The balance of financial terror, circa August 9, 2007

Back in early 2004, former Treasury Secretary Lawrence Summers highlighted the emergence of what he termed the "balance of financial terror."   China – and others – relied on the US for demand that their economies were not generating internally, and the US depended on China – and others – for financing.    Summers defined the balance of financial terror as:

 "a situation where we [in the US] rely on the cost to others of not financing our current account deficit as assurance that financing will continue."

The balance of financial terror can also be framed in more financial terms.  China has a highly concentrated -- and rapidly expanding -- position in US dollar-denominated bonds.  It depends, wisely or unwisely, on the US to provide a somewhat stable store of value for China's external savings.  The United States, in turn, is extraordinarily dependent on China’s government for external financing.   

China’s holdings of US bonds are hard to discern in a real time basis, but if China kept the dollar share of its reserves roughly constant at 70%, its $1.34 trillion in central bank reserves – along with at least another $100b stashed away in the state banks – imply that China now holds about a trillion dollars worth of US bonds.   That is about 1/3 of China’s GDP.    China's growing dollar holdings, in turn, finance much of the US current account deficit.  Summers noted the United States growing dependence on the discretionary acts of "political entities" in early 2004:

"There is surely something odd about the world’s greatest power being the world’s greatest debtor. In order to finance prevailing levels of consumption and investment, must the United States be as dependent as it is on the discretionary acts of what are inevitably political entities in other countries? It is true and can be argued forcefully that the incentive for Japan or China to dump treasury bills at a rapid rate is not very strong, given the consequences that it would have for their own economies. That is a powerful argument, and it is a reason a prudent person would avoid immediate concern. But it surely cannot be prudent for us as a country to rely on a kind of balance of financial terror to hold back reserve sales that would threaten our stability."

Since then, the United States' dependence on a single political entity has only increased. 

In 2004, China and Japan combined to add around $400b to their reserves in 2004.  In 2007, China alone is on track to add $500b to its reserves (counting the CIC) this year: China added $400b to its reserves over the last four quarters, and the trend is strongly up.  That implies that China’s government will provide the US with between $350 and $400b of financing this year. Some of that outflow is offset by an inflow of US money into China, but China is still likely to provide at least $300b of the net financing the US needs to finance its $800b plus current account deficit. 

If China’s government wasn’t willing to issue RMB bonds – whether PBoC sterilization bills for CIC long-term bonds – to buy dollar assets, the global economy wouldn’t balance.   At least not the way it does now.  No one else is willing to transform Chinese demand for RMB-denominated financial assets into demand for US bonds.  

Yet the United States' large and growing dependence on the willingness of China’s government to continue to act as an intermediary rarely attracts a lot of popular attention.    It is just part of the economic landscape, sort of like the United States need to import roughly 14 mbd of oil every day.

But I suspect that there is an underlying unease, a concern that the balance of financial terror may not prove to be as stable as the balance of nuclear terror proved to be during the cold war.   Every now and then the United States' need for Chinese financing does attract a lot of attention.   Yesterday was one such day.  

He Fan (of the Chinese Academy of Social Sciences) published an oped in the China daily suggesting that China might sell (one day) some of its treasuries.   Xia Bin (director of the State Council Development Research Center) suggested that China should use its financial leverage to keep a few “silly senators” from setting US-Chinese economic policy.  Treasury Secretary Hank Paulson dismissed the risk that China would ever cut off its financing of the US.    Chinese financing became an issue in the Presidential campaign.  Barack Obama, for example, picked up on Bill Clinton’s (effective) 2004 line on China: "It's pretty hard to have a tough negotiation when the Chinese are our bankers."

CNBC switched from discussing which US company China’s investment authority (or its big banks) might buy next to discussing the possibility that China might not buy any US financial assets at all. 

And cool heads – Michael Pettis of Peking University's Guanghua School of Management, for example – appealed for calm.

The general consensus in the US is that China cannot cut off the US without “shooting itself in the foot."

"China would be shooting itself in the foot,'' said Greg Gibbs, a currency strategist at ABN Amro Holding NV in Sydney. ``

I disagree.  At least in part. 

China is already shooting itself in the foot – financially speaking.  It loses money every time it buys another dollar bonds.  The dollar will depreciate against the RMB some day, leaving China – which finances its purchase of dollars by selling RMB-denominated debt – with large losses. 

And, generally speaking, adding to a losing position adds to your ultimate losses.

China would be better off financially if it let the RMB appreciate substantially, stopped financing the US and took large losses now rather than continuing to finance the US, adding to its stock of dollars and adding to the scale of its future losses.   A bank that is lending to a failing company reduces its ultimate loss by cutting the company off and taking its lumps now, not by covering ever bigger losses with new loans to avoid “turmoil.”  China is in a similar position.  The US isn’t a failing company, but China is lending to the US on terms that imply very large financial losses for China.

