The second area of concern as I see it is the balance sheet implications of this relationship, and it is the national balance sheet that determines how a country reacts to shocks and how financial shocks are transmitted into the real economy. From the Chinese point of view, the balance sheet consequences are complex, and not very good in my opinion. At first everything seems rosy -- the Chinese are accumulating huge amounts of reserves, with little external debt, so they are absolutely protected from the possibility of a financial crisis, right?
Wrong. We make a serious mistake when we assume that crises are, by definition, currency or external debt crises. Some are, most aren't. In the 19th century the US had a whole series of financial crisies -- one nearly every ten or fifteen years -- but none of them involved external debt to a significant extent except perhaps in 1837, and all of them, including the 1837 crisis, were primarily caused by breakdowns in the domestic financial system.
This is where China is running a significant risk. China's brutally mercantilist trade policies coupled with its rigid currency regime may be condemning it to a sharp increase in non-performing loans, industrial overcapacity, and rising (hidden) government debt. This creates all the classic balance sheet vulnerabilities. A sufficiently large adverse shock could quickly lead to an unravelling of the national financial system, which is very fragile and is completely dominated by rigidly managed banks with little transparency, weak governance, and almost no experience in risk management.
Analysts who point to China's huge reserves as proof that it can buy its way out of a crisis simply do not get it. A domestic financial crisis cannot be fixed with foreign currency reserves. Aside from the fact that foreign currency cannot be spent domestically, these reserves are the asset side of the PBoC balance sheet, and they are balanced by domestic borrowings. Any spending of reserves would result in a net increase in PBoC debt. Since a domestic crisis will almost certainly involve concerns about excess government debt levels (which I suspect are already much higher than most of us realize), it is unlikely that they can spend themselves out of a crisis because that will mean increasing total debt.
If you need more convincing that record levels of central bank reserves are not the obvious antidote to financial crisis, consider the US in 1929. Several year of massive trade surpluses and capital inflows -- turning it into the world's leading creditor nation and leading it to accumulate, in Keynes' words, "all the gold in the world" -- were of no avail in protecting it from the Great Depression, which started as a domestic financial crisis (and never involved external debt at all).
If the balance sheet implications for China of the current system are worrisome, the balance sheet implications for the US are less dire. Brad Setser in the same blog entry quotes a statement by Larry Summers in which he says "There is surely something odd about the world’s greatest power being the world’s greatest debtor."
But there is nothing odd about this at all. Any country that acts as a safe haven for foreign savings, or provides great investment opportunities, runs the risk of becoming a net capital importer. Any country that is a net capital importer must run a trade deficit, and if it consistently runs a trade deficit it can become a large net debtor to the rest of the world. Just before WWI, for example, the US was the world's largest debtor nation because for generations European investors were eager to finance US development in order to share financially in the benefits of US growth (and in so doing they forced the US into a trade deficit position for much of its history).
This would be a worry if the accumulation of debt led either to an inability to repay or to balance sheet instabilities that made the US vulnerable to a crisis. Neither is the case. Total external debt may seem like a largish number when compared to GDP, but of course this is the wrong comparison. Either total external debt should be measured against total external and net domestic assets, or net external debt servicing costs should be measured against GDP. I am not sure what the value of total assets is in the US, but I am certain that it completely dwarfs external debt. The World Bank estimates total US wealth as of 2000 to be nearly $150 trillion ("Where is the Wealth of Nations", World Bank: 2006). Similarly, net payments (what Americans pay foreigners on foreign investment in the US minus what foreigners pay Americans for investments abroad) are very low and tiny compared with the ability of the US to finance it.
Moreover the US has a well-structured balance sheet and a very flexible financial system. Unlike many other countries, including China, it's external obligations are mostly structured in what I call in my book "correlated" obligations, such that events that triggered payment difficulties would automatically lessen the burden of those payments. This significantly reduces the possibility of exploding debt that is a fundamental factor in every debt crisis.
If the US were a corporation it would be a triple-A-rated company with the added benefit that it could print the money to pay off most of its obligations if it ever needed to. At any rate if you believe, as I do, that the US trade deficit is not "caused" by excess US consumption (except by definition, of course) but rather by excess foreign investment, it would be hard to imagine that the US faced a financing crisis.
Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is a member of the board of directors of ABC-CA Fund Management Co., a Sino-French joint venture based in Shanghai.
Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. He has also worked as a partner in a merchant banking boutique that specialized in securitizing Latin American assets and at Credit Suisse First Boston, where he headed the emerging markets trading team. Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt.
Pettis is a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. He is the author of several books, including The Volatility Machine: Emerging Economies and the Threat of Financial Collapse (Oxford University Press, 2001). He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University.
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January, 2008
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