The US-China Marriage of Convenience: Prospects for Global Imbalances and Economic Recovery

1
The US-China Marriage of Convenience
Prospects for Global Imbalances and Economic
Recovery

• Terry McKinley
• Director, Centre for Development Policy and
  Research,
• School of Oriental and African Studies
• Presentation, 29 January 2010, Delhi Conference,
• Recovery or Bubble? The Global Economy Today

2
The Starting-Point of The Debate

• The US and China remain locked together in
  interdependence
• China has relied, for some time, on the US as a
  market for its exports
• The US now relies on China as the prime lender
  that can continue financing its massive
  current-account deficits
• Is China equally to blame for global imbalances
  and the failure to reduce them?
• Will the US continue to run huge current-account
  deficits and undermine the basis for global
  recovery?

3
Pinning the Blame on China for Global Imbalances

• China is often blamed for causing global
  imbalances, mainly through exchange-rate
  manipulation (US Treasury Secretary Geithners
  early 2009 criticism)
• China has pegged the value of renminbi to the US
  dollar (for a while loosely, until 2008)
• Martin Wolf, the well-known columnist of the
  Financial Times, has laid the basis for blaming
  China in a series of columns on the global
  crisis
• The driving force behind these global
  imbalances has been the policies of surplus
  countries and particularly China (January 20,
  2009)
• The world cannot safely absorb the current
  account surpluses that China is likely to
  generate under its current development path
  (April 7, 2009)

4
What Is the Main Source of Global Instability?

• The main source of global instability is located
  not in China but in the US, which is the worlds
  dominant, reserve-currency country, and its most
  profligate spender
• It has regularly spent beyond its income level,
  based on borrowing from abroad (e.g., from
  China!!!)
• Being the dominant reserve-currency country gives
  it greater freedom to do so (adjusting at its own
  pace)
• A Major Question Will US current-account
  deficits undergo enough adjustment in order to
  substantially reduce global imbalances and remove
  the basis for renewed crisis?

5
The Basis for the US Over-Consumption Binge

• What were the origins of the US crisis?
• During the 1990s, current-account deficits were
  substantially increasing and Reagans huge fiscal
  deficits from the 1980s were being reduced by the
  Clinton administration
• External demand and public-sector demand for
  goods and services were declining. But the
  biggest problem was the ballooning
  current-account deficits
• This drag implied that the private sector (either
  households or corporations) had to be the main
  source for supplying additional aggregate demand
  to the US economy in order to maintain economic
  growth

6
The Basis for the US Over-Consumption Binge

• The US household sector began to spend well above
  its income level its net savings declined from
  3 of GNP in the early 1990s to a deficit of -4
  of GNP!
• Households were increasingly borrowing to sustain
  higher levels of consumption and housing
  investment
• But why did households borrow so heavily? Their
  personal assets (equities and housing stock)
  seemed to be inexorably appreciating in value
• This process was sustainable only as long as
  asset appreciation kept pace with the rise of
  household liabilitiesand interest rates remained
  low

7
The Basis for the US Over-Consumption Binge

• But the stock market bubble burst in 2001
• The US government responded with very
  expansionary fiscal and monetary policieskeeping
  interest rates low and fuelling, in effect, a
  larger ensuing financial crisis caused by the
  real-estate bubble (exacerbated, indeed, by new
  complex forms of leveraging of risk and lax
  regulation)
• US current-account deficits began to balloon
  dramatically in the early 2000s, requiring the
  need for more external borrowing, that is, more
  purchase of US Treasury Securities by foreign
  central banks (such as Chinas)
• Identifying such purchases of securities by China
  and other surplus countriesas is often doneas
  the source of the global financial crisis
  misinterprets its origins
• The crisis was due to US over-consumption, not
  Chinese excessive savings

8
Has There Been a Global Savings Glut?

• Critics of China in the West attribute global
  imbalances primarily to a so-called Global
  Savings Glut, which has supposedly made the US
  borrowing binge much cheaper to finance
• Developing Asia and the Middle East have been the
  major regions running large current-account
  surpluses and accumulating foreign-exchange
  reserves (often in low-interest US Treasury
  Securities)
• Reserves of Developing Asia in 2009 2.8
  trillion projected
• Reserves of the Middle East in 2009 870
  billion projected
• These regions have been the major Savers at the
  global level their domestic savings rates
  significantly exceed their domestic investment
  rates they are exporters of savings

9
Stock of Foreign-Exchange Reserves (US
Billions)
Region 2001 2007 2009 proj.
All Developing 857 4,378 5,323
--Africa 64 289 318
--CIS 44 549 483
--Developing Asia 380 2,132 2,867
China 216 1,531 2,240
--Middle East 135 696 870
--W. Hemisphere 159 445 517
10
Has There Been a Global Savings Glut?

