QE2 and the Titanic

China reported an October trade surplus of $27 billion Wednesday. This is a very big number and not one likely to soothe anger directed at China. It will be very hard for China credibly to argue that it is trying to contribute to global growth while pulling in more and more foreign demand. Here is the article in the People’s Daily:

China’s exports rose 22.9 percent in October from a year earlier, while imports increased 25.3 percent, the General Administration of Customs said Wednesday. China’s trade surplus expanded to 27.1 billion U.S. dollars last month, compared with 16.88 billion U.S. dollars in September, making the October figures the second highest this year after July’s 28.73 billion U.S. dollars.

Exports and imports totaled 244.81 billion U.S. dollars last month, a Customs spokesman said. In the first 10 months, the country’s trade surplus totaled 147.77 billion U.S. dollars, down 6.7 percent compared with the same period last year.

Last week I argued that Tim Geithner’s proposal on restricting current account imbalances directly, rather than targeting currencies, was a good idea. October’s trade surplus shows both why it is a good idea and why it will be hard to accept.

The proposal was a good idea because trade responds to a lot more than the level of the currency, and just pushing for currency adjustment might have no impact on the balance. My biggest concern was that if countries like China were forced to raise the value of their currencies faster than they liked, or if tariffs were imposed on their products, there would be a huge temptation to intervene in other areas, especially by lowering real interest rates.

This would not only prevent the tariffs or currency appreciation from having much impact on the trade imbalance (indeed the imbalances might actually get worse), but it could seriously increase domestic distortions. As undervalued as the renminbi might be, I am convinced that the most serious domestic distortion in the Chinese economy, and the biggest cause of the trade surplus, is excessively low interest rates.

Low interest rates (along with their cousin, socialized credit risk) are the main causes of capital misallocation and excess capacity in China, and are probably also the main forces pushing down household income and household consumption as a share of GDP. In that case the rebalancing benefits of an increase in the value of the currency could easily be swamped by the damage caused by reducing real interest rates.

It’s the interest rate, stupid

This by the way is what happened, in my opinion, in Japan after the Plaza Accord. Not only did Tokyo wait way too long to begin the rebalancing process, but when the rest of the world (i.e. the US) refused to absorb its huge and expanding trade surplus and forced up the value of the yen, Tokyo made things worse – it counteracted the impact of the rising yen by expanding investment, expanding credit, and lowering interest rates. This accelerated Japan’s structural imbalances, set off a further frenzied rise in asset prices and capacity, and worsened the eventual adjustment. This also seems to have happened after China began revaluing the RMB after July 2005.

That is why I think a current account target would have been a more effective way of forcing a rebalancing, although of course if you are eager to postpone the adjustment as long as possible, restricting very easy-to-monitor current account balances creates a real problem. So when the initial reactions from China seemed favorable to Geithner’s idea, I thought this was good news.

But when Yi Gang, a deputy central bank governor, said last week, seemingly in response to Geithner’s proposal, that China aimed to reduce its surplus to 4 per cent of GDP in the medium-term, I was nonetheless surprised that China seemed so eager to go along. After all, as early 2009 amply demonstrated, China is very dependent for its growth on widening trade surplus, and if the surplus was cut by a third in the next year or two, which is what it would take to bring it to under 4% of GDP, it would cause a several percentage point slowdown in Chinese growth, which could only be reversed by another surge in bank-driven investment.

But events and policy speeches in China seem to suggest that the leadership is finally starting to see how risky continued expansion in investment has become. There is a growing sense, I think, that capital is not being wisely invested. Monday’s People’s Daily had what I thought was an interesting article:

China will continue to steadily push forward reforms in its interest rate mechanism, the Shanghai Securities News reported Friday, citing Guo Qingping, assistant governor of the People’s Bank of China (PBOC), the central bank.

…He explained that in order to achieve that goal, China’s central bank will further strengthen and improve macro-control of its financial system and steadily promote the market-oriented interest rate reform. It will also promote reforms of larger commercial banks to establish a modern enterprise system, he added.

It seems to me that perhaps those in China who have wanted to improve the capital allocation process by liberalizing interest rates are trying to speed up the process a little (a cynic might say: by trying finally to start the process).

