from Follow the Money

Retired Wall Street Titans (and the renminbi-dollar)

December 9, 2004
2:51 pm (EST)

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

Henry Kaufman’s name sits on the building where I work. If nothing else, that means you tend to take notice of his opinion.

He nicely summarizes why many believe the dollar won’t fall much further, or perhaps why the dollar remain the world’s reserve currency even if it does fall a bit further: the US remains the world’s leading power, and with power comes privileges, like issuing the world’s reserve currency; the US remains a more attractive place to invest than slow growing Europe and Japan (and US interest rates are now higher than European interest rates); and China and the rest of Asia will continue to keep financing the US so the US will keep buying their goods.

All fair points, even if I disagree with most of them. I would note that the "growth" argument is not necessarily convincing. Thailand was growing more rapidly than Japan before its crisis, and correspondingly needed external financing and was running a current account deficit. Its strong growth did not guarantee that the financing would always be available. A country that is borrowing from the rest of the world will see the value of its currency fall if the financing it needs is not available, no matter what the growth trajectory of the two countries. Either someone lends the US the $2 billion a day we need, or they don’t; if they don’t the dollar has to fall until we don’t need to borrow $2 billion a day, or US assets look cheap and someone is willing to start buying them again. It is that simple.

Sometimes rapid growth leads to capital inflows, sometimes it leads to worries that the rapid growth is generating a large current account deficit and external debt is piling up too fast ... Different people have different views on when the US is likely to reach the tipping point. Fair enough.

I want to take issue with another of Kaufman’s points: He argues that the People’s Bank of China’s dollar reserves are the perfect asset to recapitalize China’s banks. That left me confused. To my knowledge, Chinese banks generally take in deposits in renminbi and make loans in renminbi. If the renminbi loans go bad, they have more renminbi deposits than performing renminbi loans, and need to be recapitalized. But why is a dollar-denominated US agency bond a better asset to recapitalize these than say a renminbi bond? The dollar asset is being held against a renminbi deposit, and if the dollar’s value falls against the renminbi (as it must over time, given China’s productivity growth and the US current account deficit), then the value of the banks assets will fall while its liabilities would remain constant. It seems to me that a renminbi bond would better match the banks assets and liabilities.

Chines banks to have domestic dollar and other foreign currency deposits, but lots smaller than reserves -- and overwhelming majority of deposits are in renminbi.

That brings me to another point: it is often said that China cannot adjust its exchange rate because its financial system is not ready. I can see why the poor state of its financial system precludes moving to a managed float. That might lead to the development of a forex derivatives market to help firms hedge their exchange rate risk, and China does not want its banks to do something really dangerous, like betting on the forex market, rather than do things which or only slightly less dangerous, like bet on Shang Hai real estate. But I don’t see why the banks current poor health precludes a simple renminbi revaluation. To my knowledge, the state owned banks have not borrowed in renminbi to invest in dollars. Only the People’s Bank of China is stupid enough to that. So their balance sheets would not be directly affected by a renminbi revaluation.

Now, the banks’ balance sheets might well be hurt if the revaluation led to a slowdown in the chinese economy, and some of the firms who have borrowed renminbi to build factories to produce for export to the US find their investment is less profitable than expected. Or for that matter, if slowing investment and weakening growth pop China’s real estate lending bubble. But that is a broader question: it is not China’s banks that are unprepared for a revaluation, so much as China’s entire economy.

It is certainly possible that too much Chinese money is being invested in the expectation that:

US consumption will continue to expand faster than US income (i.e. US external debt will keep on rising) and US imports will continue to grow faster than US exports, at least in dollar terms (i.e. the US trade deficit will keep on rising).

US imports from China will continue to grow faster than overall US imports (i.e. China will account for a growing share of the US import market). And therefore Chinese exports to the US can continue to grow faster than China’s overall economy, and thus make up an ever increasing share of China’s GDP.

But I would submit that all these assumptions will prove to be wrong -- that some slowdown in US import growth has to be part of US external adjustment. China’s market share will likely keep on rising, but its rise will require taking market share away from someone else -- and its market share probably won’t keep on rising at its current torrid pace. US imports from china doubled between 2000 and 2004, going from $100 to $200 billion. I don’t see them doubling again -- going from $200 billion to $400 billion -- over the next four years.

My point: While China may be unprepared to accept the economic costs of changing its exchange rate regime now, those economic costs are not going to get smaller over time. Not only will the PBoC’s dollar reseves grow, increasing its future losses -- but if the investment boom in China’s export sector continues, China’s private sector also may be making investments based on unrealistic expectations about the future growth in the US import market. And to the extent they are borrowing from the banks in renminbi to finance that investmest, the banks are not going to be in a better position two years or four years from now than they are now.