American Profligacy and Chinese Patronage

in a Post-Pegged World

Josh Anderson

PG378 Chinese Political Economy

Fall 2005

America’s indebtedness to Chinahas surpasseda quarter-trillion dollars and with no sign that its deficit spending will abate, there has been much discussion among economists about the sustainability of American fiscal policy and the financial risks it poses.[1] On one side of the debate are the optimists, who argue that China will be self-deterred against permitting financial damage to the US because it relies on the well-being of US markets to accommodate its booming export sector. Its demand for US Treasuries will therefore remain insatiable because maintaining the dollar’s artificial strength against the Yuan – a requisite for continued export growth – requires swapping Yuan for dollars injected into the Chinese economy as investment and export earning; and after buying up so many dollars, it only makes sense to invest them in something interest bearing, like US Treasuries, which also have the virtue of being low-risk and highly liquid.

On the other hand, many pessimists warn that these massive dollar-denominatedreserves give China tremendous power over US monetary policy. Some fear that if China sells off its massive debt holdings, it would precipitate a collapse of the dollar and financial crisis in the US. Perhaps a more plausible scenario is that China will diversify its reserve holdings or scale back future purchases of dollars, provoking similar though less rapid results. Although the optimists have so far proven correct, China’s revaluation of the Yuan and its abandonment of the Yuan-dollar peg have redoubled the anxiety of these pessimists, who now see no reason for China to continue buying US Treasuries or hold US dollars.

In spite of these fears, this paper argues that there is relatively little prospect that de-pegging the Yuan from the dollar will alter the fundamental dynamics underlying China’s demand for US Treasuries. A deceleration of Treasuries accumulation risks undermining America’s export demand, which would critically upset further economic growth in China. Dramatic devaluation of the dollar is also counter-productive to China’s effort to recapitalize its banking sector. Even if China were to unexpectedly alter its purchasing behavior, intervention by other Asian banksand a significant time-lag to make adjustments would prevent a full-blown financial crisis from developing.

This paper will first examine US fiscal policy and its connection to the trade deficit to explain the factors underlying the current financial relationship between the US and China. Next, the disaster scenarios that concern many economists will be considered, along with an examination of the presumed causal link from de-pegging the Yuan and the dollar. The following section will explain why a Chinese sell-off of US debt is unlikely by examining the motivations underlying its past purchasing decisions, and how this logic still applies in a post-pegged world. To ascertain the danger if these assessments prove false, the next section will examine the likely behavior of other actors and financial forces in mitigating the impacts of a reverse in Chinese behavior. The concluding section explains why in spite of the relatively small risk posed by American fiscal policy, the US should scale back its rhetorical demands for future revaluations, as the Chinese financial system cannot sustain them.

I. The Twin Deficits

America has both a current account and federal budget deficit, and they are interrelated. The current account deficit results from America importing more than it exports – a negative balance of $726 billion in 2005.[2]More than a quarter of this deficit – $202 billion – results from US trade with China.[3] This profligacy is in large part sustained by American fiscal policy encouraging consumption, rather than savings. Chinese monetary policy – specifically, its purchase of US government debt – plays a critical enabling function. At the start of September 2005, China’s foreign reserves totaled $769 billion.[4] Prior to July 2005, China’s currency was pegged to the dollar, thereby artificially undervaluing the Yuan in order to increase Chinese export competitiveness. To maintain this peg, China had to prop up the dollar by buying surplus dollars that entered its market as investment and export earnings.[5] These dollar holdings were in large part recycled back to the US through the purchase of US Treasury bonds, which are sold by the US government to finance its debt. The Treasury Department calculates that after Japan, China is the world’s second largest holder of US government debt with $257 billion worth of Treasuries at the end of 2005.[6]China is also the most rapid accumulator of new debt. As Treasuries pay interest, they are preferable to holding dollars, which lose purchasing power over time because of the natural rate of inflation.There is also little risk that the US will default on its debt, making Treasuries among the safest investments.

More importantly though, funding the US budget deficit is likely a calculated decision meant to bolster American demand for goods from China – a decision motivated by the reality that China’s export-orientation is the basis for its economic assent. The relationship between America’s current account and budget deficit is three-fold: first, foreign funding of the budget deficit allows the US government to reduce its citizens’ tax burden, increasing the amount of disposable income they have to spend on Chinese products.[7]Second, since many American firms use inputs from China, some of the government’s spending indirectly finances trade with China. Third, foreign financing of the deficit prevents a ‘crowding-out’ effect, which threatens to push up US interest rates by increasing the domestic demand for credit.[8] Lower interest rates keeps mortgages low, allowing Americans to borrow against the value of their home to finance consumption; it also keeps down credit card rates, further increasing American consumers’ purchasing power. Section three will argue that in spite of the new currency regime discussed in the next section, these same motivations for financing US debt will remain in place.