China’s real problem is that it cannot stop financing the US without shooting its own exporters’ in the foot.  

Up until now, China’s exporting interests (perhaps in conjunction with all those who benefit from loose monetary policy) have driven Chinese policy.  But the interests of China’s exporters aren’t quite the same as the interests of China writ large.  

By the same token, the interest of US firms with operations in China – or US firms that rely on Taiwanese and Hong Kong firms with supply chains that stretch back into China -- aren’t quite the same of the interests of the US as whole.   There are parts of the US economy that have benefited from China’s policy of subsidizing US consumption, and US borrowing, but there are also parts that haven’t.

This discussion isn’t purely academic.  It provides the context for understanding He Fan’s now famous article in the China daily.    He Fan’s writings leave no doubt that he understands the financial risks that China is taking by holding so many dollar-denominated assets.   Dr. He and Dr. Zhang of the Chinese Academy of Social Sciences wrote in 2006 (in an early verion of this -- now restricted -- paper):

“Large amounts of trade surplus and foreign exchange reserves have put Asian economies in a position as hostage.   Once the global imbalance is adjusted in an unexpected manner, such as sudden drop in the US dollar exchange rate, East Asian economies will be confronted with [a] huge loss.”

He and Zhang think China should adjust its policy to reduce its exposure to the United States.  They write:

 “continuous growth of [Asia’s] trade surplus is harmful and dangerous …. China’s enlarging trade surplus is closely related with distorted income distribution, losing of job opportunities and disproportional development between [the] manufacturing and [the] services sector.  … to absorb the excessive liquidity caused by the increase in foreign exchange reserves, monetary authorities in East Asia [have] to continuously rely on sterilization measure[s], thus limit[ing] the room for monetary policies.”

Their arguments are in many ways the mirror image of arguments that I have made in the past.  They don’t think a policy that increases China’s large exposure to the US dollar is in China’s long-term interest, even though it helps China’s export sector.   I don’t think a set of policies that leaves the US ever-more dependent on Chinese financing is in the United States interest, even though China’s subsidy of US borrowing unquestionably helps many in the US.

The possibility that China might cut the US off is remote – barring a confrontation over Taiwan.    But it also isn’t totally beyond the realm of possibility that China might someday change a policy that many in China think benefits the US more than it benefits China.   That is one reason why the balance of financial terror may not be quite as stable as it now seems.   The costs associating with maintaining the status quo – most notably the costs associated with China’s huge dollar position – are growing, not falling.

That isn’t to say that He Fan’s argument that a stronger RMB is China’s interest – or similar arguments from Yu Yongding – will suddenly start to drive China’s exchange rate policy.   Chinese policy to date has been driven by the interests of China’s exporters, not by the views of the PBoC and prominent academics who worry that the de facto peg undermines China’s monetary policy autonomy.   The State Council hasn’t followed Dr. Fan’s advice on the RMB.   I would be surprised if it suddenly starts following his advice on its Treasury holdings.

Some on the state council think that creating export jobs now is more important that the size of China’s future financial losses.   Some may think the CIC will generate big enough returns to offset the losses from dollar depreciation.   Some may hope that the dollar starts to appreciate, allowing the RMB to appreciate without any change in Chinese policy.   Some may just be scared of the consequences of change.

A sudden adjustment would be jarring, even if adjustment arguably is in China’s long-term interest.  Cutting the US off might reduce the size of China’s ultimate loss on its dollar holdings, but it also would hurt China’s export sector.

One of the lessons of game theory is that threats are costly only when they fail.   China, the argument goes, is rattling its sabers to deter the US Congress from passing legislation that China (and for that matter President Bush and Treasury Secretary Paulson) don’t like.  But it has no desire to actually carry out its threats. 

Menzie Chinn noted in the Post: "It's not really a credible threat." 

Still, it is at least worth thinking through what might happen if China did actually decide to carry out Xia Bin’s policy. 

Suppose the US Congress ignores the noise now coming out of China and passes a law that materially hurts Chinese exporters.  The legislation now working its way through the Congress doesn’t impose across-the-board tariffs, but it would make it easier for US firms to petition for protection from “subsidized” Chinese competition.    

Suppose China then retaliates by stopping its purchases of US debt.

In the first instance, China’s exporters – the interest already hurt by US policy – would be hurt even more.   The end of Chinese purchases would push up US interest rates, and the resulting US slump would reduce US demand for China’s goods.

China’s trade surplus though wouldn’t go to zero overnight.  Nor will China’s intervention in the foreign exchange market.  Even if China didn’t sell its existing dollar reserves, it would still need to invest its growing reserves somewhere.   And there really aren’t that many options.  China would have to step up its purchases of euros.  

That would likely push the euro up against the dollar.

