Global: The Fed and China
Stephen Roach (New York)
Because of its currency peg, China does not have an independent central bank. Having elected to fix the renminbi to the dollar, the People’s Bank of China has all but abdicated control over its emerging financial system to America’s Federal Reserve. As the Fed now moves into the serious stage of its tightening cycle, that could pose a serious problem for an unbalanced Chinese economy. China may be preparing for precisely this possibility.
Despite nine months of measured tightening, America’s central bank remains well behind the curve, in my view. That is apparent if the “curve” is defined to delineate the setting of the policy rate that would be consistent both with the Fed’s inflation concerns as well as America’s current-account adjustment imperatives. The real, or inflation-adjusted federal funds rate currently stands at just 0.35% if the nominal funds rate (2.75%) is “deflated” by the year-over-year increase in the core CPI (2.4%); it is still slightly in negative territory if the headline CPI (3.0%) is used. An average of the two readings works out to a “zero” real federal funds rate -- underscoring the persistence of extraordinary monetary accommodation.
A year ago, when the balance of economic risks evened out after a very rocky recovery, I suggested that it would have been appropriate for the Fed simply to reset its policy rate quickly to a more neutral level (see my 27 February 2004 dispatch, “An Open Letter to Alan Greenspan” also published in Newsweek). Unfortunately, since the Fed has taken its sweet time, its efforts to recalibrate monetary policy have been largely offset by deteriorating conditions on four fronts -- mounting inflation risks, a runaway current account deficit, an emerging property bubble, and a profusion of speculative carry trades in fixed income markets. As a result, the US central bank can no longer afford to play it cute and seek a neutral policy stance -- the federal funds rate now needs to be pushed into the restrictive zone. We can argue over what that translates into insofar as a specific target for the nominal federal funds rate is concerned; my own view is that might be as high as 5.75% (see my 23 March 2005 dispatch, “The Test”). But even if I am guilty of exaggerating the upside to the funds rate, suffice it to say that the appropriate level is a number well above the current reading. If that’s not behind the curve, I don’t know what is.
Of equally great interest, of course, is what the Fed gets for this noble effort. The primary goal is inflation control, of course. I would add a secondary objective -- pushing up real interest rates to levels that are more compatible with America’s outsize international funding requirements; with the US current account deficit exploding to 6.3% of GDP in late 2004, the US needs $2.9 billion of capital inflows per business day. It is difficult to attract flows of that magnitude with a policy rate that remains at zero in real terms. Fed tightening also reins in the excesses in asset markets -- especially residential property but also the profusion of carry trades in risky assets such as high-yield and emerging-market debt.
The tougher question comes in assessing the costs of America’s coming monetary tightening. In my view, there are two sets of costs to consider -- internal costs for the domestic economy and external costs for the rest of the world. Insofar as the US economy is concerned, I believe the burden of the coming monetary tightening will be felt most acutely by the asset-dependent American consumer. Even Fed Chairman Alan Greenspan has finally admitted the same when he recently conceded the importance of an increasingly tight linkage between asset markets, consumer behavior, and the current account deficit (see my 6 February dispatch, “Confession Time”). To the extent that the interest-rate underpinnings of asset markets -- especially an over-extended US property market -- now move into the restrictive zone, a shift from asset- to income-based saving can be expected from American households. The reversal of nearly a decade of excess consumption growth should then follow.
That’s where a co-dependent Chinese economy enters the equation -- the economy that I believe is most likely to be on the leading edge of feeling the external impacts of the coming Fed tightening. In large part, that’s because the structure of the Chinese economy is very much the mirror image of the US. Unlike America, which is a consumer-driven spending machine, exports and export-led investment remain the name of the game in China. Personal consumption in the US currently stands at a record 71% of US GDP, whereas in China the share of household consumption stands at a rock-bottom 42%. Chinese exports have grown from 20% of GDP in 1999 to 35% in 2004, while the fixed investment share is now approaching an astonishing 50%. And, of course, China’s biggest export market is the United States, destination for exactly one-third of overseas Chinese shipments in 2004. By implication, that puts an externally-dependent Chinese economy very much in the cross-hairs of a Fed tightening that is now taking dead aim at the American consumer.
