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Different conceptions of China’s future role in the global financial system

by Brad Setser
May 15, 2009

Discussions of China’s role in the world that aren’t dominated by economists often end up focusing on China’s willingness to act as a “responsible stakeholder” in the global system. That is diplomatic code for China to do more to support the current international financial and political order that it has — in this view — helped support China’s rapid development.

This framing though assumes something that I am not sure is true, namely that there is a deep consensus on what constitutes a stable international financial order and thus consensus on what China needs to do if it wants to integrate more fully into this order.

The current order, after all, isn’t really defined just by existing institutions like the IMF; the key questions go far beyond China’s willingness to contribute more to the IMF in exchange for a few more votes.

To put it concretely, is a stable international financial order one defined by large-scale Chinese financing of the US, in dollars, to sustain a large US current account deficit – whether one that reflects a large deficit among US households or a large US fiscal deficit?

Or is a stable financial order marked by floating exchange rates among the world’s major economies, limited build-up of reserves and modest current account deficits (and surpluses)?

In the first conception of global financial order, China should continue to peg to the dollar, adopt policies that restrain domestic demand growth to avoid domestic inflation if the dollar is weak and run up large dollar reserves. That policy mix would produce large current account surpluses – and allow China’s government to continue to provide large amounts of financing to the United States. Call it Bretton Woods 2 bis. China’s current $1.5 trillion or so dollar portfolio would double over the next four years, to about $3 trillion – and keep on rising after that. The current crisis doesn’t – according to this view – signal that there is anything fundamentally wrong with a world where a poor country like China finances a rich country through the United States as a result of a policy of holding its exchange rate down to support its export sector. See Michael Dooley and Peter Garber for a forceful statement of this view combined with plenty of sharp criticism of those who have criticized Bretton Woods 2.

In the second conception of global financial order, China should allow its currency to appreciate, offset the drag from slower growth of exports with aggressive policies to stimulate domestic demand (including the rapid implementation of a broad social safety net, even if this produces sustained budget deficits) and bring its current account surplus down. China’s government would no longer steadily accumulate large quantities of dollar reserves. More balanced trade flows would allow the RMB to eventually float – allowing China to direct domestic monetary policy toward stabilizing China’s own economy rather than stabilizing its exchange rate.

The US would get less subsidized financing to be sure – but according to this view, large inflows from China and other emerging economy central banks have proved to be a mixed blessing. Dollar pegs prevented a necessary adjustment in the dollars’ value relative to a host emerging economies, keeping the trade deficit up. That changed the composition of US output, as the US shifted out of the production of tradable goods and services – and instead specialized in home construction and creative financial engineering. And, well, the US financial sector wasn’t able to effectively intermediate large inflows from the world’s central banks. US financial institutions – and European ones running large offshore dollar balance sheets – were stuck with a lot of credit risk from lending to increasingly indebted American households, as the world’s central banks were far more willing to take currency risk than credit risk. And now – as Martin Wolf likes to note – there is a risk that a new buildup of dollar (and euro) reserves will finance an unsustainable buildup of government debt in the US (and Europe).

The apparently cheap credit that the US obtained from the world’s central banks over the past few years – in my view – came at a high price: it masked the buildup of vulnerabilities in the US economy, and likely prevented some natural circuit breakers from kicking in and cutting the housing boom off at an earlier stage. As superstar economist and pop culture sensation Nouriel Roubini* notes in the New York Times, “A system where the dollar was the major global currency allowed us [the US] to prolong reckless borrowing.”

Of course, non-reserve currency countries also sometimes engage in a bit of reckless borrowing. But during the last boom, private creditors abroad generally speaking weren’t willing to provide the US with the low-cost dollar-denominated financing needed to sustain a huge boom in an interest-rate sensitive sector like housing. Over the past several years, net private demand for US assets from the rest of the world fell well short of what the US needed to sustain its external deficit, creating an equilibrium that — in my view** — could only be sustained so long as the world’s central banks provided the US with large amounts of financing.

Nouriel Roubini’s article in the New York Times suggests that China might have a third — and rather different — conception of a stable global financial order in mind. According to this view, China’s basic problem is not that it is running a large current account surplus and accumulating financial claims on the world. Rather, its problem is that those financial claims are denominated in dollars and euros rather than in China’s own currency. If China was lending to the US – and Europe – in renminbi, China could continue to run large current account surpluses without taking on as much financial risk as it is now. If the US was required to pay China RMB, not dollars, China wouldn’t need to worry about a bout of inflation in the US that led the dollar to depreciate – or for that matter a dollar depreciation that wasn’t the product of a rise in US inflation. All China needs to do then, is to convince the US to start selling it RMB denominated Treasuries and Agencies – or, for that matter, find other borrowers willing to sell China RMB denominated debt to finance their trade deficit.

That conception of global order though isn’t one that appeals to the US. It implies that US borrowers would need to take on the risk of dollar depreciation that China now assumes. That would make sustained US deficits – and the associated buildup of US external debt — far more risky.

That highlights the ambiguities the United States’ faces in a world where emerging markets want to hold huge amounts of reserves – and where most of those reserves are in dollars.

The scale of their demand for dollars potentially creates problems for the US – as the external surpluses that often generate large reserve growth imply larger US external deficits than are really healthy. Rapid reserve growth has gone hand in hand with a very rapid large buildup of US external debt. It also implies that much of that debt will be held by states, not by private creditors – which also isn’t a necessarily a positive. A deficit financed by a diverse group of small creditors is different than a deficit financed by a few large states.

