Barry Eichengreen had a very interesting piece in last week’s Wall Street Journal. In it he argues that we are approaching the end of the period in which the US dollar is the world’s dominant reserve currency, and suggests what that might mean for the world. Here is what he says:
The single most astonishing fact about foreign exchange is not the high volume of transactions, as incredible as that growth has been. Nor is it the volatility of currency rates, as wild as the markets are these days. Instead, it’s the extent to which the market remains dollar-centric.
…The greenback, in other words, is not just America’s currency. It’s the world’s. But as astonishing as that is, what may be even more astonishing is this: The dollar’s reign is coming to an end. I believe that over the next 10 years, we’re going to see a profound shift toward a world in which several currencies compete for dominance.
I wish Eichengreen were right, but I don’t think he is. Eichengreen argues that one of the main reasons for the current dominance of the dollar was simply the lack of plausible alternatives. This is changing, he suggests, because of the rise of the euro and the RMB.
I am a huge fan of Eichengreen’s and read nearly everything he writes. In fact in January when The Economist asked a number of pundits to suggest who were the two most important economists to rise post GFC, I nominated Hyman Minsky and Barry Eichengreen. I think however on the subject of China he has pretty consistently underestimated the problems the country faces and overestimated Beijing’s accomplishments.
The RMB is unlikely to become a serious reserve currency in the foreseeable future. There are a number of reasons for this. First and most obviously, there are few realistic mechanisms by which the world can acquire RMB. Either China needs to run a large current account deficits, or it needs totally open domestic financial markets in which foreigners can easily acquire domestic RMB-denominated bonds to the tune of several percentage points of China’s GDP annually. I discussed why in a blog entry five months ago.
We are unlikely to see either for many, many decades. Although China will struggle to bring its current account surplus down, there are only two ways it can do so (remember that the current account surplus is equal to savings less investment).
One way is for a further surge in investment. At current levels, however, investment is already so value-destroyingly high (to coin a new adverb), and it is pretty clear that Beijing is desperate to reduce the economy’s dependence on further investment growth, so we can pretty much dismiss investment acceleration as something that is likely to be maintained over the next decade.
The other way is to reduce savings by raising the consumption share of GDP. As I have written before, however, this is going to be excruciatingly difficult, and will likely come about only with a sharp reduction in Chinese GDP growth (in which case one of the main reasons for predicting the rise of the RMB will be undermined).
And how long will it take to bring down savings? The household consumption share of GDP was an astonishingly low 35.1% in 2009, while the total consumption share of GDP, including government and business, was 48%. On Wednesday there were reports that Beijing wants to raise the rate by 2-3 percentage points during 12th Five year Plan.
Only 2-3 percent?
While most people took that as a good thing, to me it was an indication almost of how hopelessly difficult the whole thing is going to be. If the government is successful in increasing consumption by 3 full percentage points, and if we make the generous assumption that this increase occurs fully as an increase in the household consumption share (an increase in government consumption doesn’t count unless it is funded out of privatization proceeds, which is very unlikely), this will bring household consumption up to 38% or so of GDP.
Success? Not at all. Five years ago household consumption was at 40% of GDP, which back then already seemed astonishingly low (and was probably unprecedented in history). It was widely understood back then that such a depressingly low consumption share condemned China to an excessive reliance on investment and a trade surplus for growth. With such low consumption, in other words, it is going to take an awful long time before China can consume all it produces.
I discuss this in a lot more detail in my current newsletter, and especially in light of what has clearly been a very contentious debate in the run-up to the National People’s congress, but I think we can pretty much forget about China’s running a large current account deficit in the next decade, let alone one large enough to feed the world’s need for RMB if the RMB is indeed going to be a dominant reserve currency. That leaves the only other way for the world to accumulate large amounts of RMB bonds: China must open up its capital markets to portfolio inflows representing several percentage points of GDP.
Is that going to happen? For the reasons discussed in my blog entry of five months ago this will require a much greater reform of corporate governance and the financial sector than I think is reasonable to expect and it will probably also mean that reserve growth will actually accelerate – something no one wants to see.
That leads to the second reason why I think Eichengreen’s expectations for the rise of the RMB as a reserve currency are unrealistic. The amount of financial sector reforms required before the RMB can even achieve the yen’s level of acceptance is massive, and in my opinion there has been no significant reform, and in fact a lot of retrogression, in the past decade. Beijing simply cannot permit the necessary amount of capital inflow and outflow until the banks are reformed, liberalized, and made creditworthy.
I will write a lot more about this in the next month or so, but for now it is worth pointing out that the Chinese banking system is one of the least efficient in the world when it comes to assessing risk and allocating capital, and would be bankrupt without repressed interest rates and the implicit (and sometimes explicit) socialization of credit risk. Beijing accepts this because of the tradeoff that gives it banking stability.
Beijing greatly values this stability, even at the expense of capital misallocation, and is in no hurry to give it up by opening up the financial markets and, what’s more, for political reasons I think local governments will resist ferociously any further corporate governance reform. Remember that the phrase “corporate governance reform” in the banking context is just another way of saying that credit decisions will be made on the basis of economic considerations, and not on the basis of government preference. That particular reform will be politically contentious.
