Wednesday, January 27, 2010

Put China economy myths to the sword

Robert Samuelson's opinion piece in the Washington Post on Monday offers an excellent opportunity to to slay a few dragons - the many widespread myths about China's foreign exchange reserves and related policies.

Myth I: China's $2.4 trillion in reserves are "stupendous." This is a common misunderstanding. Compared to the size of China's economy, its money supply, its population or any other relevant denominator, China's reserves-to-size ratio is modest and appropriate when compared with similar ratios for other developing Asian economies like Singapore, Malaysia, India and South Korea (before the global financial crisis depleted it).

Remember, the US, German, Japanese and other economies China's size are fully developed and print their own reserves. Their currencies are hard currencies, so they don't hold reserves like a poor or middle-income country. China's per-capita development level ($4,000 versus $40,000 for the US) is too low to allow its currency, the RMB, to be accepted worldwide like the dollar, euro or yen. Stupendous? In a world of rapid capital flows, the more accurate terms would be "reasonable" or "prudent."

Myth II: China has been "cheating" to achieve growth. The Post piece rehashed the same worn-out formula about China's exchange rate, supposed export-led growth and alleged mercantilist trade policies. Actually, China's growth has not been export-led, has not relied on its exchange rate and is not mercantilist. In the global scale of deficits and surpluses, the United States, northern Europe, oil exporters, and non-China East Asia (eg. Japan) rule the roost.

Compared to their imbalances in the past decade, China's imbalances have been small and appeared quite late in the game. The clear cause of China's surpluses, when they finally did appear in 2005-2007, was the huge US spending spree, financed by highly leveraged debt creation, in turn made possible by excessive US financial deregulation beginning in the late 1990s.

The US spending spree sprouted large surpluses in the rest of the world beginning also in the late 1990s. These non-Chinese global surpluses matched the timing of the US real estate bubble's creation. By 2005, subprime mortgage defaults in America were already spiking and the global crisis was primed to pop.

China had nothing to do with low US interest rates in 2002-2004. China's trade balance finally succumbed in 2005-06 because it had to slow its investment and the related import of equipment to fight inflation. China's surpluses were not caused by accelerated export growth but rather by slowed importation of equipment. The whole "mercantilist" assertion flies in the face of the facts.

Myth III: China has "re-pegged" its currency to the dollar. In fact, China has followed a "basket guidance" strategy since 2005. But in 2008, when the euro suddenly weakened, China abandoned its basket guidance rather than devalue against the dollar. Even now, with the euro still weak, if China returned to its basket guidance, it would have to devalue against the dollar. To do so would only promote protectionist sentiments in America. So, China hasn't re-pegged to the dollar; it has suspended its basket guidance approach until the euro strengthens again to where it was in June 2008.

Myth IV: China is promoting growth and economic stability so the government can stay in power. Well, granted, but how different is this from the goals of any government in the world today? Denial that China's policies and performance are legitimate serves American national interest poorly. Chasing the wrong dragons only undermines America's long-term national security.

For a more detailed presentation of this analysis, click here.

Dr Albert Keidel
APP Senior Fellow

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