The $1.4 Trillion Question

>> Sunday, January 13, 2008

An excellent article from The Atlantic on Chinese investments into the U.S. economy:

Let’s say you buy an Oral-B electric toothbrush for $30 at a CVS in the United States. I choose this example because I’ve seen a factory in China that probably made the toothbrush. Most of that $30 stays in America, with CVS, the distributors, and Oral-B itself. Eventually $3 or so—an average percentage for small consumer goods—makes its way back to southern China.

When the factory originally placed its bid for Oral-B’s business, it stated the price in dollars: X million toothbrushes for Y dollars each. But the Chinese manufacturer can’t use the dollars directly. It needs RMB—to pay the workers their 1,200-RMB ($160) monthly salary, to buy supplies from other factories in China, to pay its taxes. So it takes the dollars to the local commercial bank—let’s say the Shenzhen Development Bank. After showing receipts or waybills to prove that it earned the dollars in genuine trade, not as speculative inflow, the factory trades them for RMB.

This is where the first controls kick in. In other major countries, the counterparts to the Shenzhen Development Bank can decide for themselves what to do with the dollars they take in. Trade them for euros or yen on the foreign-exchange market? Invest them directly in America? Issue dollar loans? Whatever they think will bring the highest return. But under China’s “surrender requirements,” Chinese banks can’t do those things. They must treat the dollars, in effect, as contraband, and turn most or all of them (instructions vary from time to time) over to China’s equivalent of the Federal Reserve Bank, the People’s Bank of China, for RMB at whatever is the official rate of exchange.

With thousands of transactions per day, the dollars pile up like crazy at the PBOC. More precisely, by more than a billion dollars per day. They pile up even faster than the trade surplus with America would indicate, because customers in many other countries settle their accounts in dollars, too.

The PBOC must do something with that money, and current Chinese doctrine allows it only one option: to give the dollars to another arm of the central government, the State Administration for Foreign Exchange. It is then SAFE’s job to figure out where to park the dollars for the best return: so much in U.S. stocks, so much shifted to euros, and the great majority left in the boring safety of U.S. Treasury notes.

And thus our dollar comes back home. Spent at CVS, passed to Oral-B, paid to the factory in southern China, traded for RMB at the Shenzhen bank, “surrendered” to the PBOC, passed to SAFE for investment, and then bid at auction for Treasury notes, it is ready to be reinjected into the U.S. money supply and spent again—ideally on Chinese-made goods.

At no point did an ordinary Chinese person decide to send so much money to America. In fact, at no point was most of this money at his or her disposal at all. These are in effect enforced savings, which are the result of the two huge and fundamental choices made by the central government.

One is to dictate the RMB’s value relative to other currencies, rather than allow it to be set by forces of supply and demand, as are the values of the dollar, euro, pound, etc. The obvious reason for doing this is to keep Chinese-made products cheap, so Chinese factories will stay busy. This is what Americans have in mind when they complain that the Chinese government is rigging the world currency markets. And there are numerous less obvious reasons. The very act of managing a currency’s value may be a more important distorting factor than the exact rate at which it is set. As for the rate—the subject of much U.S. lecturing—given the huge difference in living standards between China and the United States, even a big rise in the RMB’s value would leave China with a price advantage over manufacturers elsewhere. (If the RMB doubled against the dollar, a factory worker might go from earning $160 per month to $320—not enough to send many jobs back to America, though enough to hurt China’s export economy.) Once a government decides to thwart the market-driven exchange rate of its currency, it must control countless other aspects of its financial system, through instruments like surrender requirements and the equally ominous-sounding “sterilization bonds” (a way of keeping foreign-currency swaps from creating inflation, as they otherwise could).

These and similar tools are the way China’s government imposes an unbelievably high savings rate on its people. The result, while very complicated, is to keep the buying power earned through China’s exports out of the hands of Chinese consumers as a whole. Individual Chinese people have certainly gotten their hands on a lot of buying power, notably the billionaire entrepreneurs who have attracted the world’s attention (see “Mr. Zhang Builds His Dream Town,” March 2007). But when it comes to amassing international reserves, what matters is that China as a whole spends so little of what it earns, even as some Chinese people spend a lot.

The other major decision is not to use more money to address China’s needs directly—by building schools and agricultural research labs, cleaning up toxic waste, what have you. Both decisions stem from the central government’s vision of what is necessary to keep China on its unprecedented path of growth. The government doesn’t want to let the market set the value of the RMB, because it thinks that would disrupt the constant growth and the course it has carefully and expensively set for the factory-export economy. In the short run, it worries that the RMB’s value against the dollar and the euro would soar, pricing some factories in “expensive” places such as Shanghai out of business. In the long run, it views an unstable currency as a nuisance in itself, since currency fluctuation makes everything about business with the outside world more complicated. Companies have a harder time predicting overseas revenues, negotiating contracts, luring foreign investors, or predicting the costs of fuel, component parts, and other imported goods.

And the government doesn’t want to increase domestic spending dramatically, because it fears that improving average living conditions could paradoxically intensify the rich-poor tensions that are China’s major social problem. The country is already covered with bulldozers, wrecking balls, and construction cranes, all to keep the manufacturing machine steaming ahead. Trying to build anything more at the moment—sewage-treatment plants, for a start, which would mean a better life for its own people, or smokestack scrubbers and related “clean” technology, which would start to address the world pollution for which China is increasingly held responsible—would likely just drive prices up, intensifying inflation and thus reducing the already minimal purchasing power of most workers. Food prices have been rising so fast that they have led to riots. In November, a large Carre­four grocery in Chong­qing offered a limited-time sale of vegetable oil, at 20 percent (11 RMB, or $1.48) off the normal price per bottle. Three people were killed and 31 injured in a stampede toward the shelves.

This is the bargain China has made—rather, the one its leaders have imposed on its people. They’ll keep creating new factory jobs, and thus reduce China’s own social tensions and create opportunities for its rural poor. The Chinese will live better year by year, though not as well as they could. And they’ll be protected from the risk of potentially catastrophic hyperinflation, which might undo what the nation’s decades of growth have built. In exchange, the government will hold much of the nation’s wealth in paper assets in the United States, thereby preventing a run on the dollar, shoring up relations between China and America, and sluicing enough cash back into Americans’ hands to let the spending go on.

An arrangement that most likely will change to some degree in the next ten years.


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