China World
China’s Bad Debtor
Yu Yongding
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BEIJING – Before the global financial crisis hit, critics of China’s economic imbalances – its twin fiscal and trade surpluses – mainly concentrated on the misallocation of resources that occurs when poor countries borrow from rich countries at high interest rates and lend the money to them at low interest rates. The great irony of the financial crisis is that the situation has become worse, not better.
China ’s foreign-exchange reserves, indeed, are facing a triple whammy: a decline in the US dollar’s purchasing power, a fall in the prices of US government securities, and possible inflation in the longer run.
The bulk of China’s $2.3 trillion in foreign reserves are held not for the purpose of protection against negative external shocks, but as savings in the form of US Treasury notes. China thus needs to preserve the value of its savings.
But there is no question whatsoever that the US dollar will go south in the long run – a depreciation that started in April 2002 and, after a short interval, resumed in March 2009. Unless the US economy improves its trade balance, the dollar will fall. But the US cannot improve its trade balance unless the dollar falls. Measured by the dollar index, therefore, capital losses on China’s foreign exchange reserves are inevitable.
Due to the huge US budget deficit, the supply of American government bonds will increase astronomically in the years ahead. But there is no guarantee that demand for these Treasury notes among foreign investors – including foreign governments – will be sufficient.
So it is very likely that when the global economy has returned to a sort of normality and safe-haven demand has declined, the prices of US government securities will fall and their yields will rise. As a result, China’s dollar-denominated foreign-exchange reserves, which account for the largest share of all the foreign holdings of US government securities, will suffer interest-rate losses.
Moreover, the US Federal Reserve is targeting a 4% annual inflation rate. This alone means that under normal circumstances the purchasing power of China’s foreign-exchange reserves will automatically depreciate by 4% each year.
Due to the extremely expansive US monetary policy that has been in place since the sub-prime crisis began two years ago, the real value of China’s foreign-exchange reserves has already been eroded, with or without inflation. China is like the shareholders of a company that has increased the supply of its shares in a stealthy way: the share price may not have fallen yet, but it will.
Unless the Fed successfully implements an exit strategy from monetary expansion, which is doubtful, China will not be able to recover its losses. A less likely but more damaging scenario is that all the money dropped on the economy by US Federal Reserve Chairman Ben Bernanke will eventually stoke a bout of serious inflation. If this nightmare comes true, China’s packed savings in the form of US government securities (which now amounts to some $900 million in Treasury bills alone) will simply go down the drain.
Despite China’s limited room for maneuver with regard to its stocks of foreign-exchange reserves, it should never give up its efforts to safeguard the value of its hard-earned wealth, which has been entrusted to the good will and supposedly responsible hands of the US government. As the stronger and more experienced party, the US can help to allay China’s fears about the safety of its national savings. For example, the US government should offer more financial instruments like Treasury Inflation-Protected Securities (TIPS), thereby allowing China to convert some of its holdings of US government securities into similar but safer assets.
Furthermore, China should be allowed to convert part of its foreign-exchange reserves into assets denominated in the International Monetary Fund’s special drawing rights (SDRs). Of course, China should not rule out the possibility of adjusting the composition of its foreign-exchange reserves to mimic the composition of the SDR.
Finally, if the US government cannot safeguard the value its securities, it should compensate China in one way or another. Only then can China and the world be certain that America’s irresponsible attitude – “the dollar is our currency, but your problem” – has become a thing of the past.
Yu Yongding, currently President of China Society of World Economics, is a former member of the monetary policy committee of the Peoples' Bank of China, and a former Director of the Chinese Academy of Sciences Institute of World Economics and Politics.
Copyright: Project Syndicate, 2010.
www.project-syndicate.org
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FFTMMFA 12:14 17 Mar 10
Professor Yu misses one glaring point: China's currency manipulation, which is based on huge purchases of US T-Bills, is a major contributor to the trade imbalance experienced by the US. China's curreceny depreciation not only makes US goods more expensive than they should be in China, but makes Chinese goods significantly cheaper than US goods in other markets as well. Thus, a solution that China could do that would benefit themselves and the US, would be to buy less US dollar reserves and unpeg the Yuan against a USD dominant basket of currencies.
Such actions would do more to benefit China's savings than the actions Professor Yu calls on the US government to perform on China's behalf. What's more, these would be actions that China could take itself, thereby acting independently and as a country in charge of its own destiny, which it is, of course. Although the powers that be in Beijing may not like this as it would mean they couldn't blame evil foreigners for their problems, but would have to take responsibilitythemselves. Quite frightening I am sure, and certainly the more difficult of decision, but we all have to fly the nest sometime, dragons included.
AndreasAntonius 03:21 17 Mar 10
Dear Professor Yu,
You cannot be so naïve to believe that the Chinese did not know, that their tremendous accumulation of US debt will ever be paid back at par. Economics is always about trade-offs. The loss in purchasing power of the Chinese reserves is the price China will have to pay for having been able to sustain for so long such a high growth environment through exports.
In our globalized world, the recipe for a supposedly "successful" economy is well known. If a country wants to enjoy rapid economic growth and avoid high unemployment, it has to be competitive, which is best achieved by keeping labor costs low and boosting labor productivity. If a country can do this better than its competitors, its exports will soar. The downside to this export success, however, is that it will cause the country's currency to appreciate.
To avoid this, a successful exporting country can peg its currency to the currency of one of its main trading partners, but this also has knock-on effects. It leads to trade imbalances where the "pegging country" (with an undervalued currency) enjoys a structural trade surplus while the country whose currency is pegged (and hence overvalued) is saddled with a structural trade deficit that it has to find a way to finance.
If the "pegged country" does not have sufficient domestic savings to rely on, it has to indebt itself by borrowing. But who would lend to such a country? The answer is plain and simple: the country that does not want to let its currency appreciate (the pegging country). In other words, if a country wants to prevent its currency from appreciating in order to retain its export competitiveness, it needs to buy foreign currency, usually by buying debt.
This is how the symbiosis between China and the United States has worked over the last decade: the US “living beyond its means” and indebting itself and China accumulating an immense amount of foreign exchange reserves.
Now China wants the money back… but all it will get is greenbacks, which will never ever have the same purchasing power then they had, when the debt was emitted. So instead of complaining about the frugality or even the fraudulence of the US, China should think, whether it wants really to continue its export-led cum pegged currency development model or whether it should start to grow by its own means through its domestic sector.
The answer isn’t an easy one but blaming others (like the US are also doing with their mantra of currency manipulation) is certainly not the right one.
MacAlpha 12:46 18 Mar 10
Reflecting again on Yu Yongding's article, and that he is an intellectual in China; we see firsthand the gap between the two countries' mindsets. Indeed his implied paradigm speaks volumes of what the Chinese intellect thinks about the rule of law and the sanctity of contract. Both are interpreted for the complete and total benefit of the state, without regard to other interests. Other interests are bootstrapped on so long as they do not interfere with the paramount order of the state and its governing mechanisms.
As for modern free market economics, clearly the professor does not belive in it. He would lock in surplus as a guarantee and treat deficits with clawbacks. That is not a monetary bent and converts ordinary market transactions into a surety scheme. Why, then, would a rational investor subject his capital to these risks? Because of the return. The gamble is that they will enjoy the return. Yes, they could exceed other returns for a time, but the economic engine is not rooted in calculable risks and concomittant (returns). Moreover, the temptation for governments to manipulate the outcome is the rule of law.
Great governments, societies, and cultures have always been built on economic freedom, rule of law, and sanctity of contract. This perception of real wealth appears lacking in the professor's essay.
FFTMMFA 03:19 18 Mar 10
@MacAlpha: I think you're mostly correct. I do, however, take objection to your final paragraph as the maxim is not a true precept. In point of fact, this paragraph would largely exclude any societies, cultures and countries prior to the 17th century. In point of fact, andcient and classical Eastern and Western cultures, both, certainly represent high points for our ethnosphere. Chinese culture, for example, which can arguably be considered to have reached its zenith during the Tang dynasty, would be excluded.
In fact, Professor Yu's position can be seen as largely rooted in the cultural and historical legacy of China itself, where markets traditionally existed for the benefit of the state. While I believe strongly that his views as expressed in this column are flawed, they are valuable to China observers to the extent that they are an endogenous reflection of the opinions and world views of the Chinese elite itself, which, almost by definition, his position would confirm they are.
wauch 11:50 18 Mar 10
I find it hard to believe that a chinese technocrat is going to lecture us when it is our insatiable Appetite for Consumption that allowed them to accrue this $2.3 Trillion figure. If you hadn't fed us we wouldn't have gotten so obese and if we had some restraint you would still be a Frontier Market. Chicken or the egg redux!
Sacrifice 08:24 22 Mar 10
The PRC embarked on an aggressive, merchantalistic export policy decades ago in order to rapidly develop their economy. It is impossible to pursue such a national policy and run up massive current account surpluses without other nations incurring large current account deficits.
As a result of this long-standing policy, the PRC has built up foreign capital reserves unprecedented in world history and in exchange has put together a huge export infrastructure.
Your suggestion that the US should put the interests of the PRC above those of its own people is absurd and irrational. It will not be done.
The past will not be the future. The US government and consumer must and will significantly de-lever in the medium term. The PRC must become more of a consumer-driven economy and must reduce its current account surpluses.
Without change, the US will default on its obligations to the PRC through sovereign default or inflationary debasement. In which case, the PRC will be left with a massive amount of mal-invested capital assets and will have sold the wealth of its people at a huge discount to the richest nation on earth.
MacAlpha 11:33 17 Mar 10
Sure, we can repay once we are compensated for 30 years of stolen patents and intellectual property infringement.