from Follow the Money

Why is China’s government trying so hard to hold down China’s current living standard? And investing so much of China’s savings in depreciating assets?

February 28, 2007

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Dr. DeLong is engaged is a rather spirited debate over at TPMCafe – one that mirrors the debate inside the Democratic party.  It is a debate over trade, but it also is a debate over US grand strategy toward China’s rise.  

DeLong argues that the United States has a compelling national interest in helping China get rich:

There is nothing more dangerous for America's future national security and nothing more destructive to America's future prosperity than for Chinese schoolchildren to be taught in 2047 and 2071 and 2075 that America tried to keep the Chinese as poor as possible for as long as possible. 

DeLong’s position – that the US needs to position itself as a friend of  China’s economic development -- is an appealing one.  But it is also one that I suspect glosses over some big issues.  

Both the US and Europe, which has stood by as China actively drove the RMB down v the euro, have done their part to support China’s development over the past few years.   US imports from China have increased from $100 b in 2001 to $280b in 2006 (overall US imports from Asia are also rising as a share of US GDP; China isn’t just taking market share from others in Asia).  Eurozone imports from China have gone from 62b euros in 2002 to something like 130b euros, maybe a bit more, in 2006.    In dollar terms, the increase in European imports from China is far more impressive.   Think of a rise from around $50b to over $160b.  Both the US and Europe have supplied a lot of demand for Chinese goods over the past few years.

The risk of a protectionist backlash is no doubt rising.  But so far, the US hasn’t taken any policy actions that have really crimped the expansion of China’s exports – which is what I think worries DeLong.   Nor for that matter has the US government done much – if anything -- to help in the US whose living standards have been adversely affected by China’s export success.   DeLong and Jeff Faux would both agree that tax cuts for the have-mores whose assets are worth even-more thanks to large financial inflows from China doesn’t count. 

The government of China, by contrast, seems determined to keep China poorer than it needs for to be.  After all, the government of China, not the government of the US, actively intervenes in the market every day to hold China’s living standards down – or, if not China’s living standard, certainly the external purchasing power of all those paid in RMB.   

A few years ago Jeff Frankel looked at the gap between China’s market GDP and its purchasing power parity (PPP) GDP.   In general, the market GDP of developing countries is well below their PPP GDP.    But China’s market GDP even then was far below what one would expect for a country with its level of development.  In 2000, its prices were 23% of US prices, while the model predicts its prices should be closer to 36% of US prices (see p. 14)  

I strongly suspect that updated data would show that the gap between China’s PPP GDP and its market GDP remains very, very large.    Since 2001, China’s exports have basically quadrupled, Chinese productivity has shot up, the set of products that China produces has expanded dramatically and the external purchasing power of the RMB has fallen. If China’s government stopped intervening and allowed the RMB to rise, the ratio between China’s market GDP and its PPP GDP to rise to a level more typical of other emerging economies with comparable levels of development.  

China’s government has had a policy of, in effect, subsidizing the use of Chinese labor for the production of goods for export.   It doesn’t just intervene to hold down China’s exchange rate – subsidizing both Chinese and foreign investment in China’s tradable sector.  It also offers foreign investors more favorable tax treatment than domestic investors. 

The enormous explosion in Chinese exports – and Chinese value-added – hasn’t just impacted the US and Europe.   It also had a big impact on many emerging markets.    China subsidizes – through its exchange rate intervention – the global consumption of Chinese goods, which leaves producers in other poor countries whose governments don’t offer a comparable subsidy at something of a disadvantage.    Chinese exports have increased from about around $265b in 2001 to about $1,000b in 2006 – and are poised to rise to $1,250b in 2007.  

Now you can argue that this policy of holding down the external purchasing power of China’s workers has worked.   Real living standards in China are growing strongly.  Chinese consumers may not be able to afford foreign goods or foreign vacations, but Chinese firms are producing more and Chinese consumers are consuming more. China is a far richer place today than it was a few years ago – even if nearly all analysts think Chinese labor’s share of Chinese GDP is shrinking.  

All true.   But China’s policy of buying dollars (and to a smaller degree euros) also means that China is sinking a growing share of its national wealth into a set of assets that are almost certain to depreciate over time.  There is a lot of talk of the China price – but there also should be talk of the China bid.    

China – counting likely flows from Chinese banks as well as flows from the PBoC almost certainly bought about $200b of US debt in 2006.   It paid – in RMB terms – a lot for those assets as well: China effectively has a policy of under-pricing its labor and overpaying for its external assets. 

The sums involved are not trivial.  China is now running a current account surplus of around 10% of its GDP.    That implies that about 20% of China’s annual savings (China saves, ballpark, 50% of its GDP) is being invested in assets that are likely to depreciate over time.   It is actually a bit bigger, since China also uses funds flowing into China looking for a big payoff to buy low yielding US assets.  Barring Chinese policy changes, the amounts will only get bigger.   China’s government effectively now has a policy of both holding China’s current living standards down and sinking a fairly large share of China’s savings into assets that are sure to lose value – in RMB terms – over time.

At some point, China will scale back its intervention and the RMB will rise far faster than it has so far.  The capital losses could destroy the PBoC’s formal capital: borrowing in RMB, even at an artificially low rate, to buy depreciating dollars isn’t a winning financial strategy.  If the PBoC follows the example of Bank Negara Malaysia, and tries “win it back” by betting on various market moves, it might end up losing even more.