A long way to go
The third thing that will limit the rise of the RMB as a dominant reserve currency is, I think, that the geopolitical conditions in this region are pretty bad. The most obvious major countries in the region that can help the process of RMB internationalization – Japan, Russia, India, Korea and to a lesser extent Vietnam and at least one or two others – have a deep mistrust of China and are unlikely to assist the process beyond some minimum level. Remember that one of the reasons sterling never achieved the dominance that the dollar has today is that the French and the Germans, not to mention some other European powers, actively undermined its role in favor of their own currencies. I don’t see why this won’t happen again.
Finally I would also point out that many of the RMB “successes” that everyone touts as evidence of the inevitability of the RMB are really not successes. The fact that Chinese companies are now more likely to bill their transactions with their foreign affiliates in RMB rather than dollars makes it seem like its use in trade is soaring (from a very low base), but it changes almost nothing meaningful, and the widely-reported swaps between the PBoC and other central banks consist for the most part either in disguised loans to countries that will take loans from almost anybody, or indirect ways of preserving dollars (as a member of the board of one such foreign central bank told my central banking seminar).
The belief in the rise of the RMB, in my opinion, is just a replay of the equally fervent belief twenty years ago in the rise of the yen, and the RMB has many of the same constraints that the yen had, but only more so. The RMB still has a long way to go before it will even match the yen.
Perhaps paradoxically, in spite of my belief that several countries will leave the euro (or “adjust” their relationships), I am more sympathetic to Eichengreen’s arguments about the euro. I think once the European crisis has stabilized in the next five to six years the euro will be on a sounder footing – perhaps that should read “on a less absurd footing” – and the euro will become increasingly important as a reserve currency. I agree with Eichengreen that the current dominance of the dollar is extraordinary, completely unprecedented historically, and simply cannot be maintained.
Nor should it. This may be a long shot prediction, but it seems to me there is a growing sense in some US circles that maintaining the dollar as the reserve currency is a public good whose cost was manageable during most of the post-War period but, perhaps since the 1980s, has become increasingly heavy for the US. If we can divorce talk of the dollar from talk of the rise or decline of the US, I think an increasing number of US policy-makers will start to see that the US would be better off if the world were forced to accumulate SDRs or other currencies rather than dollars. This, of course, would be terrible for export-led growth strategies in Asia, but given fears first of a rising Japan and now a rising China, the fact that disengaging from the dollar is bad for Asia will not be a strong argument against it in the US.
The US should take the lead
In fact it is ironic to me that it is considered pro-American to want the dollar to maintain its role as the world’s dominant reserve currency and anti-American to call for a change. I have a very different take. As I see it the dominant role of the dollar is as a public good provided by the US that, because a number of countries have taken to gaming the system, is proving too costly for the US.
In other words I think the use of the dollar as the dominant reserve currency may mean slower economic growth and higher debt for the US. A lot of strange conspiracy theories center on the role of the dollar as the linchpin to American power. In a debate on a well-known current affairs program on Chinese television two years ago, a Chinese professor from a famous Beijing university assured me that American economic dominance occurred because the dollar was the world’s primary reserve currency.
Leave aside that the US was the largest economy in the world, with the most advanced technology and the highest per capita income, by the late 19th Century, at least six or seven decades before Bretton-Woods, this is the sort of claim that can only be made by someone who has a very weak grasp of monetary economics. The strongest argument in favor of the importance to the US of the dollar’s reserve status is that it permits the US government to fund itself cheaply, and in its own currency, with the savings of the rest of the world. But this argument may get it exactly backwards.
Any country with credibility and an actively traded currency can fund itself in its own currency. So why do foreigners own such a large share of US government debt? Isn’t it because they have to buy US Government bonds to hold as reserves, and aren’t foreign purchases needed to make up the shortfall in US demand for government bonds?
No. US investors can easily fund US government debt. Foreigners own US dollar assets, of which US government bonds are the safest and most liquid, because they run current account surpluses. This is true almost by definition. Countries with current account surpluses have no choice but to acquire foreign assets, and the country whose assets are thus acquired has no choice but to run the corresponding current account deficit.
Countries whose domestic policies require large trade surpluses, in other words, must buy the assets of those countries with liquid and open asset markets that are able to run large current account deficits. In practice the US is the only economy large enough, flexible enough, and open enough to act as the counterpart to the net current account surpluses accumulated by the rest of the world.
If countries that have accumulated massive reserves, like Japan, Germany and China, chose to diversify their holdings, or were forced to, away from the dollar, this would be tantamount to saying that the US current account deficit would have to contract and other countries would be forced into absorbing those surpluses. The US would also borrow less because a lower trade deficit would require less fiscal or household borrowing to maintain any given level of growth and employment.
But very few other countries can absorb the US trade deficit. In that case countries that rely on large current account surpluses to absorb their excess capacity would be forced into reducing their surpluses and reducing their capacity. Their growth, in other words, would be lower.
The US, on the other hand, would be “forced” into either higher growth or lower debt levels. This does not seem either like a good thing for surplus countries or a bad thing for the US.
This is an abbreviated version of the newsletter that went out Tuesday. Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at chinfinpettis@yahoo.com, stating your affiliation, please. Investors who are clients of Shenyin Wanguo Securities will already receive the newsletter. Investors who are not clients but who want to buy a subscription should write to me. also at that address.
Mr Pettis
What are we to take away from Chinas report of a deficit?
Should we expect taxes in the US to rise exponentially if China was to buy less US treasuries?
Thanks
Great article.
