Change or more of the same?

Simon Johnson poses the core question facing the United States and China well:

If [China] doubles [its] holdings of US dollar assets over the next couple of years (let’s say, going towards $4trn), effectively financing our budget and current account deficit, will we all end up safer or more vulnerable?

China currently has a bit over $1.5 trillion in dollar assets, as not all of its $2 trillion in reserves (and more like $2.3 trillion to $2.4 trillion in government assets abroad) are in dollars. About ½ of the total is result of China’s purchases in just two years, 2007 and 2008. China’s trade surplus isn’t shrinking, at least not in dollar terms. Lex’s argument that China’s surplus is waning can be challenged.* And even if China’s trade surplus stabilizes in dollar terms and shrinks relative to China’s GDP, China is on track to double its foreign assets – and its US holdings – over the next four years. Think a $350-400 billion annual increase in China’s dollar assets, and a $500b plus increase in China’s foreign assets.**

That prospect should scare China’s leaders. China’s population thinks China has already invested too much in low-yielding dollar assets. Doubling down only makes the problem bigger. Bridgewater’s Ray Dalio noted in February:

But they [China] own too much in the way of dollar-denominated assets to get out, and it isn’t clear exactly where they would go if they did get out. But they don’t have to buy more. They are not going to continue to want to double down.

Nor should the US want China to double down. The past few months have made it clear that China’s dollar problem can quickly become America’s problem, as China’s doubts about the safety of its US portfolio reverberate through various US markets.

To be clear, the basic risk China is running hasn’t changed all that much recently. China’s government fundamentally is overpaying for dollars (and euros) to hold the RMB down to help China’s exporters. That policy always has carried with it a high risk of future financial losses.

The current crisis hasn’t fundamentally changed that basic reality.

Sure, the US fiscal deficit is up, something China’s state media now likes to highlight.*** And the Fed has cut policy rates in the midst of a severe downturn. But that is only half the picture. Household savings are up. Household borrowing is down. The private sector’s financial deficit is way down. The trade deficit is down too. Foreign inflows finance a trade deficit not the fiscal deficit and, in my book, financing a 6% of GDP trade deficit is more risky than financing a 3% of GDP trade deficit.

What has changed is China’s own perception of the risks. China’s population wasn’t focused on the cost of holding more dollar and euro reserves than China needs back in 2005 or 2006. Now it is.

And, or course, the over time the size of China’s portfolio grew, increasing the scale of China’s exposure. That is the nature of financing an ongoing deficit. The longer the current relationship continues, the more dollars (and euros) China will hold, and thus the greater the underlying risk.

Simon Johnson focused on Geithner’s non-confrontational tone in Beijing. But the basic message in Geithner’s Beijing speech was clear: the goal of both US and Chinese policy should be to move away from the current unbalanced relationship.

Our common challenge is to recognize that a more balanced and sustainable global recovery will require changes in the composition of growth in our two economies. Because of this, our policies have to be directed at very different outcomes.

In the United States, saving rates will have to increase, and the purchases of U.S. consumers cannot be as dominant a driver of growth as they have been in the past. In China …. growth that is sustainable growth will require a very substantial shift from external to domestic demand, from an investment and export intensive driven growth, to growth led by consumption. Strengthening domestic demand will also strengthen China’s ability to weather fluctuations in global supply and demand.

If we are successful on these respective paths, public and private saving in the United States will increase as recovery strengthens, and as this happens, our current account deficit will come down. And in China, domestic demand will rise at a faster rate than overall GDP, led by a gradual shift to higher rates of consumption. Globally, recovery will have come more from a shift by high saving economies to stronger domestic demand and less from the American consumer.

Seems like a vote for change, not more of the same.

But what leverage does the US really have to change the basis of the relationship when it wants China to buy its bonds in the near term?

That question misses two key points. First, the trade deficit is down, so the US actually needs less financing from the rest of the world right now than it did in the past. It isn’t clear to me that the US relies more on China now than it did back in 2007 and early 2008, when China’s reserves were growing faster and the US external deficit was larger. Second, China’s own concerns about its dollar risk could generate a larger constituency for change inside China.

Until now, China’s policy has been dominated by concerns about the impact of any change in China’s exchange rate on China’s exports. Yet it is hard to see how China can realistically scale back even the pace of increase in its dollar exposure so long as it is running a large trade surplus and pegging to the dollar.

Chinese policy makers have been searching for a way to avoid adding to their dollar exposure without changing their dollar peg. Here though, I suspect that my colleague (boss, actually) Sebastian Mallaby is right: China’s efforts won’t get China very far so long as China’s capital account is closed and China pegs to the dollar. As China comes to the same realization, the pressure on it to adjust its policies will grow.