But the fact that this debt is denominated in dollars is an enormous advantage for the US. The US also benefits from a world where the dollar generally rallies in times of financial – and geopolitical – turbulence. The current financial crisis would have posed more acute dilemmas if it had been accompanied by a dollar crisis. A geopolitical crisis that resulted in a massive dollar selloff also would challenge the US in new ways, as over the past fifty years the US has generally benefited from safe haven flows in times of global political stress.

China’s evident discomfort with its dollar exposure could push China to accept a stronger RMB and a smaller current account surplus. That would limit the buildup of dollar risk at China’s central bank – and at China’s sovereign fund. China would still hold a large dollar portfolio, but its dollar portfolio wouldn’t need to grow. The US dollar would remain the world’s leading reserve currency. But the stock of global reserves wouldn’t grow at the same incredible pace as it did in the past five years. A world where central banks are adding $75-150 billion a year to their dollar reserves – and providing the US with modest amounts of financing – is rather different that a world where central banks are providing the US with $750 billion (or more) in dollar financing.

Once China’s population discovered the risk associated with holding huge sums of foreign assets, they weren’t all that happy. The core trade off associated with Bretton Woods 2 – accepting low yields, and likely large losses in RMB terms, on a huge and growing stock of dollars and euros in order to spur China’s export sector – doesn’t seem to command much political support in China. China, not surprisingly, seems to have concluded that it would like to support its export sector at a lower cost to itself by accumulating RMB rather than dollar and euro claims on the world.

Same Chinese surplus, but less financial risk for China. It isn’t hard to see why that is a vision that appeals to China’s leadership.

The problem of course is that is that China’s own choices more than anything else constrain the renminbi’s ability to serve as a global reserve currency. China’s currency isn’t freely convertible and its capital account is heavily managed. And China’s government doesn’t exactly welcome foreign inflows of any sort — and it certainly doesn’t want to increase its dollar holdings to allow other countries to increase their stock of renminbi denominated reserves. Letting other central banks hold RMB means letting other central banks speculate on RMB appreciation …

That said, it isn’t clear that the US has the ability to prevent the formation of an Asian reserve currency. If say Thailand decided that it wants to hold renminbi-denominated debt as part of its reserves and China was willing to sell Thailand renminbi-denominated debt, the US can hardly stop the transaction.

At the same time, the US shouldn’t welcome a world where Asian countries try to maintain undervalued currencies – and thus run large, sustained external surpluses – while minimizing their risk by running up renminbi and yen denominated claims on the US, Europe and potentially a host of emerging economies.

Here the interest of debtors and creditors are not aligned. Debtors want their debts to be denominated in their own currency, and to carry a low interest rate. Creditors would rather lend in their own currency. The implicit pre-crisis bargain was that the US — the debtor — borrowed more than it should have, but the creditor –China — also accepted more currency risk than it should
have. I don’t see how China can start lending in its own currency without calling the overall bargain into question.

The best solution, it seems to me, is moving toward a world where trade and capital flows are more balanced. Then there would be no sustained need for the governments of the major Asian economies to buildup huge claims on the rest of the world.

One thing is clear: Some big questions about the shape of the post-crisis global financial order have yet to be resolved.

* Nouriel was spoofed on SNL. That is far more impressive than making the New York Times oped page …
** Economists who I highly respect argue that central bank purchases displaced private flows. In their view, in the absence of large scale official demand, private investors would have bought more US assets — and the overall equilibrium would not have changed all that much. Consequently, they argue that it is inaccurate to attribute the United States’ ability to finance deficit of the scale observed over the past five years directly to central banks’ willingness to accumulate dollar reserves. The precise way the global economy would have adjusted in the absence of the large observed build-up of dollar reserves is undoubtedly a complicated question.

44 Comments

  • Posted by bsetser

    djc — no comments cut and pasted from another source please; please respond to my argument.

  • Posted by guest

    At the outset, the most striking noticeable evolution, as the economic congestion evolves is the presence of government funds and states aids in all segments of the economy.
    A rampant nationalisation of the private sector, a de facto nationalisation of the financial markets. Karl Marx is alledged to have proclaimed, an end of the capitalist system to be be marked by a convergence all corporations under one one state umbrella (this may have been an ambition not a natural evolvement)
    Let us face it the private sector has been either misguided with a side effect nationalisation, or misled itself into nationalisation.The foster parents, the states may have to assume a new role.The past achievement was to deflect all management roles and private, social responsabilities to an atomised private sector.
    The resumption of government control of the key components of their economies will require a global view of their funds needs, as the private sector may no no longer be the right conduits. This situation is driving deficit countries to come closer to their creditors and a globalisation of the problems to be addressed with more participants.
    One may read a failure of this capitalist system, and the rebirth of the next one, where central banks and states government will be more careful when shadow managing the economies through collusion with the private financial sector.

  • Posted by Tom

    Thanks for your thought-provoking analysis. Interesting point about how deficits contributed to the substitution of housing and financial engineering for production of goods exports.

  • Posted by Bob_in_MA

    “The best solution, it seems to me, is moving toward a world where trade and capital flows are more balanced.”

    I think it depends what you mean by solution. That certainly would have been the best way of mitigating the current crisis if it had been implemented five or six years ago.

    Of course, we are headed toward a more balanced world economy, whether anyone likes it or not. But it doesn’t really offer a solution to the current situation. Frankly, all the choices are awful.

    Is there really a way to get from the current system to the balanced system that isn’t wrenching and painful? I have my doubts.

  • Posted by jonathan

    1. China should do what it thinks is in its best interests, managing the short versus the long term, because that’s what we do and what everyone else does. Much of the difficulty, IMHO, is cultural and historical; we don’t understand or believe we understand China’s sense of what it wants and we don’t trust them because we think of Mao and the country is still run by the Party. I’m saying, to be clear, that we have a long history with other Western countries and we accept they do what they do in their own interests and thus, in line with some Nobel Prize awards, we have certain rational expectations in those regards. We’re still confused about China and that throws off our expectational ability. What is their balance of short and long? What do they want? What will they do? As Tom Petty wrote, the waiting is the hardest part. It is, not knowing = anxiety. We know what the Germans will do and thus how to live with it. We even know roughly what the Russians will do – because even with their changes they still act like Russia. The Chinese remain a cypher. (But with absolutely fantastic food. I had wok-baked chicken, ma pa tofu and spicy & sour cabbage last night. My mouth is still alive.)

    2. You are completely right that China’s limits on itself prevent the RMB from being the reserve currency. They would need to change their entire attitude toward relative currency value, which means they’d have to see their economy as substantially more mature than we think they see it as. And as authoritarian rulers, they may feel more not less constrained to keep what they perceive as an economic edge in trade terms, simply because authoritarian rulers have no term limits and thus place more value on not losing control. (In a fair election system, parties expect to win and lose. Authoritarians need to win so they value security for their position.)

    3. As a note on Dr. Roubini’s message to the US, I thought he missed an opportunity, that he was quite tame and didn’t write with customary urgency, because he did not speak in direct policy terms that a Congressperson could see acting on. To say we need to change spending because the Chinese will displace us is vague – and maybe a little 1949-ish. Congress is given many reasons why we need to change and they’ve demonstrated many times that high level arguments don’t translate into legislative action.

  • Posted by UBMW

    If we find a way to implement Yochai Benkler style self-management techniques on a global scale, can’t we just do away with all this currency and trade baloney? A planned economy for the entire world. Keep some form of “markets” for those who really really need them, but put keep income/wealth highs and lows within a very narrow band. Then very intelligent people who are being wasted on econ blogs can do things like invent medicines or hardier wheat, instead of worry about the flow of crap around the world.

  • Posted by guest

    UBMW
    Agree but it will always take 20 years to make a doctor, five minutes to make a politician or a banker
    Still have to worry

  • Posted by Moruobai

    Masterpiece

  • Posted by K T Cat

    I would suggest that you are looking at the problem from the eyes of a sophisticated Westerner. What if China’s goal is global domination? What if they’re tired of the US being the global superpower and they want China to fill that role instead? If that’s the case, the Nouriel is right – they’re going to move towards RMB-denominated debt.

    As for having to tease the US into accepting it, what a joke! Like there are options. What will we do, print $2T a year?

    The rest of the world is not Pennsylvania with funny clothes and strange accents. They see things differently and have different goals, goals that can be totally alien to us. (See also: bombers, Islamic suicide.)

    I can see the day coming where they won’t need to go through us to invade Taiwan, they’ll simply tell us to get out of the way or else they’ll crush us monetarily.

  • Posted by Twofish

    I think that Bretton Woods II is dead.

    I don’t know of any Chinese person that thinks at this point it is either desirable or possible to grow through increasing exports. The question is will exports stabilize or will they shrink and I don’t think that this matters much in the grand scheme of things.

  • Posted by Twofish

    K T Cat: I would suggest that you are looking at the problem from the eyes of a sophisticated Westerner.

    Since I happen to be Chinese……

    K T Cat: What if China’s goal is global domination?

    I don’t think that it is. China is very, very nationalistic, it wants to be a great power, but there is no particular desire to expand its influence beyond its borders (although it defines its borders differently than other people). This could change over time, but right not there is no ideology or motivation for China to want to exercise global domination or even to challenge the United States role in the world.

    It’s very common for Americans believe that the US has the best system of government in the world and that God gave the United States a duty to spread its ideals and governmental system throughout the world.

    There isn’t anything like that belief in China. I don’t think that anyone in China thinks that China has anything like an ideal government, or that Mexico would be better off adopting the Chinese political or economic system.

    K T Cat: What if they’re tired of the US being the global superpower and they want China to fill that role instead?

    They (or rather more accurately we) aren’t. As long as the US stops messing with Taiwan or Tibet, no one in China cares what the US does anywhere else.

    K T Cat: They see things differently and have different goals, goals that can be totally alien to us. (See also: bombers, Islamic suicide.)

    The idea that not every country in the world wants to rule the world seems very alien to a lot of Americans. Also one reason that the US will do well is that there are a lot of Chinese and Muslim Americans can that explain these sorts of things.

    K T Cat: I can see the day coming where they won’t need to go through us to invade Taiwan, they’ll simply tell us to get out of the way or else they’ll crush us monetarily.

    I don’t think that anyone in the PRC really wants to invade or administer Taiwan. All people want is for Taiwan to sort of acknowledge that it is part of “China” and which point everything can be resolved over the next century.

    It’s again this misunderstand of motives. In the case of Hong Kong, all Beijing wants is for Hong Kong to wave the same flag, say its part of China, and at that point no one in Beijing cares what Hong Kong does. Same for Taiwan or Tibet for that matter.

    It’s because most people in the US think that their system of government is better than everyone else’s and would impose it on people if they could, so it’s assumed that Beijing has the same motivations, when in fact they don’t.

  • Posted by John McLeod

    Brad, about that cenbank provisioning of financing you mention in connection with your second (**) note, the level may be approaching a climax.

    If you look at all the 480 or so weeks of NY Fed data since Feb 2000, consider the Top 10 biggest weekly increases in Treasury Debt holdings. Of these, 9 lie within the last 10 months (the exception is May 21, 2003 at #8). As well, 3 of them (##2,3,9) have occurred in the last 7 weeks, ##2,3 in the last 4.

    Even considering that I’m not adjusting for inflation here, this has got to be a signal of some sort. Maybe even a bubbly one.

  • Posted by Twofish

    The interesting questions will be one of global corporate and financial governance and control. Essentially who decides what and why. The theory behind the last thirty years was that the world was converging toward something akin to the Anglo-American model of minimal state intervention, and arguing that national governments shouldn’t intervene in markets means that you don’t have think about global finance governance.

    The problem is that this distinction is dead.

    The distinction between “commercial” and “governmental” decision making has basically disappeared. Suppose Shanghai Motors wanted to buy Chrysler. This would be negotiated between the respective governments, with the board of directors of those companies in the background.

  • Posted by zebla

    great, Brad, bright !

    those economic topics look so simple when we read you

    thanks !

  • Posted by Cedric Regula

    On Brad quoting Nouriel on psycho analyzing China’s wildest dream….”If China was lending to the US – and Europe – in renminbi, China could continue to run large current account surpluses without taking on as much financial risk as it is now.”

    Hilarious thought. So I guess the US will willingly step into the role of 1994 Mexico, 1997 Asian Tigers, or 2008 Eastern Europe, and have large foreign denominated claims in a foreign currency?

    Quite a new experience for a reserve currency country. Hope we don’t go for it. I don’t want to have to become an illegal immigrant in Mexico just because the USG starts making me pay my taxes in RMB.

    But anyway, I’m really not sure where things go from here either, but I think inertia plays a big role and the whole world may do a Japanese Lost Decade thing, and creditors in shaky positions get something of a haircut on their “investments” or vendor financing.

  • Posted by OGT

    I was disappointed in Roubini’s NYT piece precisely because he didn’t make the sectoral trade offs clear. Global reserve currency status is clearly a mixed blessing.

    At this point, the US and the world would be better off if a gradual transition to a basket of reserve currencies with the dollar, Euro, Yen, Pound, and, eventually the RMB. US dollar reserve status no longer reflects the relative economic position of the US and as such is unsustainable.

  • Posted by Jian Feng

    Brad,

    It’s hard to balance trade and capital flow when United States does not want China to buy a lot of things. US wants China to become a dollarholder, not really a stakeholder. It is hard for China to rely on the full credit and faith of strangers. China has to run its own banks rather than watching other people’s banks printing IOUs. The risk associated with a full convertible currency will be increasingly easily to deal with as China grows its GDP and other things. When Dr. Doom said that “This decline of the dollar might take more than a decade, but it could happen even sooner …”, what do you think?

  • Posted by MakeMeTreasurySecretary

    Brad,

    I do not always agree with what you write. I must confess that I sometimes thought that you, in your past articles, under- or mis-calculated the effects of exploits in the financial sphere on the real economy.

    However, though a confirmed curmudgeon, I cannot find anything in this article to complain about. Here you consider the greater effects of the “Great Distortion”, the overvaluation of the dollar due to actions of foreign central banks. Historians of the future will see it for what it is: a market manipulation of gigantic proportions that has had a profound effect on America. You recognize that this subsidy is “a mixed blessing”. While others still fear that foreign central banks may withdraw their support from the dollar, which they seem to fear as the end of the world, you point-blank state: “That (subsidy) changed the composition of US output, as the US shifted out of the production of tradable goods and services – and instead specialized in home construction and creative financial engineering.” (I am sure you got an A in “Understatement for Economists 101”.) You could have perhaps mentioned that the wanton military spending would not have been possible without all the help from our good buddies.

    You proceed to explain the high price the economy (though, alas, perhaps not most economists) has paid for the “cheap” credit. “… it masked the buildup of vulnerabilities in the US economy, and likely prevented some natural circuit breakers from kicking in and cutting the housing boom off at an earlier stage….”

    In my opinion, America’s troubles have little to do with its status as the reserve-currency provider. The same could happen to, say, New Zealand (just imagine foreigners deciding that they will be buying most bonds issued in Kiwi by exchanging foreign currency for Kiwis and not bothering to ask what is the interest rate). The results would be the same as we have seen in the USA. One would hope, though, that New Zealanders would have the brains to recognize such action for what it is: economic aggression.

    Valéry Giscard d’Estaing was probably right when he talked about America’s exorbitant privilege. But, as the hapless Europeans are about to find out, China has found a better way. To paraphrase the saying about the Austria of old:

    “Let America borrow to finance its enormously expensive military machine. Thou, Happy China export. What Mars takes from others, Mercury bestows on thee.”

  • Posted by fatbrick

    I don’t see how China can start lending in its own currency without calling the overall bargain into question.

    —————————————

    It is all about management. If China can persuade energy and raw material exporters to accept RMB as trade currency in a certain extent, then a risk floor can be built. And there is little need to open domestic asset market: since the RMB held by foreigners would be used to purchase Chinese goods. This model then has little relevance to trade and investment in other parts of world. It is just a bilateral trade agreement attached with payment methods.

    Actually, I do not see China’s effort goes beyond the demand for insurance. If China truly wants to replace USD, it should establish a new currency based on the balance of trade balance between its trade partners, then the new currency wuold be used between multiple parties and really undercut USD’s status.

  • Posted by Belisarius

    Brad,

    You’ve convinced me. This crisis will never end until the imbalance is resolved.

    Once we accept your premise though, does it imply that the US and Europe should threaten a trade war in order to pressure China to speed up its internal imblance?

  • Posted by ReformerRay

    The unequal trade flow were created by the U.S. to fight the cold war. They remained because – no one who would be listened to told us to do anything different.

  • Posted by ReformerRay

    The proper way to end the imbalance is for those nations that have a large trade deficit change their behavior so as to restore their trade to a balance between imports and exports.

    Don’t tell me the U.S. can’t do this alone. We created the unbalanced system and we can correct it.

  • Posted by Larry

    Why doesn’t China requires us to borrow in RMB instead of USD?

  • Posted by ReformerRay

    You mean, why doesn’t China insist that payment for imports be sent to them in RMB?

    That would reduce our imports from China. That is the last thing China wants.

  • Posted by anon1

    The key currency question for the US is not whether foreign central banks will diversify further out of the dollar. It is whether US importers will continue to pay in dollars. That is what ensures a global supply of dollars sufficient for the US to attract capital inflows in dollars.

  • Posted by anon1

    i.e. the rest of it is simply which countries provide the required capital inflow, and which sectors – official or private – and at what price they do so

  • Posted by K T Cat

    Twofish, thank you so much for your very thoughtful response! You’ve given me a lot to think about.

    Let me try this brief summary on you: China’s lack of imperial ambitions during the Middle Kingdom period is not an anomaly, but instead a cultural trait that carries on to this day. While the Azhanti, the Aztecs and the Romans conquered as much as their armies and logistics could manage, that’s just not the Chinese way.

    Is that close?

  • Posted by Rien Huizer

    Whether informed by history, politics or economics, any desirable order is contingent upon the preferences of whowever has the power to enforce such an order. Given that currently no large country can be considered an effective repressive dictatorship, any government aspiring to define and enforce an order according to its preferences will have to take popular preferences into account in s far as they can influence those preferences (for instance a government may be informed by mainstream economics and believe that free trade is a desirable order but the electorate is (irrationally) opposed. Such government will not select its preferred order or, if forced to do so by international means show reluctance to enforce within its jurisdiction) .. The point is that textbook economics are great for tuition but not exhaustive for policy-making..Most politicians might (i have not checked of course) well believe that they can free ride whatever international order is thrown up by the random forces of markets, technology, psychological cycles and accidents of history, for as long as it lasts. All they have to do is anticipate changes. The thought that diplomacy can result in wholesome cooperation between states of vastly differing characteristics, endowments and cultures is laughable. All that diplomacy will do is weaken the strong and exploit the weak, because the collective action required to do that is feasible and cheap

  • Posted by Rien Huizer

    Twofish,

    I suspect you do not know the Chinese as well as you think. I say this not because I know better -I probably do not- but because it is inherently virtually impossible to know that “no one in China will care if…” I am sure the good custodians of the PRC would love to know these things, but unfortunately, even Chinese are human which means that their opinions and attitude are subject to variation, between individuals and within individuals over time.

  • Posted by jonathan

    I’ve been thinking about the next to last paragraph in this post, the one about balance.

    This issue gets at fundamental questions of economics and markets. Is it possible to have meaningful, persistent balance? Is that even the natural competitive state, outside of a defined ideal equilibrium? When nations and alliances rise and fall as much from internal as external causes?

    Could governance make balance? I guess the question in part depends on how you look at the existing effects of governance. Is Germany balanced? At the heart of Europe, as a prime member of Union, as a traditional Western power, they persist in their own model. Is this an area which governance is truly capable of reaching in an effective manner? I doubt it.

    As to capital flow, I guess I’m more of a fatalist and realist. We’re joined with China until and unless they decide to float, which I would bet they’d do only after the US has regained control over its fiscal deficit – unless there is a valuation catastrophe that forces a change in thinking. After this fiscal interregnum is done, I would think the economic fundamentals would reassert, meaning the US would continue to decline in relative economic importance.

    In that regard, the challenge for the US is not, IMHO, China but itself. Britain held onto coal until Thatcher and it took London’s Big Bang and then Blair to make a real dent in the conjoined class/economic order. Germany has responded to pressure by focusing more on its strength of value-added machinery. We are who we are and, though it’s difficult to put that exactly into words, our history is that we are nothing if not vicious competitors.* That bodes well for our future.

    *Example: our car companies are failing in part because states without auto employment have provided massive incentives for foreign carmakers. We don’t have national policies that prevent or which coordinate competition with other countries. We compete internally without pulling punches.

  • Posted by R Hadden

    Brad (and anybody else who can help me think it through),

    Could China lay off its USD currency risk onto individuals, who might willingly accept it, by running a currency-board arrangement where they sell Republic of China dollars (RCD) for RMB, where the RCD are backed 1:1 by USD holdings?

    The RCD would circulate in parallel with RMB and would be accepted by the Chinese state at the official USD/RMB exchange rate. However, there would be no capital controls so RCD could be used outside of China.

    I don’t know much about the mainland Chinese household balance sheet but I would bet the wealth ones hold a lot of dollars, probably clandestinely (Singapore and HK private banking); overseas Chinese certainly do. They might prefer this new instrument.

    Or is this arrangement fundamentally flawed and would merely make arbitrageurs rich?

  • Posted by bsetser

    I want to pick up on Jian Feng’s “dollar holder not a stake holder comment”

    It picks up on the part of the US conception of China as a stakeholder that always bugged me, namely that the Americans putting the argument forward tended to define “stakeholding” as increasing China’s stakes in US led institutions by a bit, but not enough to radically change the institutions. Fair enough, but i never quite saw why Chinese policy makers would be all that keen on this particular vision of stakeholding. Chinese policy makers might want something other than a slightly larger vote (in exchange for a larger contribution) in the IMF and the like. Jian suggests China might define “stakeholding” as having more say over the content of US policies that affect the value of China’s reserves.
    Fair enough — but here I don’t see what is in it for the US.

