China Pushes Hard

On his China visit, Secretary Geithner is immediately on the defensive.  The language he is using on the Chinese policy of exchange rate undervaluation-through-intervention is the mildest available.  And the commitment he is making, in terms of bringing down the US deficit – which we all favor – is an extraordinary thing to put numbers on in a foreign capital.  Such commitments are of course unenforceable, but still the wording indicates – and is understood by China – great US weakness.

Not surprisingly, China seems likely to push for more.  Their main idea is that some part of their US dollar holdings be transfered to a claim on the International Monetary Fund, which would shift it from being in dollars to being in Special Drawing Rights – and therefore a claim against (a) the IMF’s whole membership, and (b) presumably, the IMF’s gold reserves.

This is a bad idea.

No one asked China to build up a huge level of reserves.  If one country wants to run a current account surplus that is big relative to the international economy, then someone else has to run a deficit – it’s a zero sum game because “reserves” are a claim on another country (preferably a strong one, with a convertible currency).  No one has ever offered a guarantee on the real value of reserves, i.e., what China now wants. 

We can agree that the US should have a higher savings rate, but if we did have more savings – or even if we ran our a current account surplus of our own – China’s desire for foreign exchange reserves would still mean undervaluation for them (as along as they can sustain the intervention) and a current account deficit for some set of countries in the rest of the world.

There is nothing wrong with wanting to have foreign exchange reserves, and sometimes these are accumulated just through the natural cycle of activity (e.g., commodity producers are well advised to build up reserves in a boom, because the prices of their exports also crash with some regularity).  But the way China has operated within the global system has not been responsible and it has not – an important point – been in conformance with the rules (as reflected most recently in the IMF’s Surveillance Decision, which is heavy on the legalese but quite clear on this point: no sustained undervaluation through intervention in the currency market is allowed).

China needs to acknowledge that it too has responsibility for the stability of the international system.  Current account surpluses feel good for surplus countries – this has been a consistent feature of the modern global payments system – but policies that sustain big surpluses are destabilizing for that system, because they imply that someone else will run a deficit and, more than likely, eventually have to bring that deficit down through costly adjustment.

What we really need is a complete reform of the IMF – or the introduction of a new international payments body – so that countries don’t feel the need to run massive surpluses to protect themselves against external shocks.

In the meantime, we need China to allow its currency to appreciate.  If they double their holdings of US dollar assets over the next couple of years (let’s say, going towards $4trn), effectively financing our budget and current account deficit, will we all end up safer or more vulnerable?

Is Mr. Geithner trying to persuade China to reflate a new version of our financial bubble?

By Simon Johnson

41 thoughts on “China Pushes Hard

  1. “the way China has operated within the global system has not been responsible”

    This is an interesting point that you’re making. I haven’t really thought about it myself or read about it previously, for that matter. But I don’t believe this happened by accident, I think the Chinese planned this all along in order to be taken as an equal, not just a ‘factory of the world’.

  2. “the way China has operated within the global system has not been responsible”

    The system having been like it was – how should the Chinese have behaved rationally ? Like the “EA Tigers” in the 90ties?

  3. “…which would shift it from being in dollars to being in Special Drawing Rights – and therefore a claim against (a) the IMF’s whole membership, and (b) presumably, the IMF’s gold reserves.”

    “This is a bad idea”

    Oh my gosh that is a bad idea!

    The primary bargaining chip the US has left, really, is that it’s vast external debts are denominated in dollars. That means that other countries have an interest in helping nurse the US back to health. Which means that they will have to absorb some of the effects of QE, or allow the dollar to devalue massively (which will massively impact their own exports to the US and dollar-denominated investments).

    In other words, they are helping pay the US inflation tax.

    This may seem unfair, until one considers that by deliberately undervaluing currency through actively mercantilist policies, China has effectively hobbled US domestic manufacturing (and the US participated by encouraging dollarization of foreign economies, “investing” in financial services, and refusing to actively manage its own currency down early enough).

