Monday, February 14, 2005

I found time this weekend to read Nouriel Roubini's and Brad Setser�s latest paper, "Will the Bretton Woods 2 Regime Unravel Soon? The Risk of a Hard Landing in 2005-2006", and true to the billing, it was a provocative read indeed. I continue to be skeptical of their basic argument, however, that Asian financing of the US current account deficit (calling it "Bretton Woods 2" gives this arrangement far more institutional credibility and historical weight than it deserves) is on shaky ground. For political reasons most of all, I see the Asian-American balance of financial terror pivoting merrily along for the foreseeable future.

Here is the money line from the paper (page 3):
This paper argues that the current renminbi-dollar standard is not stable: the scale of the financing required to sustain US current account deficits is increasing faster than the willingness of the world�s central banks to continue to build up their dollar reserves.
That indeed is the rub after all, isn�t it? Can the Asians � and that includes far more countries than just China � keep up with the ever-growing US current account deficit? And will they continue to want to do so in the face of the mounting costs? The reasons R&S say the Asians won�t keep up the necessary pace basically boil down, on my reading, to six basic factors, three on the Asian side and three on the US side.

Today I�ll address the assumptions underlying the Asian sources of instability; tomorrow it�s the US.

On my reading of the paper, on the Asian side we have three basic sources of instability in the contemporary Asian-American balance of financial terror:
  1. Capital losses due to inevitable revaluation;
  2. Chinese inflation and associated asset bubbles;
  3. Inability of Japan to do it alone.
For each of these contradictions in the current arrangement to provoke a crisis, R&S rely upon (as of course everyone must) several fundamental assumptions which I find less than convincing. If the assumptions are flawed, the crisis prediction is flawed as well.

Capital losses

The threat of massive capital losses from unavoidable future revaluation of the renminbi as well as other Asian currencies looms large in R&S's analysis. However, as I've said before, these capital losses [1] may be seen as simply the acceptable costs of the system which pays other more valuable dividends; and [2] are only realized in the event of currency conversion from dollars to the local currency.

First, China among others are already experiencing significant losses in open market operations, losing 15-20bn renminbi in 2004. R&S's estimations of huge future capital losses (e.g. 20% of Chinese GDP by 2008) assumes an immediate shift in the currency regime rather than its likely gradual evolution. I'm not sure, also, whether R&S incorporate comparative inflation rates in China and the US. Higher inflation in China than the US (all but inevitable) means lower capital losses in the event of revaluation. Moreover, Japan has long suffered such losses more or less willingly as the costs of maintaining access to the US market.

Second, it may be that the East Asians do not convert their dollars into local currency and suffer high capital losses. China in particular does not fully sterilize and thus is not issuing as much local currency debt to soak up inflowing dollars. Japan doesn't sterilize at all. Both countries could use central bank dollars to loan to private firms looking to make investments in/purchases of oