A rising
US trade deficit with China has generated much
heat but little light about unfair Chinese trade
practices.
While sensationalized reports
over movie-copyright violations are highlighted by
Hollywood special interests in the popular media
to draw public attention, and in the halls of the
US Congress to lobby for countervailing trade
legislation against China, the validity of many of
the complaints of unfair trade does not survive
reality checks with actual macro-data. It is
similar to Wal-Mart
complaining about loss from
shoplifting while raking in obscene profits from
shoppers at the expense of its own workers and
those of its suppliers overseas. Of course
shoplifters deserve to be punished, but it is not
a valid excuse for Wal-Mart's global low-wage
policy.
In 1950, the United States
imported US$11.4 billion of goods and services and
exported $12.7 billion, for a foreign-trade total
of $24.1 billion, constituting a mere 7.3% of a
gross domestic product (GDP) of $329 billion.
There was no trade with China because of a Cold
War embargo by the US. The US trade deficit for
1950 was $1.3 billion, which came to an
insignificant 0.4% of GDP. It was an amount the US
could easily sustain as World War II had left the
country the richest and most productive economy in
a war-torn world.
Also, at that time the
US was the world's only creditor nation, with a
gold-backed dollar serving as a reserve currency
for international trade as mandated by the Bretton
Woods international finance architectural regime.
The gold-backed dollar with fixed exchange rates
ensured that war debts incurred by US allies would
be duly paid back without dilution. Thus a US
trade deficit was quite necessary for restoring a
world economy severely damaged by war. And the
dollars that the surplus trading economies
received were returned to the US to pay for war
debts but not to buy US assets, as
foreign-exchange and capital controls were the
order of the time. The minor payments imbalance
was paid with a transfer of gold holdings between
the trading economies. There was no
foreign-exchange market beyond government exchange
windows. In that arrangement, dollar hegemony was
not a serious problem, as cross-border flow of
funds were strictly controlled by all governments
and the US was obliged to redeem dollars with
gold.
The end of the Cold War in 1991
enabled the globalization of deregulated financial
markets to allow cross-border flows of funds to be
executed electronically with no restrictions for
most economies. Since then, a huge
foreign-exchange market has grown to more than $2
trillion of daily volume around the benchmark of a
fiat US dollar. The reserve-currency status of the
dollar has not been based on gold since 1971, but
only on US geopolitical prowess, which managed to
force all key commodities to be denominated in
dollars. Finance globalization since 1991 has
allowed the US to become the world's biggest
debtor nation, with the largest trade and fiscal
deficits, financed by a fiat dollar that continues
to serve as a key reserve currency for not only
international trade but, more important, for
international finance.
Imbalance of
payments and debt bubble Dollar hegemony
emerged after 1991 to allow the US to neutralize
persistent trade and fiscal deficits that
otherwise would lead to an imbalance of payments
between it and its trading partners by erasing the
payments imbalance from its trade deficit with a
US capital-account surplus.
Separate from
the trade deficit, the US fiscal deficit is
financed by the Federal Reserve's monetary-easing
policies to increase the money supply, causing an
asset-price bubble that can absorb the rising debt
without altering the debt-equity ratio, causing de
facto but stealth inflation, renamed as "growth".
This phantom growth is touted by neo-liberal
economists as the reason foreign investment is
attracted to US assets. What dollar hegemony does
is to transform the dollar-denominated payments
imbalance of the United States into a
dollar-denominated debt bubble in the US economy.
Holders of US debt and assets are rewarded with
high nominal returns provided by a high growth
rate reflecting rising asset prices denominated in
money that constantly loses purchasing power.
World trade is now a game in which the US
produces dollars by fiat and the rest of the world
produces things that fiat dollars can buy. The
world's interlinked economies no longer trade to
capture a comparative advantage; they compete in
exports to capture dollars needed to service
dollar-denominated foreign debts and to accumulate
dollar reserves to sustain the exchange value of
their domestic currencies.
To prevent
speculative and manipulative attacks on their
currencies, the world's central banks must acquire
and hold dollar reserves in corresponding amounts
to their currencies in circulation. The higher the
market pressure to devalue a particular currency,
the more dollar reserves its central bank must
hold. This creates a built-in support for a strong
US dollar that in turn forces the world's central
banks to acquire and hold more dollar reserves,
making it even stronger. This phenomenon is known
as dollar hegemony, which is created by the
geopolitically constructed peculiarity that
critical commodities, most notably oil, are
denominated in US dollars. Everyone accepts
dollars because dollars can buy oil. The recycling
of petrodollars is the price the United States has
extracted from oil-producing countries for US
tolerance of the oil-exporting cartel since 1973.
