Tuesday, June 22, 2010

The Problem is "Out There"! It's China!

The quote of Stephen Covey that continues to resonate with me is "As long as you think the problem is out there, that very thought is the problem."

With all the fuss over the movement by the Chinese to allow the value of their currency to rise we hear, once again in the background, that the real problem is that the imbalances in the world are really a consequence of “an entrenched savings excess” in China. (See the article by George Magnus, “We Need More from China than a Flexible Renminbi,” http://www.ft.com/cms/s/0/4f19ced4-7d4a-11df-a0f5-00144feabdc0.html.)

There we have it!

And, the support for this theory goes as far as Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System, who came up with this idea to provide Alan Greenspan with an excuse to keep interest rates excessively low in the earlier years of the 2000s.

The problem is “Out There”!

Those Chinese just save too much! Let them be like the Americans who reduced their savings to close to around one percent of disposable income earlier this decade. The Chinese bought a large proportion of the bonds going to finance the huge deficits of the United States government and this kept interest rates so low that the Federal Reserve could reduce their target interest rates to levels that created a bubble in the United States housing market.

As Magnus writes, the Chinese do have an unreformed rural sector, an immature social security and financial system and a one-child policy. But, China is transforming. It is just not doing it at the pace that the Western world would like it to in order to reduce or eliminate the imbalances that exist internationally.

The Chinese, however, are not going to change their social policy overnight. This is one of their “no-no’s”! They saw what happened in Russia and Eastern Europe as the social order unraveled when the Communist governments in these areas fell. They vowed to keep a lid on things, culturally, as China modernized. They will not back off this controlled approach as they move toward a state capitalism and a society that is more open to the world.

But, this is not what created the huge government budget deficits in the United States. The total amount of United States debt outstanding rose at a compound rate of over 7% from early in the 1960s through the end of 2008. This was not the fault of the Chinese!

Nor is it the solution to the low personal savings rates in the United States and the huge government budget deficits going forward. The personal savings rate in the United States stayed above 7% for most of the period between the late 1950s into the late 1980s. It exceeded 10% at times!

What eventually got to the American saver was the steady erosion of the real value of the savings put aside during this time. And, as the American saver moved into the 1990s, the personal savings rate began to fall and continued to fall into the 2000s. Consumer prices in the United States rose at a compound rate of around 4% from January 1961 through the summer of 2008. The purchasing power of a 1961 dollar dropped during this time to about $0.15.

If anything may accelerate the decline in the personal savings rate in China it may be the rising rate of inflation that is being experienced there. If the real value of savings takes a precipitous drop, even the rural Chinese may begin to adjust their behavior.

The real problem in this picture is the massive amount of United States debt that is outstanding. And, the amount of debt that is outstanding is the fault of no one but the United States. But, this problem puts a lot of pressure on other countries, especially on China.

China holds about 70 percent of its foreign exchange reserves in dollars, mostly in United States Treasury securities. This accumulation began in the 1990s and accelerated into the 2000s. The United States dollar was the reserve currency of the world and United States Treasury securities were the most secure investment around in terms of risk.

I remember working with a group from China in the early 1990s that represented Chinese pension funds. This discussion took place at the University of Pennsylvania. I was not teaching at the time, I was the president and CEO of a bank.

Chinese pension funds had a very large amount of money, yet because they could only invest on Mainland China they had limited capabilities of earning a decent return on their monies and were very limited in terms of their ability to diversify their investment holdings. This group was investigating investing pension fund monies “off-shore” and they were interested in foreign exchange risk and how this risk could be hedged. And, these discussions were a part of the general discussion going on in China at the time about investing more and more of their monies and international reserves in the rest of the world.

The point is that the early 1990s represented a time in which China was opening up and investigating how it could participate in global financial markets. Being very cautious, the Chinese were learning about how to diversify into the world but keep its risk exposure low both in term of credit risk and foreign exchange risk. I don’t see much of a change in this attitude at the present time.

Magnus mentions, in his article, that because of China’s creditor status it must play a role in helping to fix the global financial imbalances. Specifically, he argues that China cannot “back away” from these world imbalances—as the United States did in the 1920s and the Japanese did in the 1980s—because, in the end, backing away will neither help the world, or themselves.

My guess is that the Chinese will not “back away” and “dump” United States Treasury securities. This is one of the reasons why the Chinese do not want to see the value of the Yuan rise too rapidly. A “quicker revaluation would act as a stealth monetary tightening not only in China but also the US.” This is because it would have a negative effect on US equity prices and also result in higher US interest rates. (See the Lex column in the Financial Times: http://www.ft.com/cms/s/3/9db857ea-7d45-11df-a0f5-00144feabdc0.html.)

However, President Obama’s administration and the United States Congress continues to press for China to change the behavior of its government and the savings habits of its people. Yet, many of the major imbalances in the world today result from the undisciplined behavior of the United States over the past fifty years or so. The huge amounts of United States government debt outstanding are not the result of the government of China or the Chinese people. Why, then, should the Chinese bear the brunt of any adjustment that is to take place?

As long as the United States government and the people of the United States think the problem is out there, the problems and imbalances will not be resolved. The only one we can control is ourselves, so if anything is going to be accomplished, we are going to have to do it…not the Chinese.

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