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No one forced China to import US monetary policy: Commentary on yesterday’s China commentary

October 24, 2005

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Andrew Browne did something somewhat unusual in Monday's Wall Street Journal (see p. A2 of the print edition, unfortunately, I have not been able to find the link). He wrote about China, and got the key facts right.  

As he noted, China's demand for imports collapsed in 2005, largely because of the "2004 government crackdown on investment."  And as a result, China  provided far less impetus to the world economy.   China's impact on commodity exporters - so far the big winners, along with the US government (cheap financing) from China's boom - is less positive than it was in 2003 and 2004.  Continues.

There is a reason why Brazil - which unilaterally opened its market to Chinese goods in the hopes of reaping a big investment windfall - is now feeling a bit disillusioned.  Chinese goods are competing with Brazilian goods, and the huge investment boom Brazil anticipated has yet to materialize.  Brazil now seems likely to pull back a bit, and impose a few more restrictions on Chinese imports.  I guess higher iron ore exports don't fully compensate for job losses elsewhere.

Browne is right on another point as well: there are some signs that Chinese demand is bouncing back.   That could help to limit the building global concern about China's impact on the world economy.  If Brazil is having second thoughts, lots of others are too ...

And guess what happens when you invest over 50% of your GDP?  Capacity increases fast.  This is incredible: "UBS estimates that China will add about 80 million tons of steel capacity this year as a result of frenzied overinvestment.  That is 1 ½ times South Korea's overall capacity and three quarters of US capacity."  Amazing.

That brings me to Bill Pesek, who blames Greenspan for China's investment boom:

One of the more obvious manifestations can be found in China. In 2003, Andy Xie, Morgan Stanley's chief Asia-Pacific economist, noted that speculative capital flows into Asia had reached a record high, surpassing the previous peak in 1996, just before the Asian crisis. In 1996, the big recipients of capital were South Korea, Hong Kong and Southeast Asia. In 2003 it was China, and it still is. Like the capital destinations of the 1990s, China experienced an investment bubble.

The surge in speculative capital began in 2001, a year in which the Fed began a campaign of cutting rates to 1 percent to stimulate growth. Like clockwork, China's foreign-exchange reserves rose by more than its trade surplus for the first time since 1996. The inflows picked up speed and reached records by 2003.

I generally agree with Pesek that China burgeoning reserves are distorting US financial markets, driving down yields, encouraging investors to reach for yield (and sell insurance against large risks cheaply) and generally magnifying the impact of (still relatively loose) US monetary policy.  Indeed, I almost have to agree with Pesek on that -- I am one of his sources on that point.

But Mark Thoma is also right: the Fed's job is to set monetary policy for the United States, not for the world. 

And nothing required China to import US monetary policy over the past few years.   Chine choose to tie its monetary policy to that of the United States by fixing its exchange rate to the US. 

And by keeping that peg even as US economic conditions changed, the Fed aggressively cut rates and the dollar started to fall (v. Europe), China imported a monetary policy that was right for the US but wrong for China.  That is not Greenspan's fault.

One interesting asymmetry: with an undervalued fixed exchange rate, China can have a looser monetary policy than the US.   Right now deposit rates in China are lower than the Fed funds rate, and, at the margins, domestic depositors are still shifting out of dollar deposits and into renminbi deposits because they expect a renminbi appreciation.   And China certainly has loosened monetary policy this year by sterilizing less of its (massive) reserve increase ...

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