Ironically, as oil-producing economies
benefited from a suddenly rise in the price of oil
denominated in dollars, they developed a need to
preserve the value of the dollar. Thus three
conditions brought about dollar hegemony in the
1990s:
In 1971, US president Richard Nixon abandoned
the Bretton Woods regime and suspended the
dollar's peg to gold as US fiscal deficits from
overseas spending caused a massive drain in US
gold holdings.
Oil was denominated in dollars after the 1973
Middle East oil crisis, followed by other key
commodities.
Deregulated global financial markets began to
emerge in 1991 after the Cold War, making the
cross-border flow of funds routine.
A
general relaxation of capital and foreign-exchange
control in the context of free-floating exchange
rates made speculative attacks on currencies
regular occurrences. All central banks have since
been forced to hold more dollar reserves than they
otherwise need to ward off sudden speculative
attacks on their currencies in financial markets.
And dollar reserves by definition can only be
invested in US assets. Thus dollar hegemony
prevents the exporting nations from spending
domestically the dollars they earn from the US
trade deficit and forces them to finance the US
capital account surplus, thus shipping real wealth
to the United States in exchange for the privilege
of financing US debt to further develop the US
economy.
The US capital-account surplus in
turn finances the US trade deficit. Moreover, any
asset, regardless of location, that is denominated
in dollars is a US asset in essence. When oil is
denominated in dollars through US state action and
the dollar is a fiat currency, the US in essence
owns the world's oil for free. And the Quantity
Theory of Money dictates that the more the US
prints greenbacks, the higher the price of US
assets will rise. And by neo-classical definition,
a rise in asset value is not inflation as long as
wages lag behind. Thus a strong-dollar policy
gives the United States a double win while workers
everywhere, including those in the US itself, are
handed a double loss.
Through dollar
hegemony, the US, unlike many Third World nations
with similar trade and fiscal deficits, has been
granted immunity from associated penalties of
payments imbalance by having its trade deficit
finance its capital-account surplus. But instead
of reforming the fundamental structure of the US
economy that creates such trade and fiscal
deficits, many in the United States are seeking
painless yet pointless solutions to a non-existent
payments imbalance by engaging in irrational
disputes over the issue of currency exchange rates
of its trading partners, first Japan and Germany
decades ago, and now China.
On top of this
monetary scam, the US wants to push the exchange
rate of the dollar further down to erode the value
of the massive dollar holdings of its trading
partners, as the exchange rate of the dollar
affects only those who live, operate in or visit
non-dollar economies. Because the Fed can print
fiat dollars at will under a dollar-hegemonic
regime, a dollar-denominated US trade deficit does
not present a balance-of-payments problem for the
United States, as it does all other countries that
cannot print dollars. Thus a US trade deficit,
being not a balance-of-payments problem, cannot be
cured through manipulation of the exchange rate of
the dollar. The solution has to come from reducing
wage disparity between the two trading economies.
The numbers behind US-China
trade In 2005, US foreign trade of $3.30
trillion constituted 26% of its $12.7 trillion
GDP. Exports were $1.27 trillion and imports $2
trillion, resulting in a goods-and-services
deficit of $726 billion (5.7% of GDP), $109
billion more than the 2004 deficit of $618
billion.
For goods alone, exports were
$893 billion and imports $1.7 trillion, resulting
in a goods deficit of $782 billion, $117 billion
more than the 2004 deficit of $665 billion. This
meant that while the trade deficit for goods was
large and growing, the US still exported goods in
2005 valued at 192.4 billion 1950 dollars, more
than 15 times its export in 1950 and three times
its 1950 GDP. For services, exports were $379
billion and imports were $322 billion, resulting
in a services surplus of $56 billion, $8.5 billion
more than the 2004 surplus of $48 billion.
The US trade deficit with China will
greatly reduce if the US lifts high-tech-export
restrictions to China.
For China, foreign
trade in 1950 was non-existent because of the US
embargo, except some memorandum trade with other
socialist and non-aligned nations. For 2005,
Chinese foreign trade reached $1.3 trillion (81%
of GDP of $1.6 trillion), with a trade surplus of
$102 billion (6.4% of GDP). About $100 billion of
the Chinese trade surplus with the US went to pay
for Chinese trade deficits with other countries.
These figures show that trade is now a
precariously excessive portion of Chinese GDP. And
without a trade surplus with the US, China would
face a global trade deficit of about 6.25% of GDP,
more than the United States' 5.7%.
China's addiction to trade With
any addiction, initial euphoria soon turns to
agony. Chinese per capita GDP was $1,231 for 2005,
while the country's per capita foreign-trade
volume was $1,000. Take away foreign trade, and
Chinese per capita GDP would be $231, or 63 cents
a day. And that number is per capita GDP, not per
capita income, which is usually lower.
