A lot has been said by the major Western news sources (WSJ, Bloomberg, FT, NY Times) about China’s reaction to the downgrade of the U.S. creditworthiness. Although there has been no official comment from Beijing since the downgrade, the Xinhua news agency (the official mouth-piece and the usual government ‘attack dog’ for criticizing the U.S.) came up with a very harsh commentary over the weekend. (See: After historic downgrade, U.S. must address its chronic debt problems) Western reaction to China’s reaction has been just as critical, and with a good reason.
To quote the WSJ: “The official Xinhua news agency’s Saturday editorial was a hilarious moral lecture, suggesting that an addicted America’s ability to print dollars should be put under “international supervision.” But if borrowing is really an addiction that has sapped America’s self-discipline, China is both the pusher and a user.”
No one can dispute that the U.S. (government and people) needs to curb its spending addiction, save more, invest at home, and pay down its debt. But China’s export led growth, capital controls, and fixed (at an undervalued level) currency have been feeding the U.S. addiction, and are a major cause of our current global financial crisis!
China’s Exposure to U.S. Debt -
To be fair, the downgrade is particularly painful to China since it is the largest holder of Treasuries. As Patrick Frost demonstrated with his recent post, China holds officially $1.1 trillion in U.S.-government debt instruments, which comes up to $2 trillion if you include nongovernmental securities and Chinese purchases through other jurisdictions.
For many years the government in Beijing has been bragging about its sound stewardship of the Chinese economy and the profitable investment of the people’s hard-earned dollars in U.S. Treasury’s. Now, China’s portfolio seams over-exposed, and many domestic critics are chastising the government for its careless handling of the profits earned by the ‘blood and sweat’ of the Chinese workers. (If the Americans are irresponsible, then why did you lend them your money?)
Indeed, the reason why Beijing has purchased so mach U.S. debt is not benign. It’s the result of China’s policy to encourage exports by holding down the value of its currency, the yuan. Beijing does this by buying dollars from exporters in exchange for yuan, and using those dollars to buy U.S. Treasury’s. More accurately, the Peoples Bank of China requires the exchange of dollars in the Chinese market (earned by exporters) with yuan, which the government borrows from the Chinese people through the issuing in its own bonds.
To quote the same WSJ article: “The U.S. dollar assets and yuan liabilities are roughly balanced on the central bank’s balance sheet. If the U.S. government is addicted to debt, so is China’s.”
China’s Contribution to Global Financial Crisis –
China’s need to subsidize its exports has already reached dangerous levels for the global economy during this past decade. If Beijing did not apply strict capital controls, and allowed the yuan to appreciate, then its growth during the past decade would have led to higher real wages, which would have led to a certain level of natural inflation (a rise in all prices), and thus increase in the cost of exports. China would have moved away from the production of low-cost goods, its citizens would have consumed more, and the economy would have transitioned to production and export of higher-end goods.
Instead, China’s continuing production and export of cheap goods, coupled with its purchases of U.S. Treasury’s have helped to keep U.S. interest rates low for years, facilitated the continuing consumption in America, and also contributed to the housing bubble that eventually tanked the global economy. We live in such an interconnected world, where it is impossible to consider any major economic policy by a major global economy (like China or the U.S.) that is not impacting the whole world.
The Need for a Rebalancing -
The leadership in Beijing needs to remember that ‘a crisis can also be an opportunity.’! Inflation is on the rise in China (although reports are predicting a leveling in the coming months), which is putting pressure on the yuan. Although the government has allowed the currency to appreciate during the past 12 months, reaching its strongest position since 1993, more needs to be done. Although the yuan has appreciated by 6% against the dollar, it has actually depreciated against most of the other major currencies during the same period.
If the U.S. needs a balanced approach to reducing its national debt (cutting spending and increasing revenues), then China needs to rebalance its economy away from just exports of labor intensive goods and more towards the a consumption and innovation based economy!
If the Peoples Bank of China stopped buying U.S. Treasury’s and other dollar assets, the result would be an immediate increase in the value of the yuan. A more valuable yuan would put more money in the pockets of consumers by making imported goods cheaper in local currency terms. This will improve consumption, which has steadily fallen as a percentage of economic growth. However, this cannot happen as long as the authorities are reluctant to dismantle capital controls. The government imposed capital controls ensure that Chinese savings remain in the domestic banking system, offering a cheap and abundant source of funding for investments.
And What about Europe?
Ultimately, Mr. Samuelson’s question should be answered to the affirmative: “Would China contemplate bailing out Europe?” Only the reason for doing so will be self-preservation, and not some Machiavellian geopolitical maneuver.
In the short term, if China cannot stop its export led growth, and buying U.S. debt is deemed too risky, then diversifying to the ‘less risky’ European or Japanese debt might be an alternative. In the longer term, China should stop buying any foreign debt, makes the yuan convertible, and liberalize the financial system to integrate it into the world economy.
If either of these options sounds unpalatable for China’s Government, it’s because they are. Beijing must recognize that it has a vested interested in the long term health and longevity of the Euro (as an alternative reserve currency) and the European market (as an alternative destination for Chinese exports). Gradual appreciation of the yuan, and gradual relaxing of capital controls, coupled with a gradual diversification of foreign exchange reserves (from dollars to euros) and a gradual decoupling from the U.S. export market should be China’s short-term and long-term strategy.
Otherwise, it’s stuck with Uncle Sam, who seems to like his ‘Tea Parties’, ‘Made in America’, and ‘China-bashing’ these days.
More on China and the EU to follow…