    But frankly, China is not at all powerless – it doesn’t need to help pay the US inflation tax. All it needs to do is allow its currency to appreciate. But it doesn’t want to do this; it wants the US to honor its full debts by keeping the US dollar (and Chinese investments) strong.

    If the US abides by Chinese wishes and release China from the quandary that its own policies helped create, we will destroy our economy. We cannot commit to paying off an increasing debt load with a shrinking economy that needs real investments in (truly) productive sectors.

    The US, for its part, needs to force China to face the music: Either it sells off US assets and sees the US dollar plummet (along with its currency reserves and its dollar-denominated earning power, which it uses to buy commodities in third-party countries). Or it helps pay the inflation tax. If China is threatening to disrupt the capital markets by playing hardball (opportunistically sitting out of US debt auctions to give the markets some jitters), the US must respond in kind.

    So now is Geithner’s chance to prove he isn’t the weak-hearted, frail little thing that he has appeared to be from time to time.

  4. “No one asked China to build up a huge level of reserves.”

    But they have them, the US got boatloads of cheap goods in return and China are nervous about the administration’s monetary policies.

    There’s plenty of blame to go around.

  5. Is Mr. Geithner trying to persuade China to reflate a new version of our financial bubble?

    Of course he is because financial engineering and consumer spending ( 70% of GDP ) are key drivers for the debt laden ‘bubble’ US economy.

    And Obama and his Wall St bought and paid for economic team have put all their chips on the Banking Oligarchs !

    This will not end well….

  6. The only way out of this is for the US to begin producing in this country to keep cash here. We also need to find shortages elswhere in the world and export where we can.

    I have yet to see anyone explain how china can make cheap wrenches (example) ship them across the ocean, truck them to stores and make a profit and yet we can’t manage to do it here. There are so many unemployed and it is such an automated process it makes no sense.

  7. No one has ever offered a guarantee on the real value of reserves, i.e., what China now wants.

    What about TIPS? Is the volume of TIP issuance simply not great enough to absorb Chinese demand?

  8. This analysis of foreign monetary policy of China would have another meaning in another international monetary system. Suppose China is buying monetary security by building up foreign holdings. China’s considers its financial system being too weak to accumulate safely the capital it needs for its long term development. The problem may be in the present international financial system not being able to respond to Chinese demand.
    A national currency is the representation of a nation wealth as well as its State of Law. China buys the strongest state of law because of its feeling of own weakness. The only way to get it is running a current account surplus from United States. It wouldn’t be necessary if there was an international currency warranted by international State of law. If developed countries guaranteed international debts, which are international savings, by the community of their national wealth and State of Law, the burden wouldn’t weight exclusively on United States.
    That should be the reform of IMF : transform SDR in a real international currency warranted by international State of Law. IMF would become an international central bank providing liquidity to an international banking system domiciled in the countries which guarantee the system. The international monetary policy would aim at price level stability all over the world. Chinese reserves would stay in United States but not in dollars.
    United States international debt would be drawn up in international currency. IMF would be responsible for the liquidity of foreign debts between international savers and domestic economies. Foreign exchange rates would reflect both payments balance and capital balance. China couldn’t afford international warranty within reevaluation. United States could sell its political power without sacrificing its industry.
    Why such an international State of Law shouldn’t be possible ?

  9. “…bringing down the US deficit – which we all favor”

    Not true, actually. I would direct your attention to the “excellent Winterspeak blog” (in the parlance of Steve Waldman’s “Interfluidity”). To quote:-

    “If the private sector wants to save, it will either shrink aggregate demand and fail, or it will generate larger deficits and succeed….For the private sector to save, the public sector *must* dissave, the same way every asset must be balanced by a liability. It’s an iron law of accounting. Public deficits, far from thwarting a private demand to save, are necessary and sufficient to enable that saving.

    As for whether fiscal dissaving pushes equilibrium interest rates upwards, surely the example of Japan shows that interest rates respond to whether fiscal deficits are large enough fund private savings demand. Japan’s been at ZIRP for years, and public debt runs at 250% of GDP.”

