China and the Global Financial Crisis

Paper to the Wairarapa Branch of the NZIIA, July 21 2010.

Keywords: Globalisation & Trade; Macroeconomics & Money;

Introduction

Future historians are likely to identify the topics of this evening’s presentation as the two major economic forces of our times: the rising importance of the Chinese economy and the Global Financial Crisis. My task tonight is to show how they are related and how they are not, but also to suggest how the two are radically changing the political economy of the world.

I begin with a structural imbalance in the world which underpinned the financial instability which led to the global crisis. It arose from a savings surplus by a group of countries, of which China was the largest, which perforce had to be offset by a savings deficit by another group of countries, of which the United States was the most important. I’ll simplify by focussing on the China-US imbalance but let’s not forget others were involved.

A savings surplus means one’s total spending (including consumption and investment) is less than country’s income. This is evident when it exports more than it imports so it has a surplus in its current account. But if one country, say China, is exporting more than it it is importing, then there has to be another country, say the US, which is importing more than it is exporting. It has a savings deficit, and a deficit in its current account.

A Chinese exporter is paid in US dollars, some of which importers use for their purchases. Because there is a current account surplus, China will have dollars left over which it will invest in such financial instruments as US Treasury bills, government securities with a short life. There were plenty of these Treasury bills available, because a large part of the US savings deficit was by the US government. If it spends more than its revenue, it does this by issuing cash, say dollar notes. It mops them up by swapping the notes for Treasury bills, which have the advantage to the holder that they pay interest, to encourage people to hold them.

The argument is that if they just held dollar notes, this would be inflationary because people would want to convert their notes into goods. Because they paid interest, the Treasury bills were less likely to be converted into goods. Even so they are still very ‘liquid’, that is easily converted into cash. They have a relatively short life after which they are redeemed in cash, and there is an extensive intermediate market so they can be converted into cash even before their life comes to an end, by selling them to someone else.

China converting its export surplus into US Treasury bills was only possible because the US government was running a deficit which it funded by issuing the bills. Had it been more fiscally conservative and not run a deficit, the Chinese investments would not have been possible. Any alternative scenario is complex; perhaps the Chinese would not have been able to sell as much to the US, and so its export surplus would not have been as great.

The US government’ deficit funding is privileged, since its dollar is the currency of international choice. The majority of the world carries out its international transactions in US dollars, and tends to hold its international reserves in US dollar denominated securities such as those Treasury bills. That is quite different from when the New Zealand government tries to run a deficit. Since not everyone wants to hold the New Zealand denominated securities, they get converted into US dollars, and – to simplify – there is a run on the New Zealand currency. However, in the pure model where the US dollar is the currency of choice, investors keep holding the US denominated securities. Given that so many of them were liquid – near cash – the global financial system was looking troubled as they built up.

The Speculative Boom

The high degree of international liquidity facilitated international financial speculation. There are various ways of thinking about this. A familiar one is that there was insufficient regulation of the financial sector, perhaps with the addition that very often the incentives which dominated the money managers’ behaviour were perverse, thereby encouraging financial instability. Additionally, since 1987 it has been evident – to me anyway – that measuring the value of financial assets, an activity on which the financial system relies, is not a simple scientific exercise but involves judgements which for various reasons (including perverse incentives) tend to overvalue the assets compared to the reality test of hindsight.

So the assets side of the balance sheet of many financial institutions gets overvalued. That is not so true so for a plain vanilla trading bank, such as those that operate in New Zealand. Their major vulnerability is their provisions for bad debts, but that is usually such a small element of their total book that any errors affect profits but not the entire viability of the bank nor of the banking system.

On the other hand, a finance company involved in a large development will have among its assets an estimate of the value of the development which may be vastly over valued. More sophisticated financial institutions – you might call them ‘Neapolitan’ because they slice up the financial assets and sell the slices separately – have a variety of financial assets with a alphabetic soup acronyms all of which require judgements as to their market values, and whose the values can change markedly if market sentiment changes.

The balance sheets of the Neapolitans can be very complicated, but what is important here is the tendency for their asset side to be overvalued. To simplify, consider a finance company with over-valued assets, taking deposits in from the general public. It may well be that the deposits are sufficiently less than the apparent value of the assets for it to pay its shareholders (or managers) generously. However they have assets and not cash, so they pay out of the new deposits invested in the company.

The Speculative Bust

When the true value of the assets become apparent, the company finds its liabilities exceed its assets, and so depositors lose their money. Where did the value go? A short – and incomplete – answer is that it went with the remuneration to those working for the businesses and the dividends to the shareholders. A stunning example is that of Lehman Brothers, which was floated on the sharemarket in 1994 and paid generous remuneration until it went bankrupt in 2008. A Lehman investor would have got a better return if they put their money in a sock in 1994. The Lehman managers did far better, of course. Too often the long run effect of the financial investment market is the transfer of the savings of ordinary investors to those who own and manage the financial institutions.

