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Different conceptions of China’s future role in the global financial system

May 15, 2009

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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 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. 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 – 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 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. 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.

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 capital 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.

* Nouriel was spoofed on SNL. That is far more impressive than making the New York Times oped page ...

** Economists who I highly respect argue that central bank purchases displaced private flows. In their view, in the absence of large scale official demand, private investors would have bought more US assets -- and the overall equilibrium would not have changed all that much. Consequently, they argue that it is inaccurate to attribute the United States’ ability to finance deficit of the scale observed over the past five years directly to central banks’ willingness to accumulate dollar reserves. The precise way the global economy would have adjusted in the absence of the large observed build-up of dollar reserves is undoubtedly a complicated question.

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