Even if the RMB were to assume a greater role in global reserves, it would still be a frankenstein version of the dollar reserve standard. This is because the RMB is a liability on – by and large – dollars and dollar-denominated assets. It would be something more akin to the gold exchange standard of the late 1920s; in which global reserves were mostly in sterling, which – itself – was redeemable into dollars (which was redeemable into gold).. Even if the RMB were embraced globally (any time soon), global monetary policies would become even more levered to US monetary policy.
Thanks again for continuing to post. I always learn something reading your posts and feel that I am coming to understand currencies (and the effects of surpluses and deficits in trade) much better from reading your articles.
You thoughts on the pluses and minuses of being the reserve currency are eye openers for me. Hopefully, our policy makers are reading this, but, I admit that I doubt it.
It is, I think, not selfish or anti-China to hope that the US will start to focus on getting our own house in order. I believe that as part of doing that China will inevitably be forced to become less of an export driven economy and more consumer driven.
I think the biggest obstacle to that change is that it requires more wealth (and hence more power) being transferred to the average Chinese citizen. I do not think that the Chinese ruling class will willingly surrender any of their wealth and power. The fact that the business and government elites are, IMO, essentially the same is a complicating factor.
Conversely, in the US, the consumer needs to become less powerful with the balance swinging more to small and medium business investment and influence (not to the government or its analog, big business).
In short, we both need to get the government out of business and business out of the government. That will only occur if the government becomes less powerful. I don’t know if either country can make that change peacefully.
Michael,
Thank you for another great post. I also have another question. About a month ago, in response to a question of mine about the timing of adjustment, you said it all came down to debt capacity: “Once businessmen or government officials believe that debt levels are too high to be sustained or increased, then they behave in ways that cause growth to collapse.”
Last week, there was a Bloomberg story, “Railway Yield Gap at Six-Month High as Debt Mounts.” This sums up the point:
“The yield on the railway ministry’s 3.88 percent September 2020 bonds exceeded the rate for similar-maturity government notes by 115 basis points yesterday, almost double the 59-point gap when the security began trading in September…”
….
‘“A lot of investors believe the ministry’s debt is too much,” said Fan Wei, a Beijing-based senior vice president of fixed income at Hong Yuan Securities Co., a unit of the nation’s sovereign wealth fund. “Railway construction is still going to expand a lot and huge debt financing will continue in 2011.”’
Is this the type of thing you were referring to? Or does it not really matter until the railway ministry itself decides it’s too much?
EXCELLENT ANALYSIS
Cogent, insightful, articulate and correct, but ultimately irrelevant because the conventional wisdom that pervades the nation and especially Washington is exactly the opposite. The Thomas Friedmans and Barry Eichengreens of the world dominate the conversation with their “America in Decline” meme and they are supported by the punditocracy and right-wing noise machines. Of course, they will be proven wrong simply because they are wrong, but they will never cease spouting their rhetoric.
Once again, I think you’ve hit the nail on the head, particularly in your description of the dollar as a public good. I can’t tell you how frustrating it has been over the past several months to hear other countries (particularly China) lambasting the US Treasury for urging China to make reforms that would allow China to make its own independent monetary policy, and then lambasting the Federal Reserve for not making monetary policy in China’s best interests. I’ve come to see the dollar’s status as an enormous burden–both political and financial–and as the primary mechanism enabling certain countries to resist necessary adjustments, on the one hand, and preventing other countries from making their own necessary adjustments, on the other hand. Every time I read about the RMB’s rise to reserve currency status, I get a little warm and fuzzy feeling inside, but it doesn’t last very long. I have similar thoughts regarding the US forward military presence in Asia–enormous financial and political costs to the US, generally positive tangible externalities accruing primarily to third countries–but I guess that’s a topic for another blog. Is the US an empire? In a broad sense of the word, sure. Is the dollar’s status an indication of that imperial reality? Sure. I suppose what worries me the most about current global trends is that China too often appears to want to tear down and replace what it sees as the pillars of US empire, even as it leans quite heavily on those pillars to support its growth and often appears all too reluctant to replace them with pillars of its own.
Trade deficits were run up by the private sectors, so the Chinese government should convert their US government bonds into private sector assets. Japan was an ally so there was no outcry when they diversified into other American assets such as the Rockefeller Center. Not so if China tries to buy 10% of the Index 500 companies.
Prof Pettis- It only seems to be on the right in the US that the ‘strong’ dollar is taken as a patriotic point of pride and power. But it is taken very seriously there, most of the Republican Prez candidates have added lines to their speeches about a ‘sound’ or ‘strong’ dollar, most of which I take as a sop to the Gold bugs. I wonder, however, if this will become a partisan issue in 2012.
I am more skeptical than you on Europe, though, the cross section of dysfunctional politics and structural economic problems seems particularly unfortunate.
RS, the February trade deficit, like the March trade deficit of last year, is probably nothing more than a consequence of the spring festival holidays, during which time normal trade patterns are heavily distorted. The timing of the distortion varies because the spring festival is a lunar festival, so it occurs during different times of the solar year.
As for your second question, I am not sure why US taxes would rise at all. I would argue that if foreigners were to buy fewer US dollar assets, including Treasury bonds, by definition the US trade deficit would fall. With it US employment would rise and US debt would be lower. For all I know taxes might actually fall. That is why I argue that the US should take the lead in forcing the world to disengage from the dollar as the dominant reserve currency.