    I think this is a key point, that receives -way- too little coverage.



  10. ANSWERED MY OWN QUESTION: (from John Rutledge blog:)

    …A few weeks ago I received a request for a private meeting with Vice Premier Zeng Peiyan to discuss economic issues between our countries. He was most eager to understand two things. First, why was the U.S. government spending so much money on the stimulus packages. (China’s stimulus package was not as big as advertized, mainly accelerated infrastructure projects that were already in the budget.) Second, why was the Federal Reserve flooding the market with dollars? Bank reserves in the U.S. have increased from $85 billion one year ago to roughly $1000 billion today.

    I explained that the crisis first became visible in June 2007 when banks revealed they were holding some $300 billion of toxic (covenant-light) leveraged loans. From then until August, 2008 the Fed talked stimulus but walked tight money–bank reserves grew only 1% during this period–because the Fed acted to sterilize the impact of their newly-announced liquidity measures (Bear Stearns, AIG,…) by selling Treasury bills from their portfolio (idiots!). But in September, after the near run on money market funds, after depositors began to take money out of their banks in earnest, and after Lehmann died the Fed panicked and started shoveling reserves into the banking system, which is why reserves have increased 10x in 8 months.

    Explaining the budget explosion was not so easy. Some economists in Washington actually believe that increasing government spending raises GDP growth like it says in the textbooks. (I am not one of those economists.) But most of the spending increase was the result of Hank Paulson’s ($700 billion) power grab last fall and the change in administrations that allowed the Obama team to come in and take advantage of the crisis by adding every program they have ever dreamed of to the Federal budget. As a consequence, Obama’s first (2010) budget will spend $1.8 trillion more than revenues and the CBO projects deficits of roughly $1 trillion per year, basically forever. (And the budget does not yet include national healthcare!)

    To a holder of $2 trillion in U.S. securities all this isn’t the best news. He then asked a third question: what can china do to protect the value of its assets from U.S. inflation and a falling dollar? I told him that if I were in his shoes I would have a quiet conversation with Geithner and arrange a private transaction in which he would swap all his Treasury holdings for inflation-protected Treasuries, or TIPS.

    I wonder what they are talking about at the meetings in Beijing today?

  11. I am vastly amused by Americans saying what “China must do” in order to make things easier for us. Fact is we have next to no bargaining power at all and will be on the receiving end of whatever China decides to do for the foreseeable future. Geithner’s promise to preserve the value of the dollar is hilarious. Eventually for the US the only way out of the mess it has made will be to resort to massive inflation and devaluation of the dollar. China knows this and if Geithner doesn’t he’s too stupid to be where he is.

  12. “Chinese assets are very safe,” Geithner said in response to a question after a speech at Peking University, where he studied Chinese as a student in the 1980s.

    His answer drew loud laughter from his student audience, reflecting scepticism in China about the wisdom of a developing country accumulating a vast stockpile of foreign reserves instead of spending the money to raise living standards at home.
    In his speech, Geithner renewed pledges that the Obama administration would cut its huge fiscal deficits and promised “very disciplined” future spending, possibly including reintroduction of pay-as-you-go budget rules instead of nonstop borrowing.
    Those students saw through Geithner’s nonsense easily. Geithner has no more ability to “promise” what the US will do than does Fidel Castro.

  13. This situation is very complicated. China built up foreign exchange reserves in order to acquire political power. They wanted to buy foreign technology and influence foreign governments. Some of their influence came from doing business with politically powerful corporations, some of it came from the leverage of holding enormous foreign currency reserves. If they were to spend huge quantities of dollars quickly it could be inconvenient for the U.S.. for example by buying natural resources they might drive up the costs of scarce raw materials.

    However the way in which China built up these foreign exchange reserves can best be described as evil. They used forced labor in prison camps to underbid the workers in other developing countries who of course had to be paid. For documentation of this check Human Rights Watch, Anti-slavery International, the Lao Gai Research Foundation, Amnesty International or just read Harry Wu’s book “Troublemaker”. Many American companies profited from this system.

