Hudson to Premier Wen Jaibao, March 15, 2010
Dear Premier Wen Jiabao,
I write this letter to counteract some of the solutions that Western politicians are recommending for China to cope with its buildup of excess foreign-exchange reserves. Raising the renminbi’s exchange rate against the dollar will not cure the China-US payments imbalance. The dollar glut will continue, and so will the currency fluctuation among the dollar, euro and sterling, leaving no stable store of value. The cause of this instability is that each of these three currency areas has grown top-heavy with by debts in excess of the ability to pay.
What then should China should it do with its buildup of excess reserves, if not recycle its inflows into their bonds? Four possibilities have been suggested: (1) to revalue the renminbi, (2) to flood China’s economy with credit (as Japan did after the Plaza Accord of 1985), (3) to buy foreign resources and assets, and (4) to use excess dollars to buy back foreign investments in China, given US reluctance to permit Chinese investment in America’s own most promising economic sectors.
I explain below why China’s best course is to avoid accumulating further foreign exchange reserves. The most workable solution is to use its official reserves to buy back US and other foreign investments in China’s financial system and other key sectors. This policy will seem more natural as a response to an escalation of US protectionist moves to block Chinese imports or block China’s sovereign wealth funds from buying key US assets.
China’s excess reserves will impose a foreign-exchange loss (as valued in renminbi)
Every nation needs foreign currency reserves to ward off currency raids, as the Asia Crisis showed in 1997. The usual kind of raid forces currencies down. Speculators see a central bank with large foreign currency holdings, and seek to empty them out by borrowing even larger sums, selling the target currency short to drive down its price. This is the tactic that George Soros pioneered against the British pound when he broke the Bank of England.
Malaysia’s counter-tactic was not to let speculators cover their bets by buying the target currency. Its Malaysia’s success in resisting that crisis showed that currency controls prevent speculators from “cashing out” on their exchange-rate bets, blocking their attempt to drive down the currency’s value.
China’s case is the opposite. Speculators are trying to force up the renminbi’s exchange rate. Foreign inflows into China’s banks – especially those owned by US, British or other foreign companies – is flooding China with foreign currency. Its central bank finds itself obliged either to recycle this inflow back abroad, or to let the renminbi rise – and ultimately take a loss (as measured in yuan) when its currency rises against its holdings in dollars, sterling and euros. Speculators and other foreigners holding Chinese assets will get a free currency ride upward.
The effect within China’s economy will be to load it down with debt, while obliging it to buy foreign securities denominated in dollars that are falling in price. So the question is, how can China best cope with the foreign exchange flowing into its economy?
China’s major response has been to invest in the mineral resources and other imports it will need to sustain its long-term growth. But this option is limited by foreign protectionism against overseas investment in minerals and agricultural land, and by speculators from foreign countries using their own free credit to buy up these resources. So excess foreign exchange is continuing to build up.
Traditionally, central banks used their payments surpluses to buy gold as “money of the world.” Gold has the advantage of serving as a store of value, enabling central banks (in principle) to avoid taking a loss on their dollar holdings. Settling payments deficits in gold also has the global advantage of limiting the ability of other countries to run chronic payments deficits – especially war spending throughout history. This is why US diplomats oppose a return to gold.
In the 1960s foreign governments asked the US Treasury to provide a gold guarantee. The excess dollars thrown off by America’s overseas military spending in Southeast Asia and Europe ended up in the central banks of France (which dominated banking in Indo-China), Germany (as exporter and host to the major European military base), and Japan (for rest and recreation). France and Germany cashed in these dollars for gold, whose price came under pressure as US monetary gold stocks were depleted. To deter the central banks of France (under General de Gaulle), Germany and other countries from cashing in their dollars for gold, the U.S. Treasury gave a gold guarantee so that if the dollar lost value, these central banks would not lose.
