Brad Setser: Follow the Money reports about China's future role in the global financial system.
(emphasis mine) [my comment]
Different conceptions of China's future role in the global financial system
Posted on Friday, May 15th, 2009
Discussions of China's role in the world that aren't dominated by economists often end up focusing on China's willingness to act as a "responsible stakeholder" in the global system. That is diplomatic code for China to do more to support the current international financial and political order that it has — in this view — helped support China's rapid development.
This framing though assumes something that I am not sure is true, namely that there is a deep consensus on what constitutes a stable international financial order and thus consensus on what China needs to do if it wants to integrate more fully into this order.
The current order, after all, isn't really defined just by existing institutions like the IMF; the key questions go far beyond China's willingness to contribute more to the IMF in exchange for a few more votes.
To put it concretely, is a stable international financial order one defined by large-scale Chinese financing of the US, in dollars, to sustain a large US current account deficit — whether one that reflects a large deficit among US households or a large US fiscal deficit?
Or is a stable financial order marked by floating exchange rates among the world's major economies, limited build-up of reserves and modest current account deficits (and surpluses)?
In the first conception of global financial order, China should continue to peg to the dollar, adopt policies that restrain domestic demand growth to avoid domestic inflation if the dollar is weak and run up large dollar reserves. That policy mix would produce large current account surpluses — and allow China's government to continue to provide large amounts of financing to the United States. Call it Bretton Woods 2 bis. China's current $1.5 trillion or so dollar portfolio would double over the next four years, to about $3 trillion — and keep on rising after that. The current crisis doesn't — according to this view — signal that there is anything fundamentally wrong with a world where a poor country like China finances a rich country through the United States as a result of a policy of holding its exchange rate down to support its export sector. See Michael Dooley and Peter Garber [click on this link for a dose of absolute Keynesian stupidity] for a forceful statement of this view combined with plenty of sharp criticism of those who have criticized Bretton Woods 2.
In the second conception of global financial order, China should allow its currency to appreciate, offset the drag from slower growth of exports with aggressive policies to stimulate domestic demand (including the rapid implementation of a broad social safety net, even if this produces sustained budget deficits) and bring its current account surplus down. China's government would no longer steadily accumulate large quantities of dollar reserves. More balanced trade flows would allow the RMB to eventually float — allowing China to direct domestic monetary policy toward stabilizing China's own economy rather than stabilizing its exchange rate.
The US would get less subsidized financing to be sure — but according to this view, large inflows from China and other emerging economy central banks have proved to be a mixed blessing. Dollar pegs prevented a necessary adjustment in the dollars' value relative to a host emerging economies, keeping the trade deficit up. That changed the composition of US output, as the US shifted out of the production of tradable goods and services — and instead specialized in home construction and creative financial engineering [Sad, but true]. And, well, the US financial sector wasn't able to effectively intermediate large inflows from the world's central banks. US financial institutions — and European ones running large offshore dollar balance sheets [via London (See *****European Banks Desperate To Avoid Recognizing Losses On Their 8 Trillion Us Holding*****)] — were stuck with a lot of credit risk from lending to increasingly indebted American households, as the world's central banks were far more willing to take currency risk than credit risk. And now — as Martin Wolf likes to note — there is a risk that a new buildup of dollar (and euro) reserves will finance an unsustainable buildup of government debt in the US (and Europe).
The apparently cheap credit that the US obtained from the world's central banks over the past few years — in my view — came at a high price: it masked the buildup of vulnerabilities in the US economy, and likely prevented some natural circuit breakers from kicking in and cutting the housing boom off at an earlier stage. As superstar economist and pop culture sensation Nouriel Roubini* notes in the New York Times, "A system where the dollar was the major global currency allowed us [the US] to prolong reckless borrowing."
Of course, non-reserve currency countries also sometimes engage in a bit of reckless borrowing. But during the last boom, private creditors abroad generally speaking weren't willing to provide the US with the low-cost dollar-denominated financing needed to sustain a huge boom in an interest-rate sensitive sector like housing. Over the past several years, net private demand for US assets from the rest of the world fell well short of what the US needed to sustain its external deficit, creating an equilibrium that — in my view** — could only be sustained so long as the world's central banks provided the US with large amounts of financing.
