Rebalancing World Consumption -- China and the US

Yesterday Professor Simon Johnson made a presentation to the US House of Representatives on US Debt to China.  Johnson is one of the economists I read regularly, and with whom I usually agree.  For those who have the time I recommend you read his blog referenced above.  If not, here is a summary (italicised below) with my own comments.



It should be clear to every thinking person that the only way to restore some hope of normal economic activity and peace in the world is for the enormous economic imbalances built up over many decades and centuries to "gradually" and "non violently" disappear.  It should also be clear to everyone that seven billion people or so, growing gradually to nine billion, cannot ever attain a current wealthy industrial life style, while the wealthy countries double their own consumption every generation (3% CAGR).   One of the peaceful and gradual approaches (among many others) to rebalancing the world  is to allow national currencies to change values gradually with respect to each other.  In the particular case we are now considering, (China and the US) it means the long term devaluation of the dollar with respect to the renmimbi.   Such a move must happen, and eventually will happen, but it does begin a very serious and not easily predictable set of effects.  Some of the effects will be, eventually, a decrease in the rate of "off shoring" American jobs to China, an increase in the cost of oil measured in dollars, and an increase in the average standard of living of Chinese citizens compared with American citizens.

Here is Professor Johnson:

China is the largest holder of official foreign currency reserves in the world, currently estimated to be worth around $2.4 trillion – an increase of nearly $500 billion in the course of 2009 (on the back of a current account surplus of just under $300 billion, i.e., 5.8 percent of China’s GDP, and a capital account surplus of around $100 billion).  These reserves are accumulated through arguably the largest ever sustained intervention in a foreign exchange market – i.e., through The People’s Bank of China buying dollars and selling renminbi, and thus keeping the renminbi-dollar exchange rate more depreciated than it would be otherwise. 
China is also currently the second largest holder of US Treasury Securities – at the end of December 2009, it held $755.4 billion – just behind Japan (which had $768.8 billion).
The US Treasury data almost certainly understate Chinese holdings of our government debt because they do not reveal the ultimate country of ownership when instruments are held through an intermediary in another jurisdiction.

For example, UK holdings of US debt rose during 2009 from $130.9 billion to over $300 billion, despite the fact that the UK ran a substantial current account deficit last year.  A great deal of this increase may be due to China placing off-shore dollars in London-based banks (Chinese, UK, or even US), which then buy US securities.  China may also purchase US securities through other routes. 
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There is a perception that China’s large dollar holdings confer upon that country some economic or political power vis-à-vis the United States and, in particular, that Chinese reserves prevent us from putting pressure on that country’s authorities to revalue (i.e., appreciate) the renminbi.  This view is incorrect and completely misunderstands the situation.
It is in the interests of both the United States and global economic prosperity that China discontinues its massive intervention in the market for renminbi.  This intervention is a breach of China’s international commitments (as a member of the International Monetary Fund) and constitutes a form of unfair trade practice.
If China were to end its intervention, the renminbi would appreciate substantially – likely in the region of 20-40 percent.  China would also stop accumulating dollars (and other foreign assets). 
The primary effect would therefore be an effective depreciation of the US dollar against the Chinese renminbi – and against all other countries’ currencies that are implicitly pegged to the renminbi (more precisely, to the dollar rate with an eye on China’s competitiveness).  On a trade-weighted basis – and in real effective terms (despite the fact that the currencies of our other major trading partners float freely) – the dollar would also likely fall in value.
Such a movement in the dollar would help expand our exports and improve our ability to compete against imports; this would aid in the process of recovery, job creation, and broader adjustment in the US economy.  Even a substantial movement in the dollar – e.g., a 20 percent depreciation in real effective terms, which is most unlikely – would have no noticeable effect on inflation and therefore would not force the Federal Reserve to increase interest rates.  The “hard landing” scenario for the dollar – feared by analysts since the traumatic experiences of the 1970s – is unlikely for the US today, given the low level of inflation expectations and the high “output gap” (reflected in measured unemployment near 10 percent and true unemployment of at least 15 percent). 
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In another potential scenario, there is concern that China would threaten to reduce its purchases of US government securities without allowing its currency to appreciate.  But if China continues to intervene to maintain its currency peg, it will accumulate foreign reserves – so they need to hold increasing amounts of foreign assets of some kind.  What else would the Chinese authorities buy?

1. If they buy other dollar denominated assets issued by US entities, this would push down spreads on those assets relative to Treasuries.  This would directly help private US borrowers – thus stimulating growth in the US.
2. If they directly buy dollar denominated assets issued by non-US entities, this will still reduce spreads more broadly and help US borrowers – as there is a global market for dollar assets and there is not much high grade non-US dollar debt available for sale.
3. If they buy dollar equities – which is most unlikely – this would help the stock market, household balance sheets, and firms’ access to funding (as well as helping to shift our economy from debt to more equity financing, which would a desirable move in any case.)
4. If they buy non-dollar assets, given that the Fed will keep interest rates near to zero, this will push down the value of the US dollar and help boost US growth.  Such a move would produce protests from the eurozone and Japan, but this change in currency value would be solely China’s responsibility.

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A depreciation of the dollar directly reduces the value of their foreign holdings and does not, under current circumstances, pose any kind of threat to the US. There is still an open question of how best to push China to revalue the renminbi.

1. Bilateral negotiations, as championed for example by former Treasury Secretary Paulson, have achieved essentially nothing since 2002.  This is not a promising way forward.
2. The International Monetary Fund (IMF) has proved itself incapable of calling China to account.  The IMF’s much vaunted “Surveillance Decision” is a failure and the general Fund mandate of “multilateral surveillance” has (again) proved to be a paper tiger.  Working with the IMF on this issue is not worth any additional effort by the US government.
3. China is obviously a currency manipulator and should be so labeled by the US Treasury in its next report to Congress.  China’s threat to react by selling Treasuries is – as explained above – at worst a bluff and at best a way to help the US with a depreciation of the dollar.  This bluff should be called.

This, of course, raises the issue of what the US should do beyond applying labels.  Bilateral trade sanctions are never a good idea and can easily get out of hand.  Given the failure of the existing multilateral mechanisms around the IMF, the US should take up this issue at the level of the G20 – there are two summits of leaders this year and plenty of support around the world for addressing China’s exchange rate.
The most plausible proposal is to expand the mandate of the World Trade Organization – which should operate in this respect without the involvement of the IMF – in assessing exchange manipulation on the same basis as it deals with unfair trade practices (as proposed by Mattoo and Subramanian).  While full implementation for such a rearrangement of responsibilities would take some years, concrete moves in this direction would concentrate the minds of the Chinese authorities in a potentially constructive manner.