• By running a huge current-account surplus, China
  has allegedly been contributing to a global
  savings glut
• This assumption is endorsed by a wide range of
  mainstream economists, Martin Wolf, Ben Bernanke
  and Lawrence Summersand been used to shift
  global blame onto China
• Although widely embraced, does this assumption
  make any sense?
• At the global level, total savings must equal, by
  accounting definition, global investment (unless
  there are errors in estimation)
• In other words, excess savings in one grouping of
  countries, such as Asia, must be balanced out by
  deficient savings in another part of the world,
  such as the US

11
Has There Been a Global Savings Glut?

• Another interpretation of the savings glut is
  that global savings has been rising relative to
  global income
• The table shows that broad averages since the
  late 1980s do not support such a claim
• As a ratio to global income, savings has been
  relatively stable, at 22-23
• So there has been no pronounced upward savings
  trend, no evidence of a savings glut
• But there has been a marked downward trend in the
  savings of Advanced Economies, which has been
  compensated by a substantial rise in the savings
  of Emerging and Developing Economies

12
Savings as a Ratio to GDP ()
    1986-1993 1994-2001 2002-2008
Global Global 22.7 22.1 22.7
  Advanced Economies 22.2 21.6 19.8
  USA 16.3 17.0 13.9
Emerging and Developing Economies Emerging and Developing Economies 24.3 24.2 31.1
  Middle East 17.6 25.5 38.7
  Developing Asia (including China) 28.8 32.7 41.2
13
What Is the Main Source of Global Instability
Now?

• The US is currently trying to replace huge
  private-sector spending deficits (mainly of
  households) with massive public deficits in order
  to stimulate economic recovery
• The 2009 US fiscal deficit is projected by the
  IMF to reach 12.5 of GDP (and to still be 10 in
  2010)
• Such a fiscal deficit tends to enlarge the
  current-account deficit increased domestic
  spending spills over into increased imports
• The alternative is to devalue the US dollar,
  making its exports cheaperand thereby reduce the
  US current-account deficit

14
The Impact of a Depreciated US Dollar

• When this option is taken, relative to the US
  dollar, the currencies of many other countries
  will appreciate, worsening their trade balances
• Just as importantly, the US will lower the
  relative value of its external debt
• The US can effectively inflate away its
  external debt by printing more dollars (the
  internationally reserve currency, for which there
  remains a global demand)
• Countries holding their reserves in US Treasury
  Securities will find their value reduced in their
  own currencies (will suffer a loss of asset
  value)
• To some degree, the US remains in the drivers
  seat

15
The Depreciation of the US Dollar

• Generally, the US dollar has been depreciating
  since February 2002 (because of current account
  deficits) about 21, overall, in nominal terms
• Its value hit a low point in April 2008, having
  fallen in nominal terms by 26 since 2002
• But the dollar appreciated between roughly April
  2008 and April 2009 as money flooded, seemingly
  perversely, into US securities as a safe haven
• As global economic conditions worsen (including
  US recession), the US dollar becomes more
  valued!!
• Along with global recovery, the US dollar should
  depreciate further, but currently it has been
  holding fairly steady as prospects for a speedy
  recovery remain uncertain. Figure

16
Depreciation of the US DollarNominal Broad
Index, Jan. 2002 Jan. 2010
17
Who Gains from Depreciation of the US Dollar?

• Continued depreciation of the US dollar is
  necessary in order to reduce global imbalances
  but its reserve-currency status impedes this
  adjustment
• But if depreciation of the US dollar proceeds too
  far and too fast, interest rates on US securities
  will have to rise to compensate foreign investors
  in its securities, possibly choking off recovery
  from recession, and jeopardizing global recovery
• If China too quickly shifts its foreign-exchange
  reserves out of US securities, the US dollar will
  depreciate faster, and more dangerously
• Thus there is a continuing uneasy strategic
  Marriage of Convenience!

18
Capital Has Been Flowing Uphill

• As a result, China, along with other Low-income
  and middle-income countries, have ended up
  exporting huge quantities of capital to the
  richest countries (primarily the US)
• This is not only inequitable but also inefficient
  globally
• Emerging and developing economies have mounted a
  massive foreign aid program to the US since
  they have to borrow from the US at high interest
  rates but lend their reserves to it at very low
  rates
• Large Current Account Deficits, of GDP 2007
• US -5.2, UK -2.7, Spain -10.0, Australia
  -6.3
• Large Current Account Surpluses, of GDP 2007
• Developing Asia 7.0 (China 11.0)
• Middle East 18.1 (Saudi Arabia 24.3)
• CIS 4.2 (Russia 5.9)
• Africa 2.9 (Nigeria 18.8)