Nouriel Roubini's article in the New York Times [article is below] suggests that China might have a third — and rather different — conception of a stable global financial order in mind. According to this view, China's basic problem is not that it is running a large current account surplus and accumulating financial claims on the world. Rather, its problem is that those financial claims are denominated in dollars and euros rather than in China's own currency. If China was lending to the US — and Europe — in renminbi, China could continue to run large current account surpluses without taking on as much financial risk as it is now. If the US was required to pay China RMB, not dollars, China wouldn't need to worry about a bout of inflation in the US that led the dollar to depreciate — or for that matter a dollar depreciation that wasn't the product of a rise in US inflation. All China needs to do then, is to convince the US to start selling it RMB denominated Treasuries and Agencies — or, for that matter, find other borrowers willing to sell China RMB denominated debt to finance their trade deficit.
That conception of global order though isn't one that appeals to the US. It implies that US borrowers would need to take on the risk of dollar depreciation that China now assumes. That would make sustained US deficits — and the associated buildup of US external debt — far more risky.
That highlights the ambiguities the United States' faces in a world where emerging markets want to hold huge amounts of reserves — and where most of those reserves are in dollars.
The scale of their demand for dollars potentially creates problems for the US — as the external surpluses that often generate large reserve growth imply larger US external deficits than are really healthy. Rapid reserve growth has gone hand in hand with a very rapid large buildup of US external debt. It also implies that much of that debt will be held by states, not by private creditors — which also isn't a necessarily a positive. A deficit financed by a diverse group of small creditors is different than a deficit financed by a few large states.
But the fact that this debt is denominated in dollars is an enormous advantage for the US [Agreed]. The US also benefits from a world where the dollar generally rallies in times of financial — and geopolitical — turbulence. The current financial crisis would have posed more acute dilemmas if it had been accompanied by a dollar crisis. A geopolitical crisis that resulted in a massive dollar selloff also would challenge the US in new ways, as over the past fifty years the US has generally benefited from safe haven flows in times of global political stress.
China's evident discomfort with its dollar exposure could push China to accept a stronger RMB and a smaller current account surplus. That would limit the buildup of dollar risk at China's central bank — and at China's sovereign fund. China would still hold a large dollar portfolio, but its dollar portfolio wouldn't need to grow. The US dollar would remain the world's leading reserve currency. But the stock of global reserves wouldn't grow at the same incredible pace as it did in the past five years. A world where central banks are adding $75-150 billion a year to their dollar reserves — and providing the US with modest amounts of financing — is rather different that a world where central banks are providing the US with $750 billion (or more) in dollar financing.
Once China's population discovered the risk associated with holding huge sums of foreign assets, they weren't all that happy. The core trade off associated with Bretton Woods 2 — accepting low yields, and likely large losses in RMB terms, on a huge and growing stock of dollars and euros in order to spur China's export sector — doesn't seem to command much political support in China. China, not surprisingly, seems to have concluded that it would like to support its export sector at a lower cost to itself by accumulating RMB rather than dollar and euro claims on the world.
Same Chinese surplus, but less financial risk for China. It isn't hard to see why that is a vision that appeals to China's leadership.
The problem of course is that is that China's own choices more than anything else constrain the renminbi's ability to serve as a global reserve currency. China's currency isn't freely convertible and its capital account is heavily managed. And China's government doesn't exactly welcome foreign inflows of any sort — and it certainly doesn't want to increase its dollar holdings to allow other countries to increase their stock of renminbi denominated reserves. Letting other central banks hold RMB means letting other central banks speculate on RMB appreciation ...
That said, it isn't clear that the US has the ability to prevent the formation of an Asian reserve currency. If say Thailand decided that it wants to hold renminbi-denominated debt as part of its reserves and China was willing to sell Thailand renminbi-denominated debt, the US can hardly stop the transaction. [exactly]
At the same time, the US shouldn't welcome a world where Asian countries try to maintain undervalued currencies — and thus run large, sustained external surpluses — while minimizing their risk by running up renminbi and yen denominated claims on the US, Europe and potentially a host of emerging economies.
