Yuan: Dissecting the Clinton Argument, and thoughts on the sustainability of the US-China imbalances

The Geither argument has been shifted aside in light of the current financial crisis. There is more attention being paid to the financial linkages between the US and China. US Secretary of State Hilary Clinton encourages China to purchase US treasury securities and fund US treasury fiscal deficits.

The Hilary argument is ironically in direct contradiction to the Geithner argument as if China is to support the US fiscal deficits it needs to maintain its below equilibrium exchange rate, and collect $US foreign reserves to continue investing in treasury securities.

In Economic talk, one often hears of how the BOP surpluses of China and its undervalued Yuan are interconnected with the consumption binge in the US. This is because China’s undervalued Yuan has led to an export-led boom, with growing trade surpluses to the US, and by accumulating BOP surpluses and investing in US treasury securities it is propping up the dollar and lowering interest rates, making Chinese products relatively cheaper and fuelling the US consumption demand for Chinese products. This further increases China’s trade surpluses and BOP surpluses, which further fuel US consumption. The real question is whether this cycle can be sustainable, and whether it can continue in light of the current crisis. This is hard to answer, so what I have done is try to answer a series of related questions on the US-China capital flows relationship.

1) Will China try to sell its holdings of treasury assets in light of its expectation of a US monetisation of fiscal deficit?

If China were to sell US treasury securities, what would happen? Krugman suggests that if China sells current holdings of US treasury securities it might trigger a mass dumping of US currency and securities, severely dampening remaining value of China’s asset holdings. On the other hand, given the burgeoning fiscal debt, the US dollar will depreciate in the long-term, automatically reducing the value of China’s $US denominated asset holdings. Either way, this crisis will result in a capital loss for China’s investments.

2) Will the US suffer if China reallocates its BOP surplus to holdings of non-US treasury assets?

The US Government are not so worried about China selling their treasury securities, but rather the possibility of China reallocating future BOP surpluses to other investments, say, European Governments’ bonds for example. Such a reallocation, ceteris paribus, would lead to an oversupply of treasury bonds and an interest rate increase, limiting the size of US fiscal deficits as well as increasing the interest repayments on existing debt. Would this adversely affect the ability of US to prevent a deflationary spiral and maintain income? Krugman suggests that if China were to reallocate by purchasing, say, German treasury securities, then $US will depreciate against the Euro and increase net exports to compensate the reduction in Government expenditure. Thus from a US perspective China’s funding of their treasury deficits is not necessary.

I do think that Krugman is missing a vital point. If China do stop funding US fiscal deficits, then the oversupply of treasury bonds may be purchased domestically- the ‘flight to quality’ the US has been experiencing is precisely the preference of the financial sector to lend to the government in light of increased risk and liquidity premia on private market assets. If the financial sector further indulges in financing the deficit, it further amplifies the credit crunch and lack of funding to the private sector. The increase in ‘flight to quality’ may not be crowding out the private sector borrowing- as long as any increase in the ‘flight to quality’ is funded by an injection of reserves into banks, for example, then the private sector’s borrowing capacity will not be affected (I will discuss this at length in a future post).

The main problem with Krugman’s argument is that he implicitly assumes an IS-LM interpretation of a small open economy as applied to the US, where any fiscal contraction is met by an export-led recovery. However it is clear that Krugman would negate the opposite- that fiscal stimulus crowds out net exports, and would use the argument of how the world, by all coordinating easy monetary policy, are in a fixed ER regime where ‘beggar thy neighbour’ policies may not work.

3) Will China suffer if China reallocates its BOP surplus to holdings of non-US treasury assets?

In 2) we were discussing the effects on US of China cutting its credit lines to the US government. But is it in the interest of China to reallocate its BOP surpluses to finance different countries’ fiscal debt? Firstly, one must understand that the $US is the international reserve currency. This means that China’s BOP surpluses are always denominated in $US. If they decide to fund German fiscal deficits, then they are required to sell $US and purchase Euros. This might trigger a depreciation of the $US and make it harder for China to reallocate their investment. This is why senior government officials in China have called for a change to the international reserve currency, so China can protect its investments without worrying about a $US depreciation.

I think that since the World is suffering from an excess supply of desired savings, it is in the interest of the Chinese government to spend its BOP surpluses rather than save it. For starters, they could stop sterilising the net flow of $US and trying to inject their savings into the domestic economy. There is natural concern that if China stops reinvesting their earnings in the US economy then their trade surpluses with the US and their export-led boom will stop growing. However maybe it is time for China to address some of its internal imbalances, namely the fact that their heavy investment and export-led boom has come at the cost of an under-consuming household sector.

In a nice article by David Leonhardt on the US-China trade relationship, he comments on how the consumption in China as a % of GDP is a mere 40%, whereas it is 70% in the US. It is obvious then that the growing trade imbalances between US and China is partly due to over-consumption by the US and under-consumption by China. This crisis may provide the impetus to change these imbalances, and one can see this happening in the US, where Obama is encouraging more investment in education, science, medicine and alternative energy, to replace the past trend of US growth as being consumption driven. For China, the repercussions of heavy investment and an export-led boom is seen as the lack of a safety-net for Chinese households, who do not have adequate health cover, for example, and a lack of growth of infrastructure for households to live more comfortably and to spend freely. China should meet the shortfall in global demand for its exports by stimulating domestic demand and consumption, and by doing this it will help not only China but the world by reducing the excess supply of desired savings.

There is no doubt that the fundamental linkages between countries such as the US and China needs to change. The fact that we are in this crisis is because of this unsustainable consumption binge in the US, driven by the savings glut of the Asian countries (including China) and the Middle East. This savings glut drove down interest rates/marginal product of capital and was a major contributor to US housing bubble. Therefore a lesson from this crisis is that we need to change the structure of the interrelationships between the economic entities on this planet. The US-China relationship over the past decade is unsustainable and changes need to occur on both sides to reduce trade/capital imbalances over time.