But it is not going to be easy. Repressed interest rates may indeed be the biggest source of China’s domestic imbalance, but they are also the biggest cause of rapid Chinese growth in the short term. Give up one and you must give up the other.

Irreconcilable differences

If Beijing really is starting to worry about the negative long-term impact of increased and increasingly misallocated investment, then how could it support the idea of a significant contraction in the current account surplus? If it were to happen, Beijing would be forced to choose either a sharp slowdown in growth or a rapid increase in investment, and the rumors are (and mind you, these are only rumors) that Beijing is hoping to reduce credit expansion next year to RMB 6 trillion – it was RMB 9.6 trillion last year and expected to be RMB 7.5 trillion this year

How much of a slowdown? Li Ruogu, chairman of the Import-Export Bank of China, had what I thought was a rather novel way of expressing China’s dependence on trade and why the rest of the world should accommodate China. According to an article in Wednesday’s South China Morning Post:

In a possible preview of Beijing’s position in Seoul, the head of a government bank on Wednesday rejected suggestions the yuan is undervalued. He said a rapid rise in the yuan would cause massive job losses and Western nations would have to be ready to accept millions of Chinese immigrants.

“If you are not ready, then please don’t pressure China to appreciate its currency, because it cannot solve the issues faced by the West,” said Li Ruogu, chairman of the Import-Export Bank of China, speaking at a conference in Beijing.

Mr. Li, is right, I think. A rapid revaluation would be very difficult for China, as I have argued many times because it cannot afford to bring down the trade surplus rapidly, but on the other hand a failure to address the trade imbalance is likely to be very difficult for deficit countries.

Perhaps not surprisingly Beijing, it turns out, was not that eager to support Geithner’s proposal. Here is what an article in Friday’s South China Morning Post had to say:

China pushed back strongly against US policies yesterday ahead of the G20 summit, saying Washington’s plan to impose current account targets resembled a “planned economy”.

The remarks by Cui Tiankai , a deputy foreign minister (pictured), was the first high-level official stance from Beijing on the issues. “We believe a discussion about a current account target misses the whole point,” he said. The United States proposed at the G20 finance ministers’ meeting last month that countries should cap current account surpluses or deficits at 4 per cent of gross domestic product as part of efforts to rebalance the global economy. “Of course, we hope to see more balanced current accounts,” Cui said.

“But we believe it would not be a good approach to single out this issue and focus all attention on it. The artificial setting of a numerical target cannot but remind us of the days of planned economies.”

Enough people have chuckled at the irony of Beijing’s disparaging of planned economies for me not to comment, but it is worth pointing out that China is very worried about the double impact of a contraction in the trade surplus and the impact of the Fed’s quantitative easing. If the former occurs, it will be almost impossible for Beijing to reduce the impact of the latter without causing a sharp slowdown in growth

Beijing claims that QE2 makes it impossible for other countries to protect themselves from massive capital inflows that will destabilize local asset markets. Actually, Beijing is wrong. There is a way for countries to protect themselves against QE2, but it would require that they give up intervening in their currency. In other words the only reason QE2 will create excessive monetary expansion in China is because the PBoC will insist on purchasing all dollar inflows at the exchange rate set by the PBoC and monetizing them. So QE2 is fairly explicitly the US countermove in the great global game of beggar-thy-neighbor.

QE2 and the currency war

Meanwhile there has been a real flurry of attacks on QE2 in China. Tuesday’s People’s Daily has an article (“China vows to collar US over monetary policies”) that starts:

China yesterday urged the United States to “act responsibly” in its monetary policies, and said that concerns will be raised at the upcoming G20 summit in Seoul, South Korea. Vice Minister of Finance Zhu Guangyao made the remarks at a press briefing on President Hu Jintao’s attendance to the meeting.

The US Federal Reserve last week announced plans to purchase US$600 billion worth of government bonds in a bid to revive the sluggish economy. The near-zero US interest rate and a weak dollar are expected to push liquidity into Asian countries, potentially destabilizing emerging economies.

Zhu urged the United States to “realize its responsibility and obligation as a major currency issuing country, and take responsible macroeconomic policies. “We will have candid discussions with the US side. We hope its macroeconomic policy can be conducive to the development of the world economy, not the contrary,” Zhu said.