19
Why Has China (and East Southeast Asia) Adopted
Export-Led Growth?

• The historical roots of the Export-led Model are
  in the successes of Japan and the East Asian
  Tigers, and in the bitter lessons of the Asia
  Financial Crisis
• The countries that had hastily liberalized their
  trade and capital flows (based on IMF advice)
  learned from the 1997-98 Crisis that they must
  avoid, at all costs, current-account deficits
  (especially if those deficits are financed by
  short-term external loans)
• They were subjected to speculative attacks on
  their currencies and sharp painful
  recessionsattacks on otherwise sound economies
• They were forced to endure a heavy and
  humiliating burden of IMF conditionalities (an
  experience that they wished never to repeat)

20
Why East Southeast Asia Adopted Export-Led
Growth

• Afterwards, East and Southeast Asian countries
  began to run sizeable yearly current-account
  surpluses, amassing large stocks of
  foreign-exchange reserves
• The reserves were seen as a necessary form of
  precautionary savings designed to deal with any
  attacks on their currencies
• Is it necessary to invest a countrys reserves in
  low-yielding, risky foreign assets, such as US
  T-bills?
• Is it necessary to amass such large stockpiles of
  reservesbeyond precaution?
• Does this stockpiling have a deflationary global
  impact, diverting funds from more productive
  outlets?

21
Does China Save Too Much?

• If a countrys current-account balance is in
  surplus, then macroeconomic accounting will show
  that its total domestic savings exceeds its
  domestic investment it saves too much or invests
  too little
• The country is recorded as having Excess
  Savings (adding to its overall savings rate)
• Has China been investing too little? Its Gross
  Capital Formation approached 40 of GDP during
  1990-2004 and more recently has approached 45.
  Figure
• China has an exceptionally high savings rate,
  i.e., over 50 of GDP in recent years and the
  gap between savings and investment has widened
  ominously savings have become misaligned with
  investment

22
Investment and Savings in China1990-2007 ( of
GDP)
  1990-1994 1995-1999 2000-2004 2005-2007
Gross Domestic Savings 41.2 42.0 41.1 52.4
Gross Capital Formation 39.5 38.8 38.7 44.1
Difference between the Two 1.7 3.2 2.4 8.3
23
Savings, Investment and Current-Account Surpluses

• China has been a high-savings, high-investment
  economy for a long time, growing rapidly and
  channelling its huge rural labour surplus into
  the production of higher-productivity tradables,
  i.e., it has been developing
• Its current fiscal stimulus (5 of GDP), mostly
  in investment, is designed to continue this
  momentum during the global recession
• It has ample fiscal space to expand domestic
  demand without creating unsustainable public debt
• Critics argue that China should boost domestic
  consumption (and thus imports) to rebalance its
  economy (and the global economy)
• Would this improve Chinas economic conditions?

24
Rebalancing Chinas Growth

• Rebalancing Chinas growth model by stimulating
  more domestic consumption is certainly feasible
  since its domestic market is large
• Its consumption has continued to grow rapidly
  (9.3 in 2009) but its investment has still been
  growing faster (14.8)
• Striving for consumption-led growth makes no
  sense for an underdeveloped economy, especially
  since Chinas equity and housing markets are
  showing signs of an incipient bubble
• The transition to a Chinese growth model based
  more on domestic demand (particularly household
  consumption) would necessarily be a protracted
  process, in any case, based on fundamental
  restructuring of the economy
• In the meantime, China is operating as an engine
  of growth for the rest of Asia, whose exports to
  China are now booming

25
Rebalancing Chinas Growth

• Global imbalances have recently diminished The
  US current-account deficit is expected to decline
  to -2.2 of GDP in 2010 and Chinas
  current-account surplus to decline to 8.6 (IMF
  World Economic Outlook)
• China will continue, for a while, to rely on the
  export of manufactured exports as the engine of
  rising productivity and growthbut probably to
  more diversified markets
• China does need to shift from low-return and
  risky reserve accumulation to higher yielding
  direct foreign investment in other developing
  countries
• Such a shift already appears to be happening as
  the previous surplus on its capital account is
  diminishing
• But, like Brazil and India, China still faces the
  problem of increased inflows of speculative
  capital

26
Chinas Trade Diversification

• Chinas trade has been diversifying for some time
• Since only 16 of Chinas exports were directed
  to the US market in 2007 (with a falling trend),
  pegging strictly to the US dollar does not
  necessarily make sense
• China should continue managing the exchange rate
  but could peg the renminbi to a more diversified
  set of major currencies since its trade is
  becoming increasingly diversified
• But pegging to the dollar makes more sense
  precisely for maintaining the renminbi value of
  its dollar-denominated foreign-exchange reserves
• Otherwise, China would incur huge book-value
  losses on these assets as the US dollar
  depreciates

