Daily Archives: October 5, 2011

Once again the US Congress is finding it more convenient to play the China currency card as the panacea for America’s economic woes, rather than deal with the difficult issues in President Barack Obama’s recent employment bill.

China’s response to the proposed bill pressuring it into allowing the renminbi to appreciate was predictable, with simultaneous protests from all the relevant agencies. Given the threat to the global economy from the problems in the eurozone and the US, China’s leadership regards the currency bill as a distraction from the real issues that need to be resolved. At a time when China is one of the few sources of global growth, ratcheting up protectionist sentiments only makes it harder to secure the necessary multilateral co-operation. The country’s government sees the currency debate as yet another sign of why the American political system is broken.

Beijing is quick to note that the history of rapid appreciation of the yen under the Plaza Accord under pressure from the US did not eliminate its trade deficit with Japan but in China’s view only contributed to the latter’s long-term economic ills.  Moreover America’s trade deficit began to increase sharply in the late 1990s, well before China’s trade surplus began to take off in 2005.  America’s trade problems are thus seen as stemming from its large fiscal deficits that emerged with increased military expenditures abroad.

Many within China thought that given recent developments, criticism of its exchange rate policies would become more muted. After all, China has continued its policy of gradual appreciation of 5-6 six per cent annually. With the euro crisis and strengthening US dollar, the renminbi has been the exception in appreciating, while other major currencies have depreciated. China also notes that its trade surplus has declined sharply from 7 per cent to 8 per cent of gross domestic product five years ago to a projected 1-2 per cent for this year. And while reserves continue to pile up, this is seen as having more to do with capital inflows seeking higher returns – encouraged by expansionary US monetary policies – than by misaligned exchange rates.

Moreover, Beijing argues that bilateral trade balances are meaningless in a world dominated by production networks using China as the assembly plant for the world. More than half of the country’s exports come from “processing” trade, with China accounting for some 20 per cent of the value produced and the rest from components imported from other Asian countries, Europe and America. China’s trade surplus comes from processing trade. Thus America’s large bilateral trade deficit is not really with China but with east Asia more broadly. Take the iPod: it is recorded as a $150 export from China to the US – yet only $5 of the value added originates in China, the rest comes from half a dozen other countries with the bulk accruing to Apple itself.

In this context if Congress gets its way, the net impact will not be more American jobs but reduced global demand and higher prices for US consumers. As the recent ‘Spillover Report’ by the International Monetary Fund concluded – a 10 per cent appreciation of the renminbi would have a negligible effect on the US trade balance or its GDP. The positive impact would be greater although still marginal for other Asian economies.  Thus any jobs lost by China from a major appreciation would gravitate not to the US but to other developing countries.

Yet China has little appetite to turn this affair into a full-blown trade war since it has benefited greatly from open markets. Thus while the leadership will not let any perceived negative action go unchecked, its motivation will be to work towards constructive solutions.  But there is a danger that in the transition to its next generation of leaders, Beijing may find it necessary to take a harder line in response to any perceived politically driven actions by the US.

America should worry more about maintaining its position at the upper end of the technology spectrum as China may feel the need to reinvent itself if the pressure to sharply appreciate its exchange rate continues. Currently China exports an unusually wide range of technologically sophisticated products for its income level.  However, its high-technology exports are really processed finished products with the more sophisticated components coming from elsewhere. No wonder most US companies are more concerned about market access and technology transfer than futile currency wars.

The writer is a senior associate at the Carnegie Endowment and a former country director for the World Bank in China

Response by Rodger Baker

The more China reaches, the more insecure it feels

Beijing has embarked on a relatively steady appreciation of the renminbi since shifting to a managed peg last year. The Obama administration is mostly satisfied with this slower pace and has refrained from using the levers available to pressure China for any more rapid adjustments. However, as Yukon Huang argues, the current US domestic situation may be conducive to using the China issue for political gain. When there is a tough economic problem at home that cannot be resolved easily or quickly, it is often politically expedient to accuse a foreign power of unfair practices. The debate alone can often serve as a rallying point for political support.

