PART 1:
Follies of fiddling with the yuan By Henry C K Liu
Dollar
hegemony emerged after 1971 from the peculiar phenomenon
of a fiat dollar not backed by gold or any other species
of value, continuing to assume the status of the world's
main reserve currency because of the US's geopolitical
supremacy. Such currency hegemony has become a key
dysfunctionality in the international finance
architecture driving the unregulated global financial
markets in the past two decades. China's overheated economy
is the result of hot money inflow caused by dollar
hegemony. China's developing economy should be able to
absorb huge amounts of capital inflow, but dollar
hegemony limits foreign investment to only the Chinese
export sector, where dollar revenue can be earned to
repay capital denominated in dollars. Since China's
export sector cannot grow faster than the import demands
of other nations, excessive dollar capital inflow
overheats the export and exported-related sectors, while
other sectors of the Chinese economy suffer acute
capital shortage.
Overheated economies produce
growth-inhibiting inflation through excessive import of
money and sudden rises in prices for imported
commodities and energy. The imported inflation is then
re-exported, causing inflation in other parts of the
global economy. Inflation causes interest rates to rise,
which in turn causes unemployment and recession in all
economies that are plagued by it.
China's
currency, known as the renminbi (RMB) yuan, has been
pegged to a fiat dollar within a narrow band (0.3%)
around an official rate of 8.28 to 1 since 1995. Even
though the yuan is still not entirely freely
convertible, any change in dollar interest rates will
impact yuan interest rates due to the peg.
While the
linkage between exchange rate and interest rate is
direct, the exchange rate policies of most countries do
not always operate in sync with their interest rate
policies, leading to imbalance and disequilibrium in
their economies. This is because these two related
policies impact different segments of the population
differently. Thus conflicting political dynamics push
them in conflicting directions.
Capital
generally prefers a strong currency since it reflects
financial strength, while labor prefers a weak currency
to boost exports that provide domestic employment.
Capital prefers high interest rates for better returns
while labor prefers low interest rates for cheaper
consumer loans and affordable mortgages. China will be
no exception as its moves toward interest rate
liberalization and free currency conversion.
Dollar
hegemony enables the US to be the only exception from
macroeconomic penalties of unsynchronized exchange rates
and interest rates. The US, because of dollar hegemony,
is the only country that can claim that a strong
currency that leads to trade deficits is in its national
interest in a global economy dominated by international
trade. This is because a strong dollar backed by high
interest rates helps produce a US capital account
surplus to finance its trade deficit.
While other
economies must earn dollars to finance their dollar
deficits, US trade and fiscal deficits need only be
repaid with dollars that the US can print at will, not
from dollars that the US must earn. That in essence is
the benefit of dollar hegemony to the dollar economy.
But while dollar hegemony is good for the dollar
economy, it imposes costs of job loss and a debt bubble
on the US economy.
Off the
dollar, and back China's
exchange rate policy is not always synchronized with its
interest rate policy. Currency control has protected
China from severe macroeconomic penalties so far. On the
exchange rate side, China has changed the exchange value
of the yuan many times since its introduction on January
1, 1970, when currency reform substituted 10,000
renminpiao for one RMB yuan fixed at an official rate of
2.46 yuan to a dollar. After the collapse in 1971 of the
Bretton Woods regime of fixed exchange rates based on a
gold-backed dollar, pressure grew to appreciate the yuan
against a floating dollar no longer backed by gold. With
the RMB's theoretical gold content unaltered, a new
official rate was set on December 23, 1971 at 2.26 yuan
to a dollar. The alarming free fall of the dollar led
China to tie the yuan to the Hong Kong dollar and the
British pound sterling.
Hong Kong shifted from a rule-based
currency board to a discretionary currency board over
the course of its monetary history. From 1935 to 1967,
Hong Kong as a British colony operated a classic
colonial currency board pegged to the pound sterling,
except that private banks - not the government - issued
the currency, a practice that continues to this day.
Instability in the value of the pound in the late 1960s
pushed Hong Kong to switch to a dollar peg. The dollar,
too, came under speculative attack after 1971. To avoid
sinking with the dollar, Hong Kong also decided to let
its own currency float. It worked reasonably well until
the commencement of Sino-British negotiations on the
return of Hong Kong to China, which unleashed wild
speculation against the Hong Kong dollar, pushing the
free-floating exchange rate temporarily to 9.6 to 1 on
September 24, 1983.
By the end of October 1983, Hong
Kong had ended its brief experiment with floating
exchange rates and announced that it was pegging its
currency to the dollar at a rate of 7.8 to $1 with a
discretionary currency board regime. The peg amounted to
an official devaluation from the pre-crisis floating
market rate of 4.6 to 1 to defuse market panic. In 1985,
two years after the adoption of the HK peg, the Plaza
Accord, aiming to halt the rising US trade deficit,
pushed the already steadily falling dollar sharply
further down against the yen. The Hong Kong peg produced
a sharply undervalued Hong Kong currency that in turn
gave birth to a bubble economy that burst 12 years later
in 1997 as part of the Asian financial crisis.
The independent yuan In April 1972, with the Hong Kong
currency free floating, China began listing an official
effective rate for the yuan independent of the Hong Kong
currency. On August 19, 1974, the effective rate of the
yuan was pegged to a trade-weighted basket of 15
currencies, the composition of which was undisclosed to
the market. The effective rate was fixed almost daily to
the floating market value of that basket. By December
31, 1979, the yuan's effective rate rose to 1.5 to a
dollar when the US Federal Reserve under Paul Volcker
mounted its heroic struggle to halt US inflation by
raising dollar interest rates to historical heights.
On January
5, 1980, the State Council issued a decree prohibiting
payments in foreign exchange within China. On April 1,
1980, Foreign Exchange Certificates (FEC), or waihuijuan, equal in value to
the yuan at the effective rate, were put into
circulation, issued to non-residents in exchange for
designated hard currencies, for paying hotel bills,
transportation fares and for purchases at Friendship
Stores. Consumer prices were set at separate levels for
the yuan and the FEC to reflect purchasing power
disparity between the two currencies.
On January
1, 1981, a foreign trade rate with two categories was
introduced for the RMB. For internal settlements under
the foreign exchange allotment quota, the official rate
was set at 2.80 yuan per dollar. This rate was formed by
adding to the effective rate an "equalization price" for
balancing export and import profits and losses, and
applied to all national enterprises and corporations
engaged in foreign trade as well as to receipts and
expenditures in foreign exchange for trade-related
transactions in invisibles such as shipping and
insurance.
