Fault Lines: How Hidden Fractures Still Threaten the World Economy (40 page)

An analogy may be useful. In an international athletic race, one of the participants is found to have taken an energy booster. He is disqualified for violating the rules. But on closer investigation, we find that when the race began, one set of participants had the latest, specially designed aerodynamic equipment, specifically allowed by the rule-making body, which is dominated by representatives of this set of countries, whereas the participant who took the energy booster used ordinary, off-the-shelf, cheap equipment. Who is competing unfairly now? Under the rules of the game, it is still the competitor who took the energy booster. But the rules themselves entrench disadvantages.

The term
unfair
takes a lot as given, including the framework of evaluation, and it is a term that cuts little ice with the leaders of developing countries. Dani Rodrik at Harvard University, for example, has argued that currency undervaluation may be the way for developing countries to offset their institutional disadvantages. Clearly, undervaluation is unfair once they fix their deficiencies (and the Chinese athletes today do have state-of-the-art equipment). It is also unfair to the poorer countries that do not have even China’s advantages but have to compete with it to export. Nevertheless, judging what is unfair is not easy.

A stronger argument against persistent undervaluation is based on China’s own interests. Undervaluation of the currency is a form of subsidy to a country’s export sector that is financed by taxing those who import and those who finance the mechanism of exchange-rate intervention. The argument against continued Chinese intervention is that the subsidy does not help those who receive it and is becoming increasingly burdensome on those who pay for it.

Many of China’s industries are beyond the stage where they need infant-industry protection. Also, because of fierce competition among Chinese firms, any subsidies they get are passed on to industrial-country buyers in the form of lower prices. Because other Asian economies also intervene in their currency’s exchange rates and subsidize their exporters to remain competitive with China, poor households across Asia are effectively taxed to transfer benefits to exporters and are thus subsidizing the consumption of rich households in industrial countries. This situation is neither efficient nor fair.

Moreover, firms that invest on the basis of the competitive advantage obtained from an undervalued currency are creating an additional inefficient base of production that will remain competitive only if undervaluation persists. These firms will eventually join those that already lobby for undervaluation. Like many inefficient distortions, undervaluation is creating its own constituency in China, which will fight hard to preserve the status quo because its existence depends on it. Continued undervaluation is increasing China’s dependence on traded goods while reducing its room to maneuver.

Most important, though, the effort to keep the currency undervalued is creating enormous distortions in the economy, holding down consumption, making all forms of production extremely capital intensive in a country with an abundant supply of labor, and leaving the financial sector underdeveloped.
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If China’s central bank, the PBOC, buys dollars from Chinese exporters so as to keep the renminbi from appreciating, it has to give them renminbi in exchange. If it intervenes a lot, the abundance of renminbi in circulation will push up inflation. To avoid inflation, the PBOC issues its own debt at the same time as it buys dollars, so as to mop up and thereby “sterilize” the excess renminbi. Put differently, exporters effectively exchange dollars for renminbi-denominated claims on the PBOC—a process that is known as
sterilized intervention.
The PBOC uses the exporter’s dollars to buy interest-earning U.S. assets, including the agency bonds discussed in
chapter 1
, thus earning interest on dollar assets while paying interest on renminbi claims.

If the interest paid on dollar assets is low, while renminbi interest rates are high, the central bank will effectively be holding a low-yield asset while issuing a high-yield liability—which means it will incur a loss. If this negative spread were multiplied by the $2 trillion worth of foreign reserves (not all dollars, of course) that China has, it would blow a gigantic hole in the Chinese budget. Moreover, a high renminbi interest rate would attract yet more foreign capital inflows. In order to sterilize without making huge losses, the PBOC fixes the economywide interest rate at a lower level than the dollar interest rate, both by forcing banks to pay households a low rate on their deposits and by paying a low rate on its own borrowing.

A direct effect of such a policy is that China mirrors the United States’ monetary policy. If interest rates in the United States are very low, China also has to keep interest rates low. Doing so risks creating credit, housing, and stock market bubbles in China, much as in the United States. With little freedom to use interest rates to counteract such trends, the Chinese authorities have to use blunt tools: for example, when credit starts growing strongly, the word goes out from the Chinese bank regulator that the banks should cut back on issuing credit. Typically, private firms without strong connections bear the brunt of these credit crunches. Chinese industry goes from credit feast to credit famine, which disrupts long-range planning.

The low interest rate has other adverse effects: it reduces household income and, somewhat perversely, may force households to save more in order to build a sufficient nest egg for retirement.
¹¹
It thus depresses household consumption and makes China yet more dependent on foreign final demand. More problematic, it keeps the cost of capital unnaturally low. So when banks are willing to lend, firms borrow to the hilt to finance capital-intensive projects (and to keep some reserves for when lending stops), with machinery substituting for jobs. So a country with a labor surplus invests a tremendous amount in capital-intensive industries, creating far fewer jobs than needed.

Last, but not least, despite lending at rates that are very low in real terms to industry, the even lower rate they pay on deposits gives banks an enormous profit spread. This cushion, accumulated at households’ expense, allows them to make gigantic lending mistakes without going under. It also allows them to exclude other competing sources of finance, such as corporate bond markets. All a bank has to do is to cut its spread a little to persuade firms not to issue in the bond market, thus keeping those markets illiquid and unattractive.

There are other, related, distortions. One of the dangers of having an inefficient, bank-dominated financial system, as we have seen, is that firms with good connections in the system get loans, while others do not. In China, the dominant state-owned banking system typically lends to state-owned companies—no loan officer risks being accused of corruption if he lends to a state-owned firm—and starves the private sector of funds. The Chinese private sector is thus squeezed between a state-owned sector, which gets cheap local funds, and foreign companies investing in China, who can raise cheap money outside. No wonder so few large private Chinese companies exist, as they do, for example, in India.
¹²
Far from being the brains of the economy, which it will increasingly need to become if China is to allocate capital and resources better, the Chinese financial sector is becoming the inefficient tool of state policy. This cannot be good for China in the long run.

