Mr. Geithner Goes to China

At his confirmation hearing in January, Tim Geithner nailed the China Question.  China prevents its exchange rate from appreciating through intervention (buying foreign currency), and this allows it to sustain a large current account surplus.  Geithner said, as plainly as you can expect from a senior official: this is not in accordance with international rules and should stop.

Not only is this sensible economics and correct on the rules, it is also good politics.  If you want to head off the considerable inclination towards protectionism in Congress, it would help greatly for the Chinese renminbi to rise in value (e.g., review the discussion at this House hearing).

But almost as soon as Geithner spoke on this issue, there was slippage.  By late February, Hillary Clinton was asking the Chinese nicely to continue holding US Treasury securities and, it now seems, punting the exchange rate issue.  Above all else, China wants to be left alone on the renminbi – variously arguing that any appreciation would jeopardize jobs, derail growth, and plunge the country into chaos.

So what should we expect from Geithner’s upcoming China trip?

Not much.

China refuses to talk politely about its exchange rate and rebuffs all sensible diplomatic initiatives on this front – they have held the IMF at bay for nearly 2 years on this exact issue.  The rhetoric is that their fiscal stimulus will bring down their current account surplus without need for significant exchange rate appreciation.  This is smokescreen.

The reality is that the administration is afraid that China will shift out of its dollar holdings, pushing up interest rates on Treasury debt and jeopardizing their Fiscal First reflation strategy. The Chinese have played up these fears by speaking obliquely on the desirability of a non-dollar international reserve currency – this is a pipedream, but you get the point.

The administration has essentially blinked in the face of Chinese growling.  This is strange for two reasons.

First, where would China move its reserve holdings?  The other reserve currencies are generally considered to be the pound, the yen, and of course the euro.  Which one would you definitely prefer to the dollar these days?

Second, any shift in the Chinese portfolio would also tend to depreciate the dollar – depending on what else is going on at that time – and this would likely push up inflation.  However, the administration might welcome some inflation right around now, reducing real debt burdens, and helping banks’ balance sheets and their operating profits.  And a depreciated dollar would raise exports, greatly facilitating our economic recovery.  It would be awkward for this to be explicit US policy, but any Chinese move would provide the administration with plausible deniability.

The standard view among the very people now running US macroeconomic policy is that the large Chinese current account surplus during the boom – and the consequent build-up of foreign exchange reserves – was destabilizing, because it helped make credit conditions looser in the US.  In fact, “don’t blame us, it was the global [Chinese, Japanese, oil producers’] savings glut” is almost a mantra among our policy elite. 

Personally, I would not overweight this element of the global credit mania – the financial services metabubble started long before China’s surplus became significant.  But I’m seriously worried about the potential protectionist backlash today, given that China is the only major country that does not play by standard international trade and finance rules.  The administration thinks it can safely postpone discussing China’s exchange rate for another, sunnier day.  I’m not so sure.

Still, not wanting to discuss difficult topics should make for an easy visit to China.

By Simon Johnson

35 thoughts on “Mr. Geithner Goes to China

  1. The problem of currency manipulation should have been confronted much sooner and we could have avoided much of the mess that we have with indebtedness in the US. So, while I believe that “the global savings glut” was a primary causative factor for our current problems, the government cannot escape blame for failing to confront the currency issues aggressively much earlier. Michael Pettis and Martin Wolf make a very compelling argument that the Federal Reserve (in the absence of a resolution of the currency issues), had only two choices: Promote *increasing* indebtedness through artificially low interest rates to maintain GDP growth with the trend line OR to allow unemployment to rise (2001-2002) much higher to remove demand for Chinese goods in order to keep private debt levels stable.

    “The rest of the world’s capital outflow supports the dollar. At the resulting elevated real exchange rate for the United States, the output of the sectors in the US economy that produce tradable goods and services shrinks, other things being equal. The Federal Reserve cuts interest rates to expand the economy, thereby preventing excessive unemployment. As it does so, a large excess demand for tradable goods and services emerges in the United States. This finally, appears in the trade and current account deficits.”

    “One consequence of all this is that US domestic demand has had to grow faster than real GDP, to ensure that the latter grows in line with potential. The difference between the two is, of course, the increase in the current account deficit, in real terms. With trend growth in GDP between 3 and 3.5 percent a year, domestic demand has to grow even faster. That is precisely what has happened. US real demand (or gross domestic purchases) grew faster than real GDP in 1993 and 1994 and then again every year from 1996 to 2004 inclusive. Cumulatively, between 1993 and 2004 US real GDP grew by 46 percent, while gross domestic purchases rose by 53 percent. That is how the current account deficit emerged. It is also how the United States absorbed the supply of excess capital from abroad.” (Martin Wolf)

  2. “First, where would China move its reserve holdings?”