An experimental trading system for
foreign exchange was established by the Bank of China in
a few areas such as Beijing, Guangdong, Shanghai and
Tianjin. A foreign exchange retention quota also
permitted exporters to retain a portion of export
earnings. National enterprises holding foreign exchange
earned through the system of retention quotas were
permitted to sell this foreign exchange to other
national enterprises that had a quota for spending
foreign exchange. For dealings under the foreign
exchange retention scheme, the Bank of China acted as an
exclusive broker, charging 0.1%-0.3%, resulting in an
effective rate of 2.803-2.808 yuan per dollar. The
effective rate was applicable to all other transactions,
while the official rate was largely symbolic.
On January
1, 1985, the internal settlement official rate was
abolished and all trade was governed by the effective
rate. On November 20, 1985, authorization was granted
for residents to hold foreign exchange and open foreign
exchange accounts and to deposit and withdraw funds in
foreign exchange. This was to serve residents who might
receive foreign currency funds from relatives and
friends overseas, as individuals generally did not have
permission to engage in foreign trade to earn foreign
currency. By the end of November 1985, the yuan, pegged
to a trade-weighted basket of currencies, was trading at
3.2 to a dollar as a result of the Lourve Accord that
pushed the dollar up from the downward overshoot of the
Plaza Accord two years earlier. On January 1, 1986, the
trade-weighted basket of currencies peg was abandoned
and the effective rate was placed on a controlled float
based on developments in the balance of payments and in
inflation trends and exchange rates of China's major
trading partners and competitors.
In November
1986, a foreign exchange swap rate was created, based on
rates agreed on between buyers and sellers at over 100
foreign exchange adjustment centers available to foreign
investment corporations and at first to Chinese
enterprises in the four Special Economic Zones of
Shantou, Shenzhen, Xiamen and Zhuhai but expanded in
1988 to all domestic entities authorized to retain
foreign exchange earnings. Between July 5, 1986 and
December 15, 1989, the yuan remained at 3.72 to a
dollar, despite the 1987 crash in the US equity markets.
The
foreign exchange swap was set at 5.2 yuan to a dollar on
December 31, 1986 and lowered to 5.9 a year later on
December 31, 1987, while the yuan continued to trade at
3.72 to a dollar. Early in 1988, all domestic entities
with retained foreign exchange earnings were granted
permission to trade in the adjustment centers, and by
October, 80 adjustment centers were established.
Initially, a relatively small volume of transactions
took place in these markets, but the volume increased
substantially after access to the centers was expanded.
On
December 31, 1988, the foreign exchange swap rate was
again lowered to 6.60 while the yuan continued to trade
at 3.72 to a dollar in the controlled market at
adjustment centers. On February 1, 1989, regulations
were issued governing the use of foreign exchange
obtained in foreign exchange adjustment centers. Imports
of inputs for the agricultural sector, textile and for
technologically advance and light industries were given
priority. Purchases of foreign exchange for a wide range
of consumer products were prohibited. On March 1, 1989,
regulations were issued governing domestic sales in
foreign currency by foreign investment corporations.
Such corporations were permitted to sell in China for
foreign exchange provided the sales involved purchases
under the government's annual import plan, sales in
Special Economic Zones and other promotional areas, and
sales of import substitutes.
On December 15, 1989, affected by
the continuing global impact of the 1987 crash in the US
equity markets, the yuan was devalued by 21.2% to 4.72
to a dollar from 3.72. Dollar hegemony was causing the
dollar to rise instead of fall in the face of a massive
injection of liquidity by the Fed in the US money supply
to respond to a sudden collapse of US equity markets
that led to a multi-year recession. On December 31,
1989, the foreign exchange swap rate was raised to 5.40
from 6.60, while the yuan continued to trade at 4.72 to
a dollar. On November 17, 1990, the yuan was again
devalued by 9.6% to 5.22 to a dollar, with the foreign
exchange swap rate lowered again to 5.70.
On April 9,
1991, the management of the exchange rate was altered to
a procedure under which the rate would be adjusted
frequently as needed in light of certain indicators of
development in international exchange markets, relative
price performance, and trends in export production
costs. On September 11, 1991, new regulations governing
the use of official foreign exchange were introduced.
Priority for using foreign exchange was given to imports
of agricultural inputs, interest and amortization
payments and remittances, and imports of key
construction projects and technology. The next priority
level included raw materials used for industrial
production, critical spare parts, educational materials,
and medicines. Items for which the use of official
foreign exchange was strictly prohibited included
cigarettes, wine, clothes, shoes, small household
appliances, soft drinks, film and other luxury items.
On
October 1, 1991, specialized banks other than the Bank
of China foreign banks that were engaged in foreign
exchange business in Zhejiang and Jiangsu province began
to sell foreign exchange from export and service
receipts directly to local branches of the People's Bank
of China (PBC), later to become the central bank. These
banks were allowed to purchase foreign exchange directly
from the PBC to finance imports. The State
Administration for Exchange Control would manage this
part of the exchange reserves under the authorization of
the PBC. After December 1991, individual residents could
buy and sell foreign exchange through authorized banks
at rates established in the adjustment centers in
conformity with exchange control regulations.
On December
31, 1991, the foreign exchange swap rate was further
lowered to 5.90 to a dollar. In April 1992, revised
guidelines were issued specifying the priority uses of
foreign exchange in adjustment centers for goods not
covered by import licenses. Imports of inputs for the
agricultural sector and central and local construction
projects, and advanced equipment and technology, grain
and goods that met daily needs were given priority. On
January 31, 1993, the foreign exchange swap rate was
again lowered to 7.50 while the yuan continued to trade
at 5.75 to a dollar. On July 1, 1993, the exchange rate
at which the state sold 30% of foreign exchange
purchased from exporters to certain enterprises was
changed from the effective rate to the prevailing swap
market exchange rate. On December 31, 1993, the foreign
exchange swap rate was lowered to 8.70 while the yuan
traded at 5.8 to a dollar.
One and
only On January 1, 1994, the
effective exchange rate and the swap market rate were
unified at the prevailing swap market rate. The PBC
would announce a reference rate for the yuan against the
US dollar, the Hong Kong dollar, and the Japanese yen
based on the weighted average price of foreign exchange
transactions during the previous day's trading. Daily
movement of the exchange rate of the yuan against the
dollar was limited to 0.3% on either side of the
reference rate as announced by the PBC.
The buying
and selling rates of the yuan against the Hong Kong
dollar and the Japanese yen might not deviate more than
1% on either side of the reference rate; and in the case
of other currencies, the deviations should not exceed
0.5% on either side of their respective reference rates.
Issue of export retention quotas ceased except for
outstanding long-term contracts. In addition, Foreign
Exchange Certificates (FEC) ceased to be issued and
those in circulation would be withdrawn gradually.