What an impasse. China and other countries are right to claim that QE2 is likely to lead to asset bubbles outside the US, but only, as the US points out, in countries that intervene to prevent dollar depreciation, something the US is anyway eager to discourage. If Beijing is correct however in claiming, as it has for many years, that Chinese currency policies should be aimed at China’s needs, not those of the US, it is hard for them to dispute the Fed’s argument that Fed monetary policies should be aimed at satisfying the needs of the US economy, not the needs of China.

That doesn’t mean Beijing won’t try. Last Thursday Xinhua had a piece arguing that “global reserve currencies come with responsibilities”:

The U.S. Federal Reserve announced Wednesday it would buy 600 billion dollars of Treasury bonds, effectively printing money to jumpstart the flagging American economy. The move is a boost to the U.S. economy but risks creating new capital bubbles for other countries.

The U.S. dollar is the most widely held reserve currency in the world today. The devaluation of the U.S. dollar plus an overly loose currency policy that leads to a sharp increase in capital flow will drive large amounts of hot money to newly emerging economies in search of profits.

The International Monetary Fund (IMF) has recently warned that Asia and other emerging markets are facing the double risks of a huge influx of foreign capital and an accumulation of inflation pressure.

Chinese Commerce Minister Chen Deming has also pointed out that “out-of-control” U.S. currency issuance and big international commodity price hikes would probably saddle China with imported inflation.

Ironically, one of the factors driving big international commodity prices up is the depreciation of the U.S. dollar, the main global reserve currency. In the past few months, a vicious cycle of currency flow became obvious. The Fed launched a round of quantitative easing, causing an overflow of capital (hot money pooled in other countries). This led to imported inflation jeopardizing the economies of other countries, which were then forced to intervene in the foreign exchange market.

The last line is a little funny, since not all countries only began intervening in response to dollar weakness, but the key point is that it is mainly the combination of QE2 and intervention that causes monetary expansion outside the US. And if the US is determined to get the dollar to depreciate, something that other countries including China have no trouble accomplishing with their own currencies, it is hard to see why putting pressure on interveners would not be in the US interest.

Hot money

There will also be attempts by Beijing to manage hot money inflows: Tuesday’s Bloomberg had this article, on a topic we were all pretty much expecting:

China will force banks to hold more foreign exchange and strengthen auditing of overseas fund raising as part of efforts to crack down on hot-money inflows. The State Administration of Foreign Exchange will tighten management of banks’ foreign-debt quotas and introduce new rules on their currency provisioning, the regulator said in a statement on its website. The government will also regulate Chinese special-purpose vehicles overseas and tighten controls on equity investments by foreign companies in China, it said.

The measures underscore concern around the world that the Federal Reserve’s decision last week to buy its own debt to keep borrowing costs near zero will cause investors to seek higher yields in emerging markets. Chinese and European leaders have said they plan to discuss the impact of quantitative easing at the Group of 20 summit this week in Seoul as well as the dangers of competitive currency devaluations.

Meanwhile the South China Morning Post had this to say, on a related topic:

China signalled its intention on Tuesday to crack down on excess cash sloshing around its financial system, by unexpectedly raising the yield on bills at a central bank auction and vowing to stem hot money inflows.

The moves suggest increasing concern from Beijing about a surge in liquidity in its financial markets after the US Federal Reserve’s decided on another round of quantitative easing, heralding for some analysts further monetary tightening steps sooner than had been expected.

The expectations were fuelled by comments from two central bank deputy governors that the Fed’s easing could lead to asset bubbles and inflation and that Chinese authorities were keeping a close eye on the situation. “China still has a strong momentum of rapid credit expansion,” said Du Jinfu, one of the deputy governors, in summing up the challenges facing the central bank.

I don’t think any of these measures will make much difference. China already is experiencing a liquidity-driven investment boom, and would have already raised interest rates if it weren’t so difficult to do so (many borrowers can barely service debt even at such low interest rates), instead of letting them decline in real terms, as they have all year. And even if SAFE can prevent some hot money inflow, it will not be enough to keep matters from getting worse, especially since most hot money inflow is likely to be generated by small and medium family businesses in China with international links. These are hard to monitor and control.

