|Financial Times; Jul 31, 2003
COMMENT: The Fed is in a dangerous game with China
By Chen Zhao
The Federal Reserve is taking no half measures in its efforts to stimulate
economic recovery in the US. To ward off the spectre of deflation, it is
prepared to generate inflation and reflate the asset bubble.
China is a silent but active partner in the Fed's pump-priming. It would
not be possible for US Treasury bond yields to be at current levels were
China not a willing and able supplier of savings to the US. Combined
annual purchases of Treasury securities from China and Hong Kong have
reached $290bn - more than those by any other creditor nation. Both China
and the US are having fun at this game. The flow of Chinese savings has
enabled Americans to borrow more and spend more. Long- term bond yields
are still very low, in spite of the recent bond market shake-out. The
refinancing boom continues. The collapse in borrowing costs is reviving
China is glad to see Americans going on another shopping spree. Its
factories are cranking up production at an unprecedented pace and capacity
is tightening. China's exports to the US jumped 35 per cent in the first
quarter compared with the first quarter of last year and the trend is
accelerating. The US's bilateral trade deficit with China has reached
$110bn, bigger than with any other country.
In effect, China is trading goods for US paper. The rapid accumulation of
Chinese reserves means the Chinese are buying dollars to keep their own
currency steady. This has allowed US interest rates to remain low, which
in turn has encouraged American consumers to buy more Chinese goods.
This game of "trading goods for paper" creates a hyper-stimulative
environment for both countries' economies - which authorities on both
sides of the Pacific want. The Chinese and US currencies are falling
against the euro, money supply in both economies is going up and interest
rates are low. All of these are powerful stimulants for economic growth
and share prices.
So far there are no signs that the Chinese are about to change course.
Despite intensifying calls to revalue the currency, the authorities
recently increased the value added tax rebate for exporters. The rebate
amounts to a de facto devaluation aimed at providing pre-emptive
protection against a growing number of anti-dumping investigations of
Chinese exports. This action suggests that it is naive to think the
central bank will soon allow the currency to float upwards.
Nevertheless, trading goods for paper works only up to a point. While the
game serves the purposes of Chinese and US policymakers alike, it also
creates enormous economic and financial distortions that are both
self-limiting and self-defeating.
With a collapse in interest rates fuelling consumer spending, it is
conceivable that the US current account deficit will explode upwards.
There is no magic number the current account deficit must reach to signal
an impending crisis - but there has never been a nation that has been able
to increase its reliance on foreign savings without eventually hitting a
In the meantime, China will accumulate inflationary pressure. Its economy
has been booming for some time and foreign exchange intervention has
further fuelled money and credit expansion. China has already climbed out
of deflation, with its consumer price index rising at an annualised rate
of 1 per cent. Granted, this is a very low inflation rate. Still, with
soaring money supply, surging exports, expanding reserves, strengthening
consumer spending and fast growth in property investment, inflation will
When will the party come to an end? When the Chinese have had enough. That
will happen when inflation in China approaches 3-4 per cent - which it
could do within the next six months or so. At that point, the central bank
will be forced to revalue the currency.
Another potentially vicious shakeout in Treasury prices could be the
biggest implication of such a move. Revaluation would be deflationary for
China but inflationary for the US. Whether the Chinese economy could
withstand a higher exchange rate remains to be seen. But revaluation would
definitely help the Fed achieve higher inflation.
A further surge in bond yields could mark the start of the long-foreseen
demise of US consumer spending and damage the US economy. This will
probably be the moment when investors find out whether the game is a boon
for the world economy, or a bane that merely defers another recession and
bear market in stocks.
The writer is chief emerging markets strategist at Bank Credit Analyst