China Redux

Seeing as I’m currently taking business economics, statistics, etc., it seems only right to start back with a post on U.S. monetary policy and how it is affecting the U.S.-Sino relationship. I’m a beginner at this, but will give it my best shot.

As you know, last week the Federal Reserve cut the Fed funds rate by 50 basis points, to 4.75%. The move was unexpected — observers expected a cut half that size, or none at all, but very few saw this coming. China, in particular, must have felt like it was blind-sided.First, China’s central bankers and politicians are surely gritting their teeth as they watch the value of their $1 trillion+ investment in U.S. treasuries slowly evaporate. Then their is the delicate subject of the Chinese currency, the yuan, which has already appreciated by about 10 percent against the dollar over the past two years, and is likely to continue to strengthen in the face of a falling dollar. That helps make Chinese exports less attractive, while U.S. goods are becoming a better buy in China and the rest of the world. All in all, China can’t be happy.

I was interested in learning how the Fed’s decision might go beyond the current credit crisis, so I went back and found Ben Bernanke’s speech on September 11, 2007, roughly two weeks before the big rate cut, entitled “Global Imbalances: Recent Developments and Prospects.”  In this speech, the Fed chief updates an earlier argument from 2005 on the cause of global economic imbalances, and makes the case that responsibility for correcting this imbalance in no small part lies with China (and other developing economies). Here are some key excerpts (emphasis mine):

The increase in the Chinese surplus can be attributed primarily to an increase in the saving rate between 2004 and 2006. The increase in China’s saving rate could, in part, be a consequence of the rapid pace of growth in the country. That is, with income growing very rapidly, but with consumer credit not readily available and precautionary motives for saving remaining strong, consumption is failing to catch up. Also contributing to high saving rates was the authorities’ decision to limit currency appreciation, thereby restraining import demand and boosting exports….

… As the global perspective makes clear, the reduction of the U.S. current account deficit also requires efforts on the part of the surplus countries to reduce the excess of their desired saving over desired investment. Over the longer term, the current account surpluses of the emerging-market countries seem likely to narrow as domestic spending catches up with income. Economic policies in these countries can assist this process. For example, the oil exporters have collectively saved much of the windfall arising from higher crude prices in recent years; they should spend more in the future to develop and diversify their domestic economies. China has officially recognized the need to increase its domestic spending and scale back its reliance on exports. Measures that could help achieve these goals include further reforms of the financial sector; increased government spending on infrastructure, environmental improvement, and the social safety net; and currency appreciation. [click for full text]

One could take this be a nicer way of saying that the U.S. account deficit is China’s doing. It’s the policies of developing countries that are driving this savings glut, not America’s excessive spending. And so it’s China’s responsibility to work towards a solution.

One of the convenient things about this formulation is that there is a solid bipartisan political consensus behind it. Republicans and Democrats alike blame China for the deficit (among other things), though they have slightly different ways of rectifying the situation. The Bush Administration has always seemed to feel that the yuan’s weakness was unfairly harming its economic record. Of course, the displeasure on the Republican side is matched if not surpassed by indignation from Congressional Democrats, who have made an unseemly habit of threatening China with punitive trade measures.

So it’s worth noting that the Fed’s thesis on global imbalances as stated above ties in with a major political dynamic at home; that is, frustration and agitation over China’s fiscal policy. Furthermore, the perception in the U.S. is that despite our most patient efforts to work out a political compromise on these issues, China refuses to budge.

The U.S. may hope, need, or expect China to make “efforts…to reduce the excess of their desired saving over desired investment.” But the efforts and measures that Bernanke cited in his speech are going nowhere. China isn’t going to move its currency any more than it already has.  Nobel Prize-winning economist Robert Mundell has been telling Chinese business leaders that it is time to stabilize the RMB against the dollar and study the results of the recent appreciation before moving forward with more changes (story via Xinhua). My guess is that China will listen.  In another key area, it’s apparent that opening up China’s financial sector is likely to be a long, hard slog. And I don’t think China has had too many reasons to stop buying U.S. debt.

But maybe things have changed, with the rate cut playing a big role in the new formula.  The Fed’s weak dollar policy would seem to do some correction work on its own, with or without China’s cooperation.  Don’t look now, but the U.S. trade deficit has been falling, albeit slowly.  Maybe the rate cut will spur China to diversify its currency holdings at a faster rate, and to increase domestic consumption.  Maybe U.S. exports will rise around the world as the weak dollar makes them more competitive.  Any combination here could have a lasting impact on the U.S. account deficit.

What do you think? How will the weakening dollar affect China and the global economy?