    The bargain the US offered holders of its reserves was a liquid asset that would be there if you needed it — i.e. an emergency cash reserve. Holders of dollar reserve never got a say over US policy — and the US, especially after ending the dollar’s link to gold, has explicitly rejected directing its macro policies at maintaining the dollars external value.

    that more or less worked if countries were just holding reserves to meet their needs for foreign currency liquidity. What didn’t want a say over us policy; they wanted access to a financial asset that would be available in a pinch.

    but it doesn’t work as well if countries are holding more reserves than they need, and start viewing their reserves as investments/ or as a form of saving — not as a cash reserve that you keep as insurance even though holding the cash reserve is costly.

    And that is the dilemma china now faces; it has more liquid treasuries than it needs — and parts of its treasury portfolio isn’t that liquid in practice (b/c it is too big, china cannot sell w/o moving the market in a meaningful way .. ). Its efforts to take on more risk to get more returns produced lower returns — and a rather sudden retreat back to treasuries. but treasuries don’t make for a great investment – -and carry with them risks.

    But china cannot really turn its treasuries into influence over us macro policies w/o changing the nature of the existing relationship —

    incidentally, i am not sure that the US has nothing to worry about so long as the world accepts payments for its exports to the us in dollars. tis true that those dollars have to come back to the us — but if countries lost confidence in the dollar as a store of financial value and wanted to turn the dollars into goods instead, the dollar’s value would fall (and us rates would rise). An equilibrium where the us imports more than it exports would be hard to sustain …

  • Posted by bsetser

    Jonathan — wouldn’t an out of control us fiscal deficit be one thing that might prompt china to float, as china would conclude that the existing system required that it absorb more us paper than it thought prudent?

    incidentally, for all the talk of the dangers of the current us macro mix (big fiscal deficit/ loose monetary policy) the us is asking that the world absorb way less us paper than a year ago — as americans are investing less abroad and running a much smaller trade deficit.

    R Hadden — count me skeptical. China’s government is absorbing so many dollars precisely because (setting q4 and early q1 aside, as there were substantial hot outflows then) private chinese savers don’t want to hold dollars at the current exchange rate. normally, that would push the rmb up until the dollar became cheap enough that chinese investors thought it to be a bargain (or trade balanced, so there was no need for china to accumulate us assets), but china’s government doesn’t want that to happen either — leaving it as the dollar buyer of last resort.

  • Posted by Twofish

    K T Cat: Let me try this brief summary on you: China’s lack of imperial ambitions during the Middle Kingdom period is not an anomaly, but instead a cultural trait that carries on to this day.

    I don’t think so. Chinese emperors like pretty much everyone else in the ancient and medieval period expanded as much as they could before they hit resource, technology, geography limits. Once they hit those limits they created ideologies to justify them.

    One curious thing is that in some ways, China is a relatively new country, and not really that much older than the United States. Also, I’m not a fan of historical determinism. Just because Chinese thought something in 750, 1850, or 1920 tells you very little about what Chinese think of today.

    Also, I’m not saying that Chinese are incapable of being a expansionist, global power. It’s possible that in 2025, most Chinese will think that it is essential for China to challenge the United States for global supremacy. It’s just not in the public mood right now.

    You can figure out about a country a lot by asking people what they are willing to have their kids die for.

    KT Cat: While the Azhanti, the Aztecs and the Romans conquered as much as their armies and logistics could manage, that’s just not the Chinese way.

    You have 5000 years of Chinese history. The “Chinese way” is whatever you want it to be, which I suppose is a good thing.

  • Posted by Twofish

    Rien: I am sure the good custodians of the PRC would love to know these things, but unfortunately, even Chinese are human which means that their opinions and attitude are subject to variation, between individuals and within individuals over time.

    Sure, so change no one to “no one in any position of power right now.”

    I’m sure that there may be some starving artist in some street corner in Beijing is shouting to anyone that that cares to hear him how China should rule the world. No important in 2009 cares what they think. Part of the reason I work in economics is to keep things working will enough so that delusional starving artists on street corners stay delusional starving artists on street corners rather than delusional political leaders trying to take over the world, and coming pretty close to doing it.

    Note that I’m talking about 2009. I give no assurances of what people will think in 2019.

  • Posted by Twofish

    One thing that is amusing about all of the statements about China role in the world economy is that none of the statements are by anyone that is Chinese.

    My impression right now is that the Chinese discussion is mostly on how to deal with China’s internal economic issues, and that China’s role in the world community will flow from that.

    bsetser: Chinese policy makers might want something other than a slightly larger vote (in exchange for a larger contribution) in the IMF and the like.

    Part of the reason that China isn’t terribly interested in that is that it doesn’t matter. The IMF has very limited power in the world community and essentially no power to control the major economies. The IMF can dictate conditions to Argentina, but it is not in any position to order the US or China around.

    Even within the IMF, the real power is in the permanent staff and bureaucracy.

    Now if the US were willing to let the a Chinese entity buy majority ownership in Citigroup, and put a Chinese representative on the Board of Directors, that would be different. Even letting Bank of China have an unrestricting banking license in the United States would get China more influence than more votes on the IMF. Citigroup matters to the world economy far, far more than the IMF does, since Citigroup has more influence on IMF actions than IMF actions have on Citigroup.

    Jian suggests China might define “stakeholding” as having more say over the content of US policies that affect the value of China’s reserves.

  • Posted by R Hadden

    Brad, what if China offered RMB interest rates on RCD reserves, paid in RCD? This would create a high-yield “junk dollar” (pun intended).

    Interest would be paid in new RCD backed by new USD reserves accumulated. If reserve accumulation dropped below the interest payments, China would need to either cut RMB interest rates or buy RCD for RMB, both of which would devalue the RMB and restart reserve accumulation.

  • Posted by michael gordon

    Brad says: “The problem of course is that is that China’s own choices more than anything else constrain the renminbi’s ability to serve as a global reserve currency. China’s currency isn’t freely convertible and its capital account is heavily managed. And China’s government doesn’t exactly welcome foreign inflows of any sort — and it certainly doesn’t want to increase its dollar holdings to allow other countries to increase their stock of renminbi denominated reserves. Letting other central banks hold RMB means letting other central banks speculate on RMB appreciation …

    “That said, it isn’t clear that the US has the ability to prevent the formation of an Asian reserve currency. If say Thailand decided that it wants to hold renminbi-denominated debt as part of its reserves and China was willing to sell Thailand renminbi-denominated debt, the US can hardly stop the transaction.”

    ….

    Brad:

    An important question or two:

    1) Your first paragraph here seems sound. The second begs an issue: how would Thailand get the RMB to add to its reserves?

    Right now, its reserves amount to about $104 billion — overwhelmingly held in dollars or dollar-denominated US Treasuries. There are only three ways, it seems, for the Chinese — if they want Thailand and others in Asia to hold large amounts of RMB and RMB-denominated debt — to provide Thailand with these amounts:

    * Run trade bilateral trade deficits on a fairly large scale with Thailand and Vietnam and other industrializing Asian countries. Last year, though, China’s exports to Thailand were about $20 billion, and its imports $16 billion. A similar picture arises for the other Asian countries other than Indonesia (with its oil exports).

    Are the Chinese willing to make such shifts in their growing trade with Asian countries?

    …..

    * The Chinese could up their investments in Thailand and elsewhere in Aisia — multinational and portfoilio (presumably mainly the latter if the Thai and other Asian central banks are to get more and more RMB holdings). Not only does this option require far less regulation of Chinese banks, firms, and other financial institutions, such policy changes would probably lead to a huge outflow of RMB to the rest of Asia and require that the Thais and others simultaneously commit to not selling large amounts of dollars held now in their reserves.

    Would the Chinese government like any of these changes very much?

    ……

    * Outright grants or near-zero loans of a foreign aid sort by China in RMB.

    The trouble with this? Though such RMB gifts might prompt Central Banks in Asia to start holding RMB in their reserves, there would be no way, really, that the Chinese government could stop those other Central Banks from selling RMB again for dollars or euros unless the gifts were tied to buying Chinese products.

    This option can’t be ruled out, but it is unlikely. Why? Because these other Asian countries are as desirious as China to upgrade their manufacturing production and enjoy export-led growth in it. Tied Chinese grants and loans would simply perpetuate bilateral and regional trade deficits with China . . . something these Asian governments and businesses wouldn’t like.

    …….

    2) More generally, it seems the key issue here isn’t just reserve-diversifying for the Asian central banks other than China. It seems to be a desire of Asian countries to enjoy trade surpluses, especially in mfg. goods. And that would also entail for the Chinese, would it not, the fear that existing multinational investments in China might be shifted more and more to lower-wage countries in Asia if they did move up steadily a ladder of mfg. skills, productivity, and output.

    ….

    3) Shift perspective now. Historically, the only large reserve currencies not foisted on others by means of colonial rule have been the British pound until WWII, and the $US. And Britain, as we know, ran a trade-deficit throughout almost all of the late 19th and 20th centuries . . . as has the US since the 1960s.

    In 1998-1999, to take one example, US trade in goods with Asian countries (and others) — as their currencies depreciated in the wake of the Asian financial crisis — doubled in just one year,

    Is China, a comparatively poor country with huge internal problems — and questions abouts its stability — ready to start shifting in such a direction of being indifferent to trade surpluses in order to make the RMB a regional (never mind global) reserve currency?

    ……

    4) The problems here, please note, are also political.

    Economic interdependence — financial and trade-wise — seems to contribute to peaceful relations between states only if there is a sense of mutual benefits and maybe even (over time) some sort of equity in these market-oriented changes. A rising power, China’s government and people are no doubt sensitive to how they are treated . . . but so would American opinion and Congress over time respond similarly if the relationship seems lopsided. And simultaneoulsy, as China runs up large trade surpluses thanks to its managed currency, if Beijing decides that its risk-taking in holding huge quantities of dollar-denominated debt should be offset by American taxpayers one way or another.

    …..

    Be interested in your replies here.

    Michael Gordon, AKA, the buggy professor

  • Posted by Freitas

    Brad, thanks for posting on this issue, your blog is really a must read.

    I wonder what you would say about the possibility of a global reserve system instead of those ad hoc, nationally based, transitory (un)balances. Do you consider any kind of multilateral arrangement politically feasible? Would it make sense in economic terms? What other conditions (capital controls, punishment on deficit and surplus countries, governance issues, interest rates on the global reserve) do you think it would be needed? Or dont you even consider this possibility? Have you seen Stiglitz UN Comission`s proposal on that?

    Many questions, I know. But you are the one I would like to hear about that.

    Thanks!

