On Chinese stimulus, dollars and the Great Rebalancing

Yu Yongding is the President of the China Society of World Economics, is a former member of the Monetary Policy Committee of the People’s Bank of China, and a member of the National Advisory Committee of the 11th Five Year Plan for National Economic and Social Development of the People’s Republic of China.

In a recent speech entitled “China’s Policy Responses to the Global Financial Crisis” made at a uni in Australia on November 25, he voiced some strong opinions about the long-term unintended consequences of recent aggressive Chinese interventionist policy.

The very expansionary fiscal and monetary policies have succeeded in arresting a fall in growth. However, the medium and long-term impacts of the expansionary policies are worrying.

First, the most important feature of China’s growth pattern is investment overdrive… This means that China’s overcapacity will become more serious in the future.

Second, China’s investment efficiency has been falling as a result of the stimulus package.

Third, infrastructure investment is long-term investment and will take a long time to create revenue streams.

Fourth, the over-enthusiasm of local governments for local investment may worsen [the central government's] fiscal position in the future in an unexpected and dramatic way.

Finally, as already mentioned, China’s monetary policy is too loose. There is no need for China to drop the benchmark interest rate to such a low level… The rapid expansion of credit and money supply was, to a certain extent, the result of non-market interferences.

Professor Yu also spent a bit of time on the US dollar, global imbalances and the safety of China’s foreign exchange reserves.

China is resigned to the fact that in essence it is borrowing with high costs and lending the money back to the United States for low or zero return. More troubling is that now, even the safety of China’s foreign exchange reserves is under threat. And capital losses — let alone obtaining decent returns — seem inevitable.

First, the devaluation of the dollar is inevitable, which will lead to capital losses in China’s foreign exchange reserves. The bulk of China’s 2.3 trillion dollar foreign reserve holdings are not held for the purpose of self-protection, rather they are savings in the form of US Treasuries. China needs to preserve the value of its savings. There is no question whatsoever that the US dollar will go south, which started in April 2002 and, after a short interval, restarted in March 2009. Unless the US economy is rebalanced, the dollar will fall. And unless the dollar falls, the US rebalance will not be achieved. As a result, capital losses of China’s foreign exchange reserves are inevitable.

Second, though inflation may not be an immediate threat, the US inflation rate should be around 4 per cent according to US Federal Reserve officials. This would mean that each year China’s purchasing power devalues by 4 per cent. Furthermore, due to an extremely expansive monetary policy, the dollar has been debased. Unless the Fed implements the exit strategy successfully, which is doubtful, the real value of China’s foreign exchange reserves will be eroded. Finally, as a result of dropping money from the sky by Helicopter Ben, serious inflation in the future cannot be ruled out.

Third, due to the huge budget deficit and supply of bonds by the United States, there is no guarantee that there will be enough demand for the US securities. As a result, the price of US government securities will drop, and China’s US security holding will suffer losses.

First of all, China should reduce its current and capital account surpluses. If it cannot reduce the twin surpluses, it has to translate the surpluses into assets other than US Treasuries, which include increasing outbound FDI, investing in strategic resources, engaging in mergers and acquisitions and portfolio investment abroad, lending to international organizations, selling panda bonds, engaging in currency swaps, and providing aid to developing countries.

With regard to stocks, the US Government should offer more Treasury Inflation- Protected Securities — like financial instruments. This would allow China to convert some of its holdings of US government securities into similar but safer assets. China should be allowed to convert part of its foreign exchange reserves into special drawing rights (SDR) — denominated assets. China should not rule out the possibility of adjusting the composition of its foreign exchange reserves to mimic the composition of SDR. If the US Government cannot safeguard the value of China’s holdings of US government securities, the US Government should compensate China in one way or another.

If influential policymakers such as Prof Yu are so certain of the downward trajectory of the US dollar and inflation developments there, one can but only assume that there must be some serious exit strategy talk going on behind closed doors in Beijing. Note how different exit strategy talk in China and the US are: the Chinese are concerned about losing its savings, creating asset bubbles and overstimulating the economy, while the US is worried about the value of its debt dropping, making it more expensive to repay it, while blowing its lungs out to reflate asset markets, the life-blood of the economy. The reality is that the two nations would want to continue with current policies for as long as possible – for they have served particular political interests well. But at some point the diverging stresses will become too great and force the rebalancing upon the economies with a total disregard for the politicians’ wishes.

2009-yongding