In
2005, the per capita annual income of Chinese
urban residents was 10,493 yuan, or $1,294 at the
official exchange rate of 8.11 yuan to a dollar.
The per capita annual income of rural residents
was 3,255 yuan, or $401. In fact, in the rural
interior, non-trade-related per capita GDP in 2005
was actually below overall per capita income,
meaning that rural per capita income in region
with no export trade had to be subsidized to the
tune of $170 per capita, the gap between $401 and
$231, or 47 cents a day.
The global
poverty line is set at $2 per day, substantially
higher than China's non-trade-related per capita
GDP of 63 cents per day. Chinese policy of
export-dependent growth is causing mounting social
unrest with serious political implications, which
the government is just beginning to acknowledge.
US per capita GDP in 2005 was $43,000,
while per capita foreign trade was $11,196. Take
away foreign trade, and US per capita GDP would be
$31,804. Serious trade friction is unavoidable
among all trading nations. But the macro-data show
that the US as not greatly disadvantaged by trade
with China.
The US per capita trade
deficit with China in 2005 was $685, or 1.6% of
per capita GDP, while the Chinese per capita trade
surplus with the US was $155, or 12.2% of per
capita GDP. But globally, the Chinese trade
surplus was only $102 billion, putting the per
capita trade surplus at $78.5, or 6% of per capita
GDP. Furthermore, upwards of 70% of Chinese export
is traded by foreign companies, leaving the per
capita trade surplus in 2005 at around 50 cents
net for China. Obviously, China is much more
trade-dependent than the US, and it does not take
much analysis to see that the US commands much
more market power in trade negotiation with China.
With widening income disparity in China,
the majority of the population would have income
substantially lower than the average per capita
GDP. China's overall Gini index (which measures
income disparity) officially increased from 0.35
in 1990 to 0.45 in 2005, with zero being complete
equality. Before 1978, China was the most equal
society in the world. An unofficial survey put the
Gini index at 0.6 for 2005.
According to
the World Bank, the number of people living in
poverty in China declined from 480 million in 1981
to 88 million in 2002, but in 2003, poverty rose
again for the first time since 1978, as the ill
effects of excessive export became statistically
discernable.
The fault of GDP as a gauge
for growth is plainly displayed in China, where
double-digit GDP growth has given the country a
booming economy on paper but one with widening
income disparity that keeps the majority in
poverty, irreversible environmental deterioration,
rising moral apathy, systemic official corruption
and spreading social unrest. It is hardly a
picture that fits the world's second-largest
creditor nation.
Dollar hegemony has not
done better for the US, where the Gini index for
2005 was 0.41. A Gini index above 0.4 is
considered socially destabilizing and economically
inefficient.
The Cold War was won with
neo-liberal trade The Cold War was a
political/military confrontation with an economic
dimension. Underneath the militarization was an
economic contest between the two superpowers, each
providing aid to the less-developed allies within
its own ideological bloc. There was little
economic contact between the two separate and
hostile blocs. Within each bloc, economic
relations were conducted mostly through foreign
aid. The name of the game during the Cold War was
economic development, not trade.
Neo-liberals now regularly assert that
socialism lost the Cold War to capitalism because
freedom prevailed. Yet the issue was not that
simple or clear-cut. It is true that governments
that championed socialism, by being forced into a
garrison-state mentality by hostile external
forces, became their own worst enemy by depriving
basic freedom to their citizens. But the assault
on civil liberty during the Joseph McCarthy era
did not bring down the US government and there was
not much democracy in many US allies all through
the Cold War. And one and a half decades later,
the former socialist economies, from Russia to
Poland, do not seem to fare better under market
capitalism. China is an exception only because it
hangs on to basic socialist commitments that the
US is trying its best to dismantle.
The
real Cold War was fought on the economic front
between two drastically unequal adversaries. The
socialist camp started out with a much lower level
of development and a much higher level of poverty
as a historical result of having been victims of
century-long imperialist exploitation.
Furthermore, the socialist camp did not have the
benefit of a rich and powerful economy acting as
the engine of growth, as the United States, leader
of the capitalistic camp, was the only country
undamaged by World War II. The socialist camp
registered impressive growth both before and after
World War II but began to lose momentum when the
Soviet Union was drawn into trade with the
capitalist camp to finance the Cold War arms race.
The USSR led the socialist bloc to refuse Marshall
Plan aid. COMECON (the Council for Mutual Economic
Assistance) was founded in 1949 to create an
economic bloc that endured until 1991. The word
"trade" was not mentioned in COMECON documents.
