Sept. 4, 2006 issue - Sometime over the next few weeks, a shipment of lawn furniture, brake pads, lamps or the like is going to make history. The manufacturer, one among tens of thousands churning out product 24/7 in China's humming coast-al cities, will fill an order bound for the United States, take payment in American dollars and add a 12th zero to Beijing's foreign reserve—pushing the tally over the $1 trillion mark. Neither buyer nor seller will realize the transaction's significance, and barring an unforeseen shock to the global trading system, China's reserve will continue to rise by roughly $17 billion a month.
Beijing's growing dollar hoard represents the most dangerous imbalance in today's global economy. The United States is both importing heavily from China and borrowing heavily from the country to finance those purchases, pushing the dollar down and putting the two economic superpowers on a collision course.
Washington politicians demand that Beijing raise the value of the yuan against the dollar, and Chinese officials have hinted that if pushed too hard they might shift their near-trillion-dollar reserve out of U.S. Treasury bonds, which could trigger a U.S. --and global-- recession.
The main thing preventing this confrontation is the fact that both sides have too much to lose. Former U.S. Treasury secretary Lawrence Summers once called this "the balance of financial terror." What has gone widely unremarked is that, increasingly, this balance is threatening China as much as the United States.
The United States has been worrying for the past 25 years about a mounting trade deficit and the threat it poses to America's financial pre-eminence. But China now views its surplus with growing alarm, too. Its dollar mountain reflects huge demand for Chinese goods and the Chinese currency needed to buy those goods. In mid-2005, Chinese officials, under intense pressure, did allow the renminbi to rise slightly, by just over 2 percent, but they fear—with some reason—that to go further could undermine their export competitiveness and lead to bankruptcies. Speculators, however, are betting that China will have no choice.
The global market assumption that the renminbi is destined to rise is now "the key problem" for China's economy, warned the head of the National Bureau of Statistics, Qiu Xiaohua, last week. "It is fair to say that China is actually fighting a game against worldwide speculative capital ... If not handled properly, this will damage the national interest and endanger economic security."
In an economy that, for all its might, is still in the developing stage, it is no small trick to absorb $17 billion a month without destabilizing consequences. The cash is leaching into the economy, fueling growth of 11.3 percent in the second quarter, the fastest rate since 1994, threatening a meltdown. And every solution begets new problems: China has tried command economics, like simply ordering banks to grant fewer loans or publicly denouncing provincial officials who spend too recklessly, but that undermines its efforts to reform the banking sector using the market. It has tried raising interest rates, which can restrain growth but also attracts more dollars—from investors seeking returns, not import buyers—and weakens domestic demand.
"They're in a trap," says Ronald McKinnon, a Stanford University economist, in reference to China's surging exports and undervalued currency. "And there isn't an easy way out."
Beijing works hard to dampen or "sterilize" the impact of the incoming dollars on the domestic economy. To do this, the People's Bank of China (the central bank) buys dollars from commercial banks for renminbi-denominated bonds, then limits how much the banks can lend. Yet it's no coincidence, economists say, that investments in fixed assets, from roads to real estate, have shot up in tandem with the foreign-currency reserve since 2000.
"This will be the sixth successive year in which investment rises more rapidly than the underlying economy," says Nicholas Lardy, a senior fellow at the Institute for International Economics in Washington. "Not a sustainable recipe for growth."
Another embarrassment of China's rising fortune is that it has begun to undermine financial reforms launched a decade earlier. To make banks more market-oriented, Beijing has discouraged politically motivated lending to debt-laden state enterprises, welcomed minority foreign partners and made bank chiefs accountable for their profits and losses. Yet the People's Bank also undercuts those profits when it forces banks to help sterilize dollars by buying low-interest renminbi-denominated bonds. Regulators also set real interest rates artificially low (currently under 3 percent) to deter the "hot money" betting on a yuan revaluation, but that cheap money flows into new factories and property developments. "Wholly or partially state-owned enterprises continue to receive most of the funding," says a new study by McKinsey & Co., noting that the pattern "not only explains the large volume of nonperforming loans in China's banking system but also decreases the economy's overall productivity."
Beijing is justifiably worried that any significant rise in the value of its currency could create psychological momentum for more appreciation. "The more people buy into the argument, the worse it gets," says Nicholas Kwan, regional head of economic research at Standard Chartered Bank in Hong Kong. "By the time [the renminbi] reaches the point where everyone thinks it has risen enough, they're in big trouble." But the longer Beijing keeps its currency artificially low, argues Lardy, the more capital will be misallocated into marginal investments, the slower banking reforms will progress and the costlier the bill for nonperforming loans in the financial system will ultimately be. Lardy figures (conservatively) that the renminbi is undervalued by about 15 percent, and says that if the currency were actually allowed to rise that much, many of the investments now being made in China would be pushed into the red.
Why not simply spend the dollar reserve? That's what Japan did in the '80s and early '90s, when its export surplus was mounting and its top corporations and tycoons bought everything from Hollywood studios to impressionist masterpieces. Indeed, Chinese experts are mulling spending ideas, mostly of a far less glamorous sort, from building a strategic petroleum reserve at a cost of $30 billion to forming a Chinese Peace Corps, with thousands of humanitarian workers. But none of that, economists say, is enough to significantly slow the growth of China's foreign reserves. "The problem with these ideas is that you can't actually spend much money on them," says Stephen Green, head economist for Standard Chartered in Shanghai. "They don't have many choices."
Still, China is trying to spend down at least some of its trade surplus by investing abroad. Beijing's model here is Singapore, which spends its own huge trade surplus (in excess of 10 percent of GDP) on things like telecoms and ports abroad, says Kwan. "The Singaporean way is not to hold too many T-bills, but to buy stock in Microsoft or banks in Indonesia." Now Beijing is encouraging Chinese insurance companies and pension funds to invest $8.3 billion in foreign bonds and securities, and urging others to buy up strategic raw materials, particularly petroleum reserves, in places like Africa.
The catch here is that, as an emerging giant, China can't fly under the global radar like tiny Singapore. Witness what happened when Chinese oil giant CNOOC tried to buy Unocal last year, only to be run off by U.S. congressional opposition. This kind of backlash against Chinese acquisitions is likely to rear its head again, even though it offers a solution to today's huge trade imbalance.
So China continues to park the bulk of its reserve in U.S. Treasury bills, the bonds in which creditors hold most of America's huge public debt. China now owns some $330 billion worth, second only to Japan's $640 billion. Thus China fuels American consumption, not the emergence of a Chinese consumer market that could drive long-term growth.
The roots of this contradiction go back to the early 1980s and the start of reform in China, when the late patriarch Deng Xiaoping opened the manufacturing sector, but not the banks, to foreign investors. The good news was that the closed system inoculated China against the rush of global capital that toppled banks across Asia in the crisis of 1997-98. The bad news: banks had no competitive incentive to learn proper risk management, or to introduce modern retail banking or consumer lending. Now the system is such a mess that China fears to open it. And it sits on a huge pile of idle dollars that its own banks are unable to employ fully at home.
All of which speaks to a fundamental dilemma: who wants to be a trillionaire? China does, for sure, but it is also increasingly aware of the burdens of wealth.