Here the interest of debtors and creditors are not aligned. Debtors want their debts to be denominated in their own currency, and to carry a low interest rate. Creditors would rather lend in their own currency. The implicit pre-crisis bargain was that the US — the debtor — borrowed more than it should have, but the creditor —China — also accepted more currency risk than it should have. I don't see how China can start lending in its own currency without calling the overall bargain into question.
The best solution, it seems to me, is moving toward a world where trade and ca pital flows are more balanced. Then there would be no sustained need for the governments of the major Asian economies to buildup huge claims on the rest of the world.
One thing is clear: Some big questions about the shape of the post-crisis global financial order have yet to be resolved.
The New York Times reports about The Almighty Renminbi.
The Almighty Renminbi?
By NOURIEL ROUBINI
Published: May 13, 2009
THE 19th century was dominated by the British Empire, the 20th century by the United States. We may now be entering the Asian century, dominated by a rising China and its currency. While the dollar's status as the major reserve currency will not vanish overnight [Agreed, it will take a couple of months], we can no longer take it for granted. Sooner than we think [by the end of this year], the dollar
may [will] be challenged by other currencies, most likely the Chinese renminbi. This would have serious costs for America, as our ability to finance our budget and trade deficits cheaply would disappear.
Traditionally, empires that hold the global reserve currency are also net foreign creditors and net lenders. The British Empire declined — and the pound lost its status as the main global reserve currency — when Britain became a net debtor and a net borrower in World War II. Today, the United States is in a similar position. It is running huge budget and trade deficits, and is relying on the kindness of restless foreign creditors who are starting to feel uneasy about accumulating even more dollar assets. The resulting downfall of the dollar
may be [is] only a matter of time.
But what could replace it? The British pound, the Japanese yen and the Swiss franc remain minor reserve currencies, as those countries are not major powers. Gold is still a barbaric relic whose value rises only when inflation is high [Can you believe this nonsense is coming from Nouriel Roubini, a professor of economics at the New York Stern School of Business? Modern economics has become warped by worthless Keynesian thinking.]. The euro is hobbled by concerns about the long-term viability of the European Monetary Union [Again, this is pure nonsense. Unlike the dollar, the euro is not headed for a total collapse]. That leaves the renminbi.
China is a creditor country with large current account surpluses, a small budget deficit, much lower public debt as a share of G.D.P. than the United States, and solid growth. And it is already taking steps toward challenging the supremacy of the dollar. Beijing has called for a new international reserve currency in the form of the International Monetary Fund's special drawing rights (a basket of dollars, euros, pounds and yen). China will soon want to see its own currency included in the basket, as well as the renminbi used as a means of payment in bilateral trade.
At the moment, though, the renminbi is
far from ready [close] to achieve reserve currency status. China would first have to ease restrictions on money entering and leaving the country [which it is doing], make its currency fully convertible for such transactions, continue its domestic financial reforms [all lending restrictions have been removed and Chinese banks are now diving headlong into financial innovations] and make its bond markets more liquid [China is allowing banks to trade bonds]. It would take a long [very short] time for the renminbi to become a reserve currency, but it could [will] happen [this year]. China has already flexed its muscle by setting up currency swaps with several countries (including Argentina, Belarus and Indonesia) and by letting institutions in Hong Kong issue bonds denominated in renminbi, a first step toward creating a deep domestic and international market for its currency. If [when] China and other countries were to diversify their reserve holdings away from the dollar — and they eventually will — the United States would suffer [Agreed]. We have reaped significant financial benefits from having the dollar as the reserve currency. In particular, the strong market for the dollar allows Americans to borrow at better rates. We have thus been able to finance larger deficits for longer and at lower interest rates, as foreign demand has kept Treasury yields low. We have been able to issue debt in our own currency rather than a foreign one, thus shifting the losses of a fall in the value of the dollar to our creditors. Having commodities priced in dollars has also meant that a fall in the dollar's value doesn't lead to a rise in the price of imports.
