for those who care, exerpt from DR. R's letter
In its most recent assessment of foreign trading partners’ exchange rate policies, the U.S. Treasury
Department refused to state that China is manipulating the value of its currency to enhance the international
competitiveness of its economy. Measured by its soaring dollar purchases and soaring bilateral exports surplus
with the United States, and considering also that Chinese wages are a fraction of American wages, it is a
compelling conclusion that China is not only manipulating its currency, but that it is doing so to an unprecedented
excess in history. These dollar purchases, preventing a rise of China’s currency, act as a de facto subsidy to
Chinese exports into the U.S. market.
The reason for the American silence is not difficult to guess. As earlier explained, there is a flagrant conflict
of interest between manufacturing, on one side, and Wall Street and the government, on the other. China is the
single biggest buyer of U.S. bonds in the world. Total reserves of its central bank are now close to $1 trillion.
This is up from $165 billion in 2000.
The bilateral U.S.-China surplus (as measured by the U.S. government) in 2005 amounted to $203 billion. This
is calculated Chinese imports and exports from its top 40 trading partners, covering around 90% of its total trade.
This surplus has risen from $84 billion five years ago. China’s officially reported trade surplus is only $46 billion.
The surplus with the United States represented over 9% of China’s total GDP and compares with a global
current account surplus of now 7% of its GDP, up 5 percentage points in five years. China is running deficits
with other Asian countries.
China’s international reserves of now close to $1 trillion constitute about 40% of its GDP. The composition
of these reserves is secret, but estimates of experts put the dollar share at about 70% of the total. Essentially, the
share of China’s purchases and holdings of dollars is determined by the need to maintain the fixed exchange
rate. The rapidly growing mountain of foreign currency has been generated by a swelling trade surplus,
investment and speculative inflows.
There are no signs of any near-term change in its exchange rate policy. At the top of the list of objections is
the feat of a negative impact of a rising exchange rate on exports. Yet another consideration stands out. The
leading Chinese policymaking elite is convinced that Japan’s lengthy recession has its root cause in the steep
rise of the yen, which the Japanese authorities accepted under American pressure in the later 1980s. They are
determined not to allow this to be repeated in China. In the same vein, there is a widespread view that exchange
rate stability is important for financial stability.
This is diametrically opposite to the thinking in Japan. Faced, too, with strong upward pressure on the yen,
owing to a large trade surplus and capital inflows, the Japanese authorities responded with heavy dollar
purchases, but not sufficiently to prevent an additional steep rise of the yen against the dollar.
Which of the two responses, now, was the fatal one that led to Japan’s later great economic and financial
malaise? For Japan’s authorities and experts, the central bank’s large dollar purchases were without any doubt the
main culprit. By flooding the banking system in this way with excess liquidity, the following credit explosion
propelled the two asset price bubbles in equity and real estate, which, in turn, fueled the related investment booms.
At the root of Japan’s protracted malaise is manifestly the later bursting of these two bubbles; and these
bubbles had their immediate cause just as manifestly in excess liquidity, which the Bank of Japan created with
its large dollar purchases.
An appreciating currency, on the other hand, has effects that are diametrically opposite to those of generating
asset and credit bubbles. On balance, it has strong deflationary effects, primarily hitting manufacturing. Curbing
investments and exports, this would slow the economy. But this allows the central bank to slash interest rates. In
essence, this would set in motion a very painful shift in the economy’s resource allocation, lowering its
manufacturing share in favor of services.
The trouble with the opposite policy of heavy dollar purchases and suppressed currency appreciation is that
its effect on the economy’s structure is exactly opposite. Instead of restraining manufacturing, it leads to a
booming economy with progressive overexpansion of manufacturing and ever-larger export surpluses. At the
very least, China ought to raise interest rates to slow credit demand and investment, but that is impossible. With
the fixed exchange rate, it would most probably accelerate capital inflows, flooding the banking system with
still more “high-powered” reserves.
There is a view that a central bank facing this problem of creating excess liquidity through purchases of a
foreign currency can offset this effect by “sterilizing” these purchases through sales of domestic assets,
immediately absorbing the excess liquidity. That is what China’s central bank has been doing. For this purpose,
the central bank sells short-term securities, most of which have a maturity of one year, and some even less.
From the perspective of monetary sterilization, these open market sales are an outright farce, because the
papers, which the commercial banks receive from the central bank in exchange for the dollars they sell, represent
top domestic liquidity for them, fostering credit expansion. In addition, the central bank releases them from the
exchange risk.
Genuine sterilization of the dollar purchases would require that the central bank sell long-term paper to
nonbanks, adding nothing to bank liquidity. During the past few years of rock-bottom U.S. interest rates, it made
a loss on its interest account.
Some economists see in the economic and financial relationship between the United States and China a lucky
symbiosis. One delivers the necessary demand for both by massive dissaving, and the other delivers the necessary
supply by massive saving and investment.
The Americans make their spending excesses in consumption, and the Chinese make their spending excesses
in productive investment. There are many absurd ideas around explaining why Americans enjoy the privilege of
being able to have their cake and eat it too.
First of all, American policymakers and most economists are manifestly blind to the severe and growing
structural damage that the trade deficit at its present size is doing to the U.S. economy’s ability to create
employment, incomes and capital formation. Economic growth will progressively slow.
But what about the Chinese economy’s pattern of growth? Is that sustainable? It is definitely not. The main
reason is that the permanent investment boom gets increasingly out of line with domestic consumption demand,
resulting in an ever-larger export surplus. In turn, China’s economic growth becomes ever more dependent on
rising exports. The trade surplus in the third quarter alone was $49 billion, versus $32 billion for the whole of 2004.
Pondering how China’s reckless bubble policy will end, we look at Japan’s experience as an example. We
take it for granted that China’s central bank, in contrast to the Bank of Japan, will accommodate this dollar-driven
expansion as long as it works. Meanwhile, investment excesses are going to ever greater extremes, in mirror
image of the consumption excesses in the United States.
The collapse of the asset and credit bubble happens at the latest when the banks become frightened of the
soundness of their soaring loans. We realize that in China, with banks generally government owned, the lending
excesses and malinvestments can go to extremes unimaginable in free market capitalistic economies.
But considering that the export surplus with the United States presently accounts for about 10% of China’s
GDP, we expect severe repercussion for China from a sharp economic slowdown of the U.S. economy.
CONCLUSIONS:
While U.S. real economic data overwhelmingly keep surprising on the downside, comments by economists
and the media keep surprising on the upside. According to a count by Kleinwort Benson (Dresdner Bank), the
frequency with which the word “Goldilocks” is mentioned in the financial press has risen to its highest level
since the word came into vogue as a description of the ideal U.S. economic environment.
This is grotesque. Compared with 2000, when the last downturn started, the U.S. economy’s growth
fundamentals — savings, investment and the trade balance — have dramatically worsened. Debts, in particular of
private households, have escalated as never before.
American economists have quickly decided that, after a brief lull, the next recovery is just around the corner.
Its perceived lubricants are the fall in the oil price and in the long-term interest rate.
A whole variety of downward forces on the economy is studiously disregarded. The most important first
consideration has to be that the bust of the housing bubble, with major negative implications for housing activity
and consumer borrowing and spending, has barely started. Wealth effects have disappeared and with falling
house prices — given the tremendous prior excesses — will turn substantially negative.
The most important data to watch in the coming months are house prices. Their rise was the foundation of
the economy’s recovery. Any significant fall will abort it, providing a boost to saving out of current income. |