    The answer to that question is commodities. China, despite a dramatic drop in production, is stockpiling copper, iron, oil, gasoline, and diesel fuel.

    A new policy was recently put in place to make this easier. Instead of mandating that any dollars brought in from overseas sales had to be exchanged for renminbi, the new policy allows companies to retain the dollars for international investment and purchasing.

    “The Chinese have played up these fears by speaking obliquely on the desirability of a non-dollar international reserve currency – this is a pipedream, but you get the point.”

    If it is a pipe dream then why has China provided Argentina, Venezuela, South Korea, and Indonesia with large renminbi trade reserves and are talks across Latin America and elsewhere to expand this dollar displacement plan?

  3. Doc,

    You are arguing that the Fed had to choose between unemployment and indebtedness? It seems to me that after the previous downturn at least, the shadow banking system provided us with both.

    Unless China can transform its domestic demand, the market will force China’s hand on this issue. But their threats have power because, on account of our fiscal situation, they have the ability to roil our markets at any given Treasury auction.

  4. Before we get to serious this weekend, let us assume that the US administration buys Simon’s logic and attempts to coax China into abandoning exchange rate policy as a macro-economic tool. A transcript of the ensuing discussion between Mr. Smith the US representative, and Mr. Li his Chinese counterpart follows:

    Mr. Smith: China must stop artificially lowering its currency at once! It’s against the rules.

    Mr. Li: Thank you. We will into the rule books we’ve acquired over the last five thousand years, and get back to you shortly. In the meantime we’d like to politely remind you about the Confucian tradition of honoring one’s debts.

    Mr. Smith: Damn it! We’re serious this time! Really! We will send in Commodore Perry, or nuke you, or something…

    Mr. Li (as he signs the check for yet another nuclear powered submarine): Commodore Perry? That was Japan. But anyhow, let’s not get too hasty about this. Let’s talk.

    Mr. Smith: Bul…..! Enough of this obfuscation! As Simony says we’ll get Congress to vote for sanctions on your goods.

    Mr. Li: You could do that. But let us not be too hasty. US midterm elections are coming up. Obama will soon be up for re-election. You don’t want to spoil the fun by having the US dollar drastically devalued, would you now…?

    Mr. Smith: You can’t do that! You’d loose the most.

    Mr. Li: Big deal. It’s not as if my boss is going to get voted out of the office, is it? The only thing that we’re worried about is 10 million pissed off unemployed Chinese climbing over the walls of the Forbidden City.

    Mr. Smith (as he checks the overdraft amount at the bank, and attempts to estimate the value of his pension): Errrhhh…

    Mr. Li: Furthermore, it won’t be such a big loss. All I have to do is just scare the markets for a few months, depress the dollar, see your monetary policy become ineffective. And then deal with the new president, and a new Congress. I could even help them then by coming back to buy T-bills.

    Mr. Smith: Let us not be too hasty and do let me get back to you on that one.

    Mr. Li: Nice talking to you.

  5. Geithner to reassure China that its massive US bond holdings are safe despite concerns.

    HA !!!….US economy carries about $20 trillion of excess debt.

    Until that debt is eliminated, the idea of a healthy boom is a mirage.

    A Treasury official acknowledged last Thursday that the budget deficit was “going to increase sharply” as a result of aggressive measures to jolt the economy from recession but added that once recovery was firmly established, “we are going to walk back these measures and the deficit will decrease.

    “In general, Treasury believes that by maintaining the most liquid debt markets in the world, by maintaining strong economic fundamentals, we will continue to attracts both domestic and international investment.”

    Liquid debt markets = More Tsing Tao please !

  6. Bond Girl,

    To be more accurate, Pettis and Wolf argue that and I strongly agree with them. I would assert however, that we have both high unemployment and high indebtedness now because FFR can’t go below zero and we are in a liquidity trap. The Fed ran out of rope!

  7. China has played its cards well in this. By promoting the use of Yuan for bilateral trade with its smaller trading partners, it is increasing its influence and their dependence on it.
    And at the same time it is not moving out of the USD to anything else that may cause the value of their vast reserves to decline. But I do think they have stepped up the purchase of physical gold.

  8. Geithner looks like a wimp as well as a sellout, doesn’t he? Oh for the robber barons of old!

    Surely the Chinese currency policy is a sophisticated form of protectionism? It appears to be aimed at building up the Chinese industrial economy at the expense of that of the rest of the world, especially that of the USA. Protectionism in other forms strikes me as a reasonable, though unfortunate, response, if China is not willing to give up its currency manipulations. The risks of that policy are terrible. Which means…

    More food for corvids! Krawk!

