Stephen Roach | New York Federal Reserve Chairman Ben Bernanke offered the Chinese much in the way of good advice in a speech he recently gave in Beijing as part of the newly-instituted Strategic Dialog discussions that were just held between the US and China (see “The Chinese Economy: Progress and Challenges,” December 15, 2007). Unfortunately, he also offered some very bad advice in assessing the ramifications and risks of Chinese currency policy. In essence, the Bernanke critique was a one-sided interpretation of a key issue that could backfire and lead to a worrisome deterioration in the economic relationship between the US and China.
The offensive passage in the written version of the Bernanke speech posted on the Fed’s website was the assertion that the current value of the Chinese renminbi is an “…effective subsidy that an undervalued currency provides for Chinese firms that focus on exporting rather than producing for the domestic market.” The use of the word “subsidy” is a highly inflammatory accusation — in effect, putting the Chinese on notice that America’s most important macro policy maker believes that RMB currency policy provides the Chinese with an unfair advantage in the world trade arena that fosters distortions in China’s economy, the US economy, and the broader global economy. In my view, this is a very biased assessment of the state of Chinese currency policy and reforms. It pays little attention to the context in which RMB policies are being formulated and, ironically, fails to provide any appreciation for the benefits that accrue to America as a result of this so-called subsidy. Moreover, Bernanke’s spin continues to downplay the role that the United States is playing in creating its bilateral imbalance with the China — to say nothing of the role the US is playing in fostering broader imbalances in the global economy.
The real question in all this is, Who’s subsidizing whom? Conveniently overlooked in the Bernanke critique is an important flip side to the “managed float” that continues to drive RMB policy — China’s massive purchases of dollar-denominated assets. The exact numbers are closely held, but there is close agreement that between 60-70% of China’s $1 trillion in official foreign exchange reserves are split between some $345 billion invested in US Treasuries (as of October 2006, according to the US government’s TIC reporting system) and a comparable amount held in the form of other dollar-based fixed income instruments. With Chinese reserve accumulation now running at over a $200 billion annual rate, that implies new purchases of dollar-denominated assets of at least $120 billion per year. Such foreign demand for American financial assets is absolutely critical in plugging the funding gap brought about by an unprecedented shortfall of domestic US saving — a net national saving rate that fell to a record low of just 0.1% of national income in 2005. Without China’s purchases of dollar-based assets — a key element of its efforts to mange the RMB in accordance with its financial stability objectives — the dollar would undoubtedly be lower and US interest rates would be higher. In effect, that means China is subsidizing US interest rates — providing American borrowers and investors with cut-rate financing and rich valuations that otherwise would not exist were it not for the dollar recycling aspects of Chinese currency policy.
There is an added element of China’s subsidy to the US. As a low-cost and increasingly high-quality producer, China is, in effect, also providing a subsidy to the purchasing power of US households. Close down trade with China — as many in the US Congress wish to do — and the deficit would show up somewhere else, undoubtedly with a higher-cost producer. That would be the functional equivalent of a tax hike on the American consumer — cutting into the subsidy the US currently enjoys by trading with China. The Fed Chairman is making a similar suggestion: By allowing the RMB to strengthen, China’s dollar buying would diminish — effectively eroding the interest rate and purchasing power subsidies that a saving-short and increasingly asset-dependent US economy has come to rely on.
We can debate endlessly the appropriate valuation of the Chinese currency. Economic theory strongly suggests that economies with large current account surpluses typically have under-valued currencies. China would obviously qualify in that regard — as would, of course, Japan, Germany, and many Middle East oil producers. That fact that China is being singled out for special attention is, in and of itself, an interesting comment on the biases in the international community. Nevertheless, it is quite clear that China understands this aspect of the problem. By shifting to a new currency regime 17 months ago, Chinese policy makers explicitly acknowledged the need for more of a market-based foreign exchange mechanism. The RMB has since risen about 6% against the dollar — not nearly as much as many US politicians are clamoring for, but at least a move in the right direction. Risk-averse Chinese policy makers feel strongly about managing any currency appreciation carefully — understandable, in my view, given the still relatively undeveloped state of China’s highly-fragmented banking system and capital markets. The potential currency volatility that a fully flexible foreign exchange mechanism might produce could have a very destabilizing impact on an undeveloped Chinese financial system. And that’s the very last thing China wants or needs.
