Fenil's Library

“At times, I wonder if we analyse too much. Or is it that we are where we are because that’s where we are meant to be?” she asked. 

“Have you lost your job?” I shot back, eager to stop the wave of philosophical mumbo-jumbo that threatened to break on me .

“Not yet, but I can’t help pondering these days. Times are getting so difficult.” 

“Did you read the newspapers today? Zhou Xiaochuan, the governor of the People’s Bank of China (the Chinese equivalent of the Reserve Bank of India) has written in an essay that the world needs a new global currency. Though he hasn’t mentioned the dollar directly, that is what he has hinted at. In fact, just two weeks back, Wen Jiabo, the Chinese Prime Minister, said China had lent a huge amount of money to the United States and was concerned about the safety of its assets. “To be honest, I am definitely a little worried. I request the US to maintain its good credit, to honour its promises and to guarantee the safety of China’s assets,” said Jiabo.”

“But how is this linked to the current crisis?” she asked.

“Well, China has foreign exchange reserves worth nearly $2 trillion. Of this, an estimated $1.7 trillion has been invested in US dollar assets. To give you a breakdown, around $900 billion has been invested in financial securities issued by the US government, $550 billion to buy mortgage backed securities issued by the likes of Fannie Mae and Freddie Mac, $150 billion in financial securities issued by companies in the US and the remaining $100 billion in shares and short term deposits.” 

“So?” 

“So! Almost 85% of China’s foreign exchange reserves of $2 trillion is invested in the US. The two economies are highly interlinked. So, it is in China’s interest to see that the US dollar continues to be a strong currency. Instead, we see that its leaders are crying it down. Isn’t that something?”

“Maybe. Can we have some detail?” 

“Sure. See, over the years, the US has been the biggest importer in the world. And the goods and services it has been importing have benefited countries like China. China earned dollars for its exports. These dollars found their way back into the US. As I said earlier, the Chinese invested these dollars to buy various kinds of financial securities issued in the US. So, basically, the Chinese were lending money to the US. The money lent was used by US citizens to continue buying goods and services from China. And so the cycle worked — the US shopped, China earned, China invested back in the US, the US borrowed, the US spent, and China earned again. It’s a classic case of ‘you scratch my back and I will scratch yours’.”

“But has the cycle stopped working?” 

“Yes, by and large, and for the simple reason that Americans have stopped buying and as a result, Chinese exports have crashed. In February, Chinese exports fell nearly 26% from a year earlier. As a result, there have been massive job losses as well. Estimates suggest that nearly two crore people have lost their jobs. As Hillary Clinton, the US secretary of state said recently, “It would not be in China’s interest if we were unable to get our economy moving. Our economies are so intertwined.” Think of it, as long as the US keeps importing, China keeps chugging along nicely.” 

“I get you, but I’m sure the Chinese know all that. Why then are they making those statements?” 

“Well, because the Americans have been on a massive dollar-printing spree. Excessive currency printing leads to a currency losing value. And if the dollar loses value, who loses the most but the people who have their investments in financial securities quoted in dollars? According to an estimate by Merrill Lynch, investors in securities issued by the US government have lost an average 2.7% in 2009. That’s why they want the US to go a little slow on printing dollars.” 

“Does that mean China will stop buying financial securities issued by the US?” 

“I hope not. If China doesn’t buy these securities, the US will have to print more dollars in its attempt to rescue its financial institutions and get consumers to start spending again. That would only send the dollar value down further. And the Chinese can’t get out of these securities by selling them either, for then, the prices of these securities will crash and China’s own investments will suffer. It would be like shooting themselves in the foot. What’s worse, as exports to the US slow down, the Chinese will have lesser number of dollars to keep buying securities issued by the US government. And that may lead to the US printing more dollars. So there, the Chinese are stuck.” 

“But isn’t there a way out? Some people say Chinese consumption will save the world.” 

“I wish it was as simple as that. In fact, the Chinese government has also started printing money in the hope that people will spend and that will keep the economy growing at rates seen in the past. Chinese banks have lent 4.9 trillion yuan of new loans in the first two months of 2009, an increase of 35% year on year. But for the trend to sustain, the whole structure of the Chinese economy has to change from one focused on exports to one driven by domestic consumption. More importantly, China has been a country of savers, and it cannot be turned into a country of spenders overnight.” 

“What do you mean?” 

“I will give you an example from a recent article in The Financial Times. The article was on a violin factory, which made a third of the world’s violins. Almost all of these violins were exported. The factory would have continued to do well if the Chinese were to buy all the violins produced. But they are not. The factory can start producing something like furniture, which the Chinese would be interested in buying. But the changeover will take time because you would need to retrain workers, develop new distribution systems and so on.” 

“The hope is that Chinese consumption will revive global demand for commodities and lift the world out of recession. But that is a very simplistic argument. Much as people assume it would, China’s dependence on the US consumer won’t go overnight, though when it does, China won’t need to continue buying US financial securities.” 

“We live in interesting times,” she said. “Doesn’t that call for a cup of coffee?” 

k_vivek@dnaindia.net 

(The example is hypothetical)

References: The Three Ways China May Deal With Growing US Debt, By William Patalon III and Jason Simpkins, www.moneymorning.com,March 25,2009; China announces stimulus plan,By Chuck Butler, www.dailyrecokning.com,March 5,2009; Central Banks Unleash NuclearOption, Gary Dorsch, www.safehaven.com,March 19, 2009; China - The Great Red Hope,Bill Bonner, www.dailyreckoning.com,March 12, 2009.