By Alexander Friedman: ZURICH – The
twenty-first-century economy has thus far been shaped by capital flows
from China to the United States – a pattern that has suppressed global
interest rates, helped to reflate the developed world’s leverage bubble,
and, through its impact on the currency market, fueled China’s meteoric
rise. But these were no ordinary capital flows. Rather than being
driven by direct or portfolio investment, they came primarily from the
People’s Bank of China (PBOC), as it amassed $3.5 trillion in foreign reserves – largely US Treasury securities.
The
fact that a single institution wields so much influence over global
macroeconomic trends has caused considerable anxiety, with doomsayers
predicting that doubts about US debt sustainability will force China to
sell off its holdings of US debt. This would drive up interest rates in
the US and, ultimately, could trigger the dollar’s collapse.
But
selling off US Treasury securities, it was argued, was not in China’s
interest, given that it would drive up the renminbi’s exchange rate
against the dollar, diminishing the domestic value of China’s reserves
and undermining the export sector’s competitiveness. Indeed, a US defense department report
last year on the national-security implications of China’s holdings of
US debt concluded that “attempting to use US Treasury securities as a
coercive tool would have limited effect and likely would do more harm to
China than to the [US].”
To
describe the symbiotic relationship between China’s export-led GDP
growth and America’s excessive consumption, the economic historians
Niall Ferguson and Moritz Schularick coined the term “Chimerica.”
The invocation of the chimera of Greek mythology – a monstrous,
fire-breathing amalgam of lion, goat, and dragon – makes the term all
the more appropriate, given that Chimerica has generated massive and
terrifying distortions in the global economy that cannot be corrected
without serious consequences.
In 2009, these distortions led Ferguson and Schularick to forecast Chimerica’s collapse
– a prediction that seems to be coming true. With the reserves’
long-term effects on China’s internal economic dynamics finally taking
hold, selling off foreign-exchange reserves is now in China’s interest.
Over
the last decade, the vast quantities of short-term capital that were
being pumped into China’s banking system drove commercial banks and
other financial institutions to expand credit substantially, especially
through the shadow-banking system, leading to a massive credit bubble
and severe over-investment. In order to man age the resulting increase in
risk, China’s new leaders are now refusing to provide further liquidity
injections, as well as curbing loans to unprofitable sectors.
But
these efforts could trigger a financial crisis, requiring China to
initiate a major recapitalization of the banking system. In such a
scenario, non-performing loans in China’s banking system would probably
amount to roughly $1 trillion.
The
most obvious means of recapitalizing China’s banks would be to inject
renminbi-denominated government debt into the banking sector. But
China’s total public debt, including off-balance-sheet local-government
financing vehicles, probably amounts to around 70% of GDP already.
Despite debate over the details, the conclusion of Carmen Reinhart and Kenneth Rogoff
– that a high debt/GDP ratio can inhibit economic growth – remains
widely accepted; so it is unlikely that raising the debt ratio to 100%
would be in China’s long-term interest.
Even
if China’s leaders decided that they had the necessary fiscal latitude
to pursue such a strategy, they probably would not, owing to the risk of
inflation, which, perhaps more than any other economic variable, tends
to lead to social unrest.
Given
this, in the event of a crisis, China would most likely have to begin
selling off its massive store of US debt. Fortunately for China, the
negative consequences of such a move would probably be far less severe
than previously thought.
To
be sure, an injection of US Treasuries into the banking sector, and
their subsequent conversion to renminbi, would still strengthen China’s
currency. But the rise would most likely be offset by capital outflows,
as looser capital controls would enable savers to escape the financial
crisis. Moreover, even if the renminbi became stronger in the short
term, China is no longer as dependent on maintaining export
competitiveness as it once was, given that, excluding assembly and
reprocessing, exports now contribute less than 5% of China’s GDP.
Against
this background, the US Federal Reserve, rather than focusing only on
“tapering” its monthly purchases of long-term securities (quantitative
easing), must prepare itself for a potential sell-off of US debt. Given
that a Fed-funded recapitalization of China’s banking system would
negate the impact of monetary policy at home, driving up borrowing costs
and impeding GDP growth, the Fed should be ready to sustain
quantitative easing in the event of a Chinese financial crisis.
After
spending years attempting to insulate the US economy from the upshot of
its own banking crisis, the Fed may ultimately be forced to bail out
China’s banks, too. This would fundamentally redefine – and, one hopes,
rebalance – US-China relations.
Illustration by Paul Lachine
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