On Wednesday there were also reports that the PBoC raised minimum reserves again, in order to soak up liquidity. According to an article in the South China Morning Post:

China has increased required reserves for its biggest banks to mop up some of the cash that is streaming into the country and posing a growing inflationary threat. Although Chinese officials have directed their ire at US monetary easing as a cause of unwanted speculative inflows, data on Wednesday provided a reminder that a whopping trade surplus is the main source of Beijing’s liquidity headache.

The central bank lifted the reserve requirement ratio for Bank of China and Bank of Communications (SEHK: 3328) by 50 basis points, three industry sources told Reuters. Chinese media said the increase also targeted the country’s other main state-owned lenders. The move means the biggest banks are setting aside a record 18 per cent in reserves, BNP Paribas said in a note to clients.

You can’t sit out a trade war

I feel bad for countries like Brazil and Thailand that are being caught up in this monetary tug-of-war between the US on one side and China and countries that intervene on the other. So apparently does Martin Wolf. In a very testy piece in Wednesday’s Financial Times (“anyone with half a brain should realise that the US can no longer combine a large trade deficit with a manageable fiscal position”) he expressed his frustration with the inability of some analysts to see why the US has little choice but to attack the global imbalances. If it doesn’t, the desperate need of the rest of the world to grow its share of global demand will swamp the US economy.

Against Wolf I saw another very interesting piece in the Financial Times by Yao Yang, director of Peking University’s CCER, that among other things said:

The real question is whether China has the power, long enjoyed by the US, to stand steadfast against outside pressures. Put another way, China will only undertake a fast revaluation if other countries can credibly threaten punishment. The long-standing view in China is that the US and its allies lack the will to punish, even if they may have the means.

China’s leaders believe that, when the political dust of the midterm elections falls to earth, Americans will see they benefit from the cheap goods a weak renminbi provides. They also gain little from an upward valuation. Research suggests that even a 20 per cent appreciation will have minimal impact on the US economy. China, on the other hand, will see employment and GDP drop by over 3 per cent.

No wonder there is a firm belief among China’s elites that rational American policymakers are not serious about appreciation, because it makes no sense for a rational actor to inflict costs on others without gains.

Wow, if this true, we have a real problem. Beijing believes that there is no real desire on the part of Washington to address the deficit, while Wolf argues that if Washington doesn’t act soon it will face a rising trade deficit, more unemployment, and a worsening fiscal deficit. I think they are both right – Washington is worried about the deficit and Beijing believes Washington doesn’t care. This is a great setting for some pretty foolish brinkmanship. Yang even adds that in the argument between the two “it is conveniently forgotten that China is also contributing to the world, by providing cheap goods and credit.”

Wow! You hear this a great deal in China, and even by a lot of American economists – that somehow China’s great gift to the world is that it provides subsidized consumption to foreigners while taxing foreign consumption at home. But if the world has an overconsumption, problem along with an unemployment problem, why would the world consider this to be a gift? And if it really is a gift, shouldn’t Beijing be delighted when the US offers back to China the same gift – by forcing up the renminbi it wants to lower the cost to Chinese households of foreign consumption and pay for it by raising the cost to Americans of Chinese consumption?

Expect nothing from G20

Maybe not. Perhaps my mother was right, and it really is much more fun to give a gift than to receive one.

Each major country (and many minor) is pursuing monetary policies that attempt to create domestic growth at the expense of their neighbors. One of the terrible consequences of trade and currency war is that every country eventually gets caught up in the process and must play the same brutal game or suffer the consequences. No one paid much attention to beggar-thy-neighbor polices when the world was growing quickly, but it should have come as a surprise to no one that once global demand growth slowed, it was going to create a huge problem for international trade.

I hate to sound like a broken record, but since China and the US have seemingly valid and actually quite similar reasons for insisting on policies that are mutually contradictory, and neither can force the other except by accelerating their incompatible currency policies, there is almost no possibility of a happy solution to the trade disputes. In fact before the G20 meetings have even started, bad tempers and frayed nerves seem to provide some ominous signs. Here is what an article in Wednesday’s South China Morning Post said:

An all-day G20 planning session grew so intense that officials had to leave the door open to keep the room from overheating, underscoring deep tensions over global economic rebalancing one day before the start of a summit.

Deputies drafting a final statement to be released after the Group of 20 summit concludes on Friday remained far apart on pivotal issues, including currency exchange rates, G20 spokesman Kim Yoon Kyung said on Wednesday. “We had to open the door because the debate was so animated and the room was getting hot,” he said.