Chairman Bernanke’s criticism of the Chinese for subsidizing their export competitiveness by maintaining an undervalued RMB completely ignores the benefits being enjoyed in the US through equally important subsidies to domestic interest rates and purchasing power. Sure, a careful reading of the Bernanke China speech will find it laced with the typical caveats of Fedspeak that, in this instance, acknowledge America’s role as a deficit nation in contributing to this problem, as well as special considerations China deserves as a developing economy. But the tone and emphasis are clear: The Fed Chairman is paying no more than lip-service to the other side of the coin through his emphasis on a sharp critique of China’s monetary and currency policies. Particularly striking in this regard is Bernanke’s failure to acknowledge the extraordinary fragmentation of a highly regionalized Chinese banking system — dominated by four large banks that still have well over 60,000 autonomous branches between them. How a central bank gets policy traction with such a decentralized banking system is beyond me. Moreover, he basically overlooks another critical reason for China’s irrational investment process — the lack of well-developed capital markets and the continued reliance on policy-directed lending by China’s large banks. Instead, Bernanke suggests that a flexible currency is the best means to foster an efficient allocation of investment projects. In short, the flaw in the Bernanke critique is his failure to appreciate the very special transitional needs of a still blended Chinese economy — currently straddling both state and private ownership systems, as well as centrally-planned and market-directed allocation mechanisms. The Fed Chairman is offering advice as if China was a fully functioning market-based system — perfectly capable of achieving policy traction with the traditional instruments of monetary and currency policies. Nothing could be further from the truth for today’s Chinese economy.
This is not the first time Ben Bernanke has assessed an international financial problem with such one-handed analysis. In his earlier capacity as a governor of the Federal Reserve Board and then as the Chairman of President Bush’s Council of Economic Advisers, he led the charge in pinning the problem of mounting global imbalances on the so-called “saving glut” thesis — in effect, arguing that the US was doing the rest of the world a huge favor by consuming an inordinate surplus of saving (see Bernanke’s March 10, 2005 speech, “The Global Saving Glut and the US Current Account Deficit,” available on the Fed’s website). While a most convenient argument from the Administration’s standpoint, it downplayed America’s role in fostering the problem — unchecked structural budget deficits and a plunge in the income-based saving rate of US households. Lacking in domestic saving, the US must import surplus saving from abroad in order to grow — and run massive current account and trade deficits in order to attract the capital. This is quite germane to the debate over China. As noted above, the Chinese have emerged as important providers of saving for a saving-short US economy.
The scapegoating of China remains a most unfortunate feature of the global climate. US politicians want to pin the blame on China for America’s trade deficits and pressures bearing down on US workers. Now Ben Bernanke piles on by accusing China of using its macro policies as de facto export subsidies. Sure, China could do better on trade policy — especially in the all-important area of protecting intellectual property rights. But I think the world can also expect more of the global leader — like facing up to a very serious and potentially destabilizing saving shortfall that requires the rest of the world, including China, to subsidize its own profligate ways. The longer the US frames this debate in such a biased and one-sided fashion, the more difficult it will be for others in the world, like China, to accept a face-saving compromise.
There are some interesting footnotes to the Bernanke speech. Significantly, the Fed Chairman actually flinched when it came to the oral version of his speech — offering a last-minute substitution of the word “distortion” for “subsidy.” That may have saved him from an embarrassing moment or two on the stage in Beijing, but it did nothing to diminish the subsequent flap that has arisen over this accusation. Meanwhile, US politicians were quick to take the cue from Bernanke. Sander Levin, Democrat Congressman from Michigan and soon-to-be Chairman of the House Sub-committee on Trade, immediately threatened to re-introduce legislation that would require the US Commerce Department to cite Chinese currency manipulation as a violation of US anti-subsidy laws — thereby allowing US companies to seek the remedy of offsetting, or countervailing, tariffs. Moreover, while Bernanke may have stumbled on the word “subsidy” in public, it remains the operative concept on record in the official version of the speech on the Fed’s website. Sadly, as evidenced by the predictable reactions of Washington protectionists, the damage has already been done.
I have long argued that the US-China relationship could well be the most important bilateral underpinning of a successful globalization (see my March 20, 2006 Special Economic Study, “Globalization and Mistrust: The US-China Relationship at Risk,” presented to the 7th annual China Development Forum in Beijing). I worry increasingly that the economic tensions between these two nations are in danger of being politicized, with the nation-specific considerations of localization increasingly taking precedent over globalization. I am encouraged by US Treasury Secretary Hank Paulson’s attempts to put the China debate in a much broader context. Unfortunately, the Bernanke speech is a major step backward.