On April 1,
1994, the China Foreign Exchange Trade System (CFETS) in
Shanghai (an integrated electronic system for inter-bank
foreign exchange trading) came into operation.
Twenty-two cities were linked to this system by the end
of 1994. On July 1, 1996, foreign-funded banks were
allowed to sell foreign exchange for bona fide
transactions and become designated foreign exchange
banks. On April 1, 1997, 12 branches of the PBC began to
operate forward purchases and sales of RMB against
underlying transactions on a trial basis. Two years
later, on April 1, 1999, the longest maturity of forward
purchase and sale of foreign exchange was extended to
six from four months.
Thus on the exchange rate side,
Chinese policy has always been reactive to US policy.
From a high of 1.5 yuan to a dollar in 1979, the yuan,
falling steadily against the dollar, has been fixed at
8.28 to a dollar since 1995 and remained unchanged
through the 1997 Asian financial crisis, the 1998 and
2000 US recessions when pressure to further devalue the
yuan was resisted by China. Recent US official policy of
a strong dollar being in America's national interest
provided the rationale for holding the yuan-dollar peg.
On the
interest rate side, Chinese policy tended to respond to
the needs of its banking system more than the needs of
the Chinese economy. Between 1979 and 2000, the PBC
adjusted loan rates on 19 occasions and bank deposit
rates on 21. China last raised the yuan lending rate on
July 1, 1995 to 12.06% from 10.98 when the yuan exchange
rate was pegged at 8.28 to a dollar. This was at a time
when the US Federal Reserve raised the Fed funds rate
(ffr) to 6%, and cross-border flow of funds between the
US and China was strictly controlled. The ffr is the
rate at which US banks loan excess reserves to each
other. While the Fed cannot directly influence this
rate, it effectively sets targets for it through the way
it buys and sells Treasuries to banks.
In China,
eight reductions over a period of eight years since 1994
halved the benchmark yuan one-year lending rate to
5.31%. The yuan one-year deposit rate is now 1.98%.
China's consumer price index rose 5.3% in the year
through July, meaning that borrowers now enjoy near
interest-free loans after adjusting for inflation.
Industrial prices climbed 14% in the first seven months
of 2004, making real interest rates negative by a wide
margin in industrial sectors. Yuan bank deposits at
1.98% now suffer erosion of principal to inflation at
the rate of 3.32% a year, which then as bank loans goes
to support a built-in 8.69% annual profit for those who
borrow at 5.31% to speculate in the industrial sectors
with 14% inflation.
Clash of
interests International money
flow is closely linked to interest rate differentials
between economies, in the direction of the higher rate.
Speculative hot money poured into China for the past two
years as the Fed cut ffr to 1%. Ample liquidity
triggered an investment boom in China that exacerbated
inflation. The resulting negative real interest rate
amplified investment demand and caused a speculative
bubble. Some $200 billion has been misallocated to
overheated export-related sectors by the market, with
fixed investment running 20% above annual absorption
rate, while non-export-related sectors faced acute
capital shortages.
With a yuan-dollar peg, keeping yuan
interest rates in tandem with dollar interest rates has
been suggested as the only way for China to stop a
further inflow of hot money. China's foreign exchange
reserves rose by $67.3 billion in the first half of 2004
despite a $20 billion trade deficit that cuts the $30.3
billion in foreign direct investment to a net of only
$10.3 billion. The discrepancy of $57 billion in new
foreign exchange reserves growth is attributable to hot
money inflows sneaking into China in the first six
months of 2004, only to be transmitted through China's
central bank into its foreign reserves in the form of US
treasuries.
This requires the PBC to release 472
billion yuan into China's money supply. While the Fed
raises rates on signs of recovery in the US economy,
China is being pressured to follow the Fed's interest
rate moves even when its domestic economy is slowing
because of cost-pushed inflation, mostly through higher
prices for imported fuel and commodities that are needed
by the overheated export sector that overshoot market
growth. While conventional wisdom proclaims that keeping
money too inexpensive for too long is a recipe for
trouble for an unregulated market economy, it is not
necessarily so for a planned economy where credit
allocation can be directed by government policy, or an
economy with a currency control regime.
Yet Chinese
interest rates have been well above US and Hong Kong
rates since the Federal Reserve began cutting ffr target
13 times from 6.5% in January 2001 to 1% on June 25,
2003 and kept it there for a whole year until June 30,
2004. The Fed lowered the discount rate to 0.75% on
November 6, 2002 and raised it in three steps to 2.75%
for primary (generally sound) financial institutions and
3.25% for secondary (less creditworthy) institutions.
Institutions use the discount window as a backup rather
than a regular source of funding. This meant that banks
could borrow at the discount window at a rate generally
500 basis points below the ffr until January 9, 2003
when the discount rate was set at 100 basis points above
the ffr. This was another indication that the Fed was
tightening credit while still injecting liquidity into
the US banking system beginning January 9, 2003. The
spread between the discount rate and the ffr continues
to be 100 basis points for primary institutions and 150
basis points for secondary institutions.
Before
dollar's short-term rate began to rise in July 2004 from
its historical low of 1%, as the Fed boosted the
short-term rate target for a third time this year to
1.75% on September 21, the one-year domestic yuan
deposit rate at 1.98% was 142 basis points higher than
the 0.56% one-year domestic dollar deposit rate and 92
basis points higher than the 1.06% one-year US CD
(certificates of deposit) rate. As a result, dollar
funds in the form of hot money seeking quick short-term
speculative profits have been pouring into China, making
it difficult for the PBC to manage rising yuan liquidity
levels from the transmission of these dollar funds into
burgeoning foreign exchange reserves.
As China's
foreign exchange reserves increase, it faces pressure
from the US, Japan, the EU and other trading partners to
revalue the yuan upward. Yet China has begun to incur an
overall global trade deficit that may reach $40 billion
in 2004, albeit a sizable and growing surplus ($124
billion in 2003) continues from its trade with the US.
Domestically, China is reluctant to raise yuan interest
rates for fear of triggering massive loan defaults by
distressed borrowers, leading to a crisis in the already
fragile banking system, hoping instead that
import-pushed inflation can be moderated from regulatory
measures.
With both exchange rate policy and
interest rate policy kept intact, China hopes to deal
with its overheated economy with administrative means.
To curb rising inflation and runaway speculative
investments fueled by negative interest rates coupled
with a fixed exchange rate, the government since last
spring has been trying to rein in China's overheated
economy by canceling projects that had started without
proper regulatory approvals. Administrative measures,
such as restrictions on bank loans for overheated
sectors, have slowed the economy slightly in the past
few months. Industrial output moderated to15.5% in July
compared with a year earlier, down from a peak growth
rate of 23% in February.
