The twenty-first-century economy has thus far been shaped by capital flows from China to the United States – a pattern that has suppressed global interest rates, helped to reflate the developed world’s leverage bubble, and, through its impact on the currency market, fueled China’s meteoric rise. But these were no ordinary capital flows. Rather than being driven by direct or portfolio investment, they came primarily from the People’s Bank of China (PBOC), as it amassed $3.5 trillion in foreign reserves – largely US Treasury securities.
The fact that a single institution wields so much influence over global macroeconomic trends has caused considerable anxiety, with doomsayers predicting that doubts about US debt sustainability will force China to sell off its holdings of US debt. This would drive up interest rates in the US and, ultimately, could trigger the dollar’s collapse.
But selling off US Treasury securities, it was argued, was not in China’s interest, given that it would drive up the renminbi’s exchange rate against the dollar, diminishing the domestic value of China’s reserves and undermining the export sector’s competitiveness. Indeed, a US defense department report last year on the national-security implications of China’s holdings of US debt concluded that “attempting to use US Treasury securities as a coercive tool would have limited effect and likely would do more harm to China than to the [US].”
To describe the symbiotic relationship between China’s export-led GDP growth and America’s excessive consumption, the economic historians Niall Ferguson and Moritz Schularick coined the term “Chimerica.” The invocation of the chimera of Greek mythology – a monstrous, fire-breathing amalgam of lion, goat, and dragon – makes the term all the more appropriate, given that Chimerica has generated massive and terrifying distortions in the global economy that cannot be corrected without serious consequences.
In 2009, these distortions led Ferguson and Schularick to forecast Chimerica’s collapse – a prediction that seems to be coming true. With the reserves’ long-term effects on China’s internal economic dynamics finally taking hold, selling off foreign-exchange reserves is now in China’s interest.
Over the last decade, the vast quantities of short-term capital that were being pumped into China’s banking system drove commercial banks and other financial institutions to expand credit substantially, especially through the shadow-banking system, leading to a massive credit bubble and severe over-investment. In order to manage the resulting increase in risk, China’s new leaders are now refusing to provide further liquidity injections, as well as curbing loans to unprofitable sectors.
But these efforts could trigger a financial crisis, requiring China to initiate a major recapitalization of the banking system. In such a scenario, non-performing loans in China’s banking system would probably amount to roughly $1 trillion.
The most obvious means of recapitalizing China’s banks would be to inject renminbi-denominated government debt into the banking sector. But China’s total public debt, including off-balance-sheet local-government financing vehicles, probably amounts to around 70% of GDP already. Despite debate over the details, the conclusion of Carmen Reinhart and Kenneth Rogoff – that a high debt/GDP ratio can inhibit economic growth – remains widely accepted; so it is unlikely that raising the debt ratio to 100% would be in China’s long-term interest.
Even if China’s leaders decided that they had the necessary fiscal latitude to pursue such a strategy, they probably would not, owing to the risk of inflation, which, perhaps more than any other economic variable, tends to lead to social unrest.
Given this, in the event of a crisis, China would most likely have to begin selling off its massive store of US debt. Fortunately for China, the negative consequences of such a move would probably be far less severe than previously thought.
To be sure, an injection of US Treasuries into the banking sector, and their subsequent conversion to renminbi, would still strengthen China’s currency. But the rise would most likely be offset by capital outflows, as looser capital controls would enable savers to escape the financial crisis. Moreover, even if the renminbi became stronger in the short term, China is no longer as dependent on maintaining export competitiveness as it once was, given that, excluding assembly and reprocessing, exports now contribute less than 5% of China’s GDP.
Against this background, the US Federal Reserve, rather than focusing only on “tapering” its monthly purchases of long-term securities (quantitative easing), must prepare itself for a potential sell-off of US debt. Given that a Fed-funded recapitalization of China’s banking system would negate the impact of monetary policy at home, driving up borrowing costs and impeding GDP growth, the Fed should be ready to sustain quantitative easing in the event of a Chinese financial crisis.
After spending years attempting to insulate the US economy from the upshot of its own banking crisis, the Fed may ultimately be forced to bail out China’s banks, too. This would fundamentally redefine – and, one hopes, rebalance – US-China relations.
Alexander Friedman is Global Chief Investment Officer for Wealth Management.
Copyright: Project Syndicate, 2013.