Brad Setser has an excellent and very thoughtful posting on his blog, called The Balance of Financial Terror. In discussing whether or not China can change its policy of accumulating dollars, he says “China would be better off financially if it let the RMB appreciate substantially, stopped financing the US and took large losses now rather than continuing to finance the US, adding to its stock of dollars and adding to the scale of its future losses. A bank that is lending to a failing company reduces its ultimate loss by cutting the company off and taking its lumps now, not by covering ever bigger losses with new loans to avoid “turmoil.” China is in a similar position. The US isn’t a failing company, but China is lending to the US on terms that imply very large financial losses for China.”
Well said, and spoken like a trader. One of the arguments often made, by those arguing that China should not revalue, is that any appreciation in the RMB would imply a loss on the value of its dollar holdings. Aside from the fact that the local currency value of foreign reserves doesn’t matter except to the extent that the central bank may become insolvent, which is not the case in China (this is because reserves can only be used to purchase foreign assets, so what matters is not the value of dollars in RMB terms but rather the value of the dollar in terms of China’s basket of external debt and foreign imports), it doesn’t make sense to protect a losing position by adding on more losing assets.
If the dollar is undervalued relative to the RMB, rather than try to protect it from adjusting by accumulating more dollars at the current RMB price, the PBoC should raise the price at which it buys them (i.e. revalue the RMB). Otherwise it is simply adding to its underwater position, which doesn’t make sense if you are concerned about the value of your holdings.
This leads to a whole discussion about whether the existing trade relationship between the US and China is harmful for the US and/or China. I would argue that it benefits the US moderately and in some ways it actually hurts China, but because of concerns about the impact of export growth on reducing unemployment, China is stuck with the system, at least for the near future.
The way I see it, there are three different areas of concern that many Americans and Chinese have about the existing trade and capital flow relationship between the two countries. These are the current costs and benefits of the relationship, the balance sheet implications, and the question of sustainability.
As far as the current costs go, the way I see the relationship is that China is exchanging massive amounts of goods for US financial assets. Thanks to the undervalued RMB it is delivering those goods at a very low price and taking in assets at a very high price (by keeping US interest rates low). The US gets the benefit of high consumption at bargain prices. It does not pay the associated cost (of low savings) because, although its savings rate is low, and although most countries’ invesment rates are constrained by their domestic savings rate, the US has such an open financial system that its investment rate depends on global savings, not domestic savings.
For the US this is a good trade — buy cheap and sell dear. Of course this does not mean that everyone in the US benefits, and it is perfectly reasonable for Americans to demand that costs and benefits are shared fairly, but eliminating this relationship may help some parts of the country at the expense of the country overall.
For the Chinese, this trade relationship is in some ways less beneficial, but they have locked themselves into policies that allow them little room to manuever. Rising unemployment is a great concern for the leadership, and they are essentially willing to give away the shop in order to keep employment growth in the near term — one way of looking at it is that they are paying to trade Chinese unemployment in the short term for US unemployment in the short term (which is maybe one way of defining mercantilism). Unfortunately however their currency regime has locked them into an out-of-control monetary policy that may eventually require a very sharp, and perhaps ugly, adjustment.
The second area of concern as I see it is the balance sheet implications of this relationship, and it is the national balance sheet that determines how a country reacts to shocks and how financial shocks are transmitted into the real economy. From the Chinese point of view, the balance sheet consequences are complex, and not very good in my opinion. At first everything seems rosy — the Chinese are accumulating huge amounts of reserves, with little external debt, so they are absolutely protected from the possibility of a financial crisis, right?
Wrong. We make a serious mistake when we assume that crises are, by definition, currency or external debt crises. Some are, most aren’t. In the 19th century the US had a whole series of financial crisies — one nearly every ten or fifteen years — but none of them involved external debt to a significant extent except perhaps in 1837, and all of them, including the 1837 crisis, were primarily caused by breakdowns in the domestic financial system.
This is where China is running a significant risk. China’s brutally mercantilist trade policies coupled with its rigid currency regime may be condemning it to a sharp increase in non-performing loans, industrial overcapacity, and rising (hidden) government debt. This creates all the classic balance sheet vulnerabilities. A sufficiently large adverse shock could quickly lead to an unravelling of the national financial system, which is very fragile and is completely dominated by rigidly managed banks with little transparency, weak governance, and almost no experience in risk management.
Analysts who point to China’s huge reserves as proof that it can buy its way out of a crisis simply do not get it. A domestic financial crisis cannot be fixed with foreign currency reserves. Aside from the fact that foreign currency cannot be spent domestically, these reserves are the asset side of the PBoC balance sheet, and they are balanced by domestic borrowings. Any spending of reserves would result in a net increase in PBoC debt. Since a domestic crisis will almost certainly involve concerns about excess government debt levels (which I suspect are already much higher than most of us realize), it is unlikely that they can spend themselves out of a crisis because that will mean increasing total debt.