    Over the long run the U.S. came to suffer from a financial version of the “Dutch Disease”: we shipped little pieces of paper overseas and our industrial production deteriorated. This was profitable for people who work in finance but bad for the rest of us.

    We are now in a crisis because of this with no end in sight.

  14. America’s problem is that at some point she is going to have to start taking her medicine, and her medicine isn’t going to taste good. Geithner/Obama seem to believe that the chemo can be postponed until after the cancer has run its course.

  15. You asked a question :
    Is Mr. Geithner trying to persuade China to reflate a new version of our financial bubble?

    It looks like the answer is – “yes !”

  16. I’ve been wondering when/whether China would start demanding that we denominate our paper in RMB instead of USD. SDR’s accomplish the same goal – protecting China against inflation – with slightly less humiliation for the US.

    It certainly would be bad for the US if we did it, but I don’t see that we have a choice. We’re on course for banana-republicsville, and we seem to have no way out.

  17. I was in China for almost 7 years. It’s a country I have deep feeling to (Love and hate). I wasn’t a businessman. Just a sorry English teacher with a bachelor’s degree in Finance. But I feel 7 years should count for some insight. It’s a very very nationalistic country. Really Xenophobic, because of what economists call asymmetric information. Chinese only have ONE source of info.—Xinhua news agency. If you look at North Korea, it’s also full of good people (farmers) with no information, just what they hear from government media. No tools to fight “the man”. Even if they knew the reality of what was happening. I think if the USAF (American Air Force) flew some flights with leaflets dropped over farmland, informing the farmers of the situation it would help. If they can’t feed the citizens, can North Koreans stop American fighters dropping leaflets??? As far as the 2 girls (Korean American journalists) let them suffer the results of their own decisions. Those 2 Korean American girls knew (the same as the Iranian/Japanese girl) they were putting their hand on the oven. They thought because they are Americans, they will be pulled out in 3 months and write a NYT best-seller. You play with fire you get burned….maybe killed. Would you play hopscotch on the borders between 2 communist countries??? “Oh, we are 2 beautiful Korean girls pay on the border!!!” We just smile and army guys say “Oh innocent pretty girls, go play!!!!” I DON’T FEEL PITY FOR THE 2 GIRLS!! ZERO PITY. Do you plan to play on the border between 2 nationalistic/communist countries tomorrow???? Why not?????? the answer is obvious…………

  18. I am a bit over my head with regard to the specifics of the financial situation with regards to China, the US and World economies…but from what I can tell, I am in good company…

    Anyway, I am no fan of the Chinese human rights situation, land grabs, worker abuses, political repression, environmental damage, censorship, etc. I think that in general the situation in China has improved due to development, not degraded, and the economic forces unleashed are probably putting the Chinese people on the path to more political freedom, rather than less.

    I think that one way to sum up the situation is the the Chinese government offered credit and the US consumer (or more specifically US trade and general policy makers allowed them to) accepted it. This was a gradual process, escalating over the last 10-15 years.

    Who thought that it was good for the US worker to be paid flat to down real wages, save nothing, face increasing health care costs, educational costs, loose pension benefits or be layed off before eligibility and then make up the difference in credit…?

    The answer as far as I can tell is all major public and private policy makers regardless of political party in the US for the last two decades.

    I for one blame China…

  19. Probably the older Chinese (or the more informed of the young) were crying.

    At the moment China and the US probably sink or swim together.

    Any austerity demands on the US (consumer) is likely to doom the Chinese economy (more than already) in the short to medium term. I have no idea how long it will take for China to absorb more if its own production, but I assume that roughly around half of production (and production jobs) depend on exports.

    The US cannot continue the same level of consumption (trade deficit) from China like before, especially since China won’t finance it anymore. Even China won’t be able to prop up the dollar anymore…

    The political leadership of China is blaming it all on the US (the traditional foreign devils). In the US the political and business leadership is correctly blaming each other…

  20. A question for the experts:

    This demand (to exchange T-bills for Special Drawing Rights) from China seems like a negotiating position rather than an obtainable goal.