The Marshall Plan grew out of the Truman
Doctrine, proclaimed in 1947, stressing the
moralistic duty of the United States to combat
communist regimes worldwide. The Marshall Plan
spent $13 billion out of a 1947 GDP of $244
billion, or 5.4%. This translates to $632 billion
in 2004 dollars, roughly the same amount as the US
trade deficit in 2004. The mission was to help
Europe recover economically from World War II to
keep it from communism. The money actually did not
all come out of the US government's budget, but
out of US sovereign credit. The most significant
aspect of the Marshall Plan was the US government
guarantee to US investors in Europe to exchange
their profits denominated in weak European
currencies back into dollars at guaranteed fixed
rates, backed by gold at $35 an ounce.
The
Marshall Plan concretized the Bretton Woods regime
of using the US dollar as the world's reserve
currency at fixed exchange rates. The Marshall
Plan enabled international trade to resume and
laid the foundation for dollar hegemony to emerge
half a century later, after the dollar was taken
off gold by Nixon in 1971 and the Bretton Woods
regime of restricting cross-border flows of funds
was dismantled. While the Marshall Plan did help
the German economy recover, it was not entirely a
selfless gift from the victor to the vanquished.
It was more a Trojan horse for monetary conquest.
It condemned Germany's economy to the status of a
dependent satellite of the US economy from which
it has yet to free itself fully.
The
Marshall Plan lent Europe the equivalent of $632
billion in 2004 dollars. Japan's foreign-exchange
reserves alone were $830 billion at the end of
September 2004. In other words, Japan was lending
more to the United States in 2004 than the
Marshall Plan lent to Europe in 1947. And Japan
did not get any benefits, because the loans were
denominated in dollars that the US can print at
will, and dollars are useless in Japan unless
reconverted to yen, which because of dollar
hegemony Japan is not in a position to do without
reducing the yen money supply, causing the
Japanese economy to contract and the yen exchange
rate to rise, thus hurting Japanese export
competitiveness. Thus dollar hegemony has gone
beyond the "too big to fail" syndrome. It has
created a world of willing slaves to defend the
dollar out of fear that without a strong dollar,
tomorrow's food may not be available.
What
the Cold War proved was the thesis of Friedrich
List (1789-1846), as expounded in his Das
Nationale System der Politischen Oekonomie
(1841), translated as The National System
of Political Economy, that once a nation (or a
bloc of nations) falls behind economically in the
trade arena, it cannot catch up through trade
alone without government intervention.
List's German Historical School is
distinctly different in outlook from the British
classical economics of David Ricardo and James
Mill. It argues that economic behavior and thus
laws of economics are contingent upon their
historical, social and institutional context. When
a nation is forced to adopt the national opinion
of another nation with different historical
conditions as natural laws of international
economics, it will always be the victim of such
laws. Such views have been validated by the
experience of postwar Japan and Germany, which had
to pay the price of being client states of the US
in exchange for trickled-down prosperity.
For the socialist camp, trading with the
capitalist camp was the strategic error that
caused it to expose itself unprotected to a game
it could not win and that it would lose from the
outset and never catch up. In that sense,
neo-liberals are on target in claiming that free
trade promotes capitalistic democracy, but they
are dishonest in claiming that free trade is a
win-win game for all participants. International
free trade is only good for the hegemon, as
domestic free trade is good for the monopolist.
Socialism works only if development is not
preempted by external trade. The World Trade
Organization is a regime designed to favor the
capitalist hegemon. The current anti-WTO movements
around the world are early signs of a grassroots
realization of this truism.
In the US,
List's views evolved into institutional economics,
which subscribes to the notion that government
policies are central to promoting development, not
market forces. List had been inspired by the views
of the statesman Alexander Hamilton in the early
days of the US as a nation.
The US Supreme
Court under chief justice John Marshall in
McCulloch vs Maryland (1819) established
the principles that the federal government
possesses broad "implied powers" to pass laws and
conduct policies, programs and measures, and that
the states cannot interfere with any federal
agency. Marshall ruled that the Union and its
government were created by the people, not by the
states, and that the federal government is fully
sovereign and "supreme in its own sphere of
action" as long as it is not explicitly prohibited
by the constitution. Marshall's opinion was one of
the most significant decisions in the history of
US constitutional law. It gave constitutional
grounds for a broad interpretation of the powers
of the federal government. The case became the
legal cornerstone of subsequent expansions of
federal power and by extension US global power
centuries later.
Hamilton's idea of
sovereign credit through the establishment of a
national bank, as opposed to a central bank, was
designed to protect by government measures the
weak, infant industries in a young nation and to
oppose Adam Smith's laissez-faire doctrine as
promoted by advocates of 19th-century British
globalization for the advancement of British
imperialist interests (see Banking Bunkum: The US
experience, November 16, 2002). Later, after
the War of 1812, Henry Clay's American System
argued for the establishment of the Second Bank of
the US, protective tariffs and federal
appropriations through the use of sovereign credit
for "internal development" such as infrastructure.