Yes Gresham, for now the RMB is simply a different color dollar. I think however that when people talk about the RMB as a global reserve currency they implicitly assume that China’s currency regime would change and the RMB would float, or at least peg to a true basket.
Gary you are probably right. Both countries face difficult rebalancing processes that are likely to be hindered from the interest groups who originally benefitted from the imbalances and, consequently, have become powerful constituencies.
Bob, yes, everywhere you look there is debt. This week’s Caixin has a very good article called “Peering into a Black Hole of Government Debt.” The title tells you much of what you need to know.
Liudechuan, I am not sure it makes any difference whether the trade surplus was generated by the private or public sector in determining what kind of assets China should hold. As for Chinese acquisitions in the US, I just went through that discussion Friday night on a CCTV program called Dialogue, and as usual it seems to me that the position in China is horribly simplified without any real understanding of the constraints. I would suggest two things. In the US, government ownership of private companies is strongly resisted. If the US government tried to buy Unocal, most Americans would be opposed. That would also be true if the British government tried to buy it. Why then is it so shocking that when Chinese entities that are clearly controlled by the government try to buy large US companies, there is an outcry? I am all in favor of letting Chinese companies buy US companies, but I think the fact that many in China assume that Americans should have no right to decide on an issue of such fundamental importance to Americans is a little silly.
That brings me to the second point. Can foreign companies take control of large Chinese companies? Absolutely not. If you talk to most foreign CEOs they say they wouldn’t even bother trying because the government would prohibit it. That makes it a little strange when Chinese companies complain about their lack of access to foreign purchases. Chinese complaints of victimization would be more credible if foreigners were allowed to purchase and control large Chinese companies.
OGT, I suspect a lot of the talk about a “strong dollar” is pro forma. Bankers love the strong dollar. Many domestic manufacturers hate it. As for Europe, I am not at all optimistic. I think we are going to see very serious political and debt problems, but once they get resolved the euro will be on a sounder footing.
“I think an increasing number of US policy-makers will start to see that the US would be better off if the world were forced to accumulate SDRs or other currencies rather than dollars. This, of course, would be terrible for export-led growth strategies in Asia…”
I’m sure you have written (or will write) extremely eloquently on the irony that China was the one pushing these SDRs in the first place.
Mr Pettis;
Thank you for responding to my question.
You say that if foreigners stopped buying US bonds then the deficit would shrink and taxes would not need to rise. Would not interest rates in general in the US rise? This would be a tax in consumers if they did.
As a corollary would this also require US consumers to dramatically scale back purchases of foreign made goods? Would not this transition take years if not decades to reduce the trend today off offshoring? Vietnam Cambodia and East Africa are places where some Chinese companies are looking to why would US companies not look there too.
Michael,
I just read that Caixin piece and besides the general picture it paints, I found the estimate of total local government (Y10 trillion) interesting. That would be about 30% of GDP. State & local debt here, which has prompted all these forecasts of catastrophic defaults, is about 20% of GDP. Of course, Massachusetts doesn’t have 5% inflation working for it…
Hi Michael,
I wrote a couple of reactions on this topic as comments to FT Op-eds: – in one of them I discussed Eichengreen. I thought this may be of interest to other readers. Ciao.
joseph belbruno | February 18 1:19am |
Zoellick starts with “power”, and he ends up with “shareholder democracy”. The inconsistency is all in the title to the article: Zoellick wants “a monetary r e g i m e” that is supposed to serve a (capitalist) “multipolar world”. The problem is that you simply cannot have “a monetary regime” without a “ONE POLE” world. For the simple reason that, as Zoellick correctly points out from the outset, behind every “money” there must be a “power” (a nation-state) ready to guarantee it, not only as a unit of account, but also as a means of exchange, and above all as “a store of value”. “Value” is the key word.
As we all saw, during the GFC, it was the US Fed that acted not just as lender of last resort, but given the “too big to fail” and the collapse of global finance, it also became “the lender of first resort”!
Which brings me to the point: It is especially in “a multipolar world” that world capitalism needs a “leading pole”. The only such pole available and conceivable is for the US to lead, with Europe and Japan in tow. Any dreams of “proportional representation” according to “share of world trade” – even a renewed Gold Standard, as Zoellick previously suggested! – is utter and unspeakable idiocy.
Zoellick is confusing the vertiginous expansion of the capitalist world market with political multipolarity. There is no “multipolarity”. Those who believe that have probably been diagnosed with “multipolar disease” – a strain of “bipolar disease”. What there is, growing more imperious and peremptory every day, is the need for a concentration of capitalist command in one supra-national entity – which will see the US, the EU and Japan draw closer together, in a world in which bourgeoisies are growing nervous about the future of capitalism itself, just as the capitalist world market breaks every conceivable barrier – indeed, because of this!
Report joseph belbruno | February 19 12:41am
Here is another example of “multipolar disorder” – from Barry Eichengreen.
http://www.project…hengreen21/English
As you can see, what the good professor leaves out (mesmerising in someone with his historical background) is the fact that “multipolar reserve currencies” will need more than just a mobile phone to compare exchange rates in order to work (his words, folks, not mine).
But what Eichengreen either ignores or overlooks is that it is impossible to have a “capitalist” world monetary order without a military-industrial and economic regime to guarantee the political “safety” of a currency and to forestall the implosion of world capitalist trade in a whirlpool of trade barriers and competitive devaluations.
