On his China visit, Secretary Geithner is immediately on the defensive. The language he is using on the Chinese policy of exchange rate undervaluation-through-intervention is the mildest available. And the commitment he is making, in terms of bringing down the US deficit, which we all favor, is an extraordinary thing to put numbers on in a foreign capital. Such commitments are of course unenforceable, but still the wording indicates, and this is understood by China, great US weakness.
Not surprisingly, China seems likely to push for more. Their main idea is that some part of their US dollar holdings be transferred to a claim on the International Monetary Fund (IMF), which would shift it from being in dollars to being in Special Drawing Rights, which would therefore be a claim against (a) the IMF's whole membership, and (b) presumably, the IMF's gold reserves.
This is a bad idea.
No one asked China to build up a huge level of reserves. If one country wants to run a current account surplus that is big relative to the international economy, then someone else has to run a deficit; it's a zero-sum game because "reserves" are a claim on another country (preferably a strong one, with a convertible currency). No one has ever offered a guarantee on the real value of reserves, which is what China now wants.
We can agree that the United States should have a higher savings rate, but if we did have more savings, or even if we ran our a current account surplus of our own, China's desire for foreign exchange reserves would still mean undervaluation for them (as long as they can sustain the intervention) and a current account deficit for some set of countries in the rest of the world.
There is nothing wrong with wanting to have foreign exchange reserves, and sometimes these are accumulated just through the natural cycle of activity (e.g., commodity producers are well advised to build up reserves in a boom, because the prices of their exports also crash with some regularity). But the way China has operated within the global system has not been responsible and it has not, an important point, been in conformance with the rules (as reflected most recently in the IMF's Surveillance Decision, which is heavy on the legalese but quite clear on this point: No sustained undervaluation through intervention in the currency market is allowed).
China needs to acknowledge that it too has responsibility for the stability of the international system. Current account surpluses feel good for surplus countries—this has been a consistent feature of the modern global payments system—but policies that sustain big surpluses are destabilizing for that system, because they imply that someone else will run a deficit and more than likely eventually have to bring that deficit down through costly adjustment.
What we really need is a complete reform of the IMF, or the introduction of a new international payments body, so that countries don't feel the need to run massive surpluses to protect themselves against external shocks.
In the meantime, we need China to allow its currency to appreciate. If they double their holdings of US dollar assets over the next couple of years (let's say, going toward $4 trillion), effectively financing our budget and current account deficit, will we all end up safer or more vulnerable?
Is Mr. Geithner trying to persuade China to reflate a new version of our financial bubble?
Previously posted before Secretary Geithner's trip to China
At his confirmation hearing in January, Tim Geithner nailed the China Question. China prevents its exchange rate from appreciating through intervention (buying foreign currency), and this allows it to sustain a large current account surplus. Geithner said, as plainly as you can expect from a senior official: This is not in accordance with international rules and should stop.
Not only is this sensible economics and correct on the rules, it is also good politics. If you want to head off the considerable inclination toward protectionism in Congress, it would help greatly for the Chinese renminbi to rise in value (e.g., review the discussion at this House hearing).
But almost as soon as Geithner spoke on this issue, there was slippage. By late February, Hillary Clinton was asking the Chinese nicely to continue holding US Treasury securities and, it now seems, punting the exchange rate issue. Above all else, China wants to be left alone on the renminbi, variously arguing that any appreciation would jeopardize jobs, derail growth, and plunge the country into chaos.
So what should we expect from Geithner's upcoming China trip?
China refuses to talk politely about its exchange rate and rebuffs all sensible diplomatic initiatives on this front; they have held the IMF at bay for nearly 2 years on this exact issue. The rhetoric is that their fiscal stimulus will bring down their current account surplus without need for significant exchange rate appreciation. This is a smokescreen.
The reality is that the administration is afraid that China will shift out of its dollar holdings, pushing up interest rates on Treasury debt and jeopardizing their Fiscal First reflation strategy. The Chinese have played up these fears by speaking obliquely on the desirability of a nondollar international reserve currency; this is a pipedream, but you get the point.
The administration has essentially blinked in the face of Chinese growling. This is strange for two reasons.
First, where would China move its reserve holdings? The other reserve currencies are generally considered to be the pound, the yen, and of course the euro. Which one would you definitely prefer to the dollar these days?
Second, any shift in the Chinese portfolio would also tend to depreciate the dollar, depending on what else is going on at that time, and this would likely push up inflation. However, the administration might welcome some inflation right about now, reducing real debt burdens and helping banks' balance sheets and their operating profits. And a depreciated dollar would raise exports, greatly facilitating our economic recovery. It would be awkward for this to be explicit US policy, but any Chinese move would provide the administration with plausible deniability.
The standard view among the very people now running US macroeconomic policy is that the large Chinese current account surplus during the boom, and the consequent build-up of foreign exchange reserves, was destabilizing because it helped make credit conditions looser in the United States. In fact, "don't blame us, it was the global (i.e., Chinese, Japanese, oil producers') savings glut" is almost a mantra among our policy elite.
Personally, I would not overweight this element of the global credit mania; the financial services metabubble started long before China's surplus became significant. But I'm seriously worried about the potential protectionist backlash today, given that China is the only major country that does not play by standard international trade and finance rules. The administration thinks it can safely postpone discussing China's exchange rate for another, sunnier day. I'm not so sure.
Still, not wanting to discuss difficult topics should make for an easy visit to China.
Also posted on Simon Johnson's blog,