Little wonder that China appears reluctant to impose new tightening measures on a still seemingly vigorous Chinese economy. That was the distinct impression I took away from my recent participation in the annual China Development Forum in Beijing (see my 22 March dispatch, “China Goes for Growth”). With the coming Fed tightening likely to squeeze the American consumer -- the major prop to China’s external growth dynamic -- a new round of domestic tightening measures by Chinese authorities would raise the risk of significant overkill. Focused on the always delicate balance between reforms and stability, this is not a risk that China wants to take. Repeatedly, in the past decade, Chinese authorities have erred on the side of unusual stimulus when external conditions turned treacherous. That was the case during the Asian financial crisis of 1997-98 as well as during the synchronous global recession of 2001. And with the Fed now putting the American consumer in play, I suspect that could also be the case in 2005.
All this underscores an important strategic challenge that China must address in the not-so-distant future -- the need to have a more balanced economy and a more flexible policy regime to go along with it. While its special requirements of infrastructure, urbanization, and industrialization are all supportive of a high-investment growth dynamic, China is in danger of pushing this unbalanced growth model to excess. Unfortunately, the currency peg constrains Chinese policymakers from using traditional macro stabilization tools to rein in these excesses by controlling the price of credit. Instead, the authorities revert to their central planning heritage and deploy administrative measures that control the quantity of credit. That’s what happened last spring and it appears likely to be the case again with recent measures aimed at curtailing mortgage credit. However, courtesy of the peg and its linkage to a still-accommodative Fed, speculative capital inflows are powering a persistent upsurge in the Chinese liquidity cycle that may overwhelm the impacts of administrative measures. Moreover, recent reports in the Chinese press indicate that lenders have yet to alter mortgage lending guidelines in the aftermath of recent central bank actions aimed at boosting down-payment requirements from 20% to 30%. Nor does there appear to be any reduction in the appetite for home buying, according to a recent survey conducted by the People’s Bank of China. The more China ups the ante on unbalanced growth, the tougher it becomes to break the habit.
Despite these concerns, I remain fundamentally optimistic on China. The nation’s steadfast commitment to reforms over the past 27 years is at the heart of the macro tradeoffs it now faces. That is a huge positive for China and the rest of the world. With the Chinese leadership remaining steadfast in its commitment to dismantle the state-owned economy, it is taking enormous risks by eliminating some 8-10 million jobs each year. The delicate balancing act between investment-led growth and stability arises out of the need for Chinese policy to compensate for the extraordinary employment pressures that arise from these reforms -- a Herculean task that we in the West often lose sight of.
This is an extraordinary challenge for all of us in dealing with the inevitable stresses and strains of globalization. The rich, developed world needs to do a better job in learning to cope with China. That’s especially the case for US politicians, where China bashing has become an all-too-convenient foil for America’s own unwillingness to boost national saving and wean itself from current account and trade deficits. But China, for its part, also needs to adapt better to changing global circumstances. The Chinese leadership may well need to freshen up its policy approach in order to confront the perils of its own imbalances. The strategy that has worked so well in the early stages of development may now be in need of an overhaul as China comes of age. In that important respect, by going after the asset-dependent American consumer, the Fed may be doing China a real favor.
All this points to a delicate balance in world financial markets. Further Fed tightening could prove highly disruptive to the profusion of carry trades that continues to populate global fixed income markets. It would also pose a stern threat to the interest-rate and asset-dependent American consumer. Yet to the extent US consumption fades, I still believe the Fed could flinch on its policy gambit -- thereby pushing the US current-account adjustment back onto dollar-weakening, with concomitant upside pressures on the Japanese yen and Chinese RMB. In a US-centric world, I suspect that America will continue to drive global bond markets. The initial Fed-induced sell-off could well beget the next rally.
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