Forced rebalancing

It’s not clear that there’s much useful to be blogged about from a distance on the catastrophes in China and Burma.   But one difference from the past is that the population scale of Asia relative to the rest of the world is now matched by its economic influence.  In past decades, 6 figure death tolls were something one would read about and try to grasp the misery, but never see any impact on people not directly affected.  Not now.  Even isolated and shunned Burma is an important player in the world rice market but that pales in comparison to China.  One aspect of the Chinese disaster is highlighted by a dreadfully timed report from the US Treasury on its exchange rate policy.

This is an analysis required by US law to determine whether various countries are using their exchange rates as instruments of trade policy and therefore could be subject to retaliatory measures: if the currency is deliberately undervalued to make exports more competitive, the US could in principle try to use tariffs or quotas as a compensating measure.  While various countries are covered by the Treasury analysis, the main target is always China, and here’s the summary of their analysis

China’s economic imbalances — domestic and external — continue to increase. Inflation has risen above 8 percent, which may be in part due to excessive creation of liquidity in view of China’s rigid management of the renminbi (RMB). China’s current account surplus increased by an estimated $111 billion in 2007 and is now roughly 11 percent of GDP. Official reserves increased by $462 billion in 2007 and by an additional $154 billion in the first quarter of 2008.

To address these challenges, China needs to intensify its efforts to rebalance its economy: boosting domestic demand and consumption-led growth; reforming its financial system; and achieving greater monetary policy autonomy through rapid RMB appreciation and greater flexibility of the foreign exchange regime.

Hence, Chinese exchange rate practices justifiably remain a focal point for the international community. The appreciation of the RMB increased against the U.S. dollar in the latter half of 2007 and early months of 2008 … On balance, while the recent accelerated appreciation of the RMB against the dollar is welcome, the pace of appreciation needs to continue in order to address the continuing substantial undervaluation of the RMB and the risks China is creating for itself, the Asian region, and the world economy in which China is playing a greater role. Treasury has been reinforcing that message to Chinese authorities on a frequent basis both bilaterally and multilaterally and will continue to do so.

In essence, calling for China to boost domestic expenditure and let its currency appreciate more than it has.  The reason why its awkward timing: the earthquake will do that automatically.  The government will have to undertake a massive reconstruction program in Sichuan, and not just rebuilding what was there before, but enough to convince the interior that the country is not run for the benefit of the coastal agglomerations, something that was already a sore point long before the earthquake.

China had been speaking of undertaking major global investments through its sovereign wealth fund (for which Gordon Brown had been actively campaigning to place its investment HQ in London), but how would the government justify any large overseas investment now with such transparently unmet needs back home?

Anyway, the global effect of all this will be a major redirection of Chinese savings towards domestic investment and so smaller current account surpluses, a reduced pool of global savings (for which the US was the main borrower), and an increase in global interest rates.  One geopolitical side effect: the relative power of the Arab wealth funds, the other major source of global capital outflows, will increase.  The short version for the US: be careful for what you wish for.  China spending more of its money at home may not be exactly what the US wanted.  At least not now.