The denouement of a capitalist society – and that applies foremost to “the society of nations” – in the absence of strong government is…. civil war!!
Professor,
I was predicting rather than judging the public’s reaction based on how I think American media will try to drive the discussions. I think it is a good thing if China (whether its government or its State-Owned Enterprises) get more invested in the private sector rather than U.S. government debt. China as a significant holder of U.S. government bonds can make noises but can’t really influence the U.S. government actions. Similarly, China will have to stay a passive investor of Index 500 companies if it holds no more than 10% of each company. It can also take the almost $30B in annual dividends and distribute them to 100million rural seniors.
Mr. Pettis:
What do you think are the prospects for the Chinese GDP to surpass that of the United States? If China becomes the largest economy, reserve currency status cannot be too far behind.
David, in my March 24 and April 8, 2009, entries I did try to describe the irony of Zhou’s SDR essay.
RS, US interest rates would rise or fall depending on Fed policies and the strength of the underlying economy. If you look at periods of massive foreign purchases of US debt and the concomitant trade deficits – the 1982-88 period and the 2002-present period), there is not evidence that interest rates were substantially lower than in other periods. US interest rates are mainly driven by the US economy and fiscal and monetary policies. As for the transition, it would occur immediately. If foreigners stop funding the US trade deficit the deficit will fall right away to whatever the net capital account inflow is. This could happen in a good way or in a bad way, and it could happen slowly or quickly, depending on lots of other factors.
Bob, you can’t look anywhere without finding debt.
Joseph, I don’t know if the world will move to a multi-polar world, but I would argue that as long as the US or other governments don’t intervene, the dollar will be the dominant trading currency. Liquidity draws liquidity, and there is little reason for traders to shift into less liquid and transparent currencies.
Liudechuan, if by $30 billion you mean the return on the foreign reserves, these cannot be distributed to rural seniors. Remember that the PBoC must export capital if it is to maintain the RMB peg. It cannot bring any of that capital back without losing control of the RMB peg. This money must stay out of China until China begins running current account deficits.
Nate, I am skeptical about that happening, but even if it does, why should that make the RMB the dominant reserve currency? Before 1820 China was the largest economy in the world and in the late 19th century Germany and the US were the largest economies in the world, and yet in neither of the three cases were their currencies the primary trading currencies of the world.
Lindechuan:
Fortune 500, not more than 5% in a company would be useful.
As to distribute the money to Seniors, could but wouldn’t.
As to assets, it could rather spend the money on products from elsewhere as well as hold down its currency through the purchase of foreign assets, something it might want to do were it to want to be able to lengthen its model, and actually aid in global development. Regardless, the money, at least 60 to 65% are in one form of Bond or another. Problem is, they are perceive as savings, rather than a function of currency suppression, a mistake widely held, if fundamentally untrue, whoever assists in perpetuating that myth creates problems that will eventually need to be understood. While seen as important, more importantly they helped get over a demographic hurdle, where China’s pace of growth in working age populations is decreasing, something that should have been made to be understaood by domestic populations more clearly. Yet, were that tio have been done, the very processes leading to the rise in Forex, would have been more clearly elucidated, hence why the eventual problem to occur if the “savings” and expectations relative to them, what can occur from them are not met.
Chinese savings have lent to the growth that enabled employment, savings in RMB, not supposed recycling of Holdings of Dollars and other FX. Really the first is far more important than the second, and much more impactful.
Michael: With the Unicol example, very good point. Even with purchases of Stocks, not more than 5%. Small government holdings in companies fine, plus no board membership, neither US nor Foreign, nowhere, neither in the US, or abroad, especially not in the case of a major economy.
Nate: Size of GDP is not the issue, having diversity in asset classes, have full convertibility, and as Michael says, ways for others to gain assets in an economy is what is of importance. To gain assets, be able to do what you want with the assets, as you choose. That certainly should occur, well before China could ever have an economy as large as the US, or much malinvestment prior.
China is a developing country, unfortunately, it seems, perhaps due to the interests of powerful interests that they are intent upon furtherance, and a deepening of an infant industry theory approach en masse, each such instance of this previously has led to much malinvestment. In some countries, if comparative advantages, perhaps this approach for an industry or two, to try this on a large scale, I believe will lead to much loss in opportunity cost, where attempting to plan, too much, will lead to inability for oversight and much misinvestment. The one thing that strikes me about China that is worrying, is this, if it is dynamic, considering their level of economic development, in a truly dynamic economy of such a level, there would be much more creation of millionaires to billionaires proportionately than exists across the globe. Do to the level of consumers, products, and even success in the creation of sales of products at this level, would result, in a dynamic economy, in an explosion of millionaires relative to Billionaires, one that would exceed the global norm, in a truly dynamic economy, where so many Billionaires are being created, this is problematic, and likely inhibiting to innovation.
Well, the US was not exactly the only country able to run large current account deficits. In fact the UK (Sterling) or Spain (Euro) were able to run even relatively larger deficits before the crisis. So it is not just the issuer of the reserve currency the one that can run such defcicits, but also any country openly connected to the finantial system.
In the long run, it is probably better off for the USD to lose its reserve status. However, for the short term, the US federal gov will have problems finance itself, which will most likely result in low to negative GDP growth, which will then bankcrupt many entities, which will spike the unemployment. This is probably not politically correct. But, if you have to take the bullet, you might want to do it now than later.