Today, the United States is unlikely to give a gold guarantee, or to expect Congress to agree to such an arrangement. (Often in the past, US presidents and the Executive Branch have made agreements on foreign trade and finance, which Congress has refused to confirm.) It could guarantee China’s official dollar holdings vis-à-vis a basket or whatever the Government of China preferred to hold its reserves, from euros to a new post-Yekaterinburg currency mix. But no currency today is stable. All the major Western currencies are buckling under the burden of unpayably large debts. The US Treasury owes $4 trillion to foreign central banks, but there is no foreseeable way in which it can make good this foreign debt, given its chronic structural deficit of foreign military spending, import dependency and capital outflows. That is why so many countries are treating the dollar like a “hot potato” and trying to avoid holding them. And holding euros or British sterling does not provide a better alternative.
Most central banks today hold down their exchange rates by recycling their dollar inflows to buy US Treasury IOUs. This recycling enables the United States to finance its overseas military spending and also its domestic budget deficit (largely military in character) since the 1950s. So Europe and Asia have used their foreign exchange earnings to finance a unipolar US buildup of military bases to surround them.
This situation is inherently unstable, and hence self-terminating. The era is ending where international reserves are based on the unpayably high debts of any single government, especially when these debts are run up for military purposes. Certainly the US dollar cannot continue to fill this role, given the chronic US payments deficit. For most years since 1951, US overseas military spending (mainly in Asia) has accounted for the largest part of this deficit. And increasingly, the US trade balance has fallen into deficit (except for agriculture, entertainment and military arms). Most recently, capital outflows have accelerated from the United States, especially to China and Third World countries. US money managers have concluded that the US and other Western economies are entering a period of debt-burdened, permanently slower growth. So they are looking to China, hoping to obtain its surpluses for themselves by buying out its banking and industry.
This relationship is too one-sided to continue for long. The question is, how can it best be resolved? Any solution will involve China’s avoiding further accumulation of foreign exchange as long as these take the form of “free loans” back to the US and European governments.
China’s exchange rate vis-à-vis the dollar
American China bashers blame China for being so strong. They urge it to raise the renminbi’s exchange rate to be less competitive. And indeed, over the past three months China’s currency has risen by more than 10% against the euro and sterling as one euro-using government after another is facing insolvency.
The dollar’s recent strength does not reflect intrinsic factors, but merely the fact that the euro and sterling are even more highly debt leveraged. The main problem areas to date have been Greece, Ireland, Spain, Italy and Portugal, but much larger problems are soon to come from the Baltics, Hungary and other post-Soviet economies. For a decade, they financed their structural trade deficits by borrowing in foreign currency to fuel a real estate bubble. This foreign-currency inflow (from Austrian banks to Hungary and Romania, from Swedish banks to the Baltic States) inflated prices for their housing and office buildings. But now that their real estate bubbles have burst, there is no foreign lending to support their currencies. As their real estate sinks into negative equity, the banking systems of Sweden and Austria face widespread defaults.
The EU and IMF have pressured post-Soviet governments to borrow to bail out EU banks. This shifts the bankruptcy from the private sector to the public sector (“taxpayers”), imposing a severe economic depression on these countries. Governments are slashing spending on education, health care and infrastructure so deeply as to cause personal and business mortgage defaults, emigration, and even shortening life spans.
This shrinkage is the end-result of the neoliberal Washington Consensus imposed on these countries since 1991, aggravated by the global financial bubble since 2000. It is an object lesson for what China needs to avoid.
The United States for its part is manipulating its currency to keep the dollar low, by flooding its economy with low-interest credit. This manipulation runs counter to normal practice over the past five centuries. Any economy running a balance-of-payments deficit traditional has raised interest rates to attract foreign loans and slow domestic spending. But the US Federal Reserve is doing just the opposite. Low interest rates to keep the real estate bubble fro bursting further have the effect of aggravating rather than curing the trade deficit and capital outflow.
Yet more dollars are ending up in the hands of foreign central banks. Foreign economies are expected to recycle these inflows into yet more purchases of US Treasury securities, saving US taxpayers and investors from having to finance this deficit themselves.