    Isn’t aggravating a US recovery a sort of economic “nuclear option” for China?

    If so, what could the Chinese government really hope to gain (politically)?

    I assume that the Chinese would like better position or concessions with regards to resource access, and acknowledged full peer status with US, EU, etc. in regards to institutions (WTO, etc)

    Danger and Opportunity…

  21. The Chinese government/PoBC ends up with USD because its exporters get paid in USD. Since they hold USD they have to buy stuff that is priced in USD, particularly US treasuries. I don’t think the Chinese have much room to push for a change.
    Basically, I can’t see Walmart paying for its imports in RMB instead of USD.

  22. China is instinctively isolationist. They want us to buy what they make, but the hell with us otherwise. Bad attitude. They really need to participate in a global perpective in a more cooperative fashion. Like our Wall Streeters, they may find themselves suffering from a lack of moral responsibility in their global dealings. And, unfortunately, that is very unlikely to change, no matter how much diplomacy goes on.

  23. … As for whether fiscal dissaving pushes equilibrium interest rates upwards, surely the example of Japan shows that interest rates respond to whether fiscal deficits are large enough fund private savings demand. Japan’s been at ZIRP for years, and public debt runs at 250% of GDP. …

    this is true as far as it goes, but there’s a difference between us and japan — our current account balance.

    as john hempton has pointed out, japan was awash in deposit funding as a result of its CA surplus even before 1990 — indeed its excess deposits helped fuel its boom. these excess despoits are a direct product of the CA surplus, which the banks intermediate, and enabled (when loan demand collapsed following the asset shock of 1990 on) ZIRP and malaise.

    the US, however, has long imported scads of wholesale funding for its banking system through its CA deficit. this has resulted in a systemic deposit-to-asset ratio of 66%. there are no excess deposits; there is only a massive pile of wholesale funding that must be rolled or systemic assets must be liquidated. the fed has stepped in as the wholesale-funder of last resort, but that merely means the government now has to import the capital rather than the (now collapsed) private interbank and securitization markets.

    this is why, imo, we’re seeing rocketing treasury yields. our problem isn’t like japan’s; it is instead rather more like 1998 korea, or for that matter 2007 iceland. we MUST import capital to prevent an asset liquidation spiral in the financial system as we slowly wean ourselves off wholesale funding; in the meantime, there remains ever present a real possibility of a sudden-stop capital flight.

  24. “I am vastly amused by Americans saying what “China must do” in order to make things easier for us. Fact is we have next to no bargaining power at all and will be on the receiving end of whatever China decides to do for the foreseeable future”

    And I am vastly amused by people who romanticize Chinese power in this way. China has no barganing power here. Despite its rhetoric, it continues to consume dollars and treasuries at a near-record levels, increasing its cumulative holdings hand-over-fist. It does this because it must. When you “must” do something, you are not in the driver’s seat. The view that this is a unipolar power issue is remarkably naive.

  25. Offtopic,

    I really want the dollar to plummet, the appreciation of the dollar has radically changed my finances for my MS at Stanford this fall.

  26. And oh yeah, on the other hand I am also happy that finally the US has a financial counterweight.

    Frankly, I am surprised at the “Bad China” attitude in Simon’s post. I think they did pretty well for themselves.

  27. So you want the dollar to “plummet” to help you finances for an MS at Stanford, and you feel China is a “financial counterweight.” I certainly hope your degree field does not relate to economics, because to still hold these kinds of opinions and failures of fact at the post-grad level at Stanford would be stunning. (Although they are stunning regardless of the degree field.)

    “Frankly, I am surprised at the “Bad China” attitude in Simon’s post. I think they did pretty well for themselves.”

    By abusing trade and finance every bit as much as did the U.S. and placing themselves in a financial trap with no route of extrication that does not damage themselves and likely the world financial system itself? Really?

  28. We have bargaining power in the sense that AIG had bargaining power to demand and receive bailout funds post Lehman. No?

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