[Viewpoint] Read China’s lipsThe Chinese have long admired America’s economic dynamism. But they have lost confidence in America’s government and its dysfunctional economic stewardship. That message came through loud and clear in my recent travels to Beijing, Shanghai, Chongqing and Hong Kong.
Coming so shortly on the heels of the subprime crisis, the debate over the debt ceiling and the budget deficit is the last straw. Senior Chinese officials are appalled at how the United States allows politics to trump financial stability. One high-ranking policy maker noted in mid-July, “This is truly shocking ... We understand politics, but your government’s continued recklessness is astonishing.”
China is no innocent bystander in the United States’ race to the abyss. In the aftermath of the Asian financial crisis of the late 1990’s, China amassed some $3.2 trillion in foreign-exchange reserves in order to insulate its system from external shocks. Fully two-thirds of that total - around $2 trillion - is invested in dollar-based assets, largely U.S. Treasuries and agency securities (i.e., Fannie Mae and Freddie Mac). As a result, China surpassed Japan in late 2008 as the largest foreign holder of U.S. financial assets.
Not only did China feel secure in placing such a large bet on the once relatively riskless components of the world’s reserve currency, but its exchange-rate policy left it little choice. In order to maintain a tight relationship between the renminbi and the dollar, China had to recycle a disproportionate share of its reserves into dollar-based assets.
Those days are over. China recognizes that it no longer makes sense to stay with its current growth strategy - one that relies heavily on a combination of exports and a massive buffer of dollar-denominated foreign-exchange reserves. Three key developments led the Chinese leadership to this conclusion.
First, the crisis and recession of 2008-2009 were a wake-up call. While Chinese export industries remain highly competitive, there are understandable doubts about the post-crisis state of foreign demand for Chinese products. From the U.S. to Europe to Japan - crisis-battered developed economies that collectively account for more than 40 percent of Chinese exports - end-market demand is likely to grow at a slower pace in the years ahead than it did during China’s export boom of the past 30 years. Long the most powerful driver of Chinese growth, there is now considerable downside to an export-led impetus.
Second, the costs of the insurance premium - the outsized, largely dollar-denominated reservoir of China’s foreign-exchange reserves - have been magnified by political risk. With U.S. government debt repayment now in play, the very concept of dollar-based riskless assets is in doubt.
In recent years, Chinese Premier Wen Jiabao and President Hu Jintao have repeatedly expressed concerns about U.S. fiscal policy and the safe-haven status of Treasuries. Like most Americans, China’s leaders believe that the U.S. will ultimately dodge the bullet of an outright default. But that’s not the point. There is now great skepticism as to the substance of any “fix” - especially one that relies on smoke and mirrors to postpone meaningful fiscal adjustment.
All of this spells lasting damage to the credibility of Washington’s commitment to the “full faith and credit” of the U.S. government.
Finally, China’s leadership is mindful of the risks implied by its own macroeconomic imbalances - and of the role that its export-led growth and dollar-based foreign-exchange accumulation plays in perpetuating those imbalances. Moreover, the Chinese understand the political pressure that a growth-starved developed world is putting on its tight management of the renminbi’s exchange rate relative to the dollar - pressure that is strikingly reminiscent of a similar campaign directed at Japan in the mid-1980’s.
However, unlike Japan, China will not accede to calls for a sharp one-off revaluation of the renminbi. At the same time, it recognizes the need to address these geopolitical tensions. But China will do so by providing stimulus to internal demand, thereby weaning itself from relying on dollar-based assets.
With these considerations in mind, China has adopted a very transparent response. Its new five-year plan says it all - a pro-consumption shift in China’s economic structure that addresses head-on China’s unsustainable imbalances. By focusing on job creation in services, massive urbanization and the broadening of its social safety net, there will be a big boost to labor income and consumer purchasing power. As a result, the consumption share of the Chinese economy could increase by at least five percentage points of GDP by 2015.
But by raising the consumption share of its GDP, China will also absorb much of its surplus saving. That could bring its current account into balance - or even into slight deficit - by 2015. That will reduce the pace of foreign-exchange accumulation and cut into China’s open-ended demand for dollar-denominated assets.
So China, the largest foreign buyer of U.S. government paper, will soon say, “enough.” The cavalier response heard from Washington insiders is that the Chinese wouldn’t dare spark such an endgame. After all, where else would they place their asset bets? China’s answers to those questions are clear: it is no longer willing to risk financial and economic stability on the basis of Washington’s hollow promises and tarnished economic stewardship. The Chinese are finally saying no. Read their lips.
*The writer is a member of the faculty at Yale University and nonexecutive chairman of Morgan Stanley Asia.
By Stephen S. Roach
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