While World War II catapulted the United
States into superpower status within half a
decade, the cost of the Cold War, which lasted
four decades, led the US into a Pyrrhic victory
built on recurring cycles of fiscal deficits.
Before the globalization of financial markets in
the 1990s, fiscal deficits produced only one
penalty: domestic inflation. Keynesian deficit
financing turned out to be effective in smoothing
out the cursed business cycle. And with foreign
trade merely a minor factor, there was no
foreign-exchange-rate implication as long as the
dollar was on a gold standard and the US held most
of the world's gold stock. The United States was
indeed hit by domestic inflation by the 1960 and
the effect on the US economy was stimulant enough
for government economists in the administration of
president John Kennedy to conclude that with the
"New Economy" the US could afford guns and butter
simultaneously, and even send a man to the moon,
by putting up with a little inflation.
But
because the dollar was the trade reserve currency
and much of the US fiscal deficit was being spent
overseas in the Korean and Vietnam wars and in
funding the cost of the North Atlantic Treaty
Organization in Europe and US bases in Japan,
South Korea and other US allies in Asia and the
Pacific, the Middle East and South America, a
great deal of dollars flowed overseas, putting a
drain of the stockpile of gold the US was holding
in Fort Knox. Enough gold left the US vault at
Fort Worth, Texas, to go into foreign vaults in
the same building that president Lyndon Johnson
was unable to fund his Great Society programs
while trapped in the Vietnam quagmire in the late
1960s.
In August 1971, Nixon was forced to
take the dollar off the gold standard to stop the
outflow of gold into foreign accounts, and imposed
a 10% import tariff that was removed by year-end
with a devaluation of the dollar by 2.25% from the
exchange rate fixed by the Bretton Woods regime.
Two years later, the 1973 Middle East crisis gave
the Organization of Petroleum Exporting Countries
an opening to raise the price of oil tenfold, from
$3 to $30 a barrel. The US accepted the new
oil-price regime by forcing the oil-producing
nations to denominate oil in dollars. It was not
difficult to convince the oil-exporting
governments, as most of them did not have large
enough economies to absorb all the sudden wealth,
and at the time the dollar was still the world's
most stable currency and the US was politically
more stable than any other country, and it was
immune to terrorism.
The excess
petrodollars went to finance Third World borrowing
at a higher rate of interest than in the US, to be
repaid by dollars earned by exports. Such loans
were considered safe because as the chairman of
Citibank, Walter Wriston, famously pronounced:
"Countries don't go bankrupt." Citibank became the
world's largest bank through aggressive
international lending. This was the beginning of
dollar hegemony.
But dollar hegemony did
not emerge full-blown until the emergence, after
the end of the Cold War in 1991, of deregulated
global financial markets that allow the massive
cross-border flow of funds, which the Bretton
Woods regime had restricted. The breakdown of that
restriction in 1991 was more important for
facilitating dollar hegemony than moving the
dollar off the gold standard in 1971.
With
dollar hegemony, the US central bank, the Federal
Reserve, transforms itself from a guardian of the
value of the nation's money and a lender of last
resort to a ubiquitous virtual money machine that
starts printing at the earliest signs of a slowing
economy. After 1987, the Fed under chairman Alan
Greenspan led all the world's central banks in an
orgy of liquidity injection.
The US, under
Robert Rubin as treasury secretary, former bond
trader at Goldman Sachs, discovered that all it
had to do to make money was to print more dollars;
and world trade has since become a game in which
the US makes dollars by fiat and its trading
partners make things that fiat dollars can buy,
from oil to garments, to television set and
automobiles. The US kept its defense industries
and research and outsourced old-economy
manufacturing first to Japan and Germany, and
garments and low-tech products to Asia and Mexico.
Most important, the US in essence created and ran
a new finance sector with junk bonds and other
structured finance products that other advanced
economies did not catch on to until a decade
later. The US moved into finance capitalism with
dollar hegemony while its trading partners were
stuck in industrial capitalism.
The
flawed logic of currency revaluation The
logic of revaluing the Chinese yuan, or any
currency, as a way of balancing trade with the
United States is flawed. This is particularly true
if prices are denominated in the currency of the
consumer economy, as the dollar is.
It was
ironic that US treasury secretary Lawrence Summers
in the late 1990s repeatedly lectured Japan not to
substitute sound balanced macro-economic policy
with exchange-rate or interest-rate policies,
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 last year that never before in history
had there been a case where international monetary
authorities tried to pressure a country with a not
freely convertible 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 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.
