China and the U.S.: Who’s Subsidizing Whom?
Which side benefits most from the U.S.-China economic relationship?
December 19, 2006
The offensive passage in the written version of the Bernanke speech as part of the newly instituted Strategic Dialogue discussions between China and the United States was the assertion that the current value of the Chinese renminbi is an "…effective subsidy that an undervalued currency provides for Chinese firms that focus on exporting rather than producing for the domestic market."
The use of the word "subsidy" is a highly inflammatory accusation — in effect, putting the Chinese on notice that America's most important macro policy maker believes that renminbi currency policy provides the Chinese with an unfair advantage in the world trade arena that fosters distortions in China's economy, the U.S. economy and the broader global economy.
In my view, this is a very biased assessment of the state of Chinese currency policy and reforms. It pays little attention to the context in which renminbi policies are being formulated and, ironically, fails to provide any appreciation for the benefits that accrue to America as a result of this so-called subsidy.
Moreover, Bernanke's spin continues to downplay the role that the United States is playing in creating its bilateral imbalance with China — to say nothing of the role the United States is playing in fostering broader imbalances in the global economy.
The real question in all this is, Who's subsidizing whom? Conveniently overlooked in the Bernanke critique is an important flip side to the "managed float" that continues to drive renminbi policy — China's massive purchases of dollar-denominated assets.
The exact numbers are closely held, but there is close agreement that between 60-70% of China's $1 trillion in official foreign exchange reserves are split between some $345 billion invested in U.S. Treasuries (as of October 2006, according to the U.S. government's TIC reporting system) and a comparable amount held in the form of other dollar-based fixed income instruments.
With Chinese reserve accumulation now running at over a $200 billion annual rate, that implies new purchases of dollar-denominated assets of at least $120 billion per year.
Such foreign demand for U.S. financial assets is absolutely critical in plugging the funding gap brought about by an unprecedented shortfall of domestic saving — a net national saving rate that fell to a record low of just 0.1% of U.S. national income in 2005.
Without China's purchases of dollar-based assets — a key element of its efforts to mange the renminbi in accordance with its financial stability objectives — the dollar would undoubtedly be lower and U.S. interest rates would be higher.
In effect, that means China is subsidizing U.S. interest rates — providing American borrowers and investors with cut-rate financing and rich valuations that otherwise would not exist were it not for the dollar-recycling aspects of Chinese currency policy.
There is an added element of China's subsidy to the United States. As a low-cost and increasingly high-quality producer, China is, in effect, also providing a subsidy to the purchasing power of U.S. households. Close down trade with China — as many in the U.S. Congress wish to do — and the deficit would show up somewhere else, undoubtedly with a higher-cost producer.
That would be the functional equivalent of a tax hike on the U.S. consumer — cutting into the subsidy the United States currently enjoys by trading with China.
The Fed Chairman is making a similar suggestion: By allowing the renminbi to strengthen, China's dollar buying would diminish — effectively eroding the interest rate and purchasing power subsidies that a saving-short and increasingly asset-dependent U.S. economy has come to rely on.
We can debate endlessly the appropriate valuation of the Chinese currency. Economic theory strongly suggests that economies with large current account surpluses typically have under-valued currencies. China would obviously qualify in that regard — as would, of course, Japan, Germany and many Middle East oil producers.
The fact that China is being singled out for special attention is, in and of itself, an interesting comment on the biases in the international community. Nevertheless, it is quite clear that China understands this aspect of the problem.
By shifting to a new currency regime 17 months ago, Chinese policymakers explicitly acknowledged the need for more of a market-based foreign exchange mechanism. The renminbi has since risen about 6% against the dollar — not nearly as much as many U.S. politicians are clamoring for, but at least a move in the right direction.
Risk-averse Chinese policymakers feel strongly about managing any currency appreciation carefully — understandable, in my view, given the still relatively undeveloped state of China's highly fragmented banking system and capital markets.
The potential currency volatility that a fully flexible foreign exchange mechanism might produce could have a very destabilizing impact on an undeveloped Chinese financial system. And that's the very last thing China wants or needs.
The Fed Chairman is offering advice as if China were a fully functioning market-based system — perfectly capable of achieving policy traction with the traditional instruments of monetary and currency policies. Nothing could be further from the truth for today's Chinese economy.
This is not the first time Ben Bernanke has assessed an international financial problem with such one-handed analysis. In his earlier capacity as a governor of the Federal Reserve Board and then as the Chairman of President Bush's Council of Economic Advisers, he led the charge in pinning the problem of mounting global imbalances on the so-called "saving glut" thesis.
In effect, Ben Bernanke argued that the United States was doing the rest of the world a huge favor by consuming an inordinate surplus of saving (see Bernanke's March 10, 2005 speech, "The Global Saving Glut and the U.S. Current Account Deficit," available on the Fed's website).
While a most convenient argument from the Bush Administration's standpoint, it downplayed America's role in fostering the problem — unchecked structural budget deficits and a plunge in the income-based saving rate of U.S. households.
Lacking in domestic saving, the United States must import surplus saving from abroad in order to grow — and run massive current account and trade deficits in order to attract the capital. This is quite germane to the debate over China. As noted above, the Chinese have emerged as important providers of saving for a saving-short U.S. economy.
The scapegoating of China remains a most unfortunate feature of the global climate. U.S. politicians want to pin the blame on China for America's trade deficits and pressures bearing down on U.S. workers. Now Ben Bernanke piles on by accusing China of using its macro policies as de facto export subsidies.
Sure, China could do better on trade policy — especially in the all-important area of protecting intellectual property rights. But I think the world can also expect more of the global leader — like facing up to a very serious and potentially destabilizing saving shortfall that requires the rest of the world, including China, to subsidize its own profligate ways.
The longer the United States frames this debate in such a biased and one-sided fashion, the more difficult it will be for others in the world, like China, to accept a face-saving compromise.
Stephen S. Roach
Former Non-Executive Chairman of Morgan Stanley Asia Stephen S. Roach is a senior fellow at the Jackson Institute for Global Affairs, Yale University, and a member of the Yale School of Management faculty. He was previously the Non-Executive Chairman of Morgan Stanley Asia (a position he held after serving as managing director and chief economist […]