Wednesday, April 8, 2009

SDRs for China - Does it even make sense?

China's protestations to dump the dollar in favor something else, are entirely without guile.  It’s not simply a financial problem because the US runs deficits nor is it just that China’s huge claims on the US are now in jeopardy of exploding into a valuless puddle, like Monte Python's Mr Creosote who eats one 'wafer-thin mint' too many. It's China wanting to flex is muscle. But China does not seem to have an idea where to flex or what to flex. It has no idea that it just might have become muscle-bound, with its own muscles getting in the way of what it really wants to achieve.

Indeed, China's desire to accumulate wealth and its desire to generate a strong export engine of grwoth have undermined each other as was inevitable. 

Tough Nuggies China, and others.

It was CHINA’s decision to pursue a course of export-led growth… and Japan’s and Korea’s and Germany’s and…so on. So with all that stuff flying around the world, where does it land? What does this huge surplus in motion imply for everybody else? Oh yeah, the reserve currency makes it all balance, doesn't it?  So the US gets the goods, the current account deficit and they get the reserve accumulation. What happens when that accumulation is too much? Fiddle dee dee, a problem for another day. 

Too many too-large countries with polices of export-led growth,  combined with the IMF’s failure to play the role as any kind of FX cop -- those are the ingredients that got us here. If you like it was also market failure – failure by markets that simply assumed they had the price right or that there was an end game to China's export/reserve accumulation gambit.  Markets were ‘cool’ with what was going on. Lots of Fx reserves in China, Japan, Taiwan, OPEC countries- no sweat. The sweat came later. 

It was wrong to conclude that complacency over the growing size of fx reserves and arbitrary fx pricing (by China) was equilibrium. It was wrong to think anything good was coming of all those trade patterns and stubborn deficits and surpluses.  At the very least since China’s FX rate is pegged (crawling peg) there should have been no welfare considerations attached to its trade and no applicability of WTO rules to protect China's interests since China is/was price-fixing at the macro-economic level. Any basic economic STUDENT should be able to see that. But international economics is so much more about international politics… And what you allow you also must sanction, at least for appearances. So China's policy got implicit back-door approval. 

When this sort of TRADE DEPENDENCY happens what else happens? 

China did not set out to accumulate FX reserves as much as it set out to have export led growth. The reserves were a by-product,and for a while, an enjoyable one. If China wanted to it could have tried to develop its domestic demand. But it did not do this. It is very disingenuous of China to turn on its own policy and it’s the ramifications it should have been able to see and to blame the US and blame the dollar. Where its policies would lead, to reserve accumulation and to a tangled web of extraction, was a pretty clear bet. For the past several years it has been made even clearer, but China had no plan 'B'. Instead, it is easier to blame the US for China's failed polices.  

As the principal reserve unit, the US really had no control of these events. 

What did CHINA think would happen after it accumulated $2trln or $3trln or $10trln THEN decided it had enough?  This sort of policy shift is a bit like Mr Madoff and his Ponzi scheme. Madoff claimed in court that he knew’ this day would come…’ as it surely would. And so would/has China’s. The transition from export led growth and its transformation to something else is hard to achieve, time consuming, and disruptive.  Actually China probably did see it coming, but it needed to grow so fast and absorb the upwardly mobile workers so it did not want to take the time or effort to retool its focus. It took the path of least resistance.  

Now China and other exporters are caught in the natural trap of the business cycle. I have no sympathy for countries that pursue aggressive trade expansion then cry FOUL and PROTECTIONISM when demand overseas collapses and they suffer the consequences. What else could they suffer?   

I have recently looked at the ratio of imports to GDP and their behavior in this cycle for the US and for a batch of EMU countries and found – interestingly- that the ratios had not fallen so much in recession – not a record drop certainly. The drop off in imports (other countries’ exports) is mainly due to the drop in GDP in importing countries. EVEN IN THE US that is true. The drop in imports relative to US GDP is not that large (i.e. it’s the drops in GDP that have been large and the drops in imports that have moved 'in tandem.'). Of course let’s remember here that import elasticities are greater than ‘unity’ in value. So when GDP drops, imports (others’ exports) drop by more (in percentage terms) as matter of statistical regularity. So if you live off that upside (in good times exports grow faster than GDP) you suffer that ‘exaggerated’ downside in a period of decline- nothing WTO can do about that…

Interestingly, US imports of trucks and cars are UP in unit terms in Q1 even though domestic unit sales are off at a 28% annual rate. Is that ‘protectionism’? No.


Everyone talks as if what is happening is all financial related but it's not IT”S REAL- its real sector stuff that is the real conundrum. The financial sector has merely been too accommodating, well, until it wasn't. 

Of course we have to finance our real imbalances. And the imbalances are the real problem, not the financing vehicle, though it plays a role. The idea that switching global monetary policy out of the dollar while these real sector imbalances stay in place is so much Fantasy Land, Disney could open a new theme park based on the idea. Call it CHINA LAND

I could go on but I’ll stop here. You get the idea. I think this is a much richer place to go to look for answers about what is going on in the world economy. SDRs are a red herring. If ‘we’ (El Mundo) go off the dollar standard who will run the deficits to permit ‘everyone else’ to have export led growth?  How does a shift to SDRs help that? 

It doesn't.

So what is China really after with its SDR talk? It is simply looking for a way to take US prestige down a notch. It's all about politics and power and trying to get even after something goes wrong. Saving face. It's very Asian.

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