A trade
deficit reflects the structural deficiency
embedded in a country's trade, monetary and
exchange-rate policies. In 1975, the US had a
trade surplus of $12.4 billion. By 1987, it had
incurred a trade deficit of $153.3 billion, which
was widely but mistakenly attributed to an
overvalued dollar. The effects of the 1985 Plaza
Accord to devalue the dollar by negotiation shrank
the trade gap temporarily, but a lower dollar
enabled the US economy to grow faster than those
of its trading partners, and by 1991 the US trade
deficit began rising again as finance
globalization allowed the trade-deficit dollar to
return to reinvest in US assets. Trade began to be
linked with international finance.
With
the development of a deregulated global financial
market, the world financial architecture began to
operate under the rules of dollar hegemony. The
growth in the US was concentrated mostly in the
deregulated financial sector, where the US was
unquestionably the leader in innovation. The
growing capital-account surplus made the growing
trade deficit benign as the balance-of-payments
problem was transformed into a US debt bubble.
The 1997 financial crisis in Asia sent
local currencies plummeting, making Asian goods
drastically cheaper. Yet China was the only Asian
nation that did not devalue its currency. By that
year, the US trade deficit had hit $110 billion,
and heading higher. But net capital inflow to the
US after July 1997 exceeded $100 billion, at 7.2%
of GDP. The 2004 $666 billion trade deficit was
equal to $784 billion in 1997 dollars, more seven
times what it was in 1997. Surely that geometric
increase was more than a foreign-exchange problem.
The White House Council of Economic
Advisers reports that in 2004 the United States
registered the world's largest net capital inflow
at $668 billion (70% of world total), while Japan
had the largest net capital outflow at $172
billion, followed by Germany at $104 billion, then
China at $69 billion, Russia at $60 and Saudi
Arabia at $52 billion. In 1995, developing Asian
countries had net inflows of $42 billion, but had
net outflows of $93 billion in 2004. China had $2
billion of net capital outflows in 1995, $21
billion of net outflows in 2000, and $69 billion
in net outflows in 2004.
In 1995,
developing and emerging-market countries as a
whole received $84 billion in net capital inflows.
A sudden reversal of capital flows to Indonesia,
South Korea, Malaysia, the Philippines and
Thailand from a net inflow of $93 billion in 1996
to a net outflow of $12 billion in 1997
represented a swing of $105 billion, or 11% of
their pre-crisis GDP. In 2000, they experienced
$91 billion in net outflows. In 2004, they
experienced $367 billion in net outflows. While
these countries remained net recipients of foreign
direct investment (FDI) inflows, they became large
net purchasers of foreign reserve assets made
primarily by their central banks. This represents
a capital outflow because the dollar inflows had
to be absorbed by domestic debt to be invested
abroad rather than within these countries.
The value of global foreign reserves, held
primarily by central banks, rose from roughly $1.5
trillion to $3.9 trillion between 1995 and 2004, a
160% increase in a period when the value of global
GDP increased by roughly 40%. Global reserves
increased by more than $1.3 trillion in 2002-04
alone. Three countries accounted for nearly 60% of
this reserve increase: Japan, China, and South
Korea.
With $69 billion in net outflows,
China was the world's third-largest net capital
exporter in 2004. While China receives substantial
foreign investment, it experiences even larger
capital outflows because of foreign-reserve
accumulation by its central bank that results from
its foreign-exchange regime. Foreign direct
investment (FDI) into China in 2004 totaled more
than $153 billion in new agreements, up by
one-third over 2003. Utilized FDI (the amount
actually invested during the year) also surged to
a record high of almost $61 billion, rising 13.3%
over 2003.
As China's reserves have risen
in recent years, its capital-account balance has
moved toward larger deficits and its current
account toward larger surpluses. In 2004, China's
current-account surplus was equivalent to 4% of
GDP, and is likely to have exceeded 6% of GDP in
2005. At the end of September 2005 it was $769
billion, with $58 billion added in the third
quarter.
China's reserves have increased
because of its rising current-account surpluses,
net private capital inflows, and tightly managed
pegged-exchange-rate system. To maintain this peg,
China's central bank has purchased large amounts
of foreign-currency assets in recent years. Even
after modifying its exchange-rate peg last July,
linking the yuan to a basket of currencies rather
than the US dollar alone, China's foreign reserves
have continued to rise, passing $800 billion by
the end of 2005, and may rise to $900 billion or
$1 trillion by the end of 2006. Between 2000 and
2005, China's foreign reserves increased by more
than $600 billion. But this is not surplus
national wealth, but a reflection of deficiency in
social-security funding caused by market reform.
Neo-liberals argue that with a stronger
currency, the global purchasing power of China's
currency would rise, raising its income in global
terms and consumption share, and thus reducing its
rate of domestic saving. Yet under current terms
of international trade, a higher exchange rate
translates directly into a lower domestic wage
scale for any economy heavily dependent on export,
further reducing domestic consumption. China's
social-security funding deficiency is being
mistaken for a high saving rate.
