EC My Reading Of The FT On China’s “Turning Away From The Dollar”

The Financial Times ran a very interesting article last week called “China: Turning away from the dollar”. It got a lot of attention, at least among China analysts, and I was asked several times by friends and clients for my response. The authors, James Kynge and Josh Noble, begin their article by noting that we are going through significant changes in the institutional structure of global finance:

An “age of Chinese capital”, as Deutsche Bank calls it, is dawning, raising the prospect of fundamental changes in the way the world of finance is wired. Not only is capital flowing more freely out of China, the channels and the destinations of that flow are shifting significantly in response to market forces and a master plan in Beijing, several analysts and a senior Chinese official say.

While this may be true, I am much more skeptical than the authors, in part because I am much more concerned than they seem to be about the speed with which different countries are adjusting, or not adjusting, to the deep structural imbalances that set the stage for the global crisis. My reading of financial history suggests that we tend to undervalue institutional flexibility, especially in the first few years after a major financial crisis, perhaps because in the beginning countries that adjust very quickly tend to underperform countries that adjust more slowly. As I have written many times before China’s high growth and very large capital outflows suggest to me how difficult it has been for China to shift from its current growth model.

Beijing has been trying since at least 2007 to bring down China’s high savings rate, for example, and yet today it remain much higher than it did seven years ago. Chinese capital outflows, in other words, which are driven by its excessively high savings rates, may have less to do with master planning than we think, and certainly when I think of the most dramatic periods of major capital outflows in the past 100 years, I think of the US in the 1920s, the OPEC countries in the 1970s, and Japan in the 1980s. In each case I think we misinterpreted the institutional strengths and the quality of policymaking.

Any discussion about China’s future role in global finance or about the reserve status of the dollar or the RMB is so highly politicized that you cannot approach the topic in the same way you might approach an article about the Mexican peso, or even the Russian ruble, but I figured that there are a lot of interesting points about which a discussion might anyway be illuminating. To begin with, there is much in the article with which I agree, but also some things with which I disagree. About the latter I have basically three different “sets” of disagreements:

1. In some cases my interpretation of both the information and the implications provided by the authors is a lot more skeptical than theirs.
2. The authors provide the views of several analysts concerning the impact on the US bond markets and US economy more generally of reduced PBoC purchases of US government bonds, and these views range from neutral to very negative. I would argue however that in fact these views fail to understand the systemic nature of the balance of payments, in which any country’s internal imbalances must necessarily be consistent with its external imbalances. They assume implicitly assume that PBoC purchases only affect the demand for US government bonds, whereas in fact the flow of capital from one country to another must automatically affect both demand and supply. In fact the impact of reduced PBoC purchases of US government bonds is likely to be net positive, and while this view is probably counterintuitive, and certainly controversial, in another part of the article the authors cite a Chinese official whose statement, had they explored the implications fully, would have explained why.
3. There is one point that they make which I think is fundamentally wrong, although a lot of people, including surprisingly enough economists and central bankers, have made the same mistake. It is not fundamental to their argument overall, but I think this mistake does indicate the level of confusion that exists about the way reserve currencies work and it is worth drawing out.

The first set of disagreements concern issues on which reasonable people can disagree, and while I have always been on the skeptical side, I also recognize that only time can resolve the disagreements. For example in discussing some of Beijing’s recent activity in driving the internationalization of the RMB the authors say:

What is clear is that Beijing’s intention to diversify the deployment of its foreign exchange reserves is strengthening. Over the past six months, it has driven the creation of three international institutions dedicated to development finance: the Shanghai-based New Development Bank along with Brazil, Russia, India and South Africa; the Asian Infrastructure Investment Bank and the Silk Road Fund.

There certainly have been many announcements in the past few years, not just about new global institutions that are being planned, but also about currency swap agreements and other actions taken by foreign central banks related to RMB reserves, and each of these has created a great sense of excitement and momentum. I have often thought the amount of attention they received significantly exceeded their importance, and while I won’t mention specific cases because that may come across as a little rude, some of the countries whose central banks negotiated currency swap lines with the PBoC are either credit-impaired enough that any implicit extension of credit would be welcome, or are primarily making a political statement. In at least one case the currency swap is denominated in both RMB and the counterpart’s national currency, but is actually settled in US dollars, and so is little more than a dollar loan indexed to RMB.

How certain are today’s predictions?

I am also very skeptical about the long-term importance of the various development banks that are in the works. It is not clear to me that the incentives of the various proposed members are sufficiently aligned for there to be much agreement on their loan policies, nor is it clear to me that all the members agree about their relative status and how policy-making will occur. It is easy enough to agree in principle that there is a lot of room to improve the existing infrastructure of global financial institutions – mainly the Bretton Woods institutions – but that may well be because the needs of different countries are either impractical or so heterogeneous that no institution is likely to resolve them.

We do have some useful history on this topic. The Bretton Woods institutions were established when one country, the US, was powerful enough to ride roughshod over competing needs, and so the misalignment of interests was resolved under very special and hard-to-replicate conditions, but since then it is hard to think of many examples of similar institutions that have played the kind of transformative role that is expected of the institutions referred to in the article. It is not as if proposals to change the global financial system have not been made before – I remember that burgeoning reserves among Arab OPEC members in the 1970s, or Japan in the 1980s, also generated waves of activity – but change is always easier to announce than to implement. This doesn’t mean that the new institutions being proposed will not have a very different fate, of course, but I would be pretty cautious and would wait a lot longer before I began to expect much from them.

There is anyway a more fundamental reason for long-term skepticism. As the authors note the creation of these institutions is driven largely by China and is based on current perceptions about longer-term trends in China’s growth. Historical precedents suggest however that it may be hard to maintain the current momentum. Rapid growth is always unbalanced growth, as Albert Hirschman reminded us, and what many perceive as the greatest economic strengths of rapidly growing economies are based on imbalances that also turn out to be their greatest vulnerabilities. The fact that the US in the 1920s, Germany in the 1930s, Brazil in the 1960s and 1970s, Japan in the 1980s, China during this century, and many other rapidly growing economies generated deep imbalances during their most spectacular growth phases should not be surprising at all, but it is important to remember that all of them subsequently suffered very difficult adjustments during which, over a decade or more, these imbalances were reversed (Germany after the 1930s of course “adjusted” in a different way, but it was already clear by 1939-40 that the German economy was over-indebted and substantially unbalanced).

The reversal of these imbalances involved adjustment processes that turned out very different from the predictions. While the periods of spectacular growth always get most of the attention from economists and journalists, and always create outsized expectations, the real test over the longer term is how well the economy adjusts during the rebalancing period. We can learn much more about long-term growth, in other words, by studying Japan post-1990, or the US post-1930, for example, than we can from studying Japan pre-1990 or the US pre-1930. Until we understand how adjustment takes place, and the role of debt in the adjustment process, the only safe prediction we can make, I suspect, is that the momentum that drives Beijing’s current activity will not be easy to maintain.