  • Posted by Rien Huizer

    Twofish,

    Right, knowing all Chinese is beyond even your considerable powers but knowing what those in power want is not. I am impressed. Although it is of course not too hard to guess. China appears to derive long term benefits from the IR status quo (who would not be grateful for a US president who shares that preference, see the rather meek and routine references to US humanistic hobbyhorses whilst the message of a Chinese speaking representative is very strong (and that next to a Treasury Secretary who has Chinese too!) and it appears likely that China’s view of a cooperative situation would be maintenance (some harmless rhetoric for domestic consumption included) of the status quo of a very high degree of complementarity rather than competition. China goes on expanding its sphere of economic interest in terrae nullius (from a US perspective) like Sudan, Congo etc, and life for the US in its self-dug Islamic hole is not complicated by a long term resident player in Central Asia like China. And, as usual, the economy will take care of itself. US stimulus is good for US employment, hence consumption, hence Chinese exports, hence stability in Beijing/pricincial relations and urban affairs. Meanwhile Chinese domestic stimulus is good for expanding modernity without antagonizing urban citizens and “taxpayers”. It would be utterly foolish to upset this by childish territorial ambitions. When are we going to accept that what we have got is likely to persist for quite a while: China will continue to manipulate its currency, but restrict itself to risk-free (and low return) warehousing of the cumulative BOP surplus. It will continue to tease about agencies etc but not throw good money after bad. Officials tend to be risk averse, so no one will be trying to build a career out of financial market risk taking (certainly not after the CITIC affair).

    And, with rising standards of living in China plus a decade of declining ones in the US, the wage gap may become so manageable (one China achieves rough technological parity or at least productivity growth tapers off) that BWII goes on forever. I never thought that freely floating FX rates were either feasible in the long term, or desirable if one takes into account strategic interest group behaviour in an international context. You do not have to be Chinese to be a realist.

  • Posted by bsetser

    Good comments — though rien, i certainly hope you don’t think China can or will accumulate financial claims on the US at its current pace for the next ten years. The math there would scare me — and i would hope, China’s leadership. Think of close to $5 trillion in Chinese claims on the US — and that is if China’s accumulation is constant in nominal terms … and thus falling in real terms.

    Freitas — I haven’t looked closely at the stiglitz proposals. I probably should. I tend though to be suspicious of calls for a new global currency or global reserve currency, as I don’t see the US giving up the dollar, europe giving up the euro, britain giving up the pound and so on. I am though inclined to think that over time an asian reserve currency will develop, and that if the asian reserve currency floats against the dollar and euro, that wouldn’t be a bad outcome for the uS (or the world). The existing world financial order – where much of asia and the gulf peg their currencies to the dollar, smaller european currencies manage their currencies v the euro (in general) and the euro and dollar float against each other — hasn’t necessarily worked all that well.

    michael — the suppliers of the reserve currency haven’t necessarily been debtors running trade deficits. the us ran surplus in the 50s and 60s. and britain generally speaking ran a surplus too. a debtor as a reserve currency poses some risks to the holder of the reserves – risks that countries piling up dollar claims to support their export sectors have opted to ignore.

    I agree though that for China to supply asia with a reserve currency, it either has to:

    a) run trade deficits that allow asian countries to accumulate rmb claims on china (and allow Asian countries to hold rmb as part of their reserves)

    b)or lend rmb to a host of asian countries — rmb that the countries would then lend back to china by holding s-term rmb paper. basically, long-term inflows (debt or equity) from china would be recycled back into s-term rmb claims held as reserves. that implies these inflows could not be used to support trade deficits.

    or china could sell some rmb to countries for their dollars, absorbing the rest of asia’s dollars while supplying asia with rmb. that though increases china’s dollar risk — as it is taking an inflow into rmb debt from the rest of asia and using it to increase its already substantial dollar holdings.

    china has sought to get around this with swaps — effectively promising countries that they can exchange their currencies for rmb if they need rmb. that avoids the need to hold physical rmb — and thus the need for china to absorb inflows. it isn’t clear though that it will work. for their reserves, countries typically want actual asset — not just a promise to deliver fx if needed. swap lines aren’t always renewed in a crisis — they aren’t a full substitute for reserves.

    the us is a bit of an exception; it effectively relies on its ability to swap $ for euros — but the us and the key european countries are tied together in a true security alliance as well as in a host of economic institutions. China’s relationship with the rest of asia is somewhat different.

    Thailand incidentally currently has a non-trivial portion of euros other non-dollar currencies in its reserves.

  • Posted by Jian Feng

    I don’t think that China’s leadership is so naïve as to expect a real change in US policy as China amasses astronomical amounts of US dollars. If anything, China leadership would expect more friction, perhaps in a more disguised fashion, such as the G-2 framework, from the United States. What China does expect, quite reasonably, is to be able to use its money, for example, in buying companies like Unical. The problem is that even if it did not touch any existing US laws and regulations at that point, the Congress can invent new laws at will, in the same way that it can allow Federal Reserve to print more money. There was a bipartisan disgust of the concept that a commie-controlled little oil company even dare to ask for the hand of an American darling. I have not checked it, but it perhaps still requires presidential waiver for China to buy every new airplane from Boeing. And let’s not even talk about the satellite launch business, which sees ever dwindling US market share. If history tells us anything, China is very good in dealing with difficulties. When US does not allow China to launch any satellite with a single US component, China eventually mastered the technology to build its own satellite and now does turn-key service for its poor brothers in the third world. Now China found that it is impossible to use the trillions of dollars it holds, you can bet that it will find its way to change the situation. In the end, in Smith China believes. Since when someone in debt get to run the world?

  • Posted by Rien Huizer

    Brad,

    I expect that the US/China trade balance will shrink (we must have seen the high water mark and an average of say 40% of the current level looks probable, unless the US experiences another iffy boom) and that financial revenue from the accumulated reserves will be extremely modest. But it will still be quite a lot. Pity China’s neighbours though…

  • Posted by jonathan

    Brad, regarding your response to my comment: yes. I don’t where China would draw the line and that would depend in part on available alternatives. As in, they can’t put their huge pile into gold and God knows what would also be happening to the Euro. I’m not good at guessing the future. We know they will change but exactly will push them to it are unclear – and what are the intermediate steps we might expect other than a one-off policy announcement?

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