Now, imagine a world in which China could borrow and lend internationally in its own currency. The renminbi, rather than the dollar, could eventually become a means of payment in trade and a unit of account in pricing i mports and exports, as well as a store of value for wealth by international investors. Americans would pay the price. We would have to shell out more for imported goods, and interest rates on both private and public debt would rise. The higher private cost of borrowing could lead to weaker consumption and investment, and slower growth.
This decline of the dollar
might take more than a decade [is happening this year], but it could happen even sooner if we do not get our financial house in order. The United States must rein in spending and borrowing, and pursue growth that is not based on asset and credit bubbles. For the last two decades America has been spending more than its income, increasing its foreign liabilities and amassing debts that have become unsustainable. A system where the dollar was the major global currency allowed us to prolong reckless borrowing. [it is far too late for the US dollar to avoid losing its reserve status]
Now that the dollar's position is no longer so secure, we need to shift our priorities. This will entail investing in our crumbling infrastructure, alternative and renewable resources and productive human capital — rather than in unnecessary housing and toxic financial innovation.
This will be the only way to slow down the decline of the dollar, and sustain our influence in global affairs. [There is nothing at this point which can prevent "the decline of the dollar" or "sustain our influence in global affairs."]
The New York Times reports about China's changing view of the dollar.
What many don't remember is that for years, there was either a shortage or a feared shortage of American dollars. In the 1980s, for example, the government required everyone to convert dollars into the Chinese currency, the renminbi, which literally means "people's money." As a result, American gold [ie: US dollars] became a status symbol. Despite the mandatory conversion into renminbi, many people held onto their dollars, or bought them at inflated exchange rates, if they could find a seller at all.
No one knows for sure when the tide started to turn, or the exact moment when American gold started its slow but seemingly irreversible loss of luster. But now, many shops in China no longer accept dollar-based credit cards issued by foreign banks (the customer pays in dollars, but the shopkeeper is paid in renminbi) and foreigners cannot convert American dollars into renminbi beyond a given quota.
In the past, people held dollars for no immediate purpose. Today, they are more likely to keep them only if they need them to send their children abroad for school, travel or to do business in another country. Over all, the government is becoming more worried about the safety of its investments in the United States, which are largely in Treasury bonds and quasi-sovereign securities issued by Fannie Mae and Freddie Mac.
Beijing recently called for a greater role in international trade for the special drawing rights currency of the International Monetary Fund. But China is also fully aware that the United States can veto an I.M.F. decision. China's call was more meant to sound an alarm to the United States.
Many Chinese people increasingly fear the rapid erosion of the American dollar. The United States may want to consider offering inflation-protection measures for China's existing investments in America, and offer additional security or collateral for its continued investments. America should also provide its largest creditor with greater transparency and information.
My reaction: China has lost confidence in and is moving rapidly away from the US dollar.
1) Dollar pegs prevented a necessary adjustment in the dollars' value relative, and this lead to a change in the composition of US output: the US shifted out of the production of tradable goods and services and instead specialized in home construction and creative financial engineering.
2) Once China's population discovered the risk associated with holding huge sums of foreign assets, they weren't happy. A recent Chinese bestseller called "currency wars" is evidence of this displeasure.
3) US can't stop the formation of an Asian reserve currency.
4) I wouldn't say that the next century will be dominated by Asia, but China will definitely play a much more prominent role (and the US will play a much less prominent role).
5) When China and other countries diversify their reserve holdings away from the dollar, the United States will suffer drastically.
6) China has already taken many steps towards making the yuan into an international currency:
7) Thirty years ago, the dollar was a s tatus symbol in China.
8) Today, Chinese people increasingly fear a rapid erosion of the American dollar.
Conclusion: Because the yuan is so undervalued, virtually every country in the world is running a trade deficit with China right now. Since trades with China are settled in dollar, nations running these trade deficits need dollar reserve fund them. So right now, China's trade surplus is supporting the dollar. If China starts settling trades in yuan, that support will be gone, and the dollar isn't strong enough to survive losing it.
In summary, a move by China to settle all trades in yuan, like discussed in the articles above, spells doom for the US dollar.