The Chimera on a red-figure Apulian plate, ca 350-340 BCE (Musée du Louvre)
The author explores the unsustainable economic relationship between China and the US.
The People’s Republic of China and the United States have experienced sharp disagreements in economic policies for some time, straining Sino-American relations. Among all, it is the pertinaciously undervalued Renminbi(i) that has drawn much criticism from the developed world. Due to this condition, it is generally believed that China’s economic policy is the main cause of global imbalances in current account positions and that its policy poses a great threat to global economic stability.
In response to the Great Crisis of 2008(ii), a “global saving glut”(iii) theory, postulated by Federal Reserve Chairman Ben Bernanke in 2005, emerged as the prominent narrative to explain the major causes of the crisis. The theory maintains that excessively high savings by some countries pushed their savings towards current account surpluses and away from investments. The United States, being the most salient country on the receiving end of the surplus, ran a huge current account deficit while China claimed the largest current account surplus [1]. An effect of this imbalance was the astounding accumulation of dollar reserves held by the Chinese government. The Chinese government in turn redirected most of the reserves into US government securities and agency debts and thereby indirectly flushed the US capital markets with money, depressing interest rates across asset markets. Financial institutions in the US, along with US consumers, gorged themselves on this “easy money.” Wall Street firms channeled these funds into the creation of the subprime mortgage crisis and the formation of a real estate bubble that almost brought down the global financial market.
In Martin Wolf’s book, Fixing Global Finance, he reiterates Bernanke’s supposition by pointing out that China’s “inordinately mercantilist currency policies” have caused an imbalance in current account positions that have invariably led to the biggest financial crisis in modern history. He criticizes China’s export-oriented growth, which depends on the competitiveness of Chinese exports. This competitiveness is maintained by an undervalued Renminbi [2]. Paul Krugman, in recent articles for the New York Times, echoes Wolf’s criticism of China’s distortionary exchange rate policy [3,4]. He even calls for the US Treasury to exert serious pressure on the Chinese government to stop what he claims to be “currency manipulation.” China’s deleterious economic policy is costing the global economy a stable recovery.
There are always two sides to every story. Martin Wolf’s judgment on global imbalance implicitly assumes that it is to China’s benefit to undervalue the Renminbi and sustain an enormous current account surplus. Why else would Beijing pursue such an extreme policy, unless to further its economic interest? Yet data released by the US Treasury show that China’s ballooning foreign reserve portfolio turns out to be a mixed blessing for China. Chinese investments in various forms of US government and quasi-government debt have been suffering from declining returns; the decline has been particularly drastic in recent years. In 1985, a 5-year US Treasury bond yielded a 12% return; in 2008, a bond with same maturity returned a mere 2% [5]. Other US government debts have shown similar levels of falling returns. Since US debt constituted a disproportionately large component of the Chinese foreign reserve portfolio, the losses suffered by Chinese investors in their US debt positions are substantial. In addition to the poor return that US government debts have been yielding, the likely depreciation of the dollar against the Renminbi and the possibility that the US government might effectively expropriate dollar-denominated assets by simply monetizing its debt will only accelerate Chinese investors’ losses.
Just how much has China lost from its Treasury holdings along with its active maintenance of the Renminbi value? A crude calculation based on yields of US Treasury Bonds and the US-China trade balance suggests that this loss may well have exceeded the dollar gain versus the trade surplus (worst case scenario) or wipe out much of the gain that China has earned through its export-oriented growth (best case scenario). This economic exercise does not take into account the employment gains and associated multiplier-driven employment gains, but it is sufficient to say that the economic benefit from the undervalued Renminbi is rather less than most economists from the Global Saving Glut school of thought believe. It should also be noted that Chinese citizens have foregone consumption, adding to the cost to maintain the exchange rate regime needed to fulfill China’s export-led growth.
The idiosyncratic cost/benefit condition of Beijing’s approach to economic growth has fulfilled Niall Ferguson’s prophecy of the Chimerica(iv), a dangerous state of economic symbiosis [6]. Saving by the Chinese and overspending by Americans has led to an incredible period of wealth creation that contributed to the global financial crisis of 2008. China accumulated large currency reserves and channeled them into US government securities for years, keeping nominal and real long-term interest rates artificially low in the United States.