Supporting Michael’s argument is the jump in China’s holdings of USD. This after the rumblings of QE2.
WASHINGTON (AP) — China, the biggest buyer of U.S. Treasury securities, owns a lot more than previously estimated.
In an annual revision of the figures, the Treasury Department said Monday that China’s holdings totaled $1.16 trillion at the end of December. That was an increase of 30 percent from an estimate the government made two weeks ago.
The government made the change to its monthly report based on more accurate information it obtains in an annual survey. That survey more does a better job of determining the actual owners of Treasury securities.
China was firmly in the top spot as the largest foreign holder of U.S. Treasury debt even before the revisions. But the big increase in Chinese holdings could ease fears that Chinese investors might begin dumping their U.S. holdings. Such a development could send U.S. interest rates rising. That would slow America’s economic recovery and increase Washington’s costs for financing the $14.3 trillion national debt.
China and Britain were the countries with the biggest revisions in the new report.
http://finance.yahoo.com/news/Chinas-holdings-of-US-debt-apf-3118302220.html?x=0
Europe Enters Unorganized Chaos
http://apeakunderthehood.blogspot.com/2011/03/europe-enters-unorganized-chaos.html
Prof Pettis
Of course this is my personal view, but I don’t think the RMB should throw itself into the ring in this arena with too much gusto. A lot more consideration should be given to the weaknesses of the financial system and whether the economy is capable of really facing the consequences of policies and actions.
Besides, once you throw the door open, there maybe little you can do by way of trying to shut it again. And that is most unpalatable for the Chinese government, one would expect.
A bit taken aback re the comments on the yen though, that really was a story built on trade and by the looks of central bank actions over the years, it is hardly the model of free currency system by any measure. However, at present, the Japanese are holding up well in view of the string of disasters they have been hit with. Just that the invest japan story may have to be shelved for a little while.
“[The] banking system is one of the least efficient in the world when it comes to assessing risk and allocating capital, and would be bankrupt without repressed interest rates and the implicit (and sometimes explicit) socialization of credit risk,” are you talking about China or America?
“Remember that the phrase “corporate governance reform” in the banking context is just another way of saying that credit decisions will be made on the basis of economic considerations, and not on the basis of government preference,” like in a market economy where capital allocation is underwritten by the price of risk, but the fact is that we have mixed economies with the government and markets and have seen massive capital misallocation even in the bastion of free enterprise, America, so your criticism may be just as relevant there.
Mobi:
The argument that the US needs foreign financing, should by now have been proven to be fallacious. Perhaps, it is just that the world needs growth, and US deficit spending is one way to ensure that. Even where there has been marginal movements in that equation, look at the mass movements to replace it with deficit spending, much more broadly, much more widely, and much more pervasively, if there seems to be the recycling of memes to the contrary. Although, it is likely that the world, outside of a few select cases, will grow significantly more slowly than in th 200 to 2008 period, and the situation is fairly tenuous as to how policy objectives may evolve and as to how they will be translated into implemented policy in many regions of the world.
All:
I think that there is much angst about 1 simple question, in one simple real life, living, scenario, and that is a balance between development and functioning markets. A monolithic government is despised by most globally, usually patrons of one, are despising providers of another, with much popular delusion in between, which only benefits competing interests, within and between nations, and regions.
So, the balance between development and market, invaded with values, ethics, mores, and a personal goods, almost always influenced by the prime influencer, our lives and the environment. So, the rapid development at all costs model, which is truly unique, in that is very likely unable to be replicated in any real way do to the very largeness of the system involved, and the much larger part it has come to play in global supply chains. Those who would hope to emulate it, theoretically, and in reality, for what it has been able to seemingly accomplish, would be most unable to do so. Only parts would able to replicated. If one follows the path of development in the region over the previous several decades, it can be seen that in large part, latter developers, followed previous, in a new, altered take on the Flying Geese. But, the question is to how large a part has been taken, and does it limit room, under a similar development approach, for those who would follow. In reality, there are multiple systems, a developed and populous coast, supported not mainly by an urbanising migrant class, but rather a floating workforce, whose families are split, children being reared by their grandparents, with no right for local services, who have the intention like migrants who move anywhere, to save money and return home, which is the case of most migrants. So the financial repression mechanism, in a world of great capital flow, where the China story has dominated the world press, and the global mindset, for different reasons in different parts of the globe.
