Yesterday it was an editorial piece in the main Chinese media outlet Xinhua. Today, China brings its message of helpless (for now) fury to the FT, where Yu Yongding, a former member of the Monetary Policy committee of the Chinese Central Bank has just said what everyone who realizes that mean reversions after 30 years worth of a "great moderation" can and will be a nasty, nasty thing, thinks. Namely: "the situation is ultimately unsustainable. The longer it continues, the more violent and destructive the final adjustment will be. " He is referring to the relentless recycling of Chinese trade surplus in the form of US paper which is increasingly looking like it will never get repaid. His chief rhetorical question is key: "The question is: what losses is China willing to bear in its foreign exchange reserves in order to slow the pace of the renminbi appreciation?" And that's the ballgame. Just like in Europe the question is what amount of gross economic loss is Germany willing to sustain in order to backstop Europe's insolvent countries (and with an imminent French downgrade looming, it will be the only country doing so in the form of sole EFSF funding) simply to keep the euro up and running, and its export sector humming courtesy of no return to a DEM, so in China the question now is how much risk is the country willing to take with its US-based paper holdings in order to keep its own export sector moving along courtesy of a weak CNY. Ironically, the longer Germany and China pretend all is good, the greater the impairment of their natural import partners. And in a globalized economy, even having the cheapest (no matter how artificially contrived) currency does nothing if the global economy tanks and import level implode. Alas, it will be too late for Germany and China to do anything about their flawed mercantilist policies at that point, as the third and final depression will be here. And what is the right move? The former PBOC member spells it out: "The danger for China is that it does not learn the right lesson – namely, that now is the time to end its dependency on the US dollar." And therein lies the rub.
Key statements from Yu's FT Op-Ed which everyone should read:
Chinese officials are understandably angry about the irresponsible brinkmanship demonstrated by their American counterparts in recent weeks. Unfortunately, anger counts for little in international finance. The danger facing the US is that after Tuesday’s debt deal any sense of urgency over a dire fiscal situation will dissipate. The danger for China is that it does not learn the right lesson – namely, that now is the time to end its dependency on the US dollar.
China is worried about the possibility of a US default for obvious reasons. As the largest foreign holder of US Treasuries, either a default or a downgrade would bring huge losses. Even after this week’s debt deal, however, the risk remains that US debt will continue to grow to the point where its government is left with no option but to inflate the burden away. While there is little China can do about its existing Treasury holdings, it can rethink past policies – and ask both how it fell into this trap, and how it might free itself.
Stepping back, the reason for the problem, known to most who follow international finance:
China has run a current account surplus and a capital account surplus almost uninterruptedly for more than two decades. Inevitably this has led to an accumulation of foreign reserves. It is clear, however, that running these surpluses persistently is not in China’s best interests. A developing country, with per capita income ranking below the 100th in the world, lending to the world’s richest country for decades is not reasonable. Even worse is the fact that, as one of the largest foreign direct investment-absorbing countries in the world, China essentially lends money it borrowed at a high cost back to its creditors, by buying US Treasuries, rather than importing goods and services.
To be sure this is not the first time China has jawboned at the US for taking advantage of its symbiotic Mutually Assured Destruction status :
The Chinese government has admitted that its foreign-exchange reserves have already exceeded its needs. It has tried various measures to slow down the growth of these reserves and protect the value of its existing stock. This has included demand stimulation, allowing the renminbi to appreciate gradually and creating sovereign wealth funds. It has also promoted reform of international monetary systems and the internationalisation of the renminbi. Sadly, none of these has worked. With large capital inflows and a current account surplus, China’s foreign exchange reserves have continued to rise rapidly.
The trade off: at what point does the cumulative loss probability offset CNY depreciation gains:
These policies failed because they did not address the real cause of the rapid increase in foreign exchange stocks, namely state intervention aimed at controlling the pace of renminbi appreciation. The question is: what losses is China willing to bear in its foreign exchange reserves in order to slow the pace of the renminbi appreciation?
One further factor is that any losses in the financial assets held by China will not be realised until their holders decide to cash out. If the US government continues to pay back its public debt, and China continues to pack its savings into US securities, this game may continue for a very long time. However, the situation is ultimately unsustainable. The longer it continues, the more violent and destructive the final adjustment will be.
If there is any lesson China can draw from the US debt ceiling crisis, it is that it must stop policies that result in further accumulation of foreign exchange reserves. Given that many large developed countries are simply printing money (and the recent rumours are that the US might return to quantitative easing) China must realise that it can no longer invest in the paper assets of the developed world. The People’s Bank of China must stop buying US dollars and allow the renminbi exchange rate to be decided by market forces as soon as possible. China should have done so a long time ago. There should be no more hesitating and dithering. To float the renminbi is not costless. However, its benefits for the Chinese economy will vastly offset those costs, while being favourable to the global economy as well.
Naturally, the time for China to strike, if it really means it, is now.
Although the thought experiment of the sheer chaos and market panic that will ensue should China announce it is freely floating the renminbi in the next few hours, is worth the few minutes of daydreaming.
Alas it won't happen now. And certainly not before it is too late.