I think there is a very good chance that in retrospect QE2 will be seen as the equivalent of the Plaza Accord. If the US continues to pursue quantitative easing, it could spell the last stage of China’s great growth spurt followed by the beginning of the big adjustment. And like the Plaza Accord it will sow many years of suspicion and conspiracy theories.

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On a separate note, last week CIC chairman Lou Jiwei said that we should expect China’s long-term GDP growth rate to drop to 6%. According to a Bloomberg report, he said:

“If we consider the population factors and the movement to a higher stage of development, it implies that China’s potential economic growth rate will experience quite a big drop in the next three to four years.”

Although “population factors” matter, they matter in the long term, and not in three to four years, so when he says that growth will drop sharply in the next three to four years, I suspect Lou means that the main reason will be a “movement to a higher stage of development.” Of course the phrase “a higher stage of development” sounds to me like a euphemism for “major restructuring of the growth model,” and that, I suspect, will be the main cause of a sharp slowdown in growth. To my thinking, raising household income automatically means removing the household subsidies that generated rapid growth, and this will cause growth to slow sharply.

Meanwhile last week another policy advisor said something quite similar. According to an article in Thursday’s Xinhua:

Chinese economic growth may slow to about 7 percent per annum in the next three to five years from the current 10 percent level, Liu Shijin, deputy director of the Development Research Center of the State Council, a government think tank, told a forum Saturday.

Liu said along with the slowing in growth, rising costs and price hikes will be the three major challenges China faces in the future. He warned of price hikes caused by excessive liquidity, especially after the U.S. adopted its “quantitative easing” monetary policy.

He said the U.S. policy will add to inflationary pressures in emerging economies including China. China will face great imported inflationary pressures, he said. He also said the weakening of the U.S. dollar is “inevitable” in the long run, which may prompt a “currency war.”

The Chinese economy will encounter severe challenges in the coming few years and undergo its “most significant” transformation over the next 5 to 10 years, he added. He urged more efforts to restructure and reform the economy.

About one and a half years ago I published an article in the Financial Times with the title “Get ready for lower Chinese growth.” In it I argued that

Over the next five years or more Chinese economic growth will necessarily be lower than growth in Chinese consumption. The massive but unsustainable investment in infrastructure and new production facilities that characterises the Chinese fiscal stimulus package will not be able to change this fact. From its dizzying heights during the past two decades, the world needs to prepare itself for a decade during which, if all goes well, China grows at a still respectable but much lower rate of 5-7 per cent. If the current fiscal stimulus package retards China’s adjustment process, as many analysts argue that it does, growth rates may be much lower.

The article caused a lot of comment, and some very vituperative disagreement, because at the time it seemed totally incredible for anyone seriously to argue that Chinese annual growth would shift down to 5-7% in just a few years.

In fact I wasn’t really arguing that growth would slow on average over the next decade to 5-7%. I said if all goes well it will slow to that level. To me the logic of the growth model, and all historical precedent, suggests that the necessary adjustment will be quite difficult.

It looks like slowly the consensus is moving to the 5-7% growth number. I suspect that within a year it will be all but impossible to find anyone who admits he hadn’t assumed this number all along. I apologize if I sound like I am trying to score points. I am not. I just want to remind people that the consensus is shifting (as it usually does) very slowly but very steadily. I still think average growth rates over the next decade are likely to be lower than 5-7%, heavily front-loaded of course, but of course I will wait until everyone gets to 6% before I say that.

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After such a long post I guess I guess I should provide a touch of relief. China’s recently founded sovereign credit rating agency, Dadong, is often dismissed as a sort of rating-agency clown, more eager to get publicity than to build credibility. They recently downgraded the US from AA to A+.

According to an article in Wednesday’s People’s Daily:

A leading Chinese credit rating agency yesterday downgraded the sovereign credit rating of the United States from AA to A+, claiming that the U.S. government’s solvency is “on the brink of collapse”.

Some analysts have argued that Dadong confuses nationalism with credit ratings, and that its purpose is to gain attention by regularly downgrading the US. Actually I think the critics are wrong. If the US Government’s solvency “is on the brink of collapse”, as they say, I think it is an extraordinarily generous gesture nonetheless to rank US Government debt A+. Greece should be so lucky.