Whether the bill is a serious attempt to curtail trade or just a source of renewed rhetoric, China must still respond on the basis of potential implications, rather than the likelihood of passage or action. As Beijing’s power increases, and its economy pushes Chinese interests farther from home, it is increasingly in competition with Washington. But the more China reaches, the more insecure it feels, making it particularly sensitive to any perceived pressure from the US.

Domestic issues facing China today – including an economic slowdown and stability concerns – are pushing the government to avoid any rapid shift in the renminbi’s value. And with a leadership transition planned for 2012, China could yet determine it beneficial to ratchet up tensions with the US in response to the currency bill.

The writer is vice president of strategic intelligence and lead China analyst at Stratfor, a Texas-based private intelligence company.

The repeated refrain during recent days and weeks has been that there is an absence of political leadership in addressing the crisis of the euro. That is unsurprising given the complexities of the issues and the fact that whatever is done – or not done – will lead to some redistribution of wealth and income.

Nevertheless, there are some simple truths that can and must be explained to Europe’s electorates. Until these truths are accepted, it will be impossible to move forward with the vast range of technical work that needs to be done to put new institutional arrangements in place. And the casualty list – this week Dexia, next week who knows – will continue to lengthen.

Europe’s leaders, especially those in creditor countries, need to explain three things that need to happen and one that cannot.

To start with the last: there are still people convinced that the current crisis can quickly be solved if one or more countries leave the euro. Maybe eventual divorce is possible, even though the euro was sold as marriage without that option. But divorce is not a simple matter, and some of the historical cases in Latin America or the former eastern bloc are false parallels. Leaving a currency that will continue to exist elsewhere, within a single financial market, is highly problematic.

No one knows today which euro-denominated contracts, which are found all over the world, should be redenominated into one or more new currencies. Would it be on the basis of nationality, or residence, or intended place of settlement of the contract, or law of jurisdiction over the contract? Who would decide? Which courts could enforce whatever was decided? In every case of redenomination there would be a winner and a loser, so every attempt to enforce a change would be disputed. Then arrangements for the new currency(ies) would be needed. Intricate preparations were made over many years to introduce the euro – we were involved.

It is conceivable that, after the passage of years, Greece, for example, will not be able to restore competitiveness even after a writedown of much of its debt and the implementation of a draconian austerity programme. At such a point its position within the eurozone would need serious scrutiny. But pressing the ejector button now could send the whole aircraft tumbling earthward.

Then there are three things that do need to be explained. The first is that the existing governance arrangements for the euro cannot simply be tweaked. We now know it makes no sense to hope that somehow, uniquely in a monetary union, every political unit can run a totally self-sustainable budget. No one expects this of Saxony or Sicily or even Virginia. Over the medium term there is no alternative to some form of federal fiscal arrangements. This is increasingly recognised by some German politicians. Leaders now need to explain that this must happen and start work on the difficult negotiations and treaty changes that will be needed.

The second is that we also now know that, in the period before longer term fiscal transfer arrangements can be put in place, some euro area governments will need debt relief. The social and political consequences of seeking to enforce debt collection, or war reparations, in full are well known. Leaders of creditor countries must explain to their electorates that responsibility for these debts is shared. Without willing lenders in creditor countries, these debts might not have been incurred, and without this lending, exports effectively financed by this lending and hence the overall economic performance of the creditor countries would have been far poorer. Debt relief is not charity. It is a mutual necessity within a monetary union. How much is needed by whom and on what terms is all for the future and depends on circumstances. But electorates need to know that it is going to and should happen.

Lastly, the European Central Bank must provide liquidity indefinitely to maintain the machinery of day-to-day economic activity. This is not bailing out banks. It is bailing out their customers. Banks that get themselves into difficulties need not, over time, survive as corporate entities. But their customers have to be supported. This is not an issue of moral hazard.

The ECB’s balance sheet will be extended and is likely to need support – which can ultimately only come from governments. Central banks are almost always ultimately backed by taxpayers. This need not affect their operational independence. Leaders must assure their electorates that explicit fiscal support for the ECB by eurozone governments, if it were needed, would only put the ECB in the same position as other central banks whose operational independence is unquestioned. In the rest of the world central banks support markets by buying government debt with the taxpayer, through governments, as ultimate guarantor of their soundness.