If you need more convincing that record levels of central bank reserves are not the obvious antidote to financial crisis, consider the US in 1929. Several year of massive trade surpluses and capital inflows – turning it into the world’s leading creditor nation and leading it to accumulate, in Keynes’ words, “all the gold in the world” – were of no avail in protecting it from the Great Depression, which started as a domestic financial crisis (and never involved external debt at all).
If the balance sheet implications for China of the current system are worrisome, the balance sheet implications for the US are less dire. Brad Setser in the same blog entry quotes a statement by Larry Summers in which he says “There is surely something odd about the world’s greatest power being the world’s greatest debtor.”
But there is nothing odd about this at all. Any country that acts as a safe haven for foreign savings, or provides great investment opportunities, runs the risk of becoming a net capital importer. Any country that is a net capital importer must run a trade deficit, and if it consistently runs a trade deficit it can become a large net debtor to the rest of the world. Just before WWI, for example, the US was the world’s largest debtor nation because for generations European investors were eager to finance US development in order to share financially in the benefits of US growth (and in so doing they forced the US into a trade deficit position for much of its history).
This would be a worry if the accumulation of debt led either to an inability to repay or to balance sheet instabilities that made the US vulnerable to a crisis. Neither is the case. Total external debt may seem like a largish number when compared to GDP, but of course this is the wrong comparison. Either total external debt should be measured against total external and net domestic assets, or net external debt servicing costs should be measured against GDP. I am not sure what the value of total assets is in the US, but I am certain that it completely dwarfs external debt. The World Bank estimates total US wealth as of 2000 to be nearly $150 trillion (“Where is the Wealth of Nations”, World Bank: 2006). Similarly, net payments (what Americans pay foreigners on foreign investment in the US minus what foreigners pay Americans for investments abroad) are very low and tiny compared with the ability of the US to finance it.
Moreover the US has a well-structured balance sheet and a very flexible financial system. Unlike many other countries, including China, it’s external obligations are mostly structured in what I call in my book ”correlated” obligations, such that events that triggered payment difficulties would automatically lessen the burden of those payments. This significantly reduces the possibility of exploding debt that is a fundamental factor in every debt crisis.
If the US were a corporation it would be a triple-A-rated company with the added benefit that it could print the money to pay off most of its obligations if it ever needed to. At any rate if you believe, as I do, that the US trade deficit is not “caused” by excess US consumption (except by definition, of course) but rather by excess foreign investment, it would be hard to imagine that the US faced a financing crisis.
The third area of concern is the question of sustainability, and I promise this will be my last entry on this accursed subject (at least for now). One of the things that worries most obervers about the US trade deficit, even if they think it is currently manageable, is whether it is sustainable. If the US runs trade deficits equal to 5% or more of GDP forever, they worry, at some point external debt levels will accumulate to the point where the US will be unable to pay, except at a terrible cost to domestic consumption and wealth.
This is true arithmetically only as long as the total value of US assets grows less than the amount of the US current account deficit. I have no idea if this is or isn’t happening, but it seems to me that one of the consequences of foreign investment in the US historically has been that total US wealth always climbs faster than foreign claims on US wealth, and I see no reason to assume it isn’t still happening. If this is indeed happening there is no reason why US trade deficits cannot go on forever, as they have for most of our history.
But they won’t go on forever anyway. I already mentioned that on the eve of WWI the US was the world’s leading debtor nation, and it is worth noting that it was the world’s leading creditor nation four years later. How did that happen? Obviously enough the European belligerents had to liquidate their US investments profitably accumulated over generations in order to pay for the war. They then ran substantial trade deficits with the US during the war, resulting in a massive accumulation of US claims against them.
I think something like this is going to happen in the next few decades — not because of war but because of something that will have any equally dire economic impact. Europe, Japan, China and Russia all face severe demographic crises which will probably entail rising consumption levels and flat or declining production as their working populations decline as a share of total population. That means they all are likely to run long term trade deficits at some point in the future as they work themselves through their crises.
The US on the other hand is the only major country, besides India, that doesn’t have a serious demographic crisis looming (it has a pension crisis, with which it is often confused, but that is a different thing). With its deep markets and flexible and safe financial system, it is the only country against which the others can accumulate claims, and these claims will be worked out in the form of increased US export in the future.
By allowing these countries to accumulate claims against the US (i.e. by running trade deficits with them), the US is actually helping to create the necessary conditions which will allow for a smooth transfer over the next few decades. It is also worth pointing out that foreigners’ trade surpluses with the US today are what will finance their trade deficits in the future, and as these countries age the goods and services they will need — including health, technology, and information-related services — are precisely the things that the US does better than anyone else.
When does this future take place? It’s hard to say, but it is worth noting that after watching its dependency ratio deteriorate sharply from the 1950s to the 1970s, China saw a dramatic improvement in its dependency ratio from the mid-1970s until now (as the one-child policy eliminated the young from the number of dependents). This improvement in the dependency ratio will reverse itself around 2010 and begin to deteriorate dramatically as the shortage of children becomes a shortage of workers. So worrisome are the numbers that several China scholars have called for even higher foreign reserves to help China pay for this future demographic crisis and have warned that a declining working population will soon place significant wage pressure on manufacturers.