The sheer truth is the will be need to find a balance between the development and market view. Not, as counter corollary to the Freer Market view, but as support of a greater understanding of Markets, as it is the small decisions in totality which lead to much greater stability, and a risk spreading stability, in counter trend to perspective as to the Market success of the non-market economy that China is in many ways. Now this could be seen as negative, by those who have bought into the oft repeated memes that have been spread globally on the subject, one thing in one country, another in another, and further in others, speaking to much national conscience in each. The fact, as Michael trys to illustrate, is that the way things have gone, are going, is very contrary to what is useful, and necessary for the further development of the Chinese people, where it is considered a vaible model, it is very likely less a vaiable model, for those it is perceived to be a model for, and more likely a potential model for others,taht if employed, will lessen the global development pathes of others, where many of the popular notions promulgated in the news about these topics are much further from the truth than is commonly perceived as to needs, benefits, and similar in the global economy. Functions, that are decried are the very levers by which development has occurred, where similar levers do not exist for the development of others, in the case of large countries still largely in need o f development, if shiny new, oft unoccupied buildings, and unused airports, do paint a pretty picture. This is not to be negative, but simply to point out limits to perspectives that dominate the popular mindset. I think one of the main problems is that people have such a great need for speed, where everything is quickening, the expect things too quickly in a world, where if one were to care for their fellow man, that would be secondary, to the long term success of global development in totality, where the seeming rapid development of one in particular is but an amusing aspect of a much grander process. FOREX traders will retreat within frames to review this, property developers into theirs, development economists into theirs, scientists, educators, politicians, greens, and any other category into theirs, in what is required to be a better way at points in time to move toward more universal global development. One positive, hidden among some great waste of resources in many cases, is achieving the ability to largely pass one demographic hurdle, that of a continuosly increasing, growing, workforce, where that will trend downwards. Another is in the offing in but a decade or two. Stomping on levers in an economy at the moment, may be less beneficial then focusing on those other, more real, occurrences which will stress the growth horizon, and increase budgetary expenditures, while opportunity exists to focus on meeting needs efficiently, and creating an environment able to meet such needs, that comprises the billions of small choices made better in the market, than presuming any single institution can make the right choice, rather than thousands and millions of them in a society where individuals can see what the issues are, and work to assist in solving them in ral and meaningful ways on a daily basis. Also, an important part of a true market of not only products but ideas, better were to have ideas, divorced of delusional perspectives; especially as the current model, and its replicability elsewhere. Although, parts of it may be
Steven,
It is a good point. However, I did not say it in my post that foreign financing is critical for US deficit spending. It is only my beief that one way or the other, US will have to deal with its deficit much like other countries in Europe. Actually, it is going on right now at Capitol Hill. Greek is in severe pain and UK seems to double dip. It is interesting to see the outcomes of austerity. It may not help to lose the reserve status of its currency during the process. But anyway, it is probably a moot point since I do not see it hapenning anytime soon.
Michael,
Given that we are likely to witness a major increase in Japan’s trade deficit, what are the chances it will take some burden away from the US deficits?
Mr Pettis
How can we assume that the trade deficit with China will ever change significantly? The trade deficit with Japan has always remained perhaps at a mutual detriment to both countries but It persists nevertheless.
Isn’t it safe to assume that China will take the japan route and we will re balance slowly?
Mobi, I am not sure I agree. Foreigners do not finance the fiscal deficit. They finance the current account deficit, and they do so automatically (i.e. no financing means no deficit). To say that the US needs significant foreign purchases of USG bonds to keep growth high and unemployment low is no different than saying that the US needs large trade deficits to keep growth high and unemployment low.
Glen, every time I read a panicked article about China reducing its holdings of USG bonds I feel a little disheartened. This is always based on TIC data, even though everyone knows, or should know, that TIC represent only direct holdings, and say nothing about indirect holdings. Simple mathematics should convince everyone that the PBoC is always increasing, never reducing, its holdings of USD assets, and directly or indirectly that must mean USG bonds.
Marcus, people get a little overemotional when they discuss the US and China. I think it is a little foolish to assume that when someone says that the Chinese banking system is inefficient he is also saying that the US banking system is perfectly efficient, and certainly pointing out inefficiencies in the US banking system is not much of rejoinder. In fact the US financial system does a pretty good job – better than almost any other – at allocating risk capital. Many people argue for example that the key reason for the success of high tech in the US, unlike in other countries, is the willingness and efficiency of risk capital. The fact that the system goes through periods of excess and collapse is nothing new, and hardly undermines the argument. It has been noted and explained by a lot of people. Raymond de Roover actually suggested that it may have been the tendency of the US banking system to take on too much risk and periodically crash that explained the fact that the US grew so much faster than Canada in the 19th Century.
USIKPA, I assume you meant a reduction in Japan’s trade surplus, not an increase in its deficit. If that happens, of course it will be good for global rebalancing. Japan is one of the three countries (the others are China and Germany) with excessively large trade surpluses. But I am not sure we will see a sharp drop in Japanese surpluses. It depends on how Japanese households respond to the disaster. I am sure investment will rise, as it must after such a calamity, but the impact on the trade surplus depends on what happens to savings. If Japanese households decide to increase savings, or if wage, interest rate and currency policies force them to reduce consumption, then the question is which goes up more. If investment goes up more than savings, the surplus will contract. If savings go up more, it will expand.
RS, yes, I think that the Japanese example shows how difficult it is to rebalance towards higher domestic demand, especially if you wait too long and allow debt levels to build up significantly. One point, however. It may seem that the Japanese trade surplus has only declined a little from its peak, but that is only because you are looking at it as a share of Japan’s GDP. If you look at it as a share of global GDP, it has come down sharply.
Pettis, you mentioned Japan twice. so what is the third country with an excessively large trade surplus?
Thanks James, i fixed it. Germany.
Mike,
I do not believe that US needs significant foreign purchases of USG bonds to keep growth high and unemployment low nor US needs large trade deficits to keep growth high and unemployment low. But I do believe that US needs to at least maintain the rate of federal government deficit spending at this point to hold the unemployment rate from growing and that’s where the problem is.
Prof. Pettis,
Much appreciated if you could hold a class on the economics basics:
1) Why is USD as reserve currency a public good for other nations? Wouldn’t all these nations, since Japan in the 80′s, have come out ahead if they had to use their surplus USD to purchase gold instead? How did the U.S. intentionally make it a public good? What steps should the U.S. government have taken to not allow the USD to be held as a reserve currency?