Revaluing the renminbi would exacerbate China’s financial problem, not stabilize its trade
US economic diplomats argue that increasing the renminbi’s exchange rate will help restore balance to China’s balance of payments with the United States. But the US payments deficit is structural, and hence not responsive to price changes. As noted above, a major payments outflow is overseas military spending. Another growing outflow is on capital account, to buy up foreign companies, stocks and bonds. US investors themselves are abandoning the US economy, looking mainly to China for higher yields – and for a foreign-exchange windfall gain.
The US strategy is to buy up Chinese assets yielding 20% or more annually, while China recycles these dollars to Washington and Wall Street at interest rates of only about 1% (for Treasury securities) and absorbs losses in many private-sector investments. (This is the strategy that “worked” with Japan after 1985.) Revaluing the renminbi would provide a windfall for US hedge funds and speculators. Anticipations of revaluation already are spurring higher capital outflows to China.
A higher exchange rate for the renminbi also would result in even more dollar outflows from the United States to Asia on trade account, by obliging American consumers to pay a higher dollar price. Contrary to what most “free trade” assumptions, the fact is that most trade is not responsive to small shifts in currency values. (Economic jargon calls this “price-inelastic.”)
This became clear in the 1980s when a rising exchange rate for Japan’s yen did not reduce that nation’s trade balance. US consumers simply paid more. This is why, despite the recent 21% appreciation in the renminbi, China’s trade balance increased rather than shrank. Likewise, Japan’s yen has soared since autumn 2009, yet it is still accumulating reserves.
Even if China revalues the renminbi, its export prices will not rise proportionally. This is because imports of raw materials, much machinery and other components of most exports have a common world price (typically denominated in dollars). So a higher renminbi will lower the dollar price of these imports.
About half the price received for exports covers the price and markup spent on these imports with a common world price. So if China’s currency rises by 10% against the dollar, the price of imports embodied in these exports (as valued in renminbi) will fall by 10%. Half the export price will be unaffected, so overall export prices might rise by 5%.
Given the fact that trade patterns are deeply entrenched, a quantum leap in revaluing the renminbi would be needed to reduce China’s trade surplus. Small revaluations would not “solve” the problem that US diplomats are demanding. Unless revaluation is enormous – in the neighborhood of 40% – raising the exchange rate thus will tend to increase rather than reduce China’s trade surplus. The moral is that if the aim is really to change export patterns, there is no point in devaluing except to excess (that is, about 40%). This was the principle that US President Franklin Roosevelt followed in 1933.
Creating more domestic credit at low interest rates would destabilize China
The follow-up to a renminbi revaluation is likely to be what it was in the Plaza and Louvre accords that US diplomats forced on Japan after 1985. Payments-surplus economies are told to restore “equilibrium” by easing credit to spur a balance-of-payments outflow.
The effect is to create a financial bubble, derailing industrial competitiveness and leaving the banking system in a debt-ridden shambles. Japan was willing to flood its economy with enough credit to destabilize its industry and real estate markets with debt that has remained for the twenty years since its bubble burst in 1990. China should avoid this kind of policy at all costs. To avoid the debt overhead now stifling the Western economies, it should minimize debt leveraging and limit the banking system’s ability to create credit to buy assets already in place. Foreign-owned banks in particular need to be restricted from aiding parent-country currency speculation and related financial extraction of revenue from China’s economy.
Balancing China’s international payments by buying foreign resources and assets
China already is seeking to buy mineral, fuel and agricultural resources abroad to supply the inputs that it needs for its own growth. But these efforts still leave substantial foreign exchange surpluses. Most countries have used these surpluses to buy up key sectors of foreign economies. This is what Britain, the United States and France have done for more than a century.
When the US economy runs payments surpluses with foreign countries, it insists that they pay for their foreign debts and ongoing trade deficits by opening up their markets and “restore balance” by selling their key public infrastructure, industries, mineral rights and commanding heights to US investors. But the US Government has blocked foreign countries from doing the same with the United States. This asymmetry has been a major factor causing the inequality between high US private-sector returns and low foreign official returns on their dollar holdings.