Time for
change? In theory, price
bubbles and overheated economies are created by the
interaction of interest rates, inflation, exchange rates
and credit allocation policies. Exchange rate theory
mandates that if two economies are linked by freely
convertible currencies with floating exchange rates,
free trade and free money flow, the one with higher
inflation and higher interest rates will see the
exchange rate of its currency fall. China now has higher
inflation and interest rates than the US, thus the yuan
should fall instead of rise against the dollar until the
inflation rates and interest rates of both economies
equalize, if the yuan were freely convertible at
floating rates.
But a weaker yuan will increase the
cost of imports to China thus adding further to
inflation, making the yuan even weaker. A weaker yuan
will also increase exports from China and reduce the
supply of goods and assets in the Chinese domestic
market while increasing the supply of yuan from
converting dollar earnings of exporters, thus pushing up
domestic prices, adding to inflation. High inflation
will push up interest rates. But a rise in interest
rates increases the financing cost of production, adding
to inflation. High interest rates will also attract more
fund inflows, thus causing more inflation. The net
inflation/deflation outcome from interest rate moves
then depends, among other things, on trade balance. This
rationale was given by the European Central Bank as the
logic of refusing to cut euro interest rates to get the
EU economies out of recession. Keeping euro interest
rates stable was needed to fight import-pushed inflation
to lift the euro from trading below par.
There may be
a case for higher prices for Chinese exports in order to
correct the US-China trade imbalance, if the price
increase is passed directly onto higher Chinese wages to
increase domestic demand. Chinese factory wages now
range from $60 a month in less developed inland regions
to $160 a month in the more developed coastal regions
for an almost inexhaustible labor force culturally
infused with enviable Confucian work ethics. Chinese
wages can double every year for a decade with positive
effects on its economy. Wage-pushed inflation is
beneficial to overcapacity and can defuse an overheated
economy by increasing domestic demand.
The logic of
revaluing the yuan, or any currency, as a means of
balancing trade is flawed. It was ironic that US
treasury secretary Lawrence Summers in the 1990s
repeatedly lectured Japan not to substitute sound
macro-economic policy with an exchange rate policy
because the US did exactly that with the Plaza Accord in
1985 and with its strong dollar policy after the 1997
Asian financial crisis. Robert Mundell, 1999 Nobel
laureate in economics, observed while attending a
conference in Beijing this year that never before in
history has there been a case where international
monetary authorities tried to pressure a country with an
inconvertible currency to appreciate its currency. He
said China should not appreciate or devalue the yuan in
the foreseeable future. "Appreciation or floating of the
renminbi [RMB] would involve a major change in China's
international monetary policy and have important
consequences for growth and stability in China and the
stability of Asia," Mundell said.
The exchange
value of the yuan is not crucial to the monetary
problems facing the world economy and financial
architecture today. Dollar hegemony, a peculiar
phenomenon in which a fiat dollar assumes the status as
the world's main reserve currency is the main
dysfunctionality in the current debt economy and
international finance structure. China is not the
problem; dollar hegemony is. China's economy, despite
spectacularly rapid growth, still accounts for only an
insignificant 3.5% of the global GDP, a pathetic figure
for a nation with one fifth of the world's population.
Its share of world trade has risen from less than 1% to
5% in two decades. Most Chinese export products are sold
with a retail price of less than $100 per item. Thus
self-satisfaction of alleged economic miracle is grossly
premature.
After two-and-a-half decades of
reform, China is still unable to accomplish in economic
reconstruction what Nazi Germany managed in four years
after coming to power, ie full employment with a vibrant
economy that would challenge that of Great Britain, the
then superpower. Post World War I Germany started with
an economy in every way as devastated as China's, with
no prospect of foreign credit, huge war debts and
reparations and a defeatist social milieu. While Nazi
philosophy is detestable, the effectiveness of the
national socialist economic programs of the Third Reich
cannot be summarily dismissed.
Yet China
now accounts for 60% of the growth in world trade. This
testifies not to China's strength in trade, but the
weakness of world trade growth, which has been driven
not by prosperity, but by falling wages in the past two
decades. Even the rise in foreign direct investment
(FDI) inflows to China is not caused by an undervalued
currency, but rather by the potential of China's
domestic market and growth fundamentals. Yet this
potential is constrained by dollar hegemony, which
forces FDI into China's saturated export sector. But
this export sector cannot grow because it is built on
the outsourcing of jobs from the target markets. Rising
unemployment in these markets will shrink demand for
Chinese exports.
Wrong
target China's trade surplus
with the US, a key target in the knee-jerk criticism of
China's yuan policy, has actually little direct link
with the exchange rate of the yuan. This trade surplus
has been nurtured by dollar hegemony by design in order
to finance the US capital account surplus. China's
recent export performance is primarily driven by the
country's two-decade trade reforms, its abundance of
low-wage labor that has remained low-wage after
two-and-a-half decades. And more importantly, China's
growth has been largely led by growing processing and
assembly operations in China for re-export, operated by
transnational corporations mainly to demolish the
hard-won gains of labor movements in the capitalistic
West.
Chinese exports have consistently
outperformed the competition at wide-ranging values of
the yuan pegged at different levels to a fluctuating
dollar. The Chinese export boom persisted even during
the turbulent years following the 1997 Asian financial
crisis, when strong market pressure for the yuan to be
devalued was resisted. The reason for this is that
Chinese wages are more flexible on the falling side than
on the rising side, as a result of the smashing of the
iron rice bowl by market reform and a labor movement
that had not kept pace with the introduction of
socialist market economy.
Exchange rate movements affect the
price of both imports and exports, but their impact on
trade balance may only lead to changes in the volume of
goods and services rather the monetary value of trade.
With a stronger yuan, fewer Chinese goods may be
exported to the US at a higher price; and more US goods
and services may be exported to China at a lower price,
but the trade imbalance in monetary value may remain the
same after initial price adjustments. Historical data
suggest that Chinese firms will be required by existing
agreements to continue to compensate foreign investors
at previously negotiated rates of return by lowering
Chinese wages. The lower wages will result in lower
domestic demand in the Chinese economy and eventually in
the global economy. And US firms will take advantage of
the exchange rate change to raise prices of US exports.
The result may merely be higher inflation for the US and
eventually for the global economy.
As dollar
interest rates rise, China can choose to insulate the
impact on yuan interest rates by re-pegging the yuan
upward, or to keep the current peg by following dollar
interest rates trends. But it cannot do both at the same
time without destabilizing China's financial system and
economy. Since the dollar is freely convertible at
market rates, the dollar-pegged yuan is in effect
subject to market rate fluctuation along with the dollar
with regard to other currencies. Thus the stability
argument of the dollar peg is deceptive. Fixed exchange
rates seldom produce monetary stability; it only
reflects official denial of economic reality, often at
an economy's long-term peril. There are monetary policy
autonomy benefits from controlled convertibility for any
currency, such as insulation from dollar hegemony, but
exchange rate stability is not among them.