In some ways it is a Ponzi scheme. Charles (or Carlo) Ponzi was an Italian-American who paid past investors a high return out of incoming deposits from new investors. Eventually the scheme runs out of money; his did. But not before investors flocked to deposit with it. But there were no actual earnings while some early investors made money and Ponzi spent some of the proceeds on the high life, so those who invested late lost their capital. Ponzi was neither the first nor the last to use this technique to swindle investors; just one of the most colourful. A recent example is Bernard Madoff.

What Ponzi and Madoff did was illegal, but it has been argued that the entire financial boom was a kind of Ponzi scheme albeit a legal one (perhaps because there was insufficient regulation). A finance company to pay itself generously from its deposits, justifying the dividends, salaries and bonuses by asset valuations which are too high. This can happen without fraud, which is why some investors will not even get the satisfaction of seeing those to whom they entrusted their lost savings ending up in jail.

Particular financial conditions are required for widespread Ponzi type schemes. First returns have to be low, with investors demanding something higher. Second there has to be the liquidity to enable the financial institutions to manage their cash flows. Such conditions were exactly those generated by the Chinese (and all) savings surplus, and the willingness of the banker of the world, the US government, to borrow the savings.

Does that mean that the financial system is a legalised Ponzi scheme as some have argued? An effective financial system is necessary to take in people’s savings and direct them into productive investments. An unfortunate by-product of such activity is speculation and, sometimes, Ponzi-type schemes. There is nothing wrong with speculation if you are using your own money; it gets murkier if you borrow to speculate, and plain grimy if you speculate with other people’s funds, especially if you have not told them.

When the financial system is working normally its Ponzi element is perhaps five percent or less, but at the top of the financial boom it is much higher, almost certainly over half. The conclusion is that as the boom gets strong, move your savings into safer, low return investment. At least you should have your capital at the end of the day. (And, of course, we should try to eliminate the perverse incentives and over-optimistic valuations. But that is shutting the stable door after the horse has bolted – knowing that others are trying to open another stable door.)

Those who have invested in plain vanilla securities, such as Treasury bills, and financial institutions dont lose their investments, at least not so directly. Meanwhile those who went Neapolitan lost much, most, or all their capital. The Chinese government did not seem to have lost much, because it cautiously invested in vanilla.

That is the impression I get with their foreign policy generally; internationally China has been operating very cautiously, not throwing its weight about. The failed outcome of Copenhagen on global warming is in part because they were too cautious and perhaps not prepared, rather than, as some Western commentators have argued, they were trying to undermine the whole collective agreement. Of course they were looking after their own interests, but so was the West. (Some commentators dont seem to have been aware this.)

China and the International Transition

That is the central point I want to make tonight. We need to stop judging China from the perspective of Western interests, but try to understand the world from their perspective. This is not to excuse their human rights records, nor their treatment of such regions as Tibet (with its Buddhists) or Xinjang (with its Moslems). But any criticisms need to be tempered by an understanding of the Chinese perspective.

It is especially important to do this, because the world is going through a major transition, in which the role of China is growing. Let me just talk about its economic aspects, because they are the foundation for the rest of the change.

Not long ago there was a view in the US (and Britain) that while they were losing manufacturing industry to China and other East Asian economies, the economic activity was being replaced by a competitive advantage in the provision of financial services which would be paid handsomely for taking in the savings of the world and redistributing it for the highest possible return, while minimising risk. The approach involved all sorts of assumptions, which a decade ago might have been teased out, but after 2008 is now such obvious nonsense that one does not need to.

Perhaps one should mention though, that the Chinese and other savings which passed through Wall Street to the US Treasury were being invested (if that is the right term) fighting a couple of wars in Afghanistan and Iraq. One recalls that the financial power of Britain was considerably weakened by fighting the Second World War, with its international assets cannibalised to pay for it. The beneficiary then was the US who came out of the war financially stronger.

Britain was not the dominant international economic power – we call it the ‘hegemon’ – in 1939; it may well have lost that position by 1914. But America was reluctant to take over the hegemonic role and it is not until after 1945 that it began to use its economic power to lead the world. Perhaps like China today, during the inter-war period it was cautiously feeling its way and so its power was not so obvious.

As late as the 1960s Britain was still struggling with its loss of international dominance at least half a century earlier. Tonight I am going to say some tough things about the US, but I say to them as a friend and also as someone who observed the agonies that Britain went through with a deep empathy. So is there a parallel with China today? The answer might be ‘yes’ and ‘no’; it is the ‘no’ I want to focus on.

It is very easy to project current trends and announce that one day China will rule the world. However there are three economic reasons why we cannot expect the trends to continue indefinitely plus some possibilities of various domestic disruptions.

