http://www.rgemonitor.com/emergingmarkets-monitor/254562/can_china_adjust_to_the_us_adjustment
For the past ten years the global balance of payments has been dominated by the trade and investment relationship between China and the US. This relationship is now undergoing a major shift. Most large economies will be affected, and to the extent that their economic policies do not accommodate this shift, they are likely to fail, in much the same way that economic policy failed in the 1930s.
China runs a massive current account surplus with the US and, in recycling this surplus, an equally large capital account deficit. This recycling has been both the main source of the global liquidity that has engulfed the world until recently and a constraining factor in the global economy. Given their magnitude it is impossible for either country to adjust without a major counterbalancing adjustment from the other, but it is far from clear that policy-makers on either side, especially in China, have a clear grasp of how big the necessary adjustments must be. The result is likely to be a steep drop in global growth, much of it borne by China, and possibly even a collapse in global trade.
Other countries have played a role in this imbalance too, of course, but with a few important exceptions (OPEC, for example) they have fallen broadly into two camps whose characteristics are typified either by China or the US. One set of countries, like the US, has had booming domestic consumption and high and rising trade deficits. Their highly sophisticated financial systems were able to intermediate the surge in underlying liquidity into the consumer loans that permitted the consumption binge. The second set of countries, like China, have excessively high rates of saving that have been systematically funneled into domestic investment, resulting in a huge and rising surplus of production over consumption, the balance of which is exported abroad.
Until recently excess US demand and excess Chinese supply were in a temporarily stable balance. As part of running a trade surplus, China necessarily accumulated dollars, which had to be exported to (invested in) the US. This capital export from China to the US did not occur in the form of private investment ¡V indeed it was actually exacerbated by the fact that China was a net importer of private capital ¡V but rather occurred as forced accumulation of central bank reserves, which were recycled back to the US in the form of purchases of US Treasuries and other US dollar assets. Since China had effectively pegged its currency, its central bank, the People¡¦s Bank of China (PBoC) had no choice but to accumulate reserves in this manner as long as China ran a surplus.
The recycling process also functioned as a great liquidity generator for the world, converting US consumption into Chinese savings, which were then recycled back into the US financial markets through purchases by the PBoC of highly liquid US securities. There are several self-reinforcing aspects to this system that pushed it to the extremes it ultimately took. In the US the torrent of inward-bound liquidity boosted real estate and stock market prices. As markets surged, substantially increasing the wealth of US households, these same households began diverting a steadily increasing share of their income to consumption rather than savings. At the same time rising liquidity always forces financial institutions to adjust their balance sheets as they attempt to accommodate the expansion in underlying money, and one of the most common ways they do so is by increasing outstanding loans. With banks eager to lend, and households eager to monetize the value of their assets in order to fund consumption, it was only a question of time before household borrowing ballooned.
Meanwhile in China, the country¡¦s currency regime locked it into self-reinforcing trade surpluses. As foreign currency poured into the country via its trade surplus, the money was purchased by the PBoC, whose accelerating accumulation of foreign reserves was paid for by creating money or by issuing central bank bills, a close substitute for money. In China most new money creation ends up in the banking system, whose main purpose is to fund investment (consumer lending is a negligible part of bank lending). As investment surged, industrial production inevitably grew much faster than private and public consumption. A country¡¦s trade surplus is the gap between its production and its consumption, and as this gap grew, so did China¡¦s trade surplus, which resulted in even more foreign currency pouring into the country, thus reinforcing the cycle.
In this highly instable balance, sometimes dubbed Bretton Woods II, Chinese overcapacity was matched with American over-consumption, and Chinese official lending was matched with US household borrowing. This ensured that the current account flows were matched with the capital account flows, and any change in one of these accounts required equal and opposite changes in the other three. This is a fundamental requirement of the global balance of payments ¡V it must balance.
The great imbalance
Many analysts think of the US economy as the engine that drives the rest of the world, but this is not always true. Sometimes large changes or distortions in one part of the world can force adjustments elsewhere, and as the world¡¦s largest and most open economy, with an astonishingly flexible financial system, it is often the US that absorbs adjustments originating elsewhere.
We saw this in the trade numbers. For most of last fifty years the US current account has fallen within a range of plus or minus 1% of GDP. There have been at least two exceptions. The first occurred in the mid-1980s when the US current account deficit rose to nearly 3.5% of GDP in 1986-87 before declining sharply and running into a small surplus in 1990. The second began in 1994, around the time of the Mexican crisis, when the US current account deficit climbed to around 1.6% of GDP, declined for two years, and then took off in 1997-98, after which time it raced forward in straight line to peak, in 2006, at 6.2% of GDP.
If the US trade deficit were driven simply by a US consumption binge, as is often claimed, it is a little hard to see why it would have followed a pattern of general stability over many decades marked by two surges ¡V a small one from 1984-1988 and a very large one after 1997. If it was driven by changes in Asian savings, this pattern becomes easier to understand. The 1980s surge was driven largely by Japanese trade policies and domestic savings and is a fascinating case study in itself, but it is the post-1997 surge that is much more interesting and relevant to the current crisis.
1997 was, of course, the year in which several Asian countries experienced terrifying financial crises and viciously sharp economic contractions, and the crises profoundly impressed Asian policy-makers to this day. The crises seemed to be caused by the sudden reversal of current account surpluses into deficits, along with inverted balance sheets in which large external obligations were mismatched against domestic assets. Central bank reserves normally act as a hedge against this kind of currency mismatch, but the most affected Asian countries were precisely those countries with very low levels of foreign currency reserves. When the market worried about external debt sustainability, the currency mismatch proved to be the biggest concern, and as investors fled they set into play a series of events that caused plunging asset prices, collapsing currencies and, as a consequence of the latter, a surge in the external debt burden. The result was economic chaos from which most of the affected countries have still not emerged.
One of the main lessons policy-makers learned from the crisis was the risk of a currency mismatch between external obligations and domestic assets ¡V too much dollar debt and not enough dollar reserves. To protect themselves from a repeat of the disastrous 1997 crisis many Asian policymakers engineered current account surpluses by managing trade policy and the value of their currencies. As a necessary consequence they began amassing large foreign currency reserves.
This resulted in what some have called a global capital flow ¡§paradox¡¨ ¡V the fact that in recent years developing countries have been large and growing net exporters of capital to rich countries. This is a paradox because, historically, capital-poor developing countries have generally been net importers of capital. By accumulating foreign currency reserves they are often net exporters of official capital, but for most of the last fifty years official capital exports on average were significantly less than net private capital imports.
In 1998 official capital exports in the form of foreign currency reserve accumulation among developing countries began to take off, and by 1999 net official capital exports exceeded net private capital imports. This is when the ¡§paradox¡¨ begins. Since 1998 except for a small decline in 2001 net capital exports from developing countries surged almost in a straight line to around $700 billion annually (combining $1.2 trillion of reserve accumulation versus $0.5 trillion of net private flows).
But the global balance of payments must balance. As Asian trade surpluses and net capital exports surged, some other part of the world had to equilibrate these adjustments by running large trade deficits and importing capital. The US did exactly this, and the US trade deficit soared after 1997 while at the same time US household savings collapsed.
For the past ten years the global balance of payments has been dominated by the trade and investment relationship between China and the US. This relationship is now undergoing a major shift. Most large economies will be affected, and to the extent that their economic policies do not accommodate this shift, they are likely to fail, in much the same way that economic policy failed in the 1930s.
China runs a massive current account surplus with the US and, in recycling this surplus, an equally large capital account deficit. This recycling has been both the main source of the global liquidity that has engulfed the world until recently and a constraining factor in the global economy. Given their magnitude it is impossible for either country to adjust without a major counterbalancing adjustment from the other, but it is far from clear that policy-makers on either side, especially in China, have a clear grasp of how big the necessary adjustments must be. The result is likely to be a steep drop in global growth, much of it borne by China, and possibly even a collapse in global trade.
Other countries have played a role in this imbalance too, of course, but with a few important exceptions (OPEC, for example) they have fallen broadly into two camps whose characteristics are typified either by China or the US. One set of countries, like the US, has had booming domestic consumption and high and rising trade deficits. Their highly sophisticated financial systems were able to intermediate the surge in underlying liquidity into the consumer loans that permitted the consumption binge. The second set of countries, like China, have excessively high rates of saving that have been systematically funneled into domestic investment, resulting in a huge and rising surplus of production over consumption, the balance of which is exported abroad.
Until recently excess US demand and excess Chinese supply were in a temporarily stable balance. As part of running a trade surplus, China necessarily accumulated dollars, which had to be exported to (invested in) the US. This capital export from China to the US did not occur in the form of private investment ¡V indeed it was actually exacerbated by the fact that China was a net importer of private capital ¡V but rather occurred as forced accumulation of central bank reserves, which were recycled back to the US in the form of purchases of US Treasuries and other US dollar assets. Since China had effectively pegged its currency, its central bank, the People¡¦s Bank of China (PBoC) had no choice but to accumulate reserves in this manner as long as China ran a surplus.
The recycling process also functioned as a great liquidity generator for the world, converting US consumption into Chinese savings, which were then recycled back into the US financial markets through purchases by the PBoC of highly liquid US securities. There are several self-reinforcing aspects to this system that pushed it to the extremes it ultimately took. In the US the torrent of inward-bound liquidity boosted real estate and stock market prices. As markets surged, substantially increasing the wealth of US households, these same households began diverting a steadily increasing share of their income to consumption rather than savings. At the same time rising liquidity always forces financial institutions to adjust their balance sheets as they attempt to accommodate the expansion in underlying money, and one of the most common ways they do so is by increasing outstanding loans. With banks eager to lend, and households eager to monetize the value of their assets in order to fund consumption, it was only a question of time before household borrowing ballooned.
Meanwhile in China, the country¡¦s currency regime locked it into self-reinforcing trade surpluses. As foreign currency poured into the country via its trade surplus, the money was purchased by the PBoC, whose accelerating accumulation of foreign reserves was paid for by creating money or by issuing central bank bills, a close substitute for money. In China most new money creation ends up in the banking system, whose main purpose is to fund investment (consumer lending is a negligible part of bank lending). As investment surged, industrial production inevitably grew much faster than private and public consumption. A country¡¦s trade surplus is the gap between its production and its consumption, and as this gap grew, so did China¡¦s trade surplus, which resulted in even more foreign currency pouring into the country, thus reinforcing the cycle.
In this highly instable balance, sometimes dubbed Bretton Woods II, Chinese overcapacity was matched with American over-consumption, and Chinese official lending was matched with US household borrowing. This ensured that the current account flows were matched with the capital account flows, and any change in one of these accounts required equal and opposite changes in the other three. This is a fundamental requirement of the global balance of payments ¡V it must balance.
The great imbalance
Many analysts think of the US economy as the engine that drives the rest of the world, but this is not always true. Sometimes large changes or distortions in one part of the world can force adjustments elsewhere, and as the world¡¦s largest and most open economy, with an astonishingly flexible financial system, it is often the US that absorbs adjustments originating elsewhere.
We saw this in the trade numbers. For most of last fifty years the US current account has fallen within a range of plus or minus 1% of GDP. There have been at least two exceptions. The first occurred in the mid-1980s when the US current account deficit rose to nearly 3.5% of GDP in 1986-87 before declining sharply and running into a small surplus in 1990. The second began in 1994, around the time of the Mexican crisis, when the US current account deficit climbed to around 1.6% of GDP, declined for two years, and then took off in 1997-98, after which time it raced forward in straight line to peak, in 2006, at 6.2% of GDP.
If the US trade deficit were driven simply by a US consumption binge, as is often claimed, it is a little hard to see why it would have followed a pattern of general stability over many decades marked by two surges ¡V a small one from 1984-1988 and a very large one after 1997. If it was driven by changes in Asian savings, this pattern becomes easier to understand. The 1980s surge was driven largely by Japanese trade policies and domestic savings and is a fascinating case study in itself, but it is the post-1997 surge that is much more interesting and relevant to the current crisis.
1997 was, of course, the year in which several Asian countries experienced terrifying financial crises and viciously sharp economic contractions, and the crises profoundly impressed Asian policy-makers to this day. The crises seemed to be caused by the sudden reversal of current account surpluses into deficits, along with inverted balance sheets in which large external obligations were mismatched against domestic assets. Central bank reserves normally act as a hedge against this kind of currency mismatch, but the most affected Asian countries were precisely those countries with very low levels of foreign currency reserves. When the market worried about external debt sustainability, the currency mismatch proved to be the biggest concern, and as investors fled they set into play a series of events that caused plunging asset prices, collapsing currencies and, as a consequence of the latter, a surge in the external debt burden. The result was economic chaos from which most of the affected countries have still not emerged.
One of the main lessons policy-makers learned from the crisis was the risk of a currency mismatch between external obligations and domestic assets ¡V too much dollar debt and not enough dollar reserves. To protect themselves from a repeat of the disastrous 1997 crisis many Asian policymakers engineered current account surpluses by managing trade policy and the value of their currencies. As a necessary consequence they began amassing large foreign currency reserves.
This resulted in what some have called a global capital flow ¡§paradox¡¨ ¡V the fact that in recent years developing countries have been large and growing net exporters of capital to rich countries. This is a paradox because, historically, capital-poor developing countries have generally been net importers of capital. By accumulating foreign currency reserves they are often net exporters of official capital, but for most of the last fifty years official capital exports on average were significantly less than net private capital imports.
In 1998 official capital exports in the form of foreign currency reserve accumulation among developing countries began to take off, and by 1999 net official capital exports exceeded net private capital imports. This is when the ¡§paradox¡¨ begins. Since 1998 except for a small decline in 2001 net capital exports from developing countries surged almost in a straight line to around $700 billion annually (combining $1.2 trillion of reserve accumulation versus $0.5 trillion of net private flows).
But the global balance of payments must balance. As Asian trade surpluses and net capital exports surged, some other part of the world had to equilibrate these adjustments by running large trade deficits and importing capital. The US did exactly this, and the US trade deficit soared after 1997 while at the same time US household savings collapsed.
