Yuan to talk Chinese savings?

By Phil Levy

Tom Friedman tries to make the case for China as a juggernaut in today’s New York Times in a piece entitled "Is China the Next Enron?" Not to worry, he writes:

[China] has a political class focused on addressing its real problems, as well as a mountain of savings with which to do so (unlike us)… Think about all the hype, all the words, that have been written about China’s economic development since 1979. It’s a lot, right? What if I told you this: "It may be that we haven’t seen anything yet."’

There are a lot of factors that determine the fate of a country with over 1.3 billion people. Let’s just focus on the question of savings, though, since it is central to Friedman’s case and he has raised a basic fallacy that often drives China discussions.

The mountain of savings is China’s accumulated foreign exchange reserves. Friedman facetiously offers up this wisdom:

…a simple rule of investing that has always served me well: Never short a country with $2 trillion in foreign currency reserves."

As he well knows, China’s massive reserves are unprecedented. They may also now surpass $2.4 trillion. 

This image of a dragon sitting atop a hoard of gold colors a number of international policy discussions. It was central to the debate at Copenhagen, in December, when China led the developing world in asking for compensation from the West for policies to cut greenhouse gas emissions. This seemed risible to Western nations swimming in debt and trade deficits.

China’s stock response is that it’s a poor country. Just how poor depends on how you deal with China’s misaligned exchange rate, but the numbers for 2008 range from about $3,000 to $6,000 annual income per person. That compares with roughly $47,000 per person for the United States.

What about the $2.4 trillion pile of foreign reserve lucre? That comes with some serious strings attached. First, if you just divvied it up among the 1.3 billion Chinese, it would give a one-time income boost of less than $2,000 a person. That would make for a prosperous year, but it wouldn’t put China into the league tables of high income countries, and it’s not a gift that could keep on giving.

The bigger problem for China is that these are not all-purpose savings; they are foreign reserves, bonds in dollars and euros and yen. If they are to be spent on projects in China, they need to be converted into Chinese currency, the RMB. Doing so would have two potentially dramatic effects. It could drive down the global value of government bonds and it would drive up the RMB. Consider each problem in turn.

It’s not easy to extricate yourself financially from a $2.4 trillion position. Once you start to sell, other traders will notice. They will anticipate falling bond prices and they will try to get out while they can. That pushes prices down even further. This would come at a time when the supply of bonds is enormous, as Western governments finance swollen deficits. This is the nightmare scenario that fiscal conservatives in the United States have been worrying about, since the flip side of lower bond prices is higher interest rates. But it’s also worrisome for the Chinese, since their $2.4 trillion on paper could amount to substantially less when they try to sell it.

For China, the value of the holdings depends not only on the foreign currency price at which it could sell its bonds, but the exchange rate at which the money gets converted to RMB. This was behind Chinese expressions of concern last year, in which they sought American "guarantees" of the value of their U.S. holdings (guarantees which the United States could not possibly provide).

If China were to tap its reserves to address domestic problems, it would inevitably push up the value of the RMB. That certainly needs to happen at some point, since accumulating even more reserves just exacerbates these problems. But the Chinese have been terrified of the implications and have stalled all progress on currency appreciation since mid-2008. A stronger RMB would mean the demise of many low-margin export-oriented businesses in China that have been a disproportionate source of employment. China does not have the flexible financial system to quickly shift all these unemployed workers into new endeavors. Millions of unemployed workers marching through the streets of southern China is the CCP’s nightmare scenario.

So China is left with a needy, aging population and a growing pile of paper wealth that is exceedingly hard to use.

Friedman concludes that China is not the next Enron. Just look at its account statement; everything’s fine. Perhaps we need to delve a bit deeper into the lessons of that experience.