Policy-induced exchange rates require central bank
intervention that will surface as costs in different
forms in the economy.
In theory, rising interest rates
push up exchange rates. However, this convention is only
operative if rising interest rates reduce inflation.
Rising interest rates can add to inflation under some
conditions, pushing down exchange rates. When dollar
interest rates rise, the dollar gets stronger. But
despite recent corrections, the exchange value of the
dollar is still at an 18-year trade-weighted high,
notwithstanding record US current-account and fiscal
deficits and the status of the US as the world's leading
debtor nation. There is persistent talk among trade
economists of the need for the dollar to fall another
20%.
The
US inflation rate has been moderated by low-price
imports from China. Policy-induced upward valuation of
the yuan against a rising dollar will accelerate US
inflation. It will drive up US interest rates at a
faster pace, conflicting with the Fed strategy of a
"measured pace" for interest rate moves to avoid
scuttling the anemic recovery. Similarly, raising yuan
interest rates may put upward pressure on the exchange
rate of the yuan to the dollar, making Chinese exports
more expensive in dollar terms, creating upward pressure
on US inflation rates and interest rates. These
pressures can be resisted, but not without costs to the
US economy.
Thus, recent calls from US officials
for China to simultaneously raise both the yuan exchange
rate to the dollar, and yuan interest rates further
above dollar interest rates are ill advised. Such moves
will cause an upward spiral of interest rates and
inflation in the US, China, Asia and the rest of the
world. Yuan interest rates are already substantially
above dollar rates, an upward valuation of the yuan
against the dollar with a rise in yuan interest rates
will exacerbate the destabilizing flow of hot money into
China. To understand China's dilemma on interest rate
policy as a key tool in its macro approach to cooling
its overheated economy, one needs to understand the
interlocking relationships of interest rates, inflation,
exchange rates and credit allocation.
Not again The linkage between domestic
interest rates and the exchange value of a currency is
very direct, with inevitable impacts on foreign trade.
An illustration of this is provided by the Plaza Accord
of 1985. After the US Federal Reserve under Paul Volcker
raised federal funds rate (ffr) on July 8, 1981 to a
historical high of 19.93% to fight an annual inflation
rate of over 15% that was still rising, the exchange
value of the dollar rose to cause an alarming US trade
deficit, reaching 3.5% of GDP. The Plaza Accord of 1985
was a coordinated effort by the US, Japan and Germany,
the three main trading nations of the world at the time,
to force the US dollar to fall against the yen and the
German mark, in defiance of market fundamentals, with
the purpose of reducing the US trade deficit. After the
Plaza Accord, the Federal Reserve moved the ffr target
in a downward trend, and the ffr fell to 5.56% in
October 7, 1986.
The linkage between the exchange
rate and interest rates is less direct but more
destabilizing. The Bretton Woods regime fixed the
Japanese yen at 360 and the mark at four to a dollar
until 1971. By 1985, the dollar was buying only 238 yen
and 2.95 mark. Yet the US trade deficit continued
unabated. The Plaza Accord of 1985 pushed the dollar
down to 145 yen and 1.79 mark. The Fed then reversed its
low interest rate policy in October 1986. The ffr rose
to 7.76% on October 15, 1987 and yields on 10-year
government bonds rose from 7% in January to 9.5%, a rise
that precipitated the 1987 crash four days later.
On October
19, 1987, the Dow Jones Industrial Average (DJIA)
dropped 508 points, or 22.6%, in one day on volume of
608 million shares, six times the normal volume then
(current normal daily volume is over 1.4 billion shares,
with top volume of 2.8 billion shares on July 24, 2002),
and ending 36.7% lower from its closing high of 2,787
less than two months earlier on August 25. The immediate
trigger that burst the equity bubble was identified by
some analysts in hindsight as legislation passed by the
House Ways and Means Committee on October 15,
eliminating the tax deductibility of interest on debt
used for corporate takeovers.
Interest
rate levels, in combination with exchange rate policies,
have both long-term and short-term relationships to the
forming and bursting of financial bubbles. China now
appears determined to avoid repeating past exchange rate
and monetary policy errors made by the US that had
induced the 1987, 1994, 1997 and 2000 crashes.
In response
to the 1987 crash, the US Federal Reserve under its new
chairman, Alan Greenspan, with merely nine weeks in the
powerful post, flooded the banking system with new
reserves by having the Fed Open Market Committee buy
massive quantities of government securities from the
market. Greenspan announced the day after the crash that
the Fed would "serve as liquidity to support the
economic and financial system". He created $12 billion
of new bank reserves by having the Fed buy up government
securities. The $12 billion injection of "high-power
money" in one day caused the ffr to fall by
three-quarters of a point and halted the financial
panic, though it did not cure the financial problem,
which caused the economy to plunge into a recession that
persisted for five years.
High-power money injected into the
banking system enabled banks to create more bank money
through credit multiplying, by lending repeatedly the
same funds minus the amount of required bank reserves at
each turn. At 10% reserve requirement, $12 billion of
new high power money could theoretically generate up to
$120 billion of new bank money in the form of bank
loans, if demand and borrower credit-worthiness permit,
the absence of which would leave the Fed ineffectively
pushing on a credit string. The injection of liquidity
from the Fed cemented the Plaza Accord devaluation of
the dollar into permanence without correcting the US
trade deficit.
The 1987 crash was a stock market
bubble burst that led to a subsequent real property
bubble burst that in turn caused the Savings and Loan
(S&L) crisis two years later. The Financial
Institutions Reform Recovery and Enforcement Act
(FIRREA) was enacted by the US Congress in August, 1989,
to bail out the thrift industry in the S&L crisis by
creating the Resolution Trust Corporation (RTC) to take
over failed savings banks and dispose of their
distressed assets. The Federal Reserve reacted to the
S&L crisis with a further massive injection of
liquidity into the commercial banking system, lowering
the ffr from its high of 10.71% reached on April 19,
1989 to below the 3% inflation rate, making the real
rate near zero until January 31, 1994.
Since there
were few assets worth investing in a down market, most
of the newly created money went into bonds. This
resulted in a bond bubble by 1993, which then burst with
a bang in February 1994 when the Fed started raising
rates, going further and faster than market participants
had expected: seven hikes in 12 months, doubling the ffr
target to 6%. As short-term rates caught up with long,
the yield curve flattened out. Liquidity evaporated,
punishing "carry traders" who had borrowed short-term at
low rates to invest longer-term in higher-yield assets,
such as long-dated bonds and more adventurous
higher-yielding emerging-market bonds. The rate
increases set off a bond-market crash that bankrupted
Wall Street giant Kidder Peabody & Co, California's
Orange County and the Mexican economy, all casualties of
wrong interest rate bets.