II. The Alleged Peril of a Post-Pegged World

In July 2005, China announced that it would allow a modest revaluation of the Yuan in terms of the dollar – from 8.27 to 8.11, or about 2.1 percent – and would abandon its decade-old Yuan-dollar peg, opting for a new peg to a basket of foreign currencies, the composition of which would remain secret.[9]In practice, the Yuan is still pegged to the dollar since it is only permitted to move .3 percent per day versus the dollar, while as much as 3 percent against any other currency.[10]Chinese authorities have not even permitted this degree of movement: at the close of trading on February 28, 2006, the Yuan has revalued a total of 2.8 percent since the de-pegging, in spite of assessments that it is overvalued by 20-25 percent.[11][12]
Some economists have raised the concern that this new currency regime will diminish China’s need to purchase US Treasuries. Because the Yuan is now pegged to a basket of currencies, Chinamay start diversifying its foreign reserve holdings away from dollars and dollar-denominated assets.[13]The other fear is that with the peg to the dollar broken, China might bow to US pressure and permit much larger revaluations in the future; with a less managed float, there would be no reason for China to continue the currency intervention that supplies it with the dollars it uses to buy American debt.[14]

If either fear actualized, there would be a high risk of financial crisis and recession. The immediate result in both cases would be downward pressure on the dollar, as China’s central bank slows its reserve accumulation – in the former instance, because it is now favoring other currencies, and in the latter, because it simply has no need to maintain such large reserves.[15]This would have two impacts: first, as the dollar loses purchasing power against the Yuan, Chinese goods get more expensive, accelerating inflationary pressures.[16]Second, bond yields would have to rise to keep Treasuries attractive.[17]The cumulative effect of these two factors would push up US interest rates to combat inflation and because long-term bond yields are closely tied to short-term interest rates.[18][19] Americans have such enormous credit card and mortgage debt that any increase in interest rates would substantially undermine their capacity for consumption.[20] Higher interest rates would also curtail further investment in the housing sector, which is the basis of America’s current economic recovery.[21]

American policymakers confronting a simultaneous decrease in consumption and investment would find themselves in a catch-22: fiscal policy – further deficit spending or tax cuts – to stimulate the economy would require issuing more Treasuries, forcing up bond rates even further; and monetary policy – lowering interest rates – would accelerate inflation and panic those still holding Treasuries that the US is trying to inflate the debt away, causing them to dump their remaining holdings.[22]In either case, the structural causes of the crisis would be compounded. But as the next section explains, neither of the aforementioned stimulants of this calamity is likely to manifest.

III. Embracing the Balance of Financial Terror

According to the pessimists, a financial crisis could be caused deliberately, by China’s mass sell-off of US debt; or unintentionally, by a reduced rate of accumulation of dollars in favor of reserve diversity or smaller reserves altogether, as explained in the previous section. The remoteness of both possibilities will be explored below through the lenses of China’s ongoing need to manipulate its currency, its reliance on the US as an export market, and the reserve status of the US dollar. All three perspectives help to explain China’s purchasing behavior under its old currency regime, and none of these motivations are changed by its new regime.

The Demands of the Managed Float

As discussed in the previous section, China still has a de facto peg to the dollar. Despite officially pegging the Yuan to a basket of currencies, it is clear that stability with the dollar remains of preeminent concern given China’s willingness to permit fluctuation with non-dollar currencies at a rate ten times greater than with the dollar. Urbanization in China means that it will need to absorb ten million new workers per year, and so, social stability mandates continued export growth.[23]Since the US is China’s largest trade partner, sustaining export competitiveness in the US is key to further industrialization.[24] This means that for the foreseeable future, China will need to continue accumulating dollar reserves to prop up the dollar against the Yuan.

The switch to a managed float may even increase the need to accumulate dollars. The prospect of further revaluations may cause regular influxes of hot money by speculators who hope their short-term investment will increase in value when the Yuan rises.[25] This is an additional factor underlying China’s dollar reserve accumulation in the status quo, and one likely to become more pronounced in hopes of speculative gains. Because China will continue to accumulate dollars, the need to find a low-risk, highly liquid, interest-returning investment and, as the next section expounds, to facilitate US consumption, will incentivize further investment in Treasuries.

Self-Interested Goodwill

With continued reliance on the US as an export market, China fears a downturn in the US economy. Even if it saw no need to earn a rate of return off its dollar holdings by investing them in Treasuries, and even if it determined that its reserve quantity was sufficient, the fear that decelerating its purchase of Treasuries might provoke the very financial crisis previously described is enough to deter China from taking the risk. In other words, China’s purchase of US debt is not simply an effort to better its internal economic fundamentals, but rather a recognition that it must help preserve US economic strength.