That worries me.   When the time comes for China to realize the losses that are now accumulating quietly on the PBoC’s balance sheet (and soon on the balance sheet of the state foreign investment company), I doubt China’s leaders will say, “you know, these losses were really incurred years ago, when we decided to sink a lot of Chinese savings into depreciating dollars in order to encourage our export sector and make it attractive for foreign firms to locate investment in China.  We shouldn’t blame the US for the fact that China’s investments in the US haven’t done well.  We were the ones who over-paid for US assets.”   

I suspect China’s leaders will be somewhat less magnanimous.   They will argue that the losses didn’t stem from China’s policy over-paying for US assets, but rather from the failure of the US to adopt the policies needed to maintain the value of Chinese investment in the US.

I have seen this before.   Who is responsible for the big losses when an investment goes bad, the lender, or the borrower?  Think of the debate over Argentina.   Is the bond market at fault for  lending foolishly to back an unsustainable dollar peg?  Or the Argentines, for not adopting economic policies that would have provided their creditors with a bigger real return? 

Conversely, I worry that at some point, China will conclude that investing so much of its savings in the non-tradable part of the US economy isn’t the best way of building Chinese wealth, and the flow of funds will stop.     If that process is gradual, it will be for the best – but it if it is sudden, well ...  a lot of US workers now employed in the non-tradables sector will need to shift into tradables production, pronto.    DeLong

In this alternative scenario, the U.S. has to move about ten million workers out of currently-favored sectors--construction, home-equity-credit financed consumer expenditures, and so on--into export and import-competing manufactures. How much structural unemployment does such a sectoral shift require, and how long does the structural unemployment last? Other countries have to shift up to forty million workers out of export manufactures into other industries, and to generate demand for the products of those industries

If that process isn’t smooth, I rather suspect the US won’t say, “You know, we got an awful good deal from China for all these years.   Rather than complain about the costs of the transition that followed the end of Chinese financing, we should thank China for selling us so many goods at such generous prices, lending us so much on such generous terms, and for helping keep the profits of US firms up for so long by underpricing its labor.”   

There is one big difference between the UK and the US back when the US was the rising power and the US and China today.    Back when the UK was wealthier than the US, it was the creditor, lending to support the United States development.  Right now, China is the creditor, lending to support the United States ….well, I guess you could say the United States development.   

But it is development of a very specific kind.  The development of new kinds of financial engineering.   The development of a lot of suburban real estate, to be sure.   The development of new means of leveraging up any asset that is insulated from Chinese competition and delivers a steady cash flow:  Think urban office towers filled with bankers repackaging residential mortgages into safe tranches that can be sold to the People’s bank and not-so-safe tranches that, well, are no longer so easy to sell.  China certainly hasn’t been financing investment in the US tradables sector – yet eventually, the US will need to produce something other than IOUs (and a few planes) that it can sell to pay back its Chinese creditors. 

DeLong has in the past argued that the US should aim to try to replicate its post-war success at creating a liberal international economic order.   The new liberal international economic order though would extend beyond the US, Europe and a few islands in East Asia.  It would in effect, draw in the big population centers of the Asian land mass as well.   

That is a very appealing vision – one that I think is very widely shared.    By the party of Davos.   But not just by the party of Davos. 

I worry, though, that the conditions that allowed the US to construct a liberal international order after World War 2 no longer exist.    In the 1940s and 50s, the US ran a current account surplus, so it was financing the rest of the world (Europe, most notably).    US imports and exports were small as a share of its GDP, so there was a lot of room for both to rise as a share of GDP.

Right now, though, the US is a net debtor.  So far, it has been able to finance large deficits primarily by borrowing against the rising value of the external assets that it accumulated in the past.   So its net debt hasn’t increased.   But that won’t last forever.  European markets won’t consistently outperform US markets.   And China now wants to buy the United States external assets, not just lend to the US against their rising value.    

Moreover, the US now imports something like 17% of its GDP and exports about 11% of its GDP.   The scope for US imports to continue to grow faster than US exports and for the gap between imports and exports as a share of GDP to widen seems limited.   

In 20 years, both imports and exports may be 25% of US GDP, bring the US trade deficit down to zero and stabilizing the US external debt – that implies far faster growth than US exports than imports, and a big change from the post war order. 

In a sense right now, rather than having a Marshall plan, where the US – at the time the US public sector – financed the reconstruction of Europe on very generous terms while opening its markets to European goods (creating the conditions that allowed Europe to repay the US loan), we have something that looks like a Marshall plan in reverse.   Or maybe half the Marshall plan -- China doesn't seem to have given much thought to how the US will pay it back.

China’s public sector is, as a matter of policy, providing subsidized financing to the US.  The reverse comes because China, still a very poor country, is financing the still very rich US.   Bretton Woods 2 is very, very different from Bretton Woods 1.

I am convinced the post-war analogy doesn’t quite fit.  But I also don’t have a better one to suggest.

UPDATE: DeLong responds (sort of).  I would be interested in his response to my argument that the current system looks set to lead to future tension between the US and China, with the Chinese arguing that the large losses they are likely to eventually take on their dollar holdings are the fault of the United States.  The Chinese argument won't be totally false either -- the US is unlikely to run its domestic macroeconomic policy to try to maintain the dollar's external value.   But then again, the US has never hinted that it would.

To be clear, I don't want Chinese exports to fall -- that would imply some kind of disorderly adjustment.  But I do believe that China should allow the RMB to appreciate to slow the pace of Chinese export growth -- and that China should no longer rely on net exports for a fraction of its growth.  Indeed, it would be nice if China supported global demand growth for a while, and Chinese imports grew faster than its exports. 

Josh Bivens (or is it Max?) also has some interesting thoughts -- I completey agree with the argument that China's peg has become a growing constraint on the policy choices of other emerging economies. 

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