By 1994, Greenspan was already
riding on the back of the debt tiger from which he could
not dismount without being devoured by it. The Dow was
below 4,000 in 1994 and rose steadily to a bubble of
near 12,000, while Greenspan raised the ffr target seven
times from 3% to 6% between February 4, 1994 and
February 1, 1995, to try to curb "irrational
exuberance". Greenspan kept the ffr target above 5%
until October 15, 1998 when he was forced to ease after
contagion from the 1997 Asian financial crisis hit US
markets. The rise in ffr in 1994 did not stop the equity
bubble, but it punctured the bond bubble. Despite the
Lourve Accord of 1987 to slow the Plaza-Accord-induced
fall of the dollar, the dollar fell to 94 yen and 1.43
mark by 1995. The low dollar laid the ground for the
Asian finance crisis of 1997 by fueling financial
bubbles in the Asian economies that pegged their
currencies to the dollar.
US inflation rates have been
under-reported by statisticians in the name of
scientific logic. The first significant downward
adjustment occurred in 1996 on the recommendation of the
Boskin Commission, which had concluded that the US
inflation rate had been overstated by an annual 1.1
percentage points. About half of this overstatement has
since been "corrected".
America's
hedonic pleasures But
further, far more substantial downward adjustments in
the price indices have resulted from the spreading use
of "hedonic" pricing methods, used to translate quality
improvements in products into price declines even if the
actual prices are climbing. Automobiles that now sell
for $30,000 used to sell for $10,000, but the inflation
rate of automobiles is registered as declining because
cars are technically more sophisticated. The consumer is
supposed to be getting more "car" per dollar, never mind
no one can now buy a $10,000 car. Rents for apartments
are registered as declining even when rent payment
rises, because renters get air-conditioning, marble
bathrooms and granite kitchens and high rise views. Yes,
the higher up you are from the dirty, noisy street, the
more housing you allegedly get per dollar, a real
bargain in hedonic price while the square foot price
goes through the roof. Thus prices can rise with no
inflation.
The US Bureau of Labor Statistics
(BLS) expanded the use of hedonic regressions to compare
quality differences in prices. Hedonic regressions
attempt to estimate econometrically the value that
households put on quality differences. These methods are
used for measuring quality distinctions in the
categories of apparel, rent and computers and peripheral
equipment, and as of January 1999, they have been used
for television prices. Research is under way to extend
this technique to other categories.
As this
measuring technique is being extended to a growing
number of goods, it has become a most important factor
in reducing the US inflation rate, and intrinsically
raises nominal GDP growth while the real GDP may
actually decline. Its overall effect on monitoring the
economy is kept secret from the public. The hedonic
price adjustments for computer hardware and software
alone went a long way to explain US growth and
productivity miracles of the past decade.
Another
device to lower the measured US inflation rate is the
shift to "chained" price indexing, used since 1996. It
changes the weight of items in a basket of goods on the
assumption that people generally tend to shift their
spending to cheaper goods. If the price of apples rises,
people buy more pears, whose lower prices go into the
price index instead. It is reasonable to suspect that US
inflation before the 2001 crash had been hovering around
5% on the old basis, the highest in more than a decade,
and virtually twice the rate in Europe. Inherently, this
would have cut real GDP growth by about 1.5 percentage
points and kept interest rate higher. All this suggests
two important things: first, that the reported new
paradigm increases in real GDP and productivity growth
have been exaggerated by a statistical illusion; and
second, that real interest rates have been far too low
in relation to real inflation, which also explains the
most rampant money and credit creation that the US has
ever seen in recent history.
Hedonic price indexing, by keeping
the official inflation rate significantly lower than
reality, not only played a key role in fueling the stock
market boom, but also magnified the budget surplus
during the Bill Clinton years and now understates the
George W Bush deficit. Such indexing reduces social
security payments and welfare benefits across the board,
as well as undercutting inflation-related wage
adjustments. Essentially, lower hedonic prices in
computers and electronic gadgets are paid for by less
money for food and housing of the elderly, the
unemployed and the indigent as well as the average
worker.
The most troublesome fact is that
the BLS does not keep contemporaneous calculations of
the "old" method for historical consistency, or reveal
the degree of "new" versus "old" distortion. This
cover-up opens government statistics to challenges of
reporting honesty. Bill Gross of PIMCO, the world's
largest bond fund, recently wrote: "The CPI inaccurately
calculates Americans' cost of living. Since social
security and pension benefits as well as the level of
wage hikes are predicated upon the specific number
and/or the perception of annual increases, Americans are
being in effect conned by their government and falling
behind the inflationary eight ball year after year.
After slamming the concept of the core CPI, the primary
culprits I cited were the government's use of hedonic
and substitution adjustments to lower the CPI by as much
as 1% in recent years."
Look who's
talking Greenspan made his
famous "irrational exuberance" speech at the American
Enterprise Institute in Washington DC on December 5,
1996, when the Dow was at 6,437, more than twice of the
pre-crash 1987 high. Yet the market kept rising and on
January 14, 2000, the Dow peaked at a hyper-irrational
level of 11,723. Two months later, after settling down
to hover around 10,000, it experienced its largest
one-day point gain in history - 499.19 - to close at
10,630.60 on March 16, 2000. John Maynard Keynes, who
famously warned that markets can stay irrational longer
than participants can stay liquid, must have been
laughing from heaven.
Greenspan either failed to link the
rise of equity prices to an undervalued dollar or he
deliberately skirted the issue because foreign exchange
value of the dollar was the province of the Treasury,
not the central bank. Either way, there was nothing
irrational or exuberant about the effect of a fall in
the exchange value of the dollar on a rise in US equity
prices. It was a causal effect of a finance bubble
fueled by an undervalued currency, especially when price
increases can be viewed as causing no inflation through
hedonic regression.
On April 14, 2000, some 22 trading
days after its largest one-day point gain, the Dow
plummeted 617.78 points, closing at 10,305.77 - its
steepest point decline in a single day historically so
far. This volatility came purely from speculative forces
operating on a bubble. The economy did not change in 22
trading days. When the Dow started its slide downward
after peaking at a historical all-time high of 11,723 on
January 14, 2000, the Fed lowered the ffr target from
6.5% on January 3, 2001, but could not halt the decline.
After the Dow hit a low of 7,524 on March 11, 2003, the
Fed lowered the ffr target to 1% on June 25, 2003 and
kept it there until July 2004. Since then, the Dow,
having climbed steadily to peak at 10,737 on February
11, 2004, fell back to 10,121 by August 31, 2004 when
the ffr rose to 1.5% and closed at 9,988 on September 27
with the ffr at 1.75%.