2) How does USD cash holdings work in this age of electronic banking? When money is wired to an Foreign Owned Subsidiary account in China, for example from a Wells Fargo account in the U.S., does the PBoC have to open a Wells Fargo account to transfer the USD balance from the private company account when it converts the USD to RMB for the private company? How does PBoC later prove that it has that much USD when there is no paper money involved?
3) On my suggestion to the Chinese government to take the dividend earnings from their foreign exchange reserves to distribute to the rural seniors, why would that have any impact on the USD peg? The peg is fixed by the PBoC, and it isn’t trading with anyone so the peg doesn’t have to change whether the USD dividends are distributed to the rural seniors or not. It is just a bookkeeping entry for the Chinese government: income from the dividends (in USD), spending as rural senior stipend (in RMB). The PBoC just have to print the RMB when it needs to. Currently it doesn’t need to as the tax receipts are growing faster than the government expenditures AND the GDP (so scandalous!)
Mobi, perhaps, but remember that a contraction in the trade deficit is expansionary in the same way that an expansion in the fiscal deficit is, so a smaller trade deficit would require a smaller fiscal deficit for the same level of unemployment.
Liudechuan, not only is there nowhere near enough gold to satisfy reserve needs, but a gold based reserve system is extremely unstable and Eichengreen has made thelausible argument that it cannot survive in a liberal democracy. I don’t think the US ever “made” a decision to turn the dollar into the world’s reserve currency. I think people here often believe this because in China because there is a sense that things only happen if the government wills it, but in fact several things happened that caused to dollar to replace sterling. First, the collapse of trade financing out of London during WWI shifted much of the business to NY, at a time when the vast bulk of international finance was trade finance. Since at the same time the NY markets became the most actively traded markets as European belligerents desperately tried to liqiidate their holdings of US assets, much of the msrket’s liquidity shifted to NY during the war. The two currencies, with to a lesser extent the franc after 1927-8, shared dominant reserve status until WWII and Lend-Lease further undermined sterling and London.
As for your last point, the PBoCis the only net buyer of dollars in China. It cannot take dollar dividends and give them to local Chinese sine it cannot sell them for renminbi.
Mike,
I don’t know how to rid off the reserve status of USD. However, at this point, for US trade deficit to contract, most likely it is through the reduction of import. IMO, it is not expansionary but a sign of deflation/deleverage.
Prof. Pettis,
Following up your reply on Liudechuan, you said:
“not only is there nowhere near enough gold to satisfy reserve needs”
I have heard this argument so many times but I just do not seem to get it. Mind if you can explain why something like gold, that is never consumed when it is just sitting there as a reserve, would run out of supply? Knowing that even if you have just 1Oz of gold in the world, you can divide its atoms into mega-number portions as reserve for many, isn’t the “enough or not” issue just a price issue after all? The same argument can go for silver, platinum and so on.
I am not advocating a gold standard but this “not enough gold” argument just seems so novice and just picked out of pocket.
in 5 years, Chinese economy will grow 40% larger, then it is today(assuming 7% growth/year target is hit). So, in 5 years share of consumption will be 1.4*38%=53% of today’s GDP. In real terms, assuming current GDP at $2T, Chinese will spend 1.064T on consumption, as oppose to 700B now. This is a tremendous growth, don’t you think? Exponent is a funny thing!
Prof. Pettis,
On my #1, I couldn’t understand how the U.S. government “decided” for the public good to keep the USD as a reserve currency, so I wanted to learn how the U.S. did it out of the specific intent of public good. USD as a major reserve currency would seem to be an inevitable result of America being the world’s largest economy and a staunch advocate of open trade and currency exchange. A reserve asset is just a tender instrument, so if it is scarce, wouldn’t the price of gold just have to adjust up such that there would be enough gold to be used as a reserve currency? Of course gold at $7000 an ounce may force the high-tech industry to find an alternative to gold. Global gold production is about 2500 tons, thus at $1400 it could be enough to cover 1/4 of U.S.’s 2010 trade deficits.
On my#3, I am still too dense to understand why the PBoC has to sell the USD for RMB. Can’t it just print the RMB?
Prof Pettis,
We hear of 100% debt to GDP being the “point of no return” but at what debt ratio do you think that the US can comfortably without some sort of major debt restructuring?
OT but has global implications. What is your outlook for US housing if the plan to eliminate the guarantee for GSE’s (Fannie and Freddie) goes through? How much of this debt is held outside the US in your estimation?
Excellent post! I share most of your arguments about the inability of the yuan to serve as int’l reserve currency. I also think that it will incur large costs on China if it were to provide such a public good. However, I am less sanguine about the euro. I think that the European debt crisis epitomizes the fact that a monetary union without a fiscal union won’t go very far.
You are right that countries wish to run CA surplus with the US will wind up accumulating dollar reserves and that if the ROW stop purchasing US dollar assets then the US won’t be running CA deficits. The US has the capacity to provide demand, given the status of the dollar; it enjoys the real benefits of getting real goods and services, but it also shoulders the burden of generating large enough domestic demand to support job creations. The problem, as Triffin points out long time ago, is that the increase in supply of dollar would in turn weaken its status. But currently, I really don’t see any alternative currency to replace the dollar.