Of course, a world where China provides the US will less financing implies adjustment in the US as well. A China that imports fewer bonds will tend to buy more imported goods – which will help some parts of the US economy. But it won’t help sectors with large borrowing needs. Including the US government.

The troubles the dollar has faced recently suggest that the market wants the US to continue to adjust. It now seems as though there isn’t lots of demand for US asset at current interest rates in absence of an acute crisis. The external financing that would be needed for US demand to spur a global recovery may not be there. Market pressures then could spur a more balanced global recovery. A weaker dollar will help bring about a rebound in US exports just as stronger currencies abroad will push other countries to take steps to stimulate their own economies.

Change isn’t without its risks. One of the key factor pushing China to adjust – its concerns about the safety of its US portfolio (or, in my view, its China’s belated recognition that holding its exchange rate down has costs as well as benefits, as it requires continuously overpaying for dollar and euro denominated bonds) – also makes the market nervous. And a nervous bond market tends to make policy makers a bit nervous.

On the other hand, if China (and the US) double down, the underlying problem would in some sense only get worse. The basic issues won’t change. But the stakes will be even higher.

Over the past couple of days I discussed the Sino-American financial relationship with CNBC Europe, NPR’s All Things Considered and public radio’s On Point. I tried to argue that neither the US nor China should seek to maintain a world where China saves and lends and the US (households as well as the government) borrows and spends. The goal should be the creation of a more balanced relationship – one where the US doesn’t require so much Chinese financing and China doesn’t need so much US demand – not a return to the old unbalanced relationship.

The sources of pressure for change are increasingly obvious. Even in China. That’s good. But transitions aren’t easy. Deficits – even shrinking deficits – have to be financed. And financing an orderly (think gradual) adjustment poses particular challenges.**** For everyone.

* China’s trade surplus in the 12ms through April reached $315b, v $255b in the 12ms to April 2008. The surplus in the last three months of data was $37b – v $39b at this time last year. That is encouraging – not growing isn’t the same as shrinking. Especially when China is stockpiling commodities, and thus somewhat artificially increasing imports and reducing its surplus. Let’s see what May tells us – if China really is going to lead the world out of the current slump, its surplus should shrink. ** I am assuming that China’s reserves resumed their upward March in the second quarter, as renewed confidence in China ended hot money outflows. Generally speaking, China amount of foreign exchange China has to buy to manage its exchange rate rises when the dollar is depreciating. *** China Daily, via Charles Wallace of the Big Money: “The government and experts have expressed concern that Washington’s mushrooming deficit, generated by massive government borrowing to fuel its economic recovery plan… will undermine both the dollar and US bonds.” Funnily enough, I never heard China express comparable concern about the United States ballooning trade deficit from 2003 to 2006, even though that was a more direct threat to the value of the dollar. Call me cynical. *** During an orderly adjustment, China’s dollar holdings – and thus its exposure to the US – would continue to rise. But the pace of increase would slow, until a new equilibrium was established, one that didn’t require ongoing Chinese purchases. The problem is that China’s exposure needs to rise even as China’s surplus with the US shrinks. Basically, China needs to bear the financial costs of supporting the dollar without getting the trade boost it got before. This shouldn’t be a surprise. I – and others – have long noted that the same folks who financed the expansion of the US trade deficit would likely need to finance its orderly contraction. But it isn’t clear that Chinese policy makers really ever thought out the end-game (i.e. their exit strategy from the dollar trap), despite their reputation for thinking about the long-term.


Originally published at the Council on Foreign Relations blog and reproduced here with the author’s permission.

5 Responses to "Change or more of the same?"

  1. CHRIS DAVIS   June 6, 2009 at 2:15 am

    Why are we to always assume that China’s dollar “surplus” is a net number? In the crash of 1990, the Japanese banks misallocated an amount of capital roughly equivalent to that country’s cumulative post-war trade surplus, ie, about a trillion US. So, if we were to look at Japan Inc. as one large trading company, we would see a trillion dollars on deposit being used as collateral for an equivalent amount of losses. With China, I imagine it’s much the same story: a significant portion of the so called dollar “surplus” is essentially a reserve for government mandated capital misallocations made by local banks, which, similar to Japan, are run on a command credit basis. (In the U.S. we run our banks on a heads-I-win, tails-you-lose command bonus basis). To figure China’s net surplus, it would first be necessary to compute the total internal capital credit misallocation, which could easily surpass a trillion US…..

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