U.S.- CHINA AFFAIR IS LIKELY TO RESULT IN MUTUAL PAIN / THE FINANCIAL TIMES MARKETS INSIGHT ( VERY HIGHLY RECOMMENDED READING )

US-China affair is likely to result in mutual pain

By John Plender

Published: March 8 2011 18:33

In spite of Chinese rhetoric about wanting to diversify its official reserves away from the dollar, recently revised figures from the US Treasury suggest that the world’s largest creditor country is finding the task pretty much on a par with Sisyphus’s efforts to push the boulder uphill.


China’s holdings of US Treasury securities at the end of December turned out last week to be a whopping 30 per cent higher than earlier official estimates, emerging at $1,160bn compared with $895bn a year before.

This huge increase in just one part of the dollar component of reserves that are reckoned to top $2,750bn in total, irks Beijing, which worries that the Federal Reserve’s loose monetary policy is designed to ensure an endemically weak dollar. Yet such vulnerability is the inevitable result of pursuing a mercantilist exchange rate policy while running an excess of savings over investment.


As long as China persists in subsidising exports via an exchange rate pegged to the dollar it is condemned to rack up further trade surpluses that suck in yet more dollars. And, given the difficulty of acquiring big dollar equity investments there is not much alternative to buying US government IOUs in the world’s most liquid bond market.


As the dollars flow in from exports and foreign investment, the People’s Bank of China has to buy them to prevent the Chinese currency appreciating. The resulting purchases flood the country with renminbi which then have to be mopped up, or sterilised, through the sale of bonds in order to prevent an inflationary surge. When the numbers are as big as they are in China, resisting inflation through sterilisation becomes harder and harder. And because US interest rates are so low China’s rates have to be fixed even lower to avoid incurring a running loss on its huge dollar reserves. This then causes property and other asset prices to overheat, which is where we are today.


It would help to develop a more sophisticated financial system. A recent paper by the economist Kristin Forbes estimates that if China’s bond market were as well developed as the cross-country average – about the level of development in South Korea – the country’s holdings of US bonds would be about $200bn less. Yet Beijing has a limited appetite for the deregulatory reforms that this would entail.


Meanwhile, the tone of Chinese criticism of US economic policy is increasingly moralistic. Yet the debtor-creditor compact that lay behind today’s global imbalances has been mutually convenient. The Chinese wanted to subsidise their exports by rigging the exchange rate. The Americans were happy to accommodate them in the interests of extending home ownership. So poor Chinese households ended up being taxed to subsidise consumption by rich households in advanced countries. Where is the morality in that?


The difficulty for the Americans now is that a huge debt overhang condemns them to sub-par growth. For the Chinese the value of their dollar investments is questionable and the leverage of the creditor country cannot be used without doing serious damage to itself. Selling dollars would simply shrink the value of the portfolio, inflicting severe losses on the central bank. This would then have to be recapitalised at considerable cost to the government’s budget.


There is also a political cost to any decline in the value of the dollar. Chinese nationalist feeling runs high when government investments turn sour. Indeed, Chinese sovereign wealth funds caused a public outcry when they invested too early in US investment banks during the financial crisis. The irony here was underlined by a recent WikiLeak revelation that the head of the state-owned China Investment Corporation applied pressure in 2009 to Tim Geithner, US Treasury secretary, to speed the approval of a $1.2bn investment in Morgan Stanley, which was promptly given the green light. Yet to call this pressure, if the story is true, is hilarious. The sovereign wealth fund was offering a boon to a man whose efforts to prop up a failing banking system were at a pretty desperate pass.


China is, in effect, a neurotic trillionaire, stuck on a treadmill seeking to resist the structural tendency of emerging market currencies to appreciate. The leverage that comes from being the world’s biggest creditor scarcely qualifies to be described even as soft power. Most of the time it amounts to little more than impotence. Alternatively it can lead to mutually assured destruction.


Moralising about debt – an age old habit – is in this case futile. To work, creditor-debtor relationships have to be a two-way affair. Instead, the world’s biggest lender and borrower are conducting a dialogue of the deaf. The two probable outcomes are more protectionism from the US and, ultimately, a huge currency loss for China on its dollar reserves.


The writer is an FT columnist


Copyright The Financial Times Limited 2011.