Following The G2 Trail

Part 2

In the Cowboy’s humble estimation, the column that presents sounder economic thinking is Martin Wolf’s on the same page as Taleb’s piece (here without registration).  Perhaps the biggest disappointment of the recent G20 conference is that it was not the Bretton Woods redux that many had hoped for last Fall.  Clearly, the goal of this one-day conference was not to rewrite the rules for the global economic system.  Such grandiose aims were wisely scaled back.  Evaluated as a one-day meeting of 20 countries, however, the Cowboy would call it a success.

As Wolf says:

“This summit had two achievements: one broad and one specific.

First, “to jaw-jaw is better than war-war”, as Winston Churchill remarked. Given the intensity of the anger and fear loose upon the world, discussion itself must be good.

Second, the G20 decided to treble resources available to the International Monetary Fund, to $750bn, and to support a $250bn allocation of special drawing rights (SDRs) – the IMF’s reserve asset. If implemented, these decisions should help the worst-hit emerging economies through the crisis. They also mark a return to a big debate: the workings of the international monetary system.”

Wolf’s column got the Cowboy thinking about all of the talk regarding reserve currencies, Chinese holdings of U.S. Treasuries and so forth.  Much of the discussion that the Cowboy has heard and read has been piecemeal and overly simplistic.  As is so often the case, there is a desire to make it all easy to understand so that blame can be assigned and simple solutions advocated.  The Cowboy likes simplicity, but you have to delve into the complexity before you can get to the simplicity.  Rigorous thinking, even for the layperson, requires at least a cursory attempt to follow the trail.

So let’s try to follow that trail together for a stretch.  Make sure your horse is well watered and your saddle is comfortable.  It’s a winding, rocky and sometimes steep trail.

Let’s start with the immense U.S. dollar reserves held by China.  Why do they have them?  Well, it’s because they exported more than they imported, or in economist’s terms, they ran a current account surplus.  A large portion of their exports were paid for in dollars.  Why?  Because many exported goods were sold to the U.S., and because the dollar is viewed globally as one of several stable and safe currencies.  This latter case means that if China sells to Peru, they might be paid in dollars rather than in soles, requiring Peru to buy dollars to then pay to China.

How might this current account surplus be shifted in the other direction, towards a deficit if you will?  Well, China would have to import more.  In other words, they would have to buy more from other countries.  Those purchases could range from French wine to Peruvian copper.  By not purchasing, they are effectively opting to save foreign currency rather than spend it.  So, Chinese consumers are not buying nice bottles of Burgundy or other goodies that they could otherwise afford.  They are being deprived, one might say.  Interestingly, it is their government that is doing the depriving.  Their authoritarian, non-democratically-elected government.  “We know what you want and what you need.”

How do they do this?  Well, the strongest tool at their disposal is the exchange rate for their currency.  Since the abandonment of the dollar-peg that was initiated at Bretton Woods, many currencies float freely against each other.  There are some caveats, as central banks sometimes buy or sell currencies to have an impact on exchange rates, but these are market actions rather than controls, and they are not used all that often.  So, by allowing currencies to float against each other, governments let the market determine their relative value.

Some governments, however, fix their exchange rates.  This is familiar territory to those with a history around emerging markets.  In many cases, rates are fixed in order to prevent a devaluation arising from poor economic conditions in a country, usually arising from mismanagement.  By fixing the exchange rate and adopting controls on the currency, the government tries to maintain value.  Usually a black market develops in these situations in order to trade the currency at a market rate.  There develops an official rate and a street rate for the currency.  Depending on how complicit government officials are in the black market, that market may have trouble accommodating large transactions but it can be quite efficient for smaller transaction amounts.

In the case of China, they have placed controls on the yuan in order to maintain a low value of the currency.  This is the opposite of what we so often see in emerging markets.  Why?  By keeping the value of the currency low, they accomplish two principal goals:

  1. China is able to increase the volume of its exports by making its products cheaper internationally than they would be were the currency worth more.  If you think about policy discussions in the U.S., there is often a debate about the dollar being worth less than at some previous time, thereby boosting exports.  The flip side of this is that in such cases Americans find it more difficult to vacation in Paris.  The same is true of the Chinese, which leads us to the second objective of the Chinese government.
  2. By keeping the value of its currency low, the government is able to enforce a savings rate that is higher than it would otherwise be.  Because it is more expensive for the Chinese to travel to Paris or buy French wine, they spend less and save more.  The central bank keeps the difference.

Given that the Chinese economy is already focused on exports anyway (like Germany and Japan), the currency manipulation just adds to the current account surplus, putting more foreign currency in the hands of the government.  This is money (or stored value) that is being saved by the country as a whole.  If the Chinese consumed more, there would be less production available for export, they would import more and, with a freely floating currency, you might eventually reach a current account balance.  As for a black market, the Chinese government has been pretty effective at keeping it to a minimum.  All of this begs the next question though.  Why would the Chinese government intentionally make its people worse off, allowing them to buy less and forcing them to save more, especially given how poor most of its population is?

As a rapidly growing country with a Communist past, the savings rate would already be high without the currency manipulation.  There is no natural consumer culture, past hard times make people want to try to store value if possible, the domestic consumer debt culture is immature (low penetration of credit cards, etc.), and there is less to buy than in a historically capitalist, rich country.  There are plenty of caveats to each of these savings drivers, but one can fairly safely assume that for the time being and for the last 20 years, the savings rate would already be higher in China than in a country like the U.S., without playing with the currency.  Why would the government do this?

(to be continued)

Published in: on April 8, 2009 at 20:43  Comments Off on Following The G2 Trail  
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