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BW Businessworld

China’s Dollar Dilemma

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When will China realise that it cannot accumulate dollars forever? It already has more than $2 trillion. Do the Chinese really want to be sitting on $4 trillion in another five to 10 years? With the US staring at the long-term costs of the financial bailout, as well as inexorably rising entitlement costs, shouldn't China worry about a repeat of Europe's experience from the 1970s?

During the 1950s and 1960s, Europeans amassed a huge stash of US treasury bills in an effort to maintain fixed exchange-rate pegs, much as China has done today. But the purchasing power of Europe's dollars shrivelled during the 1970s, when the costs of waging the Vietnam war and a surge in oil prices contributed to a calamitous inflation.

Perhaps, the Chinese should not worry. After all, the world leaders who gathered at the G20 summit in Pittsburgh said that they would take every measure to prevent such a thing from happening again. A key pillar of their prevention strategy is to scale back "global imbalances", a euphemism for the huge US trade deficit and the corresponding trade surpluses elsewhere, not least China.

That world leaders recognise global imbalances are a big problem is welcome news. Many economists, including myself, believe that America's thirst for foreign capital to finance its consumption binge played a critical role in the build-up of the crisis. Cheap money from abroad juiced an already fragile financial regulatory structure that needed discipline more than cash.

We have heard leaders — especially from the US — claim that they recognised the problem. In the run-up to the financial crisis, the US external deficit was soaking up almost 70 per cent of the excess funds saved by countries such as China, Japan, Germany, Russia and Saudi Arabia. But rather than taking significant action, the US continued to grease the wheels of its financial sector. The Europeans, who were called on to improve productivity and raise domestic demand, reformed their economies at a glacial pace, while China maintained its export-led growth strategy.

It took the financial crisis to put the brakes on US borrowing train. America's current-account deficit has now shrunk to just 3 per cent of its annual income from 7 per cent a few years ago. But will Americans' newfound moderation last? With the US government tapping financial markets for a whopping 12 per cent of national income (about $1.5 trillion), foreign borrowing would be off the scale, but for a surge in US consumer and corporate savings. For now, America's private sector is running a surplus sufficient to fund about 75 per cent of the government's appetite. But how long will US private sector thrift last?

As the economy normalises, consumption and investment will resume. When they do — and assuming the government does not suddenly tighten its belt — America's appetite for foreign cash will surge again. The US government claims to want to rein in borrowing. But assuming the economy must claw its way out of recession for at least another year or two, it is difficult to see how the government can fulfil its Pittsburgh pledge. Yes, the Federal Reserve could tighten monetary policy. But it will not worry too much about the next crisis when the aftermath of the current one still lingers. In our new book, This Time is Different: Eight Centuries of Financial Folly, Carmen Reinhart and I find that financial crises hold one lesson: their aftereffects have a long tail.

Any real change must come from China, which has the most to lose from a dollar debacle. So far, China has turned to external markets so that exporters can achieve the economies of scale needed to improve quality, and move up the value chain. But there is no reason that Chinese planners cannot follow the same model in reorienting the economy to a more domestic-demand-led growth strategy.

China needs to strengthen its social safety net and to deepen domestic capital markets before consumption can take off. But with consumption accounting for 35 per cent of national income, against 70 per cent in the US, there is vast room to grow. Chinese leaders clearly realise that their hoard of T-Bills is a problem. Otherwise, they would not be calling so publicly for the International Monetary Fund to advance an alternative to the dollar as a global currency. They are right to worry. A dollar crisis is not around the corner, but it is a huge risk over the next five to 10 years. China does not want to be left holding a $4 trillion bag when it happens. It is up to China to take the lead on the post-Pittsburgh agenda.

The author is Professor of Economics and Public Policy at Harvard University, and was chief economist at the IMF.
Copyright: Project Syndicate, 2009.

(This story was published in Businessworld Issue Dated 19-10-2009)