Until the eurozone’s leaders have explained to their electorates these four unavoidable facts we will all be going up blind alleys, when time is of the essence in averting potential economic and social disaster.

The writer is a former chairman of the UK’s Financial Services Authority. David Green, a former head of international policy at the FSA, is co-author. Their book, “Banking on the Future: The Fall and Rise of Central Banking”, is published by Princeton University Press

Europeans, and with them the rest of the world, are discovering what all doctors know – a persistently misdiagnosed and incorrectly treated infection can eventually threaten even the healthiest part of the body, thus requiring more drastic medical intervention whose effectiveness is less assured.

This is what is happening in Europe today. A debt and growth crisis in the outer periphery of the eurozone (Greece) has been allowed to destabilise the inner periphery and the outer core (Ireland, Italy, Portugal and Spain). In addition, signs of dislocations are now visible in the inner core – both through the banking system and directly.

In the last few weeks, European banks have come under increasing market pressure. In one case, that of Dexia, governments are being forced to counter worrisome fragility. Moreover, as recognised by policymakers, a banking system that previously was just on the receiving end of the sovereign debt crisis (because of large holdings of peripheral debt) now risks becoming a standalone source of disruptions – multiplying the policy challenges.

Stress is no longer limited to the continent. Reflecting the high interconnectivity of global banking, some American institutions have also come under pressure as contagion concerns amplify the detrimental impact of an economic slowdown and structural weaknesses that persist three years after the last global financial crisis.

Also interesting, and less noticed, is what is happening in a still-obscure market segment that sheds light on sovereign credit risk, albeit imperfectly. There, spreads on German credit default swap have quietly widened to around 120 basis points in the last few days.

Such previously unthinkable levels are fundamentally inconsistent with Germany’s very strong sovereign balance sheet and its impressive record of successful multi-year economic reforms. Admittedly, the situation is mainly a reflection of bank-related counterparty risk issues and imperfect portfolio hedging. Yet, at around twice the US level, the CDS spreads may also speak to market uncertainties regarding the size of the contingent liabilities that Germany could face on account of the eurozone crisis.

By defining a new stage in the crisis, these developments undermine a regional policy approach built on the presumption that the inner core of the eurozone – sovereigns with rock solid balance sheets and their banks – can help pull up those in the struggling rest committed to put their domestic house in order.

The priority now is to urgently reestablish this presumption, and do so in a decisive manner. To this end, Europe should move immediately on three mutually-reinforcing fronts whose impact can be reinforced by appropriate policy actions in America and the emerging world:

First, Europe needs more effective circuit breakers to stabilise the banking system. In some cases, this would require immediate equity injections and a broader range of emergency liquidity facilities. It is encouraging that European Union ministers were reported last night to be looking at bank aid plans.

Success here is closely linked to the second issue that materially impacts the asset quality of banks balance sheets – the paramount importance of a more refined and effective approach towards the peripheral sovereign debt crisis.

Europe needs to differentiate more definitively between countries whose main problem is high and volatile interest rates, such as Spain, and those where underlying solvency issues require immediate debt reduction, such as Greece. The latter implies a reformulation of the program supported by the Troika (European Central Bank, International Monetary Fund and EU) to incorporate realistic fiscal and privatisation components and a more aggressive private sector involvement.

Third, Europe should decide what it wants to look like in the future, and press forward on related structural and institutional reforms. As the largest actual and potential financier, Germany would need to choose between two corner solutions: a politically-driven, but costly, fiscal union involving the current membership (conceptually similar to what West Germany did with East Germany twenty years ago). Or a smaller, less imperfect and thus stronger eurozone, but one involving tricky transitional aspects.

Many around the world have witnessed the deepening crisis with a mix of astonishment, concern and, now, fear. Those who already rang the alarm in the hope of spurring effective policy actions are being joined by others who previously refrained from doing so due to worries that the alarm could, instead, contribute to policy paralysis. In the context of European actions on three fronts, all could contribute to containing a crisis that also risks to seriously undermine global economic growth, jobs, financial stability and social cohesion.

The writer is the chief executive and co-chief investment officer of Pimco.

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