Two Economic Giants Addicted to Credit

NEW YORK, Dec 27 — In March 2005, a low-key Princeton University economist who had become a US Federal Reserve governor devised a novel theory to explain the growing tendency of Americans to borrow from foreigners, particularly the Chinese, to finance their heavy spending.
The problem, he said, was not that Americans spent too much, but that foreigners saved too much. The Chinese had piled up so much in excess savings that they lent money to the United States at low rates, underwriting American consumption.
This colossal credit cycle could not last forever, he said. But in a global economy, the transfer of Chinese money to America was a market phenomenon that would take years, even a decade, to work itself out. For now, he said, ''we probably have little choice except to be patient.''
Today, the dependence of the United States on Chinese money looks less benign. And the economist who proposed the theory, Ben Bernanke, is dealing with the consequences, having been promoted to chairman of the Federal Reserve in 2006, as these cross-border money flows reached stratospheric levels.

In the past decade, China has invested more than US$1 trillion (RM3.6 trillion), mostly earnings from manufacturing exports, in US government bonds and government-backed mortgage debt. That has lowered US interest rates and helped fuel a historic consumption binge and housing bubble.
China, some economists say, lulled American consumers, and their leaders, into complacency about their spendthrift ways.

In hindsight, many economists say, the United States should have recognised that borrowing from abroad for consumption and deficit spending at home was not a formula for economic success. Even as that weakness becomes more widely recognised, however, the United States is likely to be more addicted than ever to foreign creditors, seeking to have them finance record government spending to revive the broken US economy.

To be sure, there were few ready remedies. Some critics argue that the United States could have pushed Beijing harder to abandon its policy of keeping the value of its currency weak — a policy that made its exports less expensive and helped turn it into the world's leading manufacturing power. If China had allowed its currency to float according to market demand over the past decade, its export growth probably would have moderated. And it would not have acquired the same vast hoard of dollars to invest abroad.

Others say the Federal Reserve and the Treasury should have seen the Chinese lending for what it was: a giant stimulus to the US economy, not unlike interest rate cuts by the Federal Reserve. These critics say the Fed under Alan Greenspan contributed to the creation of the housing bubble by leaving interest rates too low for too long, even as Chinese investment further stoked an easy-money economy. The Fed should have cut interest rates less in the middle of this decade, they say, and started raising them sooner, to help reduce speculation in real estate.

Today, with the wreckage around him, Bernanke says he regrets that more was not done to regulate financial institutions and mortgage providers, which might have prevented the flood of investment, including that from China, from being so badly used. But the Federal Reserve's role in regulation is limited to banks. And stricter regulation by itself would not have been enough, he insists.

In Washington, China was treated as a threat by some people, but mostly because it lured away manufacturing jobs. Others argued that heavy Chinese lending to the United States was risky because Chinese leaders could decide to withdraw money at a moment's notice, creating a panicky run on the dollar.
Bernanke viewed such international investment flows through a different lens. He argued that the Chinese invested savings abroad because consumers in China did not have enough confidence to spend. Changing that situation would take years, he said, and did not amount to a pressing problem for the American side.

By itself, money from China is not a bad thing. As US officials like to note, it speaks to the attractiveness of the United States as a destination for foreign investment. In the 19th century, the United States built its railroads with capital borrowed from the British.

In the past decade, China arguably enabled an American boom. Low-cost Chinese goods have helped keep a lid on inflation, while the flood of Chinese investment has helped the government finance mortgages and a public debt of nearly US$11 trillion.

But Americans did not use the lower-cost money afforded by Chinese investment to build a 21st-century equivalent of the railroads.

Instead, the government engaged in a costly war in Iraq, and consumers used loose credit to buy sport utility vehicles and big houses. Banks and investors, eagerly seeking higher interest rates in this easy-money environment, created risky new securities like collateralised debt obligations.

The United States has been here before. In the 1980s, it ran heavy trade deficits with Japan, which recycled some of its trading profits into US government bonds.
At that time, the deficits were viewed as a grave threat to America's economic might. Action took the form of a 1985 agreement known as the Plaza Accord. The world's major economies intervened in currency markets to drive down the value of the dollar and drive up the Japanese yen.

The arrangement did slow the growth of the trade deficit for a time. But economists blamed the sharp revaluation of the yen for halting Japan's rapid growth. The lesson of the Plaza Accord was not lost on the Chinese, who at that time were just emerging as an export power.