  9. Though, to be fair, an openly confrontational policy is unlikely to bring improvement. If China backs away from its currency policy, it will have to do so in some face-saving way. It is possible that negotiations have already begun.

  10. Doc,

    I agree 100% with the Pettis and Wolf argument. However, on the last statement you lost it.

    Rates had to go lower and lower because the world’s savings where flowing into the US, driving the marginal product of capital and hence the natural real rate lower and lower.

    A zero to negative savings rate was a perfectly rational and correct response from the point of view of an american faced with excessively low expected real asset returns (ie. high asset prices).

  11. Unless China can transform its domestic demand, the market will force China’s hand on this issue.

    Meaning what, exactly? As long as they are producing more than they consume and rolling the profits into dollar assets, what will “the market” do?

    But their threats have power because, on account of our fiscal situation, they have the ability to roil our markets at any given Treasury auction.

    So maybe this week’s action in the 10-year was just China’s way of rolling out the welcome mat? Half-serious question.

  12. what we should expect from geithner? a lot of talk and hardly any information on what kind of new advantages he is giving to the chinese to control american debt and our future.

  13. I was responding to the idea that China would do the opposite – move out of dollar holdings. China cannot change its portfolio quickly (such that any change would devalue what it continues to hold) and China cannot quickly change its economy away from being export-oriented. Even though they may not like the idea that the dollar’s reserve status gives the US the ability to borrow excessively, it is not in China’s intermediate-term interest to rock the boat. (The Pettis link Doc supplied addresses this – I’m just not sure about his points related to employment.)

    That said, I think it is difficult to argue that China must necessarily absorb an unlimited amount of our debt and in the term structure in which we want to issue it. China can make subtle changes in how its economy develops, which is significant when we are talking about how to push out the cost of salvaging our economy. And, even if it is not in their longer-term interests, they can still mess with us short-term. How could they overlook the power that entails?

  14. These are crocodile tears the US is shedding over the exchange rate. It takes two to tango. If the US had been serious in the past about the “unfair” exchange rate, they could have called China’s fixed rate an export subsidy and instituted increased tariffs. The exchange rate is a great excuse for more serious problems.

  15. It’s almost inevitable that China will plunge into chaos anyway. The disparities between the coastal and interior regions are only growing . Regionalism has historically been the reason behind central government collapse throughout China’s history.

  16. We are in this pickle because nominally American globalized MNC’s make profits from labor arbitrage. They have offshored manufacturing to low wage China and the difference has gone straight into the pockets of the CEOs. Of course the Bush Administration (“Some people call you the elite, I call you my base,”) did not rock the boat, because that would have underminded their buddies, the CEO class.

    It’s no surprise that the Republicans trashed and abandoned the welfare of ordinary working Americans. It is a mystery why this Administration continues those policides.

  17. The Chinese provided cheap funds to the US banks who then wasted a unique opportunity in use the funds for truly productive and potentially transformational purposes and in turn invested them in “real assets” such as real estate and financial instruments like CDOs, CDSs and other financial “innovations” and now the experts want to “blame” China for the problem. In the meantime, the Petersen Institute (N Lardy et al)in 2005 or 06 said the RMB needed to appreciate about 25% vs the US$ and in the intervening period the RMB appreciated about 22% and the deficit with the US increased even more. Does anyone really know what they are talking about?

    Even if the CEOs of the Investment Banks, the Rating Agencies and Mortgage Originators will never accept real responsibility, one would think the independent economists would recognize where the real responsibility lies instead to trying to blame a country with $2,900 per capita income and emerging market and financial systems vs the country with 20 times the per capita income and apparently the most innovative and sophisticated market and financial systems in the world. To portray the US as a “helpless” victim taken advantage of by the malevolent Chinese is ridiculous but unfortunately not surprising

  18. To put matters in proportion can anyone provide some time series data for the past 10 years showing the actual inflows of foreign funds into the US capital market,and the share/contribution of developing economies especially China of such inflows?

  19. “First, where would China move its reserve holdings?”
    That is where they are trying to move them – commodities and gold…!

  20. Have you ever stopped to consider that China has a different view of its place in the world than being an equal or lesser amongst western rule books? That it does not want to be a friend or partner with Japan?
    Or, that China’s desire to negotiate has other than economics in mind. Such as repudiating US 2-China policy? Your underlying assumptions need to be expressed so the context of what you say, which I respect and agree with, has a little more political depth.

  21. Geithner and this so called Administration of change has sold this country down the river.

  22. Very good points indeed.

    It isn’t a pipe dream. The US political elite seem to be clueless on the economic consequences of deficits as far as the eye can see and a looming entitlement crisis.

