22 September 2009

Trouble ahead for China

Let’s remind ourselves, that at the root of the current financial crisis are imbalances of international payments that have created currency surpluses which have in turn fed back into the financial system in the form of cheap and plentiful credit. The only possible resolution to the crisis that will not create yet another crisis in the near future is an end to significant and persistent imbalances of global payments.

Remember the words of Geoffrey Crowther:

“If the economic relationships between nations are not, by one means or another, brought fairly close to balance, then there is no set of financial arrangements that can rescue the world from the impoverishing results of chaos.”

And remember also that these imbalances came about because policymakers around the world had managed to convince themselves that trade imbalances were sustainable.

In the US (and also, of course, in the UK), trade deficits brought consumption growth that exceeded national income growth, allowing voters to afford a lifestyle beyond their means. In China, trade surpluses allowed national income growth to exceed consumption growth and therefore allowed the economy and employment to grow faster than it otherwise would have.

The Chinese have had to recycle the great surplus of dollars back into the US in order to keep the value of the dollar, and the therefore the competitiveness of Chinese exports, from falling. Recycling these dollars into any other currencies is only likely to lead to politically unacceptable rises in the values of those currencies, so is not a viable option for the Chinese, who—whatever they may say to the contrary—have no choice but to continue to re-invest their foreign reserves into dollars.

At least, it remains their only choice until doing so becomes politically unacceptable in the US too, which it will, as unemployment rises and pressure on US legislators to enact protectionist measures grows.

Over twenty years ago, Japan was approximately where China is now. In 1985, the Plaza Accord initiated a co-ordinated fall in the value of the dollar as a response to both the US trade deficit (of 3.5%, compared to around 5% now) and the recession of the early 1980s. The Japanese policy response to the Plaza Accord was monetary stimulus (similar to the Chinese response now). This led to the growth of asset bubbles and increasingly unprofitable investments, which in turn led to the Japanese downturn from 1990 onwards. Japanese growth since then has been lower than the OECD average and has been far below the Japanese growth rate during the post-war period.

It is not unlikely that the Chinese will face their own version of the Plaza Accord and we will see another attempt at a co-ordinated fall in the value of the dollar, this time against the Remnimbi. The only alternative is likely to be the imposition of barriers to Chinese exports by other means, which will be universally damaging to economic welfare, but nowhere more so than in China.

Regardless of the precise path taken, the appreciation of the Remnimbi—which must surely happen—will likely have consequences every bit as painful to the Chinese as those the Japanese experienced after the rise of the yen in the 1990s.

d. sofer