And then China would be faced with another choice.  It could let the RMB follow the dollar down by retaining its dollar peg amid a trade and financial skirmish.   That would at least help China’s export sector: it might be able to make up for the loss of the US market with more exports to Europe.

But it would also cause political problems with Europe.   And it wouldn’t help China’s central bank. An even weaker RMB means more expensive imports.  It also implies even more sterilization.  Since China has borrowed RMB to buy euros as well as dollars, it also means financial losses for the central bank.  

Perhaps most importantly, so long as the China kept its peg to the dollar but put all its assets in euros, it effectively would be generating massive ongoing pressure on the dollar – and thus on its own exchange rate.  Moreover, as Francis Warnock notes, the Federal Reserve would respond to a fall off in Chinese financing that raised US long-term rates and slowed the US economy by cutting US short-term rates.  

The pressures on the dollar would only grow.   Forget 2 dollars to the pound.  Think 2 dollars to the euro.

Alternatively, China could allow the RMB to appreciate against the dollar to keep its own exchange rate from depreciating along with the dollar.   That makes a certain amount of sense.  It seems to be the policy He Fan is advocating.  Why after all should China tie its currency to a sinking stone?  Why should it allow the US – whose trade policies, after all, started the whole mess – set China’s exchange rate policy?

But such a policy change would hurt China’s export sector.  And it would effectively hand the US a victory.  If the dollar fell v the euro and the RMB rose against the dollar (i.e. the dollar really depreciated), the US would in some sense get what it wants …

And if I had to guess, I would bet China won’t actually change its policy of pegging to the dollar and financing the US even if the US passed legislation that China doesn’t like.   How, after all, did China respond to the US decision to block CNOOC’s purchase? Judging from the ongoing increase in China's reserves, by buying even more US bonds.  China wasn’t prepared to hurt its export sector by slowing its purchases of US debt even after the US Congress effectively blocked a part of China’s energy policy.

But there is little doubt that China is becoming increasingly aware of the costs of its current policy – and increasingly frustrated at the US.

He Fan believes that the RMB should be allowed to appreciate, but his oped also clearly indicated that the US should not try to dictate the pace of RMB appreciation, particularly given that the RMB/ dollar is a key price in China’s economy.

“The exchange rate equals a price between between currencies in economic theories.  Price is the key to allocating resources.  …. It would be totally against the rule of the market economy when a country, through a political course, asks the Chinese government to change a key price in the economy.”

That is probably a typical attitude.   No one likes having another country tell them what they should do – or tell them what is in their own interest.

But He Fan’s argument suffers from one important problem: the RMB/ dollar isn’t just a price that matters inside China.   It also has become one of the most important prices in the US economy – and indeed the global economy.   The US Congress is uncomfortable allowing China to continue to set a key price in the US economy.  Larry Lindsey got this right in 2006: the US is uncomfortable letting China – really China’s government -- pick winners and losers.

"The matter of principle on which the American political process is now becoming focused is that it is the Chinese government, not our political process or the independent determination of markets, that is determining the result. We are buying more tee shirts, shoes and appliances and living in larger homes than we otherwise would because of a Chinese government decision. We are producing fewer appliances and less agricultural output than the market would have us make as well, thanks to a decision by the Chinese government. It does no good to tell American politicians that if the Chinese want to subsidize us we should let them, because the very fact of their subsidy changes our behavior in a way determined by them, not by us. 

American frustration with the slow pace of RMB appreciation is growing – as, I suspect, are concerns about the scale of the United States dependence on Chinese financing.   As China shifts from buying bonds to buying companies, the extent of that dependence will become a lot more visible.

China wants the freedom to set the pace of RMB appreciation on its own.   But so far the pace of RMB appreciation that has proved politically acceptable has been too slow to do anything more than offset the dollar’s slide – and far too small to slow the growth in China’s trade and current account surplus.

China’s concentrated financial position and growing dollar holdings– at least in my view – are neither good for China nor good for the US.  China is too exposed to further falls in the dollar.   The US is too dependent on a single source of financing.  

Yet unless something changes, China’s concentrated exposure to the US and the United States dependence on China will only grow.    That hardly seems healthy.

China’s insistence that its exchange rate policy its own sovereign choice – something that it and only it can set, no matter how large the impact of its choice on the rest of the world, isn’t helpful.   Nor, for that matter, is the Bush Administration’s apparent decision to making cutting the US corporate tax rate its highest economic policy priority.   A corporate tax cut isn’t going to address American workers’ concerns about globalization.

The time to find a constructive solution is growing short.    

UPDATE: I edited the initial post, which among other things left out a crucial "not". 

UPDATE 2: China's July trade surplus came in at $24.4b -- call it $25b.  Exports increased by well over 30% (almost 35% actually) year over year.   The ongoing surge in China's trade surplus -- and the implied increase in Chinese foreign asset accumulation -- only reinforces the need to find a constructive solution.  Fast.