China has pegged the exchange rate of their currency in dollars to a below-market level. In order to enforce this price control, the central bank must be willing to purchase any amount of dollars offered at the official rate. After a number of years, they have, as reported by the China Daily, accumulated over $1 trillion of so-called “reserves”. The willingness of the central bank of China to accumulate large amounts of dollar reserves and “invest” them in US government debt has been a major reason that US inflation has been low relative to the amount of money creation. The inflation has been exported to China.
As economists Nouriel Roubini and Brad Setser have written, there are not enough domestic savings in China to fund their purchases in dollars. The Bank of China is monetizing the difference, driving a credit boom in China (see Setser’s paper on bad debt in the Chinese banking system).
The exchange rate control makes their exports cheaper to Americans than they otherwise would be, and their imports more expensive. While Chinese importers may show an accounting profit in terms of their local currency, their government accumulates large amounts of dollar-denominated claims, which realistically can not be converted into dollars worth anywhere near their current purchasing power. The central bank will ultimately take a large loss on its currency position, which will be born by the people of China either in terms of inflation, higher costs for exports, or taxation.
These assets could in theory be used to intervene in the foreign exchange market, should their currency become overvalued and they wished to maintain the over-valuation. But realistically, they have far more reserves than they could ever use for this purpose. The linked China Daily article discusses a shift in thinking that is ocurring within the central bank as to what to do with these reserves:
- “How to manage such a huge reserve is a big challenge,” said Yi Xianrong, a research fellow at the Institute of Finance Research under the Chinese Academy of Social Science. “The crux of the problem is that you have to keep the value stable or increasing,” Yi said.
The ballooning foreign reserves, many economist say, is a major reason behind the loose money supply. This is because the central bank has to issue additional money to mop up the excess US dollars in the market, resulting in excessive liquidity in the banking system.
And the fluctuating foreign exchange rate also poses a huge risk, economists say.
In a bid to minimize such risks, the central bank should diversify its existing US dollar-dominated foreign reserves structure, and increase its holdings of euros or other major international currencies, said Li Yongsen, a finance professor at Renmin University of China.
The central bank, he said, could also buy more state bonds issued by other major economies and decrease holdings of US Treasury bills.
“It’s better to spread the risks, and not put all your eggs in one basket,” Li said. The professor also suggested that the country might consider using the huge foreign reserves to purchase some strategic resource reserves such as oil.
To the extent that China uses their dollars to purchase real things, rather than hold US debt, the US$ inflation originating from the Fed would no longer be shunted into the Chinese economy.
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The Fed has some interesting research on the relationship between the twin deficits, fiscal and trade at http://www.newyorkfed.org/research/current_issues/ci12-7.html
Basically, they say the link is very weak.
ME, so what’s your solution to the problem you see? Are you content with trying to educate people, or do you have some policy prescriptions?
On the idea that a country can’t live without manufacturing, I would suggest that moving manufacturing to other countries is nothing more than the globalization of the division of labor. Theoretically, it should be possible, even advantageous, to move all manufacturing out of the US to Asia and have all Americans working in services if doing so is more efficient. In other words, if Asians are better at manufacturing than us, and we’re better at services, both of us would be better off doing exclusively what we’re best at. Even further, I believe Ricardo showed that even if Asians are better at both manufacturing and services than we are, if within the US we’re better at services than manufacturing, we and the Asians will be better off if we concetrate on services and import their manufactured goods.
RogerM,
Do us all a favor, please enumerate these vaunted “Services” that will form the Economy you envision.
RogerM
â€On the idea that a country can’t live without manufacturing, I would suggest that moving manufacturing to other countries is nothing more than the globalization of the division of laborâ€.
I, completely, agree with you.
Björn Lundahl
ME:”Do us all a favor, please enumerate these vaunted “Services” that will form the Economy you envision.”
I don’t know that I’m doing you a favor, but services include financial, especially accounting, engineering/architecture, shipping/transportation, healthcare, entertainment (excluding football, which is a religion), publishing, R&D, legal, barber shops, education, etc. Can anyone else think of more services?
RogerM,
It doesn’t matter, really. . .we can name different services all day but the point is that people produce goods and services that satisfy needs. There are plenty of things that will keep any economy afloat minus the manufacturing industry–we can just get manufactured goods from somewhere else. (It is certainly, as you pointed out, merely the furthering of the division of labor to a global scale).
If it turns out that some kind of doomsday arrives and all foreign manufacturers decide to stop producing for us, then the markets will take care of that by redistributing resources back to their most urgent needs. Manufacturing plants will open up in the US, other services will cease to be profitable, innovation will take place, and life will move on.
The only real threat is if the U.S. government decides to get its hands in to *ahem* “fix” the problem. Anything from “saving X industry” to protectionist trade policies to inflation distort price signals. Businesses will have a much harder time figuring out what the most urgent needs are, and recovery will be much slower as capital and investments are wasted on innefficient uses.
On that count, I would perhaps agree (somewhat) with what I think M E Hoffer is trying to say here. (It’s hard to tell, as he’s not a very clear writer). Should almost every individual business in the U.S. rely on foreign manufacturing for its wealth, and the foreign manufacturers decide to stop their services, our own distorted economy will have a hard time adjusting. And, in fact, the government will likely be spurned to further action by the trouble, increasing the time that it would otherwise take to recover.
However, the problem is not that manufacturing is an industry that is leaving our borders; the issue at hand is how the U.S. government is setting up its citizens (and especially the poor) for hardship in the future.
Dan, I agree completely. The real threat to US manufacturing is not China, but taxes and regulation.
But let me drag out my own doomsday scenario. Mark Steyn has written a book called “America Alone” in which he basically asserts that except for Australia, the US stands alone in the world as the defender of Western Civilization, Europe having caved to Islamists. Along those lines, socialism has grown in popularity by huge amounts since the collapse of the USSR. The US and Australia stand as the last bastions of what’s left of capitalism in the world, and the rest of the world is increasingly angry at us for holding out against socialism. I fear that the rest of the world, led by Europe, will someday try to isolate us as they did South Africa, allowing no imports or exports. The issue that ignites the the blockade could be global warming.
I developed this fear, possibly irrational, a few years ago when studying the econ history of the Dutch Republic. The first capitalist state, and therefore very wealthy, the rest of Europe hated them something awful. Spain, England and France tried to destroy them in multiple wars but failed. Finally, all of Europe, including their “friends”, isolated the Dutch behind high trade barriers. The story isn’t tragic, however. The Dutch economy grew very slowly but didn’t decline. Meanwhile, England adopted Dutch capitalism and went on to led the industrial revolution.
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