion of impact investing whilst beginning to address the immediate ECE challenge, Nairobi City County has designed and is in the process of rolling out a modified DIB. In this model, a pool of donor funds for education will be leveraged through the new Nairobi City County Education Trust (NCCET).

The model seeks to apply the basic principles of results-based financing, but in a structure adjusted to address aforementioned constraints. Whereas in the classical SIB and DIB mechanisms investors provide upfront capital and government and donors respectively repay the investment with a return for attained outcomes, the modified structure will incorporate only grant funding with no possibility for return of principal. Private service providers will be engaged to operate ECE centers, financed by the donor-funded NCCET. The operators will receive pre-set funding from the NCCET, but the county government will progressively absorb their costs as they achieve targeted outcomes, including salaries for top-performing teachers. As a result, high-performing providers will be able to make a small profit. The system is designed to incentivize teachers and progressively provide greater income for effective school operators, while enabling an ordered handover of funding responsibilities to government, thus providing for program sustainability.

Nairobi City County plans to build 97 new ECE centers, all of which are to be located in the slum areas. NCCET will complement this undertaking by structuring and implementing the new funding model to operationalize the schools. The structure aims to coordinate the actors involved in the program—donors, service providers, evaluators—whilst sensitizing and preparing government to engage the private sector in the provision of social services and the payment of outcomes thereof.

      

Event Information

Register for the Event

Webcast archive:

View speaker presentations here:
1. Impact Bonds Worldwide
2. Impact Bonds for ECD

Impact bonds, also known as Pay for Success contracts in the United States, have leveraged over $200 million in upfront private capital for social services worldwide over the last six years, and by 2020 the market is expected to triple. Brookings experts have published two reports analyzing the market, the first of which is a comprehensive review of the global impact bond market and the second of which examines applications to Early Childhood Development programs.

On February 29, the Global Economy and Development program at Brookings hosted a discussion on the scope for social and development impact bonds to address social challenges globally. Sessions reflected on the types of challenges for which these new financing modalities are best suited, and the factors critical for their success. Sir Ronald Cohen, chairman of the Global Social Impact Investment Steering Group, provided keynote remarks, followed by presentations from Emily Gustafsson-Wright, fellow at the Center for Universal Education at Brookings and lead author of both reports on impact bonds.  The event included two panel discussions and a networking lunch.  

 Join the conversation on Twitter using hashtag #ImpactBonds.

Audio

• The global potential and limitations of impact bonds

Transcript

• Transcript (.pdf)

Event Materials

• 20160229_social_impact_bonds_transcript

      

In her February 25 Brookings report, Dr. Dale Farran questions the scientific case for endorsing widespread policy in preschool education. Indeed, she argues that enthusiasm for public preschool and its promise is “premature.” Her argument is founded on three points—that the data on impact is mixed, that we do not have scientific direction with respect to the key quality constructs, and that our measurement of these constructs lack empirical validity. There is a grain of truth in each of these statements. Yet, a closer look reveals that when the data are focused on high quality preschools, the weight of the evidence for effectiveness is compelling. The early childhood science is at least evidence informed on the skill sets that will promote later school and life success and valid measures exist for many of the important outcomes. While there is always more to be learned, the bulk of the scientific community contends that high quality preschool programs will play a role in preparing young children for success in school and beyond.

A look at the evidence

There is no doubt that the literature looking for relationships between preschool access and school readiness outcomes in literacy, mathematics, and other domains are mixed.  Both the Head Start Impact Study and recent findings from Farran’s own Tennessee pre-k study (Lipsey et al., 2015) indicate that preschool of less than high quality produce only modest short-term gains. 

The data do not look bleak, however, when we look across preschool outcomes in the aggregate. And when high quality programs are investigated, whether in well-controlled studies of intensive models (e.g., Perry and Abecedarian) or in studies of strong public programs in Boston (Weiland & Yoshikawa, 2013), Cincinnati (Karoly & Auger, 2016), New Jersey (Barnett et al., 2013), North Carolina (Peisner-Feinberg et al., 2015), and Tulsa (Hill et al., 2015), the results are downright promising  (Yoshikawa et al., 2013; Minervino. 2014). Society reaps benefits from fostering early skill development, as children participating in high quality preschool programs had lower rates of grade retention, less need for special education, decreased antisocial behavior, and greater productivity as adults (Reynolds & Temple, 2015; Cunha & Heckman, 2006). In 2014, over 1,200 scientists who work in the area of early education signed the ECE Consensus Letter for Researchers, attesting to the mountains of data in support of the role of preschool education in improving child outcomes in social development, language, pre-literacy, and mathematics.

