Hi Ho, Hu: The Continuing China Problem

Written by Kathleen Packard

Wednesday, October 24, 2012

Hu Jintao, president of China, is leaving office .  Xi Jinping will replace him.  Meanwhile, the yuan has been strengthening – leading  to speculation that Chinese authorities may intervene to push down its value.   “Over the past 10 years, China has accumulated more that $3tn in foreign currency reserves, a figure which is rising at more than $14,000 per second,” note Andrea Utermann of Allianz Global investors in the Financial Times. “While a sign of economic strength, this highlights the extent of trade imbalances and an uncomfortable mutual dependency between China and its trading partners, in particular, the US.”

The New York Times reported: “The renminbi has indeed weakened one percent against the dollar since February, according to Michael Pettis, a finance professor at Peking University and a senior associate at the Carnegie Endowment.  But Mr. Pettis argues that the reason for the renminbi’s fall is capital flight, not government intervention.  So many Chinese are taking money out of the country that Beijing is ‘actually forcing the renminbi up, not down,’ he said.”

Indeed there is trouble in China.  TIME’s Michael Schuman reported that foreigners “now [face] a new great Wall, one composed not of stone and earth but of regulations and restrictions, manned by an army of protective bureaucrats and aimed at controlling access to the lucrative Chinese consumer market and tilting the playing field against international businesses.  Some companies are even threatening to invest elsewhere.”  Bloomberg BusinessWeek published article about the movement of foreigners to abandon China – such as the “Why I’m Leaving China” blog by techie Charlie Custer, who wrote: “There is talk of the U.S. ‘Falling off a financial cliff,’ but right now I think China is closer to the edge of that cliff, and that it’s also a steeper cliff than ours.”

Within China, things are opaque.   According to the New York Times’ Andrew Jacobs: “Supporters of Xi Jinping, the man expected to be China’s next president, and Li Keqiang, who is all but certain to replace Mr. Wen as prime minister, have been quietly putting out the word that the new team plans to introduce a more far-reaching agenda once the incoming leaders are secure in their new posts. Some even argue that the worse things get, the better the chance the new leaders will have to deal with China’s biggest challenges after the successors are announced at the 18th Party Congress.”

China’s market is not so much a market as it is a government machine. “The undervalued yuan has allowed China to run a chronic trade surplus at the expense of other nations,” noted Ryan Brown in Finest Hour: The Journal of Winston Churchill. “This process, however, would quickly collapse under the weight of market pressure were it not enabled by government intervention.  The exchange rate is only the surface  of this problem; the root of these trade distortions is something few talk about: currency sterilization.

When the U.S. uses paper money to purchase foreign on both sides of the Pacific goods, recipients of those dollars generally use them to finance the purchase of American goods or sell them to their government in exchange for domestic currency. Both these actions stabilize the balance of trade—by increasing imports or adjusting the domestic price level upwards.

But when American money reaches China, the central bank prevents these dollars from financing imports of international goods by purchasing them with newly issued yuan.  The People’s Central Bank then raises reserve requirements on banks and sells “sterilization bonds” to pull these additional yuan off the market and keep the price level relatively static.

Of course, China has an international partner in this process, noted Brown. “The Chinese government takes this reserve of sterilized dollars, which functions as their ‘national savings,’ and purchases debt securities from the United States government to finance American deficit spending. The U.S. remonetizes these dollars by spending them, reinitiating the distorted balance of payments cycle. On one side of ‘Chimerica,’ the People’s Central Bank is hoarding vast sums of capital. On the other side, the Federal Reserve is fueling American overconsumption through excessive borrowing.”

Something has to change – and not just China’s leadership.