The US trade deficit was 3.5% of GDP
at the time of the 1987 crash. It was 5.4% by the end of
the first quarter of 2004 and rose to $166.2 billion for
the second quarter of 2004, annualized to $664.8
billion, or 6.5% of US-projected GDP. With every passing
day, more market watchers are joining the rank of those
predicting looming financial crisis in US markets from
excessive debt, particularly external debt. This danger
cannot possibly be defused by China, regardless of what
monetary policy it adopts. The dismal record of US
monetary policy that induced the 1987, 1994, 1997 and
2000 crashes discounts the value of US advice for
Chinese economic and monetary policy.
Too much of a good thing By 1994, excess liquidity had fueled
a worldwide equity rally that found its way into the
Asian emerging markets, where it fed an unprecedented
bubble of easy money in the form of undervalued
currencies pegged to a falling US dollar. When the Asian
emerging market rally crashed abruptly on July 2, 1997,
starting with the Thai central bank running out of
foreign exchange reserves trying to maintain its
currency peg, followed by the Russian debt crisis in
1998, all the major central banks of the world reacted
yet again by pumping even more liquidity into the global
banking system. Initially, this flood of hot money
inflated another bond bubble, which popped viciously in
1999. Then, more liquidity boosted equity prices further
and provided the fuel for the enormous high-tech,
Internet and telecom stock bubbles of 1999 and early
2000.
The first three years of the 21st
century saw a worldwide equity market crash followed by
a recession plagued by overcapacity, over-indebtedness
and over-leverage. And the responses of central banks
were always more liquidity through lower short-term
interest rates, which helped pump up the bond bubble in
2003, with the high fixed yields of outstanding long
bonds translating into higher bond prices. Excess
liquidity supported artificial rallies in housing
prices, equities, corporate debt, commodity prices and
mushrooming emerging markets, particularly China. Fools
are calling it a US-led recovery.
The Fed was
caught again in its own ideological vice between
contradicting interest rate policies to balance
stimulating growth and preventing inflation. To avoid
the boom-and-bust cycle, the Fed attempted to drive its
monetary vehicle in opposite directions at the same
time, simultaneously fighting inflation and stimulating
the economy. Despite the Fed's announcement that it will
raise interest rate to ward off inflation only at a
"measured pace", much talk of a repeat of a 1994 burst
of the bond bubble has since been circulating. Pushing
China to raise yuan interest rates now will only
heighten the Fed's difficulty in keeping its "measured
pace" of interest rate hikes.
Bond traders
know that a five-year duration bond fund can drop 5% in
value with an interest rate rise of one percentage
point. Conversely, a one percentage point drop in rates
would cause the same fund to increase by 5% in value.
For long-term bond funds with effective durations of at
least seven years, a rise in long-term interest rates of
2 percentage points over the next 12 months would cause
at least a 14% drop in value. With yields on long-term
Treasury bonds now around 5%, such an increase would
translate into a loss of 9% or more for shareholders -
similar to the last time the Fed tightened monetary
policy in 1994.
Many market participants intuitively
concluded that long-term rates, following the ffr, would
also rise, causing prices of outstanding long bond to
decline. Speculators shorted Treasury long bonds - that
is, they borrowed bonds to sell by promising to return
them at a later date when they hope to buy back the same
bonds at a lower price, profiting from the anticipated
price differential. But long-term rates moved
counter-intuitively in the credit markets. What the
short-sellers failed to take into account was that
foreign central banks now must buy each day between $1-2
billion of government bonds to park the additional
foreign exchange reserves they earn from the US trade
deficit. This was a factor of much smaller scale and
consequence in 1994 when the bond market collapsed from
the Fed raising the ffr target in quick succession.
Because
traders grossly misjudged the bond market's likelihood
to rally in the face of the Fed tightening and
stubbornly hanged onto conventional intuitive moves in
expectation of an easy killing, throwing in the towel
only when it was too late, the rush to cover short
positions pushed bond prices even higher from technical
effects of a short squeeze. On Wednesday, September 22,
the 10-year-note fell below the psychological 4% (3.98%)
for the first time since April when the Fed made its
third tightening in 2004. That shifted market sentiment,
and traders decided to stop throwing good money after
bad just to humor Greenspan's fantasy of a recovery.
They reacted to the rise in bond prices as a signal to
buy more. It was the market's vote that the economy
would not be heading north for a while.
Shorting on
bonds began when the non-farm payroll unexpectedly
surged by 308,000 in March 2004, suggesting that an end
might be in sight for the three-year-long recession and
the corresponding bull run on bonds. In June, the
10-year note yielded 4.9%, only a few weeks before the
Fed raised the ffr target for the first time in four
years. Surely, bond prices had no place to go but down
with a rising ffr, so figured the smart money
intuitively. The market, however, moved
counter-intuitively against the smart money. Morgan
Stanley announced on Wednesday, September 22, that its
fixed income trading revenue fell 35% in the quarter
ended August 31 from the previous quarter due mostly to
betting wrong on bond prices falling and rates rising.
Most of the other big firms suffered similar fates. The
October 6 Wall Street Journal reported on dismal second
half 2004 bonus outlooks for Wall Street bankers and
traders.
At the current inflation rate of
1.5%, the neutral rate for ffr is 3.5%, double the
current 1.75% target. According to Greenspan's announced
strategy of the "measured pace" of short-term interest
rate rises, it may take a long time to raise seven steps
of 25 basis points each to reach the level of
neutrality, if ever, because below-neutral rates cause
more inflation. The Fed may be pedaling hard to reach a
moving target mounted on the front of his interest rate
bike. The harder he pedals, the faster the target moves
with him. But the longer the Fed takes to bring ffr back
to neutral or restraining levels, the bloodier will be
the crash of the bond market when it happens. And it
will happen. Reality does not stop merely because some
short-sellers lost money. Borrowing short-term to
finance long-term bets is a deadly game that cannot be
made safe by hedging, no matter how sophisticated the
strategy. Hedging does not eliminate risk; it only
transmits unit risk onto systemic risk.
Once the
genie of excess liquidity is out of the bottle, it is
almost inevitable that more genies will get out of more
and bigger bottles to keep the ongoing bubble from
bursting to avoid nasty consequences for the financial
system and the real economy. In a planned economy,
liquidity provided by a national bank can serve a
constructive purpose by financing planned growth. In a
market economy, liquidity provided by the central bank
lets the market allocate credit to the highest bidders
rather than to where it is needed most in the economy.
This means the liquidity often ends up fueling
high-profit speculative bubbles.