The economic interest of the United States and China are now tightly entwined. There has been a calling for the decoupling of the Chimerica economic regime. After all, the symptoms exhibited by the Chimerica economic system are shared by economies across the globe. Many of the developed countries are running current account deficits while developing countries, such as those in East Asia as well as other major commodity exporting countries, are running surpluses. These two general groups share a similar relationship as China and the United States. As in the resolutions of previous crises, major players in the international financial market need to take leadership roles and determine a way out of the bondage of global imbalance. This is a formidable task. Faced with slow economic recovery, huge fiscal deficit, and many lurking recessionary pressures, the United States is in a poor position to act as the world’s stabilizer. Still, some changes within the US economic structure are warranted. Financial reform in the United States is a good start. Economic redistribution might also be necessary as the prolonged stagnant real wages lead American consumers to binge on debt-financed consumption.
This leaves the other half of the Chimerica to shoulder the burden to create a new order in the global economy. China needs to work through a major change in its institutional framework. Perhaps it should start by answering the call by many economists to reorient its growth from exporting to building domestic demand. This stands true for both Chinese consumers and businesses. Beijing has the power and the incentive to correct the current destabilizing imbalance. Hopefully, with international cooperation, China can lead the formation of a new peaceful and prosperous global economy.
Notes
i. The Renminbi is the official currency of the People’s Republic of China (PRC); the principal unit is the Yuan (¥).
ii. The Great Crisis of 2008 was a financial crisis triggered by a liquidity shortfall in the United States banking system caused by the overvaluation of assets. It has resulted in the collapse of large financial institutions, the bailout of banks by national governments and downturns in stock markets around the world. In many areas, the housing market has also suffered, resulting in numerous evictions, foreclosures and prolonged vacancies. It is considered by many economists to be the worst financial crisis since the Great Depression of the 1930s. It contributed to the failure of key businesses, declines in consumer wealth estimated in the trillions of U.S. dollars, substantial financial commitments incurred by governments, and a significant decline in economic activity.
iii. Global saving glut (or global savings glut) is a term coined by Ben Bernanke in 2005. The term describes a situation in which there are too many savings worldwide with respect to investment opportunities. On a national level a saving glut creates the tendency for savings to finance current account surpluses instead of investments. This can be observed, according to Bernanke (2005), in both developing and industrial countries. The most important receiving country of these export surpluses financed by excess savings, is the United States, which runs a current account deficit.
iv. Chimerica is a neologism coined by Niall Ferguson and Moritz Schularick describing the symbiotic relationship between China and the United States, with incidental reference to the legendary chimera.
Works Cited
[1] Bernanke, Ben. “The Global Savings Glut and the U.S. Current Account Deficit.” The Sandridge Lecture, Virginia Association of Economics. Richmond, Virginia. March 10, 2005.
[6] Ferguson, Niall. The Ascent of Money: A Financial History of the World. New York, New York. The Penguin Press, 2008.
[5] Historical Yields on U.S. Treasury Bond from 1985 to 2008. St. Louis Fed: Economic Data – FRED. http://research.stlouisfed.org/fred2/data/GS30.txt
[3] Krugman, Paul. “Chinese New Year.” New York Times. 1 Jan. 2010: A29
[4] Krugman, Paul. “Taking on China.” New York Times. 14 Mar. 2010: A23
[2] Wolf, Martin. Fixing Global Finance. Baltimore, Maryland. Johns Hopkins University Press, 2009.
Original Appearances of Visuals and/or Media
The Chimera on a red-figure Apulian plate, ca 350-340 BCE (Musée du Louvre)
1. It is inaccurate to say that China is the main cause of global imbalance. All major oil exporting countries play pretty much the same role. But because the RMB is severely undervalued and given that the monopsonic nature of the American market (think about the kinds of products China exports to the U.S.), the trade account imbalance, which spills into the U.S. current account, does create an imbalance of epic proportions which binds the Chinese economy to the U.S. economy. China earns dollars from exports and they reinvest these dollars in the U.S. capital markets (and you are right, I should have said capital market and not just government and agency debt). The point I am trying to make is that China should diversify their portofolio which it has started going recently buy purchasing large amount of Japanese debt (bad idea in my opinion).
2. I did not meant to imply that this “reorientation” will be swift. China needs better legal and business infrastructures for sure. A free and transparent capital market is a good place to start so banks make the decisions to invest and lend, not just the government. This also means the RMB has to float more freely.
3. Martin Wolf’s occupation as a journalist does not discredit his opinions on the subject of economics. He is trained as an economist at Oxford and I believe that qualifies him to engage in meaningful economic discussions
4. “China accumulated large currency reserves and channeled them into US government securities for years, keeping nominal and real long-term interest rates artificially low in the United States.”
The only inaccuracy that I am willing to concede here is that the large reserve held by Chinese is channeled into U.S. government securities as well as dollar-denominated private debt. If that’s what you considers as fallacious, I will retract the statement. Other than this, the financial mechanism here is correct.