China tied itself even more tightly to the United States than Japan had. In 1995, it devalued its currency and set a firm exchange rate of about 8.3 to the dollar, a level that remained fixed for a decade.

During the Asian financial crisis of 1997 and 1998, China clung firmly to its policy, winning praise from the administration of President Bill Clinton for helping to check the spiral of devaluation that was sweeping Asia. Its low wages attracted hundreds of billions of dollars in foreign investment.

By the early part of this decade, the United States was importing huge quantities of Chinese-made goods — toys, shoes, flat-screen televisions, auto parts — while selling much less to China in return.

It did so to protect its own interests. China kept its banks under tight state control and its currency on a short leash to ensure financial stability. It required companies and individuals to save, in the state-run banking system, most foreign currency — primarily dollars — that they earned from foreign trade and investment.

As foreign trade surged, this hoard of dollars became enormous. In 2000, China's reserves were less than US$200 billion; today they are about US$2 trillion.

Chinese leaders chose to park the bulk of that in safe securities backed by the US government, including Treasury bonds and the debt of the mortgage finance giants Fannie Mae and Freddie Mac, which had implicit government backing.

This not only allowed the United States to continue to finance its trade deficit, but, by creating greater demand for US securities, it also helped push interest rates below where they would otherwise have been. For years, the Chinese government was eager to buy US debt at yields many in the private sector felt were too low.

In the United States, more people worried about cheap Chinese goods than cheap Chinese loans. By 2003, the Chinese trade surplus with the United States was ballooning, and lawmakers in Congress were restive. Graham and Senator Charles Schumer, Democrat of New York, introduced a Bill threatening to impose a 27 per cent duty on Chinese goods.

At the People's Bank of China, the central bank, a consensus was also emerging in late 2004: China should break its tight link to the dollar, which would make Chinese exports more expensive.

Yu Yongding, a leading economic adviser, pressed the case. The US trade and budget deficits were not sustainable, he warned. China was wrong to keep its currency artificially depressed and depend too much on selling cheap goods.

Proponents of revaluation in China argued that the Chinese currency policies denied the fruits of prosperity to Chinese consumers. Beijing was investing their savings in low-yielding US government securities. And with a weak currency, they said, Chinese could not afford many imported goods.

But when Beijing finally acted to amend its currency policy in 2005, under heavy pressure from Congress and the White House, it moved cautiously. The yuan was allowed to climb only 2 per cent. The ruling Communist Party chose only incremental adjustments to its economic model after a decade of fast growth.

But US officials eased the pressure. They decided to put more emphasis on encouraging Chinese consumers to spend more of their savings, which they hoped would eventually bring the two economies into better balance. On a tour of China, John Snow, the US Treasury secretary at the time, even urged the Chinese to start using credit cards.

China kicked off its own campaign to encourage domestic consumption. But Chinese tend to save with the same zeal that, until recently, Americans spent. Shorn of the social safety net of the old Communist state, they stash away money to pay for hospital visits, housing or retirement. This accounts for the savings glut identified by Bernanke.

In late 2006, Paulson invited Bernanke to accompany him to Beijing. Bernanke used the occasion to deliver a blunt speech to the Chinese Academy of Social Sciences, in which he advised the Chinese to reorient their economy and revalue their currency.

At the last minute, however, Bernanke deleted a reference to the exchange rate's being an ''effective subsidy'' for Chinese exports, out of fear that it could be used as a pretext for a trade lawsuit against China.

For China, too, this crisis has been a time of reckoning. Americans are buying fewer Chinese DVD players and microwave ovens. Trade is collapsing, and thousands of workers are losing their jobs. Chinese leaders are terrified of social unrest.

Having allowed the yuan to rise a little after 2005, the Chinese government is now under intense pressure domestically to reverse course and depreciate it. China's fortunes remain tethered to those of the United States. And the reverse is equally true.

In a glassed-in room in a nondescript office building in Washington, the Treasury conducts nearly daily auctions of billions of dollars' worth of government bonds. For the past five years, China has been one of the most prolific bidders. It holds US$652 billion in Treasury debt, up from US$459 billion a year ago. Add in its Fannie Mae bonds and other holdings, and analysts figure China owns US$1 of every US$10 of America's public debt.

The Treasury is conducting more auctions than ever to finance its US$700 billion bailout of the banks. Still more will be needed to pay for the incoming Obama administration's stimulus package. The United States, economists say, will depend on the Chinese to keep buying that debt, perpetuating the American habit.