First, China has not got good demographic prospects with an aging population and a low birthrate; it is the only part of the poor world which has a current demographic future similar to the rich world.

Second, China is absorbing resources from the rest of the world. The most obvious example is oil, but there are many others – timber is an interest to New Zealanders, iron ore if you are Australian. Sticking with oil as an exemplar, China like the US is now a net importer of oil. These huge demands, which cannot be met by increasing supply, will drive up the price of oil, which will slow down the growth of the energy intensive economies. Since China is one of the most intensive it will suffer from the world energy shortage most intensively, and that will slow its growth down. The same story applies for timber, iron ore and so on. You might want to add to this uncomfortable prospect the problem of global warming. Parts of China are as vulnerable as anywhere else; Shanghai already has major levees against the sea – indicating how vulnerable it is to a rising sea level.

Third, Chinese growth has depended upon its ability to export to the rich countries. But they are not growing as quickly, and in many of its markets China has almost reached full penetration. So its export boom is likely to slow down and that growth driver become less powerful.

(It is interesting isnt it, that the three reasons I am sceptical about continuing the high Chinese trend growth, all involve parallels with or mechanisms involving the rich countries: poor demography, vulnerability to resource shortages and dependency on slow Western markets. )

As the export boom slows, China can switch its growth pattern to a more domestically oriented one. It is already doing this with a vast infrastructure building program. Civil engineering has always been one of China’s greatest achievements – for aeons its ability to harness its rivers for agriculture has generated the food and the surplus which enabled the Middle Kingdom to dominate the region. Today the civil engineering remains an amazing achievement – Terminal Three of Beijing International Airport is impressively spectacular and some of their high speed train services show similar flair.

A couple of cautions. Admiration for civil engineering has to be tempered by the tendency of engineers to be arrogant and neglect nature. China faces a number of pollution crises – not least it is running out of water, especially clean water. There are massive civil works to use the waters from Tibet for agriculture and hydro-energy. It will be a miracle if there are no environmental disasters, while the some of the already polluted rivers need attention.

Civil engineering can only go so far towards contributing to civil society. Rapidly growing economies create social tensions. Will the Communist Party will be able to deal with the rising expectations of the burgeoning middle class; will it be able to deal with the disgruntlement of the rural areas left behind? If I were them, I would be looking at restoring a decent public health system, and I would also be looking at designing some support for the aging population.

There is one further disruption we need to think about. How sound is the Chinese banking system? Their banks balance sheets are flush with the deposits of Chinese households, who on some measures are saving 40 percent of their incomes. Because housing is part of the root cause of the Western crash, there are also worries about the Chinese housing market, where prices are absurdly high. If that bubble bursts, there will be some households and some lenders in trouble.

The concerns are on the industrial and commercial advances of the banks. Are the banks over-invested in sectors which might collapse? And what are their bad debts and underperforming loans like? I mean ‘really’, not what they report in their books – does anyone trust (Eastern or Western) auditors nowadays? What about the cosy deals between banks and companies which almost wrecked the (South) Korean economy? China certainly has the credit underpinned entrepreneurs that Korea had. Korea recovered, and so will China. The message is that smooth Chinese growth is no more inevitable than was the never-ending boom we were promised from US financial markets. (Note to ourselves, government and exporters: dont put all your eggs in the Chinese basket.)

The US and the International Transition

Even so, I expect the Chinese economy to grow in the medium run, and Chinese living standards to lift (good for our food exports). It may not be long before China is the world’s largest economy, although be careful about just how that is being measured. However, the US and the EU will continue to have a large share of world economic activity, as will Japan which India has already caught up with. I’ll talk about the prospects of a world dominated by the big five – China, Europe, India Japan and the US – shortly. But first what are the expectations for the US (and European) economy?

The rise of the manufacturing sector (and the tradeable service sector) in Asia is reducing some sectors in the rich countries. What is going to replace it? One strategy, I call it the German one because they do it well, is that Asia may be producing the manufactures, but they produce them with German machines. What is happening then, is the really advanced manufacturing involving skilled workers, precision production and on going innovative design is being retained in the rich countries. That will continue for a while.

A related strategy relies on innovation and creativity. We talk about it in New Zealand more as an advertising slogan than a rational and coherent way to think about the world. Sure there will be some innovative and creative industries – Wellywood is an example – but I doubt they will save us or the West, and indeed if they are so successful then you’d have to be racist to say that the Asians wont be able to pursue innovation and creativity too.

Probably more important to New Zealand, and to some rich countries, is supplying resources – in our cases food and fibre. Fonterra is our exemplar, but note that it is no longer a commodity exporter; much of what it sends offshore is technologically transformed. The expectation is that the prices for food, fibre and mineral resources will rise relative to manufactures; we may not be feasting on the cow’s back, but there are possibilities for prosperity for New Zealand (and Australia) while other members of the OECD struggle with resource shortages.

