Creditors through the ages haven’t liked to take policy advice from debtors. They generally tend to think that borrowers should listen to the advice offered by those lending them money. And they often think debtors fail to pay sufficient attention to the concerns of their creditors when formulating economic policies.
China believes that the US hasn’t paid enough attention to the dollar’s value. That isn’t exactly news. Wen more or less said as much in November. Nor should any American be surprised that China no longer the US financial sector offers the best model for the future development of China’s own financial sector. Securitizing risky mortgages loans into complicated financial structures no longer looks like the highest stage of financial evolution.
But I was still struck by Edward Wong’s front page New York Times article several weeks ago. It highlighted China’s new assertiveness -- and China’s increased willingness to criticize US economic policies.
Steven Weisman’s C section article that followed the completion of the Strategic Economic Dialogue wasn’t that different than Edward Wong’s big front page story. The governor of China’s central bank now argues that China needs to learn from the United States’ mistakes as well as its successes. Clever rhetoric. Those who think that the United States needs to learn from its own recent mistakes would have trouble disagreeing with Mr. Zhou.
These articles raise some fundamental issues about how China’s economic and financial relationship with the US will evolve. Right now China has lent -- according to the US data -- about $1.1 trillion of its savings to the US. Realistically, it has lent a bit more -- let’s say $1.3 trillion. The US data tends to undercount Chinese holdings of US assets.
That is a large sum by any measure -- it is roughly 10% of US GDP, and it is more like 30% of China’s GDP. given the extraordinary pace of growth in China’s foreign assets -- and its large current account surplus -- China’s financial exposure to the US is set to increase rapidly.
Many -- see Gideon Rachman as well as the FT’s Alphaville -- have argued that the growth in financial interdependence between the US and China will reduce political tension between the two. China has a large and growing financial stake in the US economy; the US relies on Chinese financing. Their economic interests consequently largely converge.
I was never fully convinced by this line of argument. The United States and Latin America were financially intertwined for much of the twentieth century. That didn’t mean that the US and Latin American countries always saw eye to eye. Latin debtors and their American creditors often had different interests. That created conflict, or at least tension, in the United States’ relationship with Latin America.
This is true more generally: creditors and debtors often have conflicting interests.
For example, China would like to see the US place more of a priority on maintaining the dollar’s external value -- and thus the value of China’s large dollar holdings. That is code for higher US rates. Higher US rates would also make the PBoC’s life easier by reducing the incentive to sell dollars and buy RMB. Falling US rates have combined with the RMB’s appreciation against the dollar to pull huge sums of hot money into China.
The US would prefer to direct US monetary policy at stabilizing the domestic US economy rather than stabilizing the dollar’s external value.
Other areas of potential conflict also aren’t hard to see. The US may believe that China’s institutions for managing its governments external investments should converge with US norms for managing public money (think the norms governing state pension funds or Alaska’s permanent fund). China may prefer to develop its own institutions for managing its external investments -- institutions that, for example, may be more inclined to support state firms as national champions than comparable pools of public money in the US.
The US might change its domestic financial regulations in ways that reduce the value of Chinese investments in US financial institutions. Or it could refuse to bailout a bank or broker dealer that China has invested in. CITIC, remember, came close to buying a small stake in Bear Stearns.
Or China may simply want to buy assets that the US doesn’t believe China’s government should own.
China’s policy makers face a particularly difficult challenge. They have invested an enormous share of China’s savings in low-yielding, fairly long-term, dollar-denominated bonds. The value of those bonds -- expressed in RMB -- is likely to fall over time. Those losses are the cost of subsidizing China’s exports. They were baked in, so to speak, when China decided to hold its currency down and thus overpay for US financial assets.
As Dean Baker noted a while back, Chinese policy makers knew full well that they were taking on the risk of huge (paper) losses when they bought so many dollars. They effectively choose to take large financial losses rather than allow the RMB to appreciate to its market value.
But it isn’t at all clear that China’s public expects to get hit with the (deferred) bill for the last six years or so of export subsidies -- and is willing to swallow the huge losses that will be revealed as China lets its currency appreciate relative to the dollar and euro. We can debate whether or not these losses are real or not some other time. Central banks can operate with negative capital, so China doesn’t need to issue bonds to recapitalize its central banks and "realize" the loss any time soon. But it seems clear -- at least to me -- that there is an opportunity cost associated with using the funds raised by issuing RMB bonds to buy depreciating dollars rather than make domestic investments. And for that matter an opportunity cost associated with holding large government deposits at the central bank (rather than spending those funds at home) to help sterilize rapid reserve growth.
When those losses are realized, there will be a strong temptation for China’s policy makers to argue that the losses reflect bad US economic policy -- not bad Chinese currency policy. That worries me.
There are many ironies in the current situation.
The US still acts more like a typical creditor than a typical debtor.* It believes other countries should adopt its economic model to succeed. But if China adopted the US practice of allowing its currency to float, the US might lose access to the financing that allows it to sustain large deficits at low cost. Even analysts -- like me -- who believe adjustment is essential don’t want it to happen over night.
China increasingly argues that other countries should emulate its own economic policy mix. Yet it isn’t clear that it really wants the rest of the world to model all their policies on China’s own policies. If the US adopted China’s restrictive policies toward foreign portfolio investment or China’s policy of limiting foreign firms ability to take over existing Chinese firms (as opposed to making greenfield investments), China’s government would face serious limits on the kind of US assets it could buy ...
* In some ways, the US is a creditor. It has a large accumulated stock of foreign assets - and many Americans want the opportunity to trade some of their stock of existing US assets for assets abroad. In that way, it has much different interests than many other big debtors. But it unquestionably is a big global borrower too.