from Follow the Money

Creditors, Debtors, Partners, Strategic Rivals, Mallaby, Pesek

June 7, 2005

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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Sebastian Mallaby is tired of the US blaming China for its own problems -- and notes, correctly, that the US hasn’t been terribly responsive to international criticism of its own policies.

But who does have a perfect record, anyway? Not the Europeans, whose inflation-fighting sado-monetarism holds back global growth. Not the Japanese, who are the kings of farm protectionism. And not, for that matter, the U.S. Congress itself. What’s Congress doing about the U.S. budget deficit, about egregious farm subsidies or about the scandal of U.S. anti-dumping laws that are rigged against foreigners? No more than China is doing about its problems, actually.

William Pesek suggests that Asia is getting tired of financing the US -- though it is hard to see the evidence if you look at US interest rates, or at foreign central bank purchases (Federal Reserve data from Cynics Delight). But Asia certainly is getting tired of receiving lectures from the US. Creditors generally don’t like debtors telling them what to do.

Don Rumsfeld thinks the US should be able to throw "rods from God" -- i.e. have satellites that hurl Tungsten-Uranium rods down toward earth that would strike with the force of a small meteor. But Chinese missile development threatens to alter Asia’s geostrategic balance. Leaving the merits of the debate aside, the inequity clearly grates on the Chinese.

The US intends to manage its relationship with China by keeping each issue in its own lane. North Korea is one lane. Human rights occupy one lane. Pentagon military planning is in another. Changing the peg is yet another lane.

A policy of "lanes" works for the US. In the Pentagon, China can be the United States’ new strategic rival ; over at the Treasury, the People’s Bank of China can be most important buyer of US debt (The Bank of Japan still holds more Treasuries, but it ain’t buying any more right now). China may not be so keen to keep every issue its own lane forever though.

Roach correctly notes that the absence of real wage growth is undermining support for globalization and trade in the advanced economies (See the Angry Bear for more). For another possible "fat tail" kind of event that risk management systems don’t pick up, the overlap between "Strategic rival/ no friend of freedom" and "Biggest creditor/ key source of support for the mortgage market" still strikes me as a good place to look.

As much as I enjoyed Sebastian Mallaby’s final paragraph -- the phrase "inflation-fighting sado-monetarism" is wonderful -- I think Mallaby lets China off a bit too easily.

(Continues)I had three specific problems with Mallaby’s argument.

1) It is true that China is not Japan or Korea - it does not try to keep foreign firms out. Rather China does the opposite: it gives FDI far too generous a deal -- distorting the global economy.

There is a reason why American (and other firms) love doing business in China, even though (still Communist) China doesn’t allow private ownership of land, has a state-controlled banking system and lacks functioning debt or equity markets.

China gives plenty of breaks to foreign investors, at Yusheng Huang noted last week:

the Chinese government has historically favoured foreign business over domestic. ... The policy biases in favour of foreign investors are real and substantial. In 2002, the state-owned banking system lent Rmb172bn to foreign companies operating in China. In the same year, its loans to the domestic private sector amounted to just Rmb39.2bn. In any other country, it would be unimaginable for a government to treat its own entrepreneurs so shabbily. .

And by intervening massively to keep its exchange rate (and local wages down), China provides a huge subsidy to foreign investors who use China as an export platform (along with Chinese firms who export). US firms get vendor financing to help them sell their Chinese-made goods back to the US. China’s workers get lower wages in dollar terms (today), and the tax bill for the exchange rate intervention needed to provide this subsidy (tomorrow).

US trade policy has its problems -- we in no means practice the free trade we preach. But the Chinese are also no saints -- big interests with big money at stake that don’t want upward appreciation in the renminbi for rather mercantilist reasons. China no longer is a poor country off the beaten path of global capitalism struggling to attract foreign investment -- it no longer needs to offer this kind of sweetheart deal to foreign direct investors.

2) If the world’s largest economy is running a current account deficit of 6.5-7% of its GDP, almost by definition, no one country’s current account surplus will provide the bulk of the financing the world’s largest economy needs. Right now, pretty much anyone in the world who does not speak English (or Turkish) is running a current account surplus and sending to the US to finance the US deficit. China’s role is far larger than Mallaby suggests. China ran a significant current account surplus in 2004, despite being in the midst of an investment boom -- the kind of investment boom that normally generates a current account deficit. And now that the boom is fading, it is set to run a 7-8% of GDP current account surplus in 2005 even with oil at $50-55. China’s current account surplus is likely to be closer to $150b than $50b in 2005.

Moreover, China’s reserve accumulation -- something Mallaby does not mention -- far exceeds its current account surplus, and its reserve accumulation ($200b in 04, maybe $300 b in 05) provides a better proxy for China’s role financing the US deficit. China does "contributes in a major way to the U.S. trade deficit" -- it finances it.

3) Mallaby argues that China is trying to play by the "rules." Alas, I did not realize spending nearly 15% of your GDP to add to your reserves when your reserves already more than meet every test of reserve adequacy was consistent with the "rules." Moreover, I would argue the implicit postwar norm was that the major economies did not run trade deficits as large as the United States current trade deficit, or trade surpluses the size of China’s expected 2005 surplus. Both countries are playing with fire.

Mallaby leaves a sense that the core problem facing the US is how to transfer workers in protected, uncompetitive sectors like textiles into other lines of work. Looking ahead, though, I suspect the far bigger challenge will come from the need to transfer workers out of sectors that benefit from the United States current tendency to export debt to China (real estate) into sectors that export goods, or services, to China -- or to countries that themselves export to China. Mallaby focuses on what be termed "legacy" adjustment problems, like textiles -- not the looming adjustment facing the US economy should we ever have to pay for all our imports with real exports, not IOUs.

Mallaby’s piece makes the right noises on the need for China to revalue, but he did not convey -- at least to me, any real sense of urgency, or a clear sense of the risks posed by unprecedented trade and savings deficits on one side the Pacific, and unprecedented surpluses on the other. Roach’s latest missive, on the other hand, clearly did.

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