Global imbalances are about to take a dangerous turn, one that will make any escape from the present crisis almost impossible. We are on the brink of watching ill-designed global financial and trade policies collapse globally.
These policies have many players, not just the U.S. (The U.S. just happens to be one of the important lynch pins.) All have contributed their share, driven by self-interest and foolishness. No wise man has been at the helm. The mechanisms for this global collapse have been long in the making. Many of them have been studiously ignored or pooh-poohed; others have been celebrated as the new, marvelous world order.
The simplified version of this mechanism is: China has been not only one of the major purchasers of U.S. debt but also one of the main beneficiaries of the U.S. trade deficit.
That mechanism may be about to fail. If and when it does, the entire global edifice will shudder.
(rdan here…Menzie Chin weighs in with some good charts at Econbrowser)
Looking at the present fiasco from a global perspective may help the world later when it seriously tries to rebuild. If this post has any silver lining, that is it.
For a long time, China parked its export earnings in U.S. bonds–T-bills, agencies, etc–, keeping U.S. interest rates low, all of which contributed to the U.S. credit boom. (Greenspan is not the only villain; nor are the greedy banks with their subprime come-hither looks and their credit card gotchas.)
Many argued–including some commentators in this blog–that the U.S. did not have to worry about China–or any other country–losing its appetite for U.S. bonds. Such a country would be foolish to do so; after all, the U.S. is the strongest economy in the world and the dollar is the safest currency.
When Fannie and Freddie failed, Treasury insured that China’s investment was protected even at significant cost to U.S. taxpayers. The implications were clear: Always treat your major creditor with respect.
Purchase of U.S. dollars was one way in which China kept its currency artificially low, providing steam to its export machine. Earlier this year, faced with a declining global appetite for its exports, the Peoples’ Bank of China forced its
commercial banks to build U.S dollar reserves, in a move that holds down the value of the Chinese Yuan, and in effect implements exchange rate intervention, have been revealed by HSBC’s currency team in Asia. The central bank has moved five times in five months to increase the reserve requirements, and stepping up the rate of increase with two extra moves in late June. The moves have increased the mandatory holdings of dollar reserves, from 15% to 17.5%, of anything that is lent out by commercial banks. The impact has been to peg the Yuan lower, and in that in effect has eased the burden of Chinese exporters struggling with a global economic slow-down.
(Many of those Chinese exporters are, of course, foreign firms inside China. According to Vice Premier Wu Li, in 2006 as much as 85% of Chinese exports were FDI driven.)
This dangerous symbiotic and unbalanced relationship between the U.S. and China may fail in 2009-2010.
Right now, the demand for T-bills is enormous, driving the interest of T-bills almost to zero. Watching their life savings disappear into the present financial cesspool, many have simply tried to protect the remaining principal by purchasing T-bills. They want to protect what is left before it too disappears, a slight improvement on the old-fashion mattress approach. (Some opt for gold. Better put that in the mattress, too.)
As the recession deepens dangerously, China may well be thinking twice before it continues old habits. A recent New York Times article outlines why old may be changing.
In the last five years, China has spent as much as one-seventh of its entire economic output buying foreign debt, mostly American. In September, it surpassed Japan as the largest overseas holder of Treasuries
Instead of buying American debt, China is now diverting its huge reserves to its own stimulus package.
But now Beijing is seeking to pay for its own $600 billion stimulus — just as tax revenue is falling sharply as the Chinese economy slows. Regulators have ordered banks to lend more money to small and medium-size enterprises, many of which are struggling with lower exports, and to lend to local governments to build new roads and other projects
Furthermore, as its export machine falters bringing in fewer reserves, China will have less to invest in U.S. bonds.
There is, of course, a dangerous feedback mechanism here: China will be in a weaker position to protect its peg against the dollar, which in turn will weaken its already weakening export machine.
And what about multinationals in China? Well, FDI in China is shrinking.
Multinationals are hoarding their cash and cutting back on construction of new factories.
China may have to depend on its own, rather weak, consumer base. All of this may seem like good news to some. After all, maybe those multinationals will come home. I doubt it, certainly not for a good while. Furthermore, like the banks and you and me, they are trying to protect their own principal. Everyone is seeking safety. All these stimulus packages may be coming too late and be far too little. Conversely, if the correct policies had been in place, no such stimulus package would ever have been needed.
The current situation certainly has all the earmarks of a serious Depression. Increasing aggregate demand is becoming a global problem.
Furthermore, the U.S.-China trade imbalance is now coming back to haunt China. As I pointed out, its consumer base is far too weak to support the appetite for the kinds of exports it sent to the U.S. and elsewhere.
And what will the U.S. do if its favorite creditor is forced to look inward? Just how will it finance its mammoth, ever-growing U.S. debt? It won’t. Its only recourse will be to print money, more money, and more money. We know where that path leads.
When China and Japan keep their money at home to rescue and to stimulate their own economies instead of financing our debt, expect our interest rates to rise–and there will be few buyers.
The failure of the “you-buy-our-goods we-buy-your debt” may well be coming to a close.