Though Farran’s brief reviews only data from the United States, a growing literature suggests that preschool education has long and lasting and causal effects on outcomes around the globe (Atinc & Gustafsson-Wright, 2013). For example, an impact evaluation of a preschool program in Mozambique found that the program increased on-time enrollment into primary school among beneficiaries by 22 percent relative to the children in the control group. Enrolled children also experienced a 6 percent increase in fine motor development, and an 87 percent increase in cognitive development. More importantly, this is not just a story of “everything is bleak in the developing world so the program is bound to have an impact.”

With compelling data in the United States and across the globe, one might ask why there is such a great divide between Farran’s interpretation and that of the wider academic community? One reason appears to be that Farran discounts any data that did not emerge from random assignment longitudinal studies. While correlational studies are not the gold standard, they are informative. Surely practitioners and policymakers would not dismiss data on parenting practices because children were not randomly assigned to parents. Further, in the area of preschool education, there is no difference in findings between randomized trials and other methodologies with respect to targeted cognitive, achievement-related outcomes when other study and program features are taken into account (Duncan & Magnuson, 2013; Camilli et al., 2010). 

Farran also discounts many of the randomized trials because she says they do not tell us enough about cause and effect. She writes of the famous Abecedarian and Perry Preschool studies:

The primary difficulty with this approach as a basis for designing interventions is that there is no way to identify what specifically changed about children’s abilities that enabled them to perform better in school or to link those changes to any particular set of active ingredients in the treatment. Neither Perry nor Abecedarian explicitly describes beyond the broadest level the “treatment” that brought about their positive effects.

But the children did improve, and at some level—while it would be wonderful to isolate the exact recipe for preschool success—we need not deny children the benefits of preschool while scientists probe for the precise combinations of active ingredients that yield the best results. Consider an analogy: the impact of storybook reading on children. While numerous studies document that reading storybooks with children in a joint way improves vocabulary and early literacy, we have yet to isolate the exact causal factors that matter in book reading. Perhaps it is the cuddling that occurs between child and parent; perhaps this crucial unstudied variable is the key that has not yet been turned. But no one would argue that we should stop book reading as a way to foster young children’s interest in reading. So it is with preschool. A quality preschool can heighten young children’s desire to attend school and prepare them for learning—even if all the ingredients in the magic sauce have not yet been identified.

In short, the evidence does provide models of high quality preschool that effectively prepare children for entrée into school and that change a child’s trajectory toward success. Not knowing the exact mechanisms by which preschool exerts its impact is secondary to the fact that poor children need good preschools now and we know how to provide them.

But which skills should we support?

Farran raises the very important point that a narrow focus on only reading and math outcomes would be misplaced in our quest to build high quality preschool curricula. We could not agree more. She goes on to write, however, that “premature as well is the presumption that solid research exists to guide the content and structure of pre-K programs.”

Here we beg to differ. There are thousands of studies that speak to the skill sets children need to achieve success in the changing world. Reading and math are among these skills—collectively bundled under what Golinkoff and Hirsh-Pasek (2016) call “content skills.” But there is overwhelming evidence that children need to master skills that move beyond just reading and math. Content knowledge has, at its base, language and executive function skills. Language is the medium of instruction and executive function skills empower children with the ability to control their impulses and attend. Flexibility and working memory (Galinsky, 2010; Blair, 2016), also part of executive function, enable children to shift gears and remember what they have been told. But even language and executive function are not enough. Children must be prepared to participate alongside others (collaboration), to question when they are unclear (critical thinking) (Kuhn, 1999), and to have the persistence needed to stick with difficult problems—grit (Duckworth et al., 2007). These skills have been tested, are predictive of later achievement, have been shown to be malleable and to relate to academic, social, and learning outcomes in school.