China’s undervalued exchange rate, driven by a strong exporter lobby, is likely to be detrimental to China’s development. The export-led path also takes it down the same road as Japan, and that road, as we have seen, leads in a dangerous direction.

Whenever I broach the subject in China of whether the renminbi will be allowed to appreciate, my hosts remind me how Japan made the mistake of agreeing to U.S. pressure in 1987 and allowed the yen to appreciate sharply. Japan’s woes, according to the Chinese, date from that period, for they slowed the growth of the successful export sector without replacing it with anything else. The Chinese would prefer to proceed more slowly and deliberately, “crossing the river by feeling the stones,” as they put it.

What they don’t see is that the Japanese may have left the transition from export-oriented growth to more balanced growth until too late, and now have to contend with both that problem and that of a rapidly aging population. China can move to a more balanced growth path while its population is still relatively young (albeit aging as a result of the one-child policy).

The needed reforms are likely to be attractive to households, which is why multilateral institutions might find an attentive audience if they explained to the Chinese people what needs to be done and why. A stronger renminbi will allow the Chinese middle class to import cheaper foreign goods and enjoy less expensive foreign holidays. Higher and more market-driven interest rates should give them higher incomes. And a more broadly based pension or social security scheme, strengthened by allocating the shares of state-owned enterprises to the scheme, should give them greater confidence to spend.

When financial institutions have to pay higher interest rates on their borrowing, their margins will shrink, and they will have less room to offer attractive deals to favored state-owned enterprises. Some of these will raise money directly from bond markets and equity markets, forcing these firms to raise transparency, improve governance practices, and increase dividend payouts. Corporate bond markets could become a viable alternative to banks, creating funding channels outside the relationship system. If they lose their best clients, the banks will have to go beyond their comfort zone. They may start lending to small and medium-sized private enterprises, thus giving them the resources to grow. They may also expand retail credit, thus reducing the need for households to save before they can buy. China could become less of a producer-oriented, capital-intensive economy and become both more private-sector-oriented and far less dependent on foreign demand.

Such a transition is not easy, but the time is right. Because food prices are high, farmers, still the most numerous constituency in China, will not be hurt significantly by an appreciation of the renminbi that will bring in competing food imports. State-owned firms are flush with cash, so this powerful group can sustain the loss of profits as inputs like capital, energy, and land are subsidized less. They have invested a lot recently, and a slowdown in investment may not be entirely bad. However, reforms will have to depart from the path of steady experimentation and incrementalism and will require bold moves into the unknown on multiple fronts—freeing exchange rates, interest rates, and some prices, for example. Regulators will have to be extremely vigilant that the banking system does not go berserk during the process of change: this is a very important lesson from the failed Japanese transition.

There are two important reasons why China may be more open to strengthening multilateral organizations and agreements at this juncture. First, it is extremely dependent on exports, and the growing protectionist mood in developed countries has it worried. To the extent that it can ward off such moves through the persuasive efforts of multilateral organizations, it has an incentive to support them. Second, China has more than $2 trillion worth of reserves that are fully exposed to the bad macroeconomic policies of the countries whose debt it holds. More than any other country, it would benefit from a strong international economic arrangement that scrutinizes country policies. This also means that in order to persuade China of the value of change, industrial countries should show that they themselves can also be persuaded.

In sum then, this would be a good time for multilateral organizations to obtain a mandate to make the case more directly to the thinking middle class in China—to explain their research, analysis, and recommendations in understandable prose directly to the Chinese intelligentsia via articles, in conferences, and on the Internet. If the role of the multilateral organizations can be appropriately circumscribed, the Chinese leadership might possibly accept such a mandate, especially if a similar case for change is being made elsewhere and the alternative is a disintegration of the global economy into protectionism. Indeed, the G-20 should agree to permit the multilateral organizations like the IMF substantial leeway to foster broader discussion within their countries in an attempt to achieve the grand objectives of global adjustment laid out earlier. If it is to gain wide acceptance, the IMF should also be evenhanded in making a case for policy change in other countries, above all in the United States. In going beyond their own comfort zone, multilateral organizations have little to lose but their irrelevance in addressing perhaps the most important global macroeconomic problem of our time.

The fault lines that have led to the global trade imbalances and created today’s Mandevillean world are deep. Moreover, because the imbalances are the result of deeply embedded strategies, change will be painful. It is not just a matter of raising an interest rate here, a tax there, or an exchange rate somewhere else. It is tempting for the international establishment to treat adjustment as a simple matter and then express continuous surprise that change does not occur. It also gives politicians the dangerous impression that change is easy for the other side, so punitive trade sanctions can help persuade. We should have no illusions: change is difficult for all countries, though they all stand to gain in the long term, not just from a more stable world economy but also from a more sustainable domestic growth strategy.

Given that actions to reduce sustained trade surpluses or deficits require domestic political momentum, it is not surprising that nothing really happens at these international meetings. Platitudes are rolled out, but everyone knows nothing will be done. I have argued that multilateral institutions like the IMF and the World Bank should take a cue from the movements promoting action against climate change and supporting aid to poor countries. They should expand beyond making their case to the top leaders to creating more political momentum within countries, using all the modern methods of contact that technology has put at our command. They should speak directly to the influential and the connected, explaining why change is necessary and how it can be beneficial despite the pain of adjustment. The multilateral agencies should help bridge the fault lines between nations and help each one see what it needs to do.