One option that does not seem possible is that of the US and Britain living off their financial acumen. The events of the last two years suggest such a prospect is yet another over-valued asset.

When you go through this list, you concluded there is no reason to assume that the western economies will experience an acceleration of their economic growth, and it may even slow down. Thus China and India are likely to grow faster than Europe, Japan and the US for a while anyway.

This is a structural analysis ignoring the Global Financial Crisis. Past experience of such crises is that the economies which experience them come out on the same growth track but at a lower level. Just how much lower depends on a whole lot of contingencies, but the current guesses are between 3 and 7 percent lower. Allowing that these economies grow about 1.5 percent a year in per capita terms we are talking about a two to five year set back. The more gloomy think that it is even possible that it could be up to ten years before some of the rich countries return to a normal growth path.

In practice such a scenario will seem like a long recession in which the economic performance will be flatish for a long period, with wobbles around the stagnation; during the up-wobble the optimists will say that the end is in sight, during the down-wobble there will be panics and gloom. The world seems to be going into a down-wobble at the moment, with the talk of a double-dip recession. There may eventually be more than two dips.

What does this mean for the US, the hegemon of the world economy? To bring together what I have already said. It is losing (manufacturing and tradable service) industries to Asia, while the hoped for replacement, the finance industry is in tatters, even if the industry players are far from acknowledging that. The US is heavily borrowed, but much of that borrowing is not matched by useful assets – instead it is tangled up in the Middle East, and housing nobody wants or can really afford. Moreover, America is likely to experience a period of slow economic growth compared to the rest of the world. The parallels with Britain in the interwar period are striking. Essentially the hegemon is losing its hegemony.

This is not well understood in the US, just as it was not understood in Britain. There are of course sophisticated Americans who would engage with what I am saying, not necessarily agreeing but understanding the issues I am raising. However the vast majority of Americans would not.

I am not just referring to the Tea Party, with its almost clueless understanding of what is happening to the world, and its blind striking out with nostrums which hardly make sense, let alone offer a coherent account of what to do. The group represents an important dimension of US opinion, which is almost certainly wider than those who party. However more worrying is the wider Republican Party, whose current position is to oppose everything the Obama administration stands for, because it is easier to do that than to engage with the issues.

This is a not a discussion on the lamentable state of US domestic politics; perhaps the Democrats, were they in opposition, would be just as grumpy, although I do think President Obama was elected on a platform which was trying to think through some of these international issues. What is important for the world is that the US appears to be going through a troubled time, exactly when it has to engage in perhaps its greatest challenge, how to transition to the new world order.

Toward a Multipolar World

Let me given an example. It is easy to argue that the current double-dipper recession could be moderated by a fiscal stimulus, that is by increasing government spending and cutting taxes. But there is only one country that can offer the leadership of such a stimulus. The European Union does not have the authority or means for a fiscal stimulus, that rests with the individual member states. However, were the US to lead it could probably get the Europeans countries to put comparable fiscal stimuli in place, giving a lift to the world economy. However that is not going to be possible because the Republicans in Congress are obdurately opposed to a fiscal stimulus, despite their support of less justified stimuli by George W. Bush (and Reagan). The deadlock in Congress is going to make worse the recession which has followed the Global Financial Crisis. Its actions will make the loss of American hegemony earlier and more disruptive.

What is important that this time there is no replacement hegemon. That is is going to make it so much harder to find our way through the new world order, much harder than the British found, for at least they saw their power transferring to their cousins across the Atlantic.

So I am certainly not arguing that China will be the next ruler of the world, despite some making that claim. Rather, each of the big five – China, Europe, India, Japan and the US – will be sufficiently large to be able to prevent any one of the others being able to dominate the world.

What the world economy – and world international relations – will be like under these conditions is hard to say. Suppose we just think of the world as a commercial market. Then we economists can tell you a lot about how it will function if everyone is so small it is primarily a competitive market, or if there is a monopoly dominating the market, or even if there are two dominators – a duopoly. But we have only a very limited understanding if there are five big competitors.

This is only about the relatively simple analysis of a market. Add in the other dimensions of the world economic order – cultural, military and political for a starter – and you get a very complicated story. In my more gloomy moments I think it would be a better world order if China – or any one of the five – was the effective hegemon, but that is not how it is going to be.

And this is all going on while half the world – at least – is struggling with the long recession which follows the Global Financial Crisis. But hegemony transition and the crisis are not independent. The GFC is a consequence of the fading hegemony of the US, and it is also accelerating that fading hegemony. The Chinese say ‘may you live in interesting times’. Perhaps not quite this interesting.

CHINA AND THE GLOBAL FINANCIAL CRISIS