Central
banks, led by chief wizard Greenspan, despite their
central role in helping to create financial bubbles,
nevertheless declare that bubbles cannot be anticipated
and nothing can be done to prevent them. But central
bankers comfort markets by claiming near-magical power
to handle the destructive consequences of bubbles,
through a one-note monetary policy of rate cuts to
inject more liquidity, to save a bursting bubble by
creating a bigger bubble. Greenspan asserted in his
Jackson Hole symposium speech on August 30, 2002 that it
is virtually impossible to diagnose a bubble with any
certainty until it bursts, and even if a bubble could be
diagnosed, it is not the task of central banks to target
asset price, but only to control inflation and target
growth. And even if central banks were to react to asset
bubbles by raising interest rates, the extent of the
rate hikes needed to reverse asset prices in times of
exuberance might be so large that it would destabilize
the real economy worse than a bubble bursting in its own
course would. Greenspan has admitted more than once that
one of the roles of a central bank is to support the
market value of financial assets.
China's
reluctance to raise yuan interest rates reflects its
adherence to the Greenspan argument that the rate hike
needed to slow the overheated economy is so large that
serious economic damage may result, making the cure
worse than the disease, particularly when China's
overheated economy does not manifest itself in a typical
stock market bubble, since its stock market is not fully
developed. Chinese stock market performance is more
reflective of anticipatory reactions to policy reform
momentum than actual economic conditions.
China's
price bubble is more like a mountain of foam of tiny
bubbles, each with its own unique characteristics. The
steel bubble is caused not by lack of demand but by
bottlenecks of supply, particularly in electricity and
transportation. On the other hand, the real estate
bubble is caused by speculative over-investment in a
stagnant purchasing power environment associated with
low wages even for the growing population of
middle-income earners. China has an export bubble, blown
up by the US asset bubble. China's overheated inflation
is not wage-pushed, but import-pushed. China is not the
source of world inflation. It is a re-exporter of
inflation from the skyrocketing rise of imported energy
and commodity prices and from speculative profiteering.
China
also faces a problem in duplicate investment. Localities
understandably copy the successful investment strategies
of other localities. That itself should not be a bad
thing for the world's largest disaggregated domestic
market. But much duplicate investment in China has been
concentrated in the export sector, where demand is
externally constrained. The result drives otherwise
profitable enterprises into bankruptcy and exacerbates
the non-performing loan problem in the banking system.
The problem then is not with the duplication of
investment in China's huge domestic market, but that
such duplication is not directed to expand the
disaggregated domestic market, but concentrated in the
relatively slow growth export market.
Keep your dollars Led by Japan and China, East Asian
central banks have been acting as lenders of last resort
to rising US external indebtedness so that US consumers
can continue to buy Asian exports. In the process, they
are exporting real wealth to the dollar economy while
subjecting their own local currency economies to
mounting financial strains and risk of instability.
Asian central banks now hold about $2.2 trillion, or 80%
of the world's official foreign exchange reserves.
Dollar-denominated assets constituted 70% of these
reserves in 2003 while the US share of the world economy
was only 30%. Japan's foreign exchange reserves are now
in excess of $825 billion and China's now exceed $480
billion and growing. Together, they account for more
than half of Asia's total foreign exchange reserves that
are trapped in the dollar economy, while their own
economies are forced to beg for foreign capital
denominated in dollars.
The US current account deficit
reached a record 5.7% of GDP in second quarter of 2004
and a net national saving rate that fell to 0.4% in
early 2003. It has since rebounded to 1.9% in mid-2004.
The US now absorbs 80% of the world's savings not to
finance economic growth, but to finance debt-fueled
over-consumption collateralized by an asset bubble. In
2003, US net capital investment was 60% below 2000
levels.
US net international indebtedness is
expected to reach 28% of its GDP by the end of 2004.
Since 1990, foreign-owned US assets increased from less
than $2.5 trillion to approximately $10 trillion at the
end of 2003 - a fourfold increase, and approaching the
entire annual GDP. Over the same period, US ownership of
foreign assets has increased from $2.3 trillion to
nearly $7.9 trillion, resulting in a negative net
international investment position for the US, amounting
to about $2.7 trillion at the end of 2003 when valuing
direct investment at market value. But in a fundamental
sense, the entire $17.9 trillion of assets are in the
dollar economy regardless of location or ownership.
How is the
US able to earn a significantly higher return on its
assets abroad than foreigners earn on their assets in
the US? Consider currency, which pays a zero return. At
the end of 2003, dollars held abroad was estimated to be
about $320 billion, whereas only a trivial amount of
foreign currency is held in the US. America's currency
circulating abroad is about half the total US currency
outstanding. That means that the US economy only makes
up half of the dollar economy. The reason the US can do
this is because of dollar hegemony, a phenomenon created
by the dollar, a fiat currency no longer backed by
specie value such as gold since the collapse of Bretton
Woods in 1971, continuing to assume the status of a
major reserve currency for international trade. Trade is
now a game in which the US produces dollars by fiat, and
the rest of the world produce goods and services fiat
dollars can buy.
The dollar economy is in fact
devouring not just non-dollar economies, but also the US
economy. The dollar is like the rebellious computer HAL
9000 in Stanley Kubrick's 1968 film 2001: A Space Odyssey. Hal 9000
was programmed to believe that "this mission is too
important for me to allow you to jeopardize it", and
proceeded to kill everyone who tried to disconnect it.
Dollar hegemony kills all, pushing down wages everywhere
with no exceptions made for nationality. As Pogo used to
say: "The enemy, it is us."
The issue is not whether Asian
central banks will continue to have confidence in the
dollar, but why Asian central banks should see their
mandate as supporting the continuous expansion of the
dollar economy at the expense of their own non-dollar
economies. Why should Asian economies send real wealth
in the form of goods to the US for foreign paper instead
of selling their goods in their own economy? Without
dollar hegemony, Asian economies can finance their own
economic development with sovereign credit in their own
currencies and not be addicted to export for fiat
dollars. As for Americans, is it a good deal to exchange
your job for lower prices at Wal-Mart?
Next:
Macro measures and bubbles
Henry C K
Liu is chairman of the New York-based Liu Investment
Group
(Copyright 2004 Asia Times Online
Ltd. All rights reserved. Please contact content@atimes.com for
information on our sales and syndication policies.)
economy
is the result of hot money inflow caused by dollar
hegemony. China's developing economy should be able to
absorb huge amounts of capital inflow, but dollar
hegemony limits foreign investment to only the Chinese
export sector, where dollar revenue can be earned to
repay capital denominated in dollars. Since China's
export sector cannot grow faster than the import demands
of other nations, excessive dollar capital inflow
overheats the export and exported-related sectors, while
other sectors of the Chinese economy suffer acute
capital shortage. 
