THE Chinese have long admired America’s economic dynamism. But they have lost confidence in its government and its dysfunctional economic stewardship. Coming so shortly on the heels of the subprime crisis, the debate over the debt ceiling and the budget deficit is the last straw.|
China is no innocent bystander in America’s race to the abyss. In the aftermath of the Asian financial crisis of the late 1990s, China amassed about $3,2-trillion in foreign exchange reserves to insulate its system from external shocks. Fully two-thirds of that total is invested in dollar-based assets, largely US Treasuries and agency securities. China surpassed Japan in late 2008 as the largest foreign holder of US financial assets.
Not only did China feel secure in placing such a large bet on the once relatively risk-less components of the world’s reserve currency, but its exchange-rate policy left it little choice. To maintain a tight relationship between the renminbi and the dollar, China had to recycle a disproportionate share of its foreign exchange reserves into dollar-based assets.
Those days are over. China recognises that it no longer makes sense to stay with its current growth strategy — one that relies 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- 09 were a wake-up call. While Chinese export industries remain competitive, there are understandable doubts about the post-crisis state of foreign demand for Chinese products.
From the US to Europe to Japan — crisis- battered developed economies that collectively account for more than 40% of Chinese exports — end-market demand is likely to grow at a slower pace in the years ahead. 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 outsize, largely dollar- denominated reservoir of China’s foreign exchange reserves — have been magnified by political risk. With US government debt repayment now in play, the very concept of dollar-based risk-less assets is in doubt.
In recent years, Chinese Premier Wen Jiabao and President Hu Jintao have repeatedly expressed concern about US fiscal policy and the safe-haven status of Treasuries. Like most Americans, China’s leaders believe the US will ultimately dodge the bullet of an outright default. But that’s not the point. There is now great scepticism about the substance of any "fix".
All of this spells lasting damage to the credibility of Washington’s commitment to the "full faith and credit" of the US government. And that raises serious questions about the wisdom of China’s huge investment in dollar-denominated assets.
Finally, China’s leadership is mindful of the risks implied by its own macroeconomic imbalances — and of the role 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.
China will not accede to calls for a sharp one-off revaluation of the renminbi. At the same time, it recognises 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 transparent response. Its new, 12th five-year plan says it all — a proconsumption shift in China’s economic structure that addresses China’s unsustainable imbalances. By focusing on job creation in services, large-scale urbanisation, and the broadening of its social safety net, there will be a big boost to labour income and consumer purchasing power. As a result, the consumption share of the Chinese economy could increase by at least five percentage points of gross domestic product (GDP) by 2015.
A consumer-led rebalancing moves economic growth away from a dangerous over reliance on external demand, while shifting support to untapped internal demand. It takes the heat off an undervalued currency as a prop to export growth, giving China leeway to step up the pace of currency reforms.
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 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 US government paper, will soon say "enough". Yet another vacuous budget deal, in conjunction with weaker than expected growth for the US economy for years to come, spells a protracted period of outsize government deficits. That raises the biggest question of all: lacking in Chinese demand for Treasuries, how will a savings-strapped US economy fund itself without suffering a sharp decline in the dollar and/or a major increase in real long- term interest rates?
China 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.
©Project Syndicate, 2011. www.project-syndicate.org
Stephen Roach is a member of the faculty at Yale University and is nonexecutive chairman of Morgan Stanley Asia