Measuring quality

Farran argues that we cannot provide high quality preschool because we lack strong measures of quality. Again, there is some truth in her assertion, but it seems to us somewhat confused. Farran mixes together policy benchmarks, measures of classroom practice, and child outcome measures. All are useful, but for different purposes. The first is meant to set a floor across many domains including health and safety. The second is designed for providing feedback on classroom practice. The last allows us to assess children’s wellbeing and progress. Well-designed continuous improvement systems for pre-K have detailed standards for learning and teaching that align with assessments of classroom practice and systems operation as well as with child assessments. Together with program standards these can provide a clear vision of high quality. They set high expectations for children’s learning and development and for pedagogy. Our ability to specify all of this exceeds our ability to measure it with reasonable investments of time and money. Nevertheless, classroom observation measures and child assessments as elements of a continuous improvement system help inform teachers and administrators about where they are and what steps they need to take next (Hall et al., 2012; Sylva et al., 2006; Williford et al., 2013). None of us would argue that this is easy, or that any single measure of classroom quality or child development is sufficient. Providing guidance for the improvement of learning and teaching is hard work and domain specific, but it is not futile.

Letting science lead the way

Farran closes her report by suggesting that “[the] proposition that expanding pre-K will improve later achievement for children from low-income families is premature.” Perhaps instead it is Farran’s prognosis that is overly pessimistic. Research to date indicates that sustained access to high quality preschool does alter the trajectory of low-income children who are otherwise not exposed to early math and to age-appropriate books. In several now classic studies, the effects of a quality preschool education has far reaching consequences linked to not only reading and math, but to fewer incarcerations, teen pregnancies, and higher employment well into adulthood. As economists have shown, high quality early learning programs save money for society—a finding that has been replicated in different programs across the globe—in the United States, Canada, the U.K., and Mozambique.

Do we need to know more about what constitutes high quality and how to harness this reliably? Absolutely. But science offers evidence-based and evidence-informed advice on what has worked and what should work when brought to scale. We have an obligation to use the best science to serve our struggling children. Recent surveys indicate that a majority of the American public—Republican and Democrat—agrees that all children deserve a chance to reach their fullest potential. Let the science progress and let us use what we know at this point in time to meet the promise that all children should have a fighting chance to succeed. Better to light a candle than curse the darkness.

       

“For a not-for-profit it’s the equivalent of venture capital,” said Sir Ronald Cohen, chairman of the Global Social Impact Investing Steering Group, about impact bonds in his keynote address at a recent event at the Brookings Institution. Impact bonds combine results-based financing and impact investing, where investors provide upfront capital for a social service and government agencies, or donors, agree to pay investors back based on the outcomes of the service. At their best, they could allow for innovation, encourage performance management and adaptability, promote learning through evaluation, and create a clear case for investing in what works. However, impact bonds thus far have had immense transaction costs and there are risks that poor execution of the impact bond mechanism could have negative consequences for beneficiaries.

It has been six years since the first impact bond was implemented in March of 2010, and the field is beginning to move from an exploratory stage to looking at systemic change, as Tracy Palandjian, CEO and co-founder of Social Finance U.S. described. The event, “The Global Potential and Limitation of Impact Bonds,” served as a point of reflection for stakeholders at this pivotal stage of the field, bringing together over 500 individuals in the room and on the webcast, including practitioners developing impact bonds around the world. While context matters, there were notable similarities in the motivations and challenges across regions.

Potential value-add

In our presentations of our research and subsequent panels, we focused on the potential value and challenges of combining results-based financing and impact investing through an impact bond. Shri Naveen Jain, mission director of the National Health Mission of Rajasthan, India, who is working to develop an impact bond for maternal and child health services across his entire state, pointed out that the value of a results-based financing contract to him was in the added transparency it provides—the government is able to see what they are paying for, keep service providers accountable, and incentivize providers to achieve better outcomes. Louise Savell, a director at Social Finance U.K., the entity that first put impact bonds on the map, explained that results-based financing contracts are often arranged such that only one portion of the contract is based on results. This, she explained prescribes a model and does not allow for flexibility; furthermore, it forces service providers to bear a significant risk. Impact bonds allow for the entirety of payments to be based on results, which gives the provider full flexibility (at least in theory), but puts the risk of service performance on the investor. The shift of risk to investors could be particularly useful for service delivery in conflict affected areas, where donors are often highly concerned about how money will be used, mentioned Francois de Borchgrave, co-founder and managing director of Kois Invest, who is working on an impact bond with the International Rescue Committee of the Red Cross. The panelists also emphasized that impact bonds are more powerful than results-based financing contracts alone because, if successful, they pay real financial returns to investors. This draws a great deal of attention from policymakers and the public, and the added scrutiny helps in making the investment case for preventive interventions highly explicit. Mayor Ben McAdams of Salt Lake County, Utah said that “data and evidence is bridging a partisan divide” in his state—when the case for investment is clear, policymakers from both sides of the aisle are willing to invest. Impact bonds do not necessarily add value by increasing the total amount of funding available for social services, because investors are repaid if outcomes are achieved. Rather, impact bonds could help increase the outcomes achieved with given funding.