    Foreigners will stop lending us money at these absurdly cheap rates and they are increasingly seeing the huge risk of holding US dollars as a reserve currency.

    We can only hope that they divest themselves slowly, but a run on the dollar and US bonds is not out of the question.

  23. People are still trying to tell China what is “fair” to do in the name of a theoretical free-market ideology. If Malaysia could “break the rules” in 1997, so can China now. After all, the Chinese government is acting in the benefit of the Chinese people, not the entire world, and China is now in a state to dictate its terms, because it has been saving when others were carelessly spending.

    The US seems to have no choice but to inflate its way out of the debt mountain, and the Chinese just want to make sure that they continue to get a positive real interest rate on the dollar while this happens. I will not be surprised to see the 10- and 30-year rates jumping sharply in the near future, as the US desperately tries to maintain the attractiveness of its bonds.

    If, as written above, China is stockpiling on commodities, it is acting wisely because it should indeed prepare for a global inflationary wave, that may affect developing economies more seriously than developed countries, to the point of causing social unrest.

    From the Chinese point of view, it is best to support the dollar as a safe haven currency until they have finished opting out of it – which may take a while, then let it drop sharply in order to establish the yuan as the world’s new currency of choice.

    Americans perhaps find it easier to think that the Chinese pursue a policy of economic cooperation with the US. If this view is blindly followed, the consequences may be dire.

  24. From Ze:

    “From the Chinese point of view, it is best to support the dollar as a safe haven currency until they have finished opting out of it – which may take a while, then let it drop sharply in order to establish the yuan as the world’s new currency of choice.”

    Ze has it right here. Likewise for SNS.

    US currency power is in decline, and what remains of that power is largely driven by the simple fear among dollar-owners of letting their holdings devalue rapidly. They are thus supporting the currency while slowly shifting out of it. In a sense, the US itself is “too-big-to-fail” (for now).

    The US has two options (other than vascillation and incompetence) – negotiate a currency transition or preempt the fall of the US currency by printing money (leaving dollar owners holding the bag).

    The preemption option essentially involves printing a vast amount of money and using it to restructure US debt. Though tempting, this would incur tremendous domestic consequences and the US does not seem to have the ability to act decisively in such a manner. (not with the tremendous influence of financial interests who would lose out) China seems well aware of this difficulty, and has signalled such – its grumblings about not supporting US debt were clearly intended for global financial media consumption.

    The negotiation option is difficult to read, since any successful negotiation would never hit the presses. We can be certain those negotiations have taken place, but we cannot know what may have been the outcome.

    Yet it is important not to overstate China’s strength in this matter. China is in the unfortunate position that much of its production feeds US consumption, and it uses US dollars to buy commodities from other countries. It needs to redirect exports to commodity producing regions (and, essentially, cut the US dollar out of the loop). But the commodity producing regions cannot afford current Chinese exports, nor are those exports customized for those markets. This transition will not happen quickly.

    Assuming the transition is managed, the question is whether the US can get its current account in order BEFORE China has completed its economic restructuring. This, essentially, means fixing our sick economy on many dimensions (aka, living within our means). In order to do this, it would be helpful to print dollars AND to devalue the dollar to reduce imports, but China doesn’t want us to do this because this harms its reserves (and/or forces it to loan the US more to sustain the value of its reserves) and creates internal dislocations. That is why China is grumbling – it wants to control the timing of the transition.

  25. Geithner goes to China over the weekend and on the following Monday, General Motors files a pre-packaged bankruptcy.

    I for one, expect to see a smiling joint communique expressing China’s support for the dollar.

    Various sources are reporting that the new GM, with financing from the US Treasury, will be marketing small cars produced by US, unionized factory where parts imported from China will be assembled.

    And so some of the proceeds those T-Bills the Chinese are buying will apparently be recycled back to support Chinese export and heavy industry.

  26. Granted that the Chinese economic restructuring will take time, its goal may well be self-reliance, instead of an export-based economy. This idea is pursued in detail in the posts of Henry C.K. Liu:

    for example, under the section titled “Shifting China’s export towards the domestic market”.

  27. Yes, but they still need commodities to support internal manufacturing, even if it’s targeted toward the domestic market. Coal and Coke they have domestically. They need iron, other metals, oil. Hence the commodities “shopping spree”.

    The challenge is that penetrating other markets with those resources (in many languages, with many retail outlets, different local consumption patterns, etc.) takes a little time. Penetrating the US market and buying commodities with dollars was ever so easy by comparison.

  28. Pingback: China Pushes Hard

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