Current Global Crisis - The Role of United States and China

The United States and China are locked together in an interdependent relationship. A lot of the blame on the current financial crisis has been put on China. The reason why China is being blamed for the financial imbalance is China’s policy of manipulating the exchange rate to accumulate a gigantic current account surplus. However, the author feels that the source of imbalance is United States which has been spending beyond its means for a very long time. The main question that the current financial crisis has posed to the world is how long the rest of the world can fund the huge current accounts deficit of the United States.

Throughout the whole of 1990s the US current account deficit was increasing. The huge current deficit is sustainable only if asset appreciation keeps pace with interest rates. In the year 2001 there was the stock market bubble and the US adopted expansionary fiscal policy which led to a large US deficit. The external borrowing of the US ballooned and China started purchasing securities. This was largely misinterpreted as Chinese saving but actually US was stoking the increase in Chinese savings.

The total stock of foreign exchange held by all the developing countries in the year 2009 was 45.3 trillion. The foreign exchange reserves held by Africa has also been increasing rapidly (roughly $ 2.8 trillion). The huge current account surplus of China and consequent the global savings glut does not make sense because increase in savings in East Asia must necessarily be balanced by reduced by reduced savings in other parts of the world, say United States. This is easily proved by the fact that global savings as a proportion of global income has remained stable at 22.7%

The source of US deficit lies in the huge expenditure of the US. In the United States private spending was replaced with government deficit. In the year 2000 the US deficit was 12.5 % of GDP according to an estimate by IMF. Such a huge government deficit leads to a large current account deficit. One alternative in this scenario could have been devaluation of the dollar which would have made exports cheaper and reduced the current account deficit. The problem with this strategy is that if the dollar is devalued then the Middle Eastern countries and other countries which hold huge dollar reserves suffer huge losses. The US is thus able to continue borrowing in its own currency by printing dollars while all countries will suffer loss of asset value.

There was a secular decline in the dollar from 2002 to mid 2008. The phenomenon of depreciation of the dollar during 2002 to mid 2008 coincided with the ballooning of the US current account deficit. Therefore, the situation was getting worse when the dollar was depreciating. A curious development in mid 2008 was the appreciation of the dollar before the impending crisis. The dollar depreciated again very recently.
The problem facing the United States and China and the world in general is that the dollar needs to depreciate to reduce the global imbalances. However, the reserve currency status of the dollar impedes this adjustment. If China reduces its holdings of treasury securities and the US dollar depreciated then the situation becomes more dangerous.

China has been a high saving labour surplus economy. Therefore, to increase its productivity it has kept an unduly high investment rate. In the current fiscal China has invested 50% of its GDP and designs to continue with high rates of investment. China is in a comfortable position to increase global demand by increasing its domestic demand. The rate of growth of domestic consumption in China is 9% while the rate of growth of domestic investment is 14.8%. However, it does not make sense for China to strive for a consumption led growth. China will continue to rely on the policy of increasing its exports as an engine for increasing productivity and growth. The problem is that in a more diversified market China needs to shift from pegging the renminbi to a basket of other currencies. Presently 16% of Chinese exports are to the US. China should continue to manage the exchange rate but as the exports to US decline China should peg the value of the renminbi to a basket of currencies. It is more lucrative for China to peg its currency against the dollar because otherwise the book value of the dollar denominated assets will depreciate with the depreciation of the dollar.

The problem with the Chinese export led model is that in the present scenario the US dollar is not a reliable store of value. The impending depreciation of the dollar raises the question of how dollar can remain the prime currency. The large and increasing current account deficit of the United States along with counter cyclical monetary and fiscal policy of the US government only reduce the problem to how gradually the US dollar depreciates. Amidst such an inherently unstable global order any threat of withdrawal of Chinese dollar denominated investments will add to the instability.