In September 2004, Ifzal Ali, the Asian Development Bank chief told Asian Central Bankers that their level of reserves was far in excess of what they needed and should be reduced because of the opportunity costs of those holdings.[26] Yet, since then, China has increased the size of its reserves, and if its current pace of accumulation continues, China will pass Japan to have the world’s largest dollar reserves by early 2006.[27] The de-pegged world has not changed China’s realization that financing the US budget deficit facilitates its trade surplus with the US, and even in the event of future revaluations, China is likely to continue debt financing.

The Dollar as the Global Economy’s Duct Tape

China needs dollars to help finance highly indebted state banks, saddled with billions in underperforming – or non-performing – loans made to finance China’s industrialization. In 2003, $45 billion in Treasuries from China’s reserves were transferred to state banks as a means of recapitalization.[28] Chinese banks hold an estimated $200 billion in non-performing loans, denominated in dollars.[29] Thus a dual-incentive exists for China to continue propping up the dollar: first, any depreciation of the dollar reduces the real value of these loans when they are repaid; and second, a strong dollar – and non-depreciating dollar assets – gives China’s central bank more ability to bailout its banking sector.

Proactive prevention of dollar depreciation is also motivated by the current dominance of dollars in China’s reserves. Since three-quarters of its reserves are in dollars, a serious depreciation of the dollar would substantially reduce the real value of those reserves.[30] To illustrate the gravity of this concern: at the end of 2004, China had roughly $450 billion in dollar holdings; a 20 percent revaluation of the Yuan would decrease the real value of those holdings by about $100 billion – or 6 percent of China’s GDP.[31] In a certain sense, therefore, China’s past financial decisions and US profligacy have locked China into extending perpetual loans to the US: if it sells-off or decreases its amassing of US debt, it would substantially harm its own financial situation.

IV.Contingency Planning

If China were to scale back its purchases or sell-off US debt – perhaps in retribution for US support for a Taiwanese declaration of independence or a sharp economic slowdown in China or the US – other factors would intervene to prevent a full-blown financial crisis from developing. First, anything short of an abrupt sell-off would be gradual and therefore give plenty of warning signals to US policy-makers in advance of an onset of crisis. The dollar bias in China’s reserves gives it an incentive to insure that any diversification proceeds slowly, as too rapid a sell-off would decrease the value of China’s remaining dollar holdings, as well as spooking currency markets, causing a rapid decline of the dollar and hence, China’s export competitiveness.[32] If Treasury officials noted a decreasing demand for Treasuries, they could begin gradually raising bond yields to make them more attractive to private investors. The slow pace of these changes is what permits time for policy-makers to take corrective measures, and markets to adjust their expectations.

Another factor mitigating the possibility of financial crisis from an about-face by China is that other Asian central banks have signaled that they will step in. In the days after China de-pegged the Yuan from the dollar, foreign investors began speculating on the Japanese yen and South Korean won in anticipation of their own revaluations, and the heightened demand for these currencies increased their value; while Japan and South Korea can now allow their currencies to appreciate somewhat without losing market share to China, they have announced that they will resist any significant rise by buying up dollars.[33] If China made a move which threatened the strength of the dollar, these other central banks have a strong incentive to intervene.

V.Rocking the Boat

This paper has argued that the Yuan’s revaluation and de-pegging from the dollar do little to upset the current dynamics of Chinese accumulation of dollar reserves, and the investment of those reserves in US Treasuries. Such a move would be at odds with China’s continuing need to manipulate its currency’s value, would cause counterproductive harm to American demand for China’s exports, and would weaken China’s financial strength. Even if China were to make this unlikely decision, it would be implemented gradually, giving US policy makers time to adjust, and other Asian central banks would intervene to avert a serious crisis from developing.

This balance of financial terror – where China needs the US to buy its exports, and the US needs China to finance its debt – is a form of co-dependency. With China subsidizing US imports with an undervalued currency and then extending the US the credit needed to buy them, it pays to ask: is it wise for the US to be pushing so aggressively for China to float its currency? In the first place, even a big revaluation would likely have little effect on the US trade deficit: 40 percent of China’s imports are raw materials which go into export goods, so a revaluation would make its imports cheaper, offsetting the expected rise in its export prices.[34] There is also no reason to believe that a stimulation of Chinese import demand would be met by the US; more likely, other economies with a comparative advantage in labor costs would gain most of the market share.[35] With little prospect of gain, US policy-makers should be deterred by the risks of floating the Yuan. China’s banks are highly inexperienced at managing currency risk.[36] The chances of misstep affecting the value of America’s Chinese assets are only heightened by greater Yuan flexibility. More to the point, cheap Chinese goods are holding down inflation in the status quo, and prices would have to rise if the Yuan were greatly revalued.[37] This would cause the interest rate spike, which actually could precipitate crisis.