27
The Direction of China's Exports 2000-2007 ( of
total)
28
Widening Fault-Lines in The International
Monetary System

• The constraints on Chinas reliance on Export-Led
  Growth the US Dollar no longer appears to be a
  reliable store of value ? How can it continue
  functioning as the worlds prime Reserve
  Currency?
• Does supplying the worlds monetary needs imply
  that the US has to run a current-account deficit?
• The US has tended to run such deficits since the
  break-up of the Bretton Woods system it has
  almost invariably run deficits since the early
  1980s. Figure
• Its current-account deficits ballooned beginning
  in the early 1990s, reaching a floor of -6 of
  its GDP in 2006before recovering modestly, to
  -5.2 in 2007 and -4.9 in 2008

29
US Current-Account Deficits Billion, 1980-2008
30
Widening Fault-Lines in The International
Monetary System

• Because the US current-account deficits remain
  large and recent US domestic counter-cyclical
  monetary and fiscal policies have added pressure,
  the main question is not whether the US dollar
  will depreciate. It is how fast will it
  depreciate?
• When the US administration states that it favours
  a strong dollar, this means that it favours
  gradual depreciation (any prolonged appreciation
  is unrealistic)
• Holders of US-denominated reserves, such as
  China, are already suffering losses. And if they
  significantly withdrew such investment, the value
  of the dollar would drop even further
• The Problem This is an inherently unstable
  situation, which could trigger future crises

31
Why Does China Continue Investing in US Reserves?

• In a way, China was obliged to invest its
  foreign-exchange reserves in US T-Bills
• The Central Bank had to sterilize the large and
  recurrent monetary impact of both current-account
  and capital-account surpluses (foreign
  investment)
• It had to build up reserves otherwise the
  injection of additional money into the economy
  would have driven up imports, and wiped out net
  exports
• There were very few highly liquid financial
  markets in which such a large yearly stock of
  reserves could be parked
• Huge US current-account deficits conveniently
  created just such a market. However, there
  remains a clear continuing downside risk

32
Will Global Imbalances Now Disappear?

• The IMF projects the US current-account deficit
  to decline to US -325 billion in 2010 but to
  rise back up to US -475 by 2014
• The US fiscal deficit is still projected to be
  -6.7 of GDP in 2014 and thus there should be
  continuous global marketing of US Treasury
  Securities
• Hence, there is likely to be recurrent pressure
  for depreciation of the US dollar
• Developing Asia is projected to run a
  current-account surplus of US 677 billion and
  the Middle East a surplus of US 307 billion in
  2014
• The gargantuan global imbalances of recent years
  might have been modestly diminished in the recent
  period but the basis for recurrent global
  imbalances and instability will likely remain

33
Resultant Calls for International Monetary Reform

• A 2008 paper by Bruce Greenwald and Joe Stiglitz
  has provided a Keynesian perspective on reserve
  accumulation, viewing it as a subtraction from
  global purchasing power (A Modest Proposal for
  International Monetary Reform)
• As the US increasingly absorbs the reserves of
  surplus countries (by borrowing to finance its
  growing current-account deficits), the world
  becomes increasingly flooded with dollars
• But the world economy is also subjected to a
  deflationary bias, they claim, because of the
  unnecessary stockpiling of reserves by individual
  countries
• Some precautionary savings is necessary but the
  recent build-up has been excessive (this is
  wasted investment)
• US debt-fuelled consumption and government
  deficit spending have merely counteracted this
  deflationary bias without providing a sustainable
  basis for global growth
• While the continuous threat of dollar
  depreciation still poses a destabilizing threat
  to the global economy

34
Modest Reform of the International Monetary System

• Their Modest Proposal Issue Special Drawing
  Rights on a substantial and regular basis
• SDRs could be a stable store of value linked to a
  diversified set of convertible currencies
• Reserves could be credited to the IMF accounts of
  member countries in proportion to their IMF
  funding positions
• Each country would no longer have to bury in the
  ground some of its purchasing power by the
  precautionary accumulation of its own reserves
• Any country could run a deficit (enjoy net
  imports of more real resources), which would be
  equal to its mandated receipts of new reserves
  from the IMF
• Countries would not have to worry so much about
  pressure on their currency and recurrent
  financial crises associated with global imbalances

35
How Realistic and Equitable Are Such Monetary
Reforms?

• Current imbalances are based on a dynamic under
  which the richest country in the world continues
  to spend beyond its means in order to prop up
  global aggregate demand
• The US remains in a stronger position to do so
  than any other country or grouping of countries
  (e.g., Europe) it can force adjustment onto
  other countries
• There is no immediate alternative to the US
  dollarnot even the Euro (which accounts for
  about 30 of all reserves)
• Emerging and developing countries are not yet in
  a strong enough position to negotiate a new
  international monetary system that would be in
  their own interests
• Note the disadvantages of current reform
  proposals 1) they centre on the IMF (without
  fundamental governance reforms) and 2) they
  allocate international reserves according to
  measures such as GDP (namely, not equitably)