Overall there was agreement that impact bonds have enormous potential to lead to more outcome-focused financing that focuses on preventive interventions and incentivizes collaboration. However two critical considerations for the use of impact bonds arose throughout the day.

Optimal impact bond size

The first consideration discussed was whether or not impact bonds can support innovation or scale. As found in our first report, impact bonds have been relatively small in scale in terms of capital and beneficiaries. The average upfront investment in impact bonds to date is $3.7 million, reaching an average of 1,900 beneficiaries. They also have not, on average, focused on particularly innovative interventions—in fact they have almost all had a relatively strong base of evidence behind them. Views on the panel differed on whether the uses of impact bonds could be expanded—if they could be used for highly innovative pilot programs or proven large scale programs. One perspective was that impact bonds could indeed provide seed capital to test new ideas for service delivery. This would require investors who are willing to test not only the innovation but also this relatively new financing mechanism. Given the high transaction costs that impact bonds entail, however, this may not be the most efficient use of resources. Impact bonds could also reach more beneficiaries per transaction (greater scale) with changes in public procurement and the creation of markets for tradeable impact bond assets. Government can play a role in facilitating larger impact bonds by creating central government outcome payment funds, providing tax breaks for investment in impact bonds, and enabling the development of investment vehicles, all of which are being implemented in the U.K. Impact bonds could also help effective social services reach scale by encouraging government to fund programs at scale after the impact bond is over or by improving data use and performance management in government-funded services broadly.

Outcome evaluation design

A second, and related, discussion happened around evaluation methodology—which may differ depending on whether the impact bond is intended to test an innovative intervention or scale an intervention already backed by significant evidence. The “gold standard” randomized controlled trial (RCT) is the only methodology that eliminates the possibility that impact could be attributed to something other than the intervention, though the majority of impact bonds thus far use evaluation methodologies that are less rigorous. The panelists explained that it is important, however, to consider the status quo—currently, less than 1 percent of U.S. federal spending on social services has been shown to be effective. The same is true in low- and middle-income countries, where there are relatively few impact evaluations given the number of interventions. At the end of the day, the government agency acting as the outcome funder must decide on the importance of attribution to trigger payment through the impact bond in view of the already available evidence of program effectiveness and weigh the criticism that might ensue in the absence of a valid counterfactual.

Challenges

Though impact bonds are a potentially useful tool in the toolbox of many financing mechanisms, there are some significant constraints to their implementation. The biggest barrier to impact bonds and other results-based contracts is the administrative hurdle of contracting for outcomes. Peter Vanderwal, innovative financing lead at the Palladium Group, and Caroline Whistler, co-president and co-founder of Third Sector Capital Partners, both stated that governments often are unable or do not know how to contract for outcomes, and there is a need to invest in their capacity to do so. Appropriation schedules are part of this challenge, governments are often not allowed to appropriate for future years. When an audience member asked how we go about changing the culture in government to one of contracting for outcomes, Mayor McAdams answered that impact bonds may have a contagious effect—contracting for outcomes will be the expectation in the future. Additionally, the transaction costs of establishing the partnership are large relative to other mechanisms, though they may be worthwhile. Jim Sorenson, of the Sorenson Impact Center, pointed out that service provider capacity and data collection systems could be barriers to the development of future impact bonds. There is also still a long way to go in developing outcome measures and in particular in calibrating those outcome measures to low- and middle-income countries.

The role of governments and research groups

The influence that impact bonds have on the provision of quality services globally depends on the quality of implementation. With a rapidly growing market, there will inevitably be “bad” impact bonds in the future. To ensure that impact bonds are used as effectively as possible, governments and the research community have a pivotal role to play in asking the right questions: Will a results-based contract help improve outcomes in this particular case? What should the outcomes be to avoid perverse incentives or potentially negative externalities? And would an impact bond structure add value?