Rising
domestic demand through higher wages is essential
for China's future growth. But dollar hegemony
makes it impossible for China to move in this
direction by siphoning domestic savings into
useless foreign reserves.
Causal
dispute over current and capital accounts
There is sharp disagreement among
economists about the causal relationship between
current account and capital account. It is an idle
dispute about where a circle starts.
Market bears tend to see changes in the
capital account as following passively changes in
the current account. Market bulls tend to see
causation running from the capital account to the
current account, confident that the United States
could run a huge trade deficit without any
collapse in the foreign-exchange value of the
dollar because foreigners have no choice but to
sell their domestic currencies to buy US assets,
supplying dollars for the US to buy foreign goods.
The problem arises when many in the US are no
longer happy with further selling of US assets to
foreigners, or loss of jobs to outsourcing. But if
the US capital-account surplus shrinks, the
current-account deficit will re-emerge as a
classic balance-of-payments problem.
Most
US journalists, and almost all politicians, line
up with the dollar bears in fixating on the trade
deficit rather than on the capital surplus. And
they blame that deficit on China as the newest
scapegoat that carries a great deal of residual
hostility from Cold War days and even from
century-old racial prejudice.
According to
the China-bashers, the US is a victim of Chinese
mercantilism, notwithstanding that mercantilism
involve the quest for gold, not fiat currencies.
As they tell it, China has kept its currency
undervalued to promote export-led growth. To back
this assertion they point to China's rapid buildup
of foreign-exchange reserves, which are really
loans to the US to balance its trade deficits,
notwithstanding the fact that the exchange rate
has been in effect for more than a decade, that
China withstood temptation to devalue the yuan
after the 1997 Asian financial crisis, and that
fixed exchange rates were a US idea at Bretton
Woods when the United States was a creditor
nation.
Furthermore, the US
current-account deficit represents 1.6% of global
GDP, while the current-account surplus for all the
countries in emerging Asia without Japan accounts
for only 0.5% of global GDP. Oil-exporting
countries also account for a surplus of 0.5% of
global GDP. Japan's surplus is almost as large,
0.4% of global GDP.
To correct the trade
imbalances, if that's the game, would require much
more than a revaluation of the Chinese yuan. The
rapid rise in reserves accumulation was due only
in part to trade, with the bigger contribution
came from capital transactions, accounting for 29%
of China's foreign reserve growth. Currency
speculating accounted for 37%, betting that the
yuan will be revalued upward to please irrational
demands from Washington. Hedge funds engage in
"carry trade" to borrow low-interest yen to buy
dollars to send to China, accumulating Chinese
sovereign debt denominated in yuan and
contributing to the pileup of dollars in the
People's Bank of China (PBoC), the central bank.
The political intervention by Washington in
Chinese monetary policy over rising Chinese
reserves is driving an increase in dollar holdings
by China.
Of course $800 billion of
foreign reserves is no small number. But it is not
anywhere big enough to fund what the US wants
China to do to open up its financial market
further. Because China cannot print dollars, it
must keep enough dollars on hand, at least $500
billion, to meet routine foreign-transaction
needs, given the size of the Chinese economy, its
money supply and the import needs of its export
sector.
A wholesale opening of China's
financial sector as demanded by the US would
require China to cure the massive
non-performing-loan problem in the Chinese banking
system as defined by the Bank of International
Settlement (BIS). This is a structural problem
that arose from shifting from a regime of national
banking to central banking. This task is
ultimately going to cost upwards of $1 trillion
(see China: Banking on bank reform,
June 1, 2002). Making the yuan freely convertible
will require upwards of $500 billion to ward off
speculation. Add it all up, and China needs
foreign reserves on the scale of $2 trillion to
implement financial liberalization. It is less
than halfway there and will not reach the
necessary target if current US policy on China
prevails.
The US trade deficit finances
the US capital-account surplus in the form of
foreign (Chinese) purchase of US Treasuries with
dollars that the PBoC purchased from China's
export sector with Chinese sovereign debt
denominated in yuan. What China earns is a meager
commission on the foreign profit from Chinese
export trade. And because of tax preference
granted to foreign capital and export earnings,
China's foreign-financed export sector has managed
to externalize its social and environmental costs
to the domestic sector. Such negative
externalities are about to come due soon.
With a stronger yuan against the dollar,
Chinese sovereign debt denominated in yuan will
buy more dollars from China's export sector, which
means each yuan will buy more US Treasuries. This
will reverse the historical interest-rate
disparity between the yuan and the dollar and
cause a halt to the carry trade of borrowing
low-rate dollars to invest in high-rate yuan asset
and stop the flow of dollars to the PBoC to buy
more US Treasuries. So revaluation of the yuan
will not help the US.