The refusal of the US Government to behave symmetrically by not letting China buy key US companies with the dollar inflows that enter China to buy its own companies, above all its financial and banking sector, is largely responsible for the asymmetrical situation noted above, in which US investors earn 20% in China, but China earns only 1% in the US.
Buying back foreign investments in China
The wave of the future is to avoid a buildup of foreign exchange at all. The main way to do this is an option that European governments have discussed: to use their excess dollars to buy out US investment holdings in their countries, at book value. In effect, China would say to the United States:
“We have let you invest in out own factories and even our banks, and we have let you participate in our key sectors even where these have special domestic privileges. Your economists advised us that this was the most efficient way to run an economy. But it is not advice that the United States itself has followed. You are not letting us use the dollars that you invest here – and the dollars that China earns by exporting the products of its labor – to buy corresponding investments in your country.”
“It is of course the sovereign right of every nation to determine who shall own and control its industry, bank credit-creating privileges and other resources. We accept this principle of international law. So by the same token, we are using the surplus dollars to buy out US and other foreign investments in China. We are willing to do this according to international law, and pay the book value that your own accountants report their investments in China as being worth.”
“This will stabilize international exchange rates by restoring balance to international payments. It is especially natural inasmuch as we understand that the US consumer-goods market is shrinking, obliging us to turn more to our own domestic market.”
Obviously, US holders of investments in China would complain that their holdings are worth more than the book value they have declared. Indeed, this is a major reason why current investors in China are trying to prevent the US Government from engaging in more anti-Chinese protectionist policies. But in the event that the governments rejects their advice and “goes it alone” by taking anti-China measures, China would be in the position of responding to a US initiative rather than acting independently. And it certainly would have the support of other countries in a similar position vis-à-vis US attempts at politicizing foreign investment.
This problem came up in the 1960s and ‘70s, when the US Government directed foreign affiliates of US firms to adopt US Cold War policies to avoid trading with China, the Soviet Union and other targeted economies. Foreign governments pointed out that US directions as to how affiliates incorporated in foreign countries could act, as these were subject to their host-country laws, not those of the United States.
This issue is being revived today with regard to sanctions against Iran and other countries. International law has long backed host countries regarding trade and investment policy, credit policy and so forth. I expect this to become a major factor in foreign repurchases of US investments abroad – in Europe and other Asian countries as well as China.
Perhaps a commission will be necessary to debate a fair price for these future buyouts. But such cases usually take a considerable time to resolve. There are implications of this policy that I would prefer to discuss orally at an appropriate point in time rather than elaborate further at present.
Summary: The inequity of the dollar deficit
China, the rest of Asia and Russia have been financing the US overseas dollar spending to pay for America’s military encirclement of the Eastern Hemisphere and for US investors to buy out the crown jewels of Asian industry, financial institutions and public infrastructure. This situation is asymmetrical not only economically, but also politically. In 1823, America’s Monroe Doctrine told Europe to keep out of the Western Hemisphere, ending European colonialism and political hegemony in Latin America. The United States replaced the major European powers as investor and political and military influence.
Today, many people in the United States, Canada and Europe wish to see global disarmament in a multi-polar world rather than a unipolar world. They believe that no country should get a free ride or dominate the world militarily. That would not be a free market. In the end, international economic, political and military relations tend to settle at symmetrical common rules for all parties. A generation ago, Harvard economist Albert Hirschman called for U.S. disinvestment in Latin America and third world countries, on grounds of U.S. economic interest itself. Today, the US economy is suffering from chronic domestic budget deficits that are largely military in character, and chronic payments deficits. Scaling back military spending would free resources for use in its own economy, while enabling foreign economies to wind down their own military budgets.
This logic is endorsed by many US citizens and economists. It can be promoted by a system in which no national economy remains in a monetary system based on the military spending of a military nation in chronic deficit and rising debt beyond its foreseeable ability to pay. This kind of free ride characterized the empires of times past, but the present century promises a more fair, equitable and (one hopes) less militarized world.
Distinguished Professor of Economics, University of Missouri (Kansas City)
Honorary Professor, Huazhong University of Science and Technology (Wuhan)