US Federal Reserve Chairman Ben Bernanke offered the Chinese
good advice in a speech he recently gave in Beijing as part of the
newly instituted strategic discussions between the United States
and China. Unfortunately, he also offered some very bad advice in
assessing the ramifications and risks of Chinese currency
policy.
In essence, the Bernanke critique was a one-sided interpretation
of a key issue that could backfire and lead to a worrisome
deterioration in the economic relationship between the United
States and China.
The offensive passage in the written version of the Bernanke
speech posted on the Fed's website was the assertion the current
value of the Chinese renminbi is an "... effective subsidy that an
undervalued currency provides for Chinese firms that focus on
exporting rather than producing for the domestic market."
The use of the word "subsidy" is a highly inflammatory
accusation in effect, putting the Chinese on notice that America's
most important macro policy maker believes RMB currency policy
provides the Chinese with an unfair advantage in the world trade
arena that fosters distortions in China's economy, the US economy,
and the broader global economy.
In my view, this is a very biased assessment of the state of
Chinese currency policy and reforms. It pays little attention to
the context in which RMB policies are being formulated and,
ironically, fails to provide any appreciation for the benefits that
accrue to America as a result of this so-called subsidy.
Moreover, Bernanke's spin continues to downplay the role the
United States is playing in creating its bilateral imbalance with
China to say nothing of the role the United States is playing in
fostering broader imbalances in the global economy.
The real question in all this is, who's subsidizing whom?
Conveniently overlooked in the Bernanke critique is an important
flip side to the "managed float" that continues to drive RMB policy
China's massive purchases of dollar-denominated assets.
The exact numbers are closely held, but there is close agreement
that between 60-70 percent of China's US$1 trillion in official
foreign exchange reserves are split between some US$345 billion
invested in US treasuries (as of October 2006, according to the US
Government's TIC reporting system) and a comparable amount held in
the form of other dollar-based fixed income instruments.
With Chinese reserve accumulation now running at more than
US$200 billion each year, the above mentioned estimates imply new
purchases of at least US$120 billion per year of dollar-denominated
assets.
Such foreign demand for US financial assets is absolutely
critical in plugging the funding gap brought about by an
unprecedented shortfall of domestic US saving a net national saving
rate that fell to a record low of just 0.1 percent of national
income in 2005.
Without China's purchases of dollar-based assets a key element
of its efforts to mange the RMB in accordance with its financial
stability objectives the dollar would undoubtedly be lower and US
interest rates would be higher.
In effect, that means China is subsidizing US interest rates
providing American borrowers and investors with cut-rate financing
and rich valuations that otherwise would not exist were it not for
the dollar recycling aspects of Chinese currency policy.
There is an added element of China's subsidy to the United
States. As a low-cost and increasingly high-quality producer, China
is, in effect, also providing a subsidy to the purchasing power of
US households.
Close down trade with China as many in the US Congress wish to
do and the deficit would show up somewhere else, undoubtedly with a
higher-cost producer. That would be the functional equivalent of a
tax hike on the American consumer cutting into the subsidy the
United States currently enjoys by trading with China.
The Fed Chairman is making a similar suggestion: By allowing the
RMB to strengthen, China's dollar buying would diminish effectively
eroding the interest rate and purchasing power subsidies that a
short saving and increasingly asset-dependent US economy has come
to rely on.
We can debate endlessly the appropriate valuation of the Chinese
currency. Economic theory strongly suggests that economies with
large current account surpluses typically have under-valued
currencies.
China would obviously qualify in that regard as would, of
course, Japan, Germany, and many Middle East oil producers.
The fact that China is being singled out for special attention
is, in and of itself, an interesting comment on the biases in the
international community.
Nevertheless, it is quite clear that China understands this
aspect of the problem.
By shifting to a new currency regime 17 months ago, Chinese
policy makers explicitly acknowledged the need for more of a
market-based foreign exchange mechanism.
The RMB has since risen about 6 percent against the dollar not
nearly as much as many US politicians are clamoring for, but at
least a move in the right direction.
Risk-averse Chinese policy makers feel strongly about managing
any currency appreciation carefully understandable, in my view,
given the still relatively undeveloped state of China's
highly-fragmented banking system and capital markets.
The potential currency volatility that a fully flexible foreign
exchange mechanism might produce could have a very destabilizing
impact on an undeveloped Chinese financial system. And that's the
very last thing China wants or needs.
Bernanke's criticism of the Chinese for subsidizing their export
competitiveness by maintaining an undervalued RMB completely
ignores the benefits being enjoyed in the United States through
equally important subsidies to domestic interest rates and
purchasing power.
?
Bernanke failed to acknowledge the extraordinary fragmentation of a
highly regionalized Chinese banking system dominated by four large
banks that still have well over 60,000 autonomous branches between
them.
How a central bank gets policy traction with such a
decentralized banking system is beyond me. Moreover, he basically
overlooks another critical reason for China's irrational investment
process the lack of well-developed capital markets and the
continued reliance on policy-directed lending by China's large
banks.
Instead, Bernanke suggests that a flexible currency is the best
means to foster an efficient allocation of investment projects.
In short, the flaw in the Bernanke critique is his failure to
appreciate the very special transitional needs of a still blended
Chinese economy currently straddling both State and private
ownership systems, as well as centrally-planned and market-directed
allocation mechanisms.
There are some interesting footnotes to the Bernanke speech.
Significantly, the Fed Chairman actually flinched when it came to
the oral version of his speech offering a last-minute substitution
of the word "distortion" for "subsidy."
(China Daily December 25, 2006)