The danger for the
dollar is not that China might sell US Treasuries
of which China is already too big a holder to sell
without suffering substantial net loss in the
market. The danger is that the US sovereign debt
rating is now dependent on the credit rating or
soundness of Chinese sovereign debt.
If
the Chinese economy hits a stone wall, as it will
when the US debt bubble bursts and Chinese export
to the US falls drastically, Chinese sovereign
debt will lose credit rating, causing yuan
interest rates to rise, causing more hot money
into China, causing the PBoC to buy more US
Treasuries, forcing dollar interest rates to fall
and more hot money to rush into China, turning the
process into a financial tornado that will make
the 1997 Asian financial crisis look like a
harmless April shower. This happened to Japan, but
with foreign trade constituting only 18% of GDP in
2003, Japan was able to contain the deflation
domestically. Still, the impact of protracted
Japanese deflation on the global economy was
substantial. With China, where foreign trade
hovers above 81% of GDP, with an economy already
highly concentrated on the coastal regions and
unbalanced with little breadth and depth, a
financial crisis will transmit beyond its borders
quickly. This is the real danger for dollar
hegemony.
Surging capital inflows can be a
double-edged sword, inflicting unwelcome and
destabilizing side-effects, including a tendency
for the local currency to gain in value above
market fundamentals, undermining export
competitiveness, and give rise to inflation.
Capital inflows cause a buildup of
foreign-exchange reserves held by the central
bank, releasing local currency to expand the
domestic monetary base without a corresponding
increase in production, causing too much money
chasing after too few goods, the classic cause of
inflation. This creates an undesirable situation
of the currency being worth more externally and
being worth less internally, setting a perfect
opportunity for attack on the currency by hedge
funds. This is the situation facing China today
and the problem will turn into a crisis as soon as
the yuan becomes freely convertible.
Under
dollar hegemony, capital flow is mainly
denominated in dollars. Despite all the talk about
the euro as an alternative reserve currency, the
euro is still just a derivative currency of the US
dollar, like all other currencies. To ease the
combined threat of external currency appreciation
and domestic inflation, central banks must
implement what is known as the "sterilization" of
capital flows. In a successful sterilization
operation, the domestic component of the monetary
base (bank reserves plus currency) must be reduced
to offset the reserve (dollar) inflow, at least
temporarily.
For the situation of external
currency depreciation and domestic deflation, like
the Japan experience, the reverse needs to be
done. In theory, this can be achieved in several
ways, such as by encouraging private investment
overseas, but this option appears to have been
blocked by US protectionism. Another way is to
allow foreigners to borrow local currency from the
local market, but this would invite currency
attacks from unruly hedge funds. The classical
form of sterilization under dollar hegemony,
however, has been through the use of open market
operations, that is, buying or selling US Treasury
bills and other dollar-denominated instruments to
adjust the domestic component of the monetary
base. The problem is that, in practice, such
sterilization can be difficult to execute and
sometimes even self-defeating, as an apparently
successful operation may raise or lower domestic
interest rates and stimulate even greater
undesirable dollar capital inflows or outflows.
The ability to sterilize has an inverse
relationship with the degree of international
capital mobility. If capital is highly mobile,
attempts at sterilization will prove futile,
because they can be rapidly overwhelmed by renewed
inflows, particularly if the Fed continues to
issue more dollars by lowering the Fed funds rate.
Because of dollar hegemony, the United States is
the only country that needs no sterilizations, as
all inflows and outflows are in dollars. While
sterilization may be useful temporarily for
non-dollar economies, it cannot work for long if
the capital inflows persist, because sterilization
can deal only with the effect rather than the
underlying cause of shocks to the system. The same
is true with exchange-rate manipulation.
Also, the scope for classical open-market
operations may be severely restricted by the
instruments available, particularly in developing
countries, including China, which are unlikely to
have well-developed financial markets. Issuing a
large stock of securities in an attempt to mop up
the inflowing liquidity places a heavy
debt-service burden on the government or central
bank. It can lead to deterioration in the fiscal
or quasi-fiscal balance, such as state-owned
enterprises. For a central bank, operating losses
can occur when the funds it raises are invested in
foreign assets, which earn prevailing dollar
interest rates often lower than rates the central
bank must pay on the bills it has sold.
Large-scale losses can even lead to the need for a
recapitalization of the central bank or defaults.
In a worst-case scenario, the building up
of a central bank or Treasury balance sheet may
also expose it to greater credit risks, making the
whole system more vulnerable to a sudden reversal
in capital flows. This is more likely where much
of the capital inflow is in the form of short-term
portfolio investment, known as hot money, which
can be reversed much more quickly and easily than
foreign direct investment.
Next:China's internal debt problem
Henry C K Liu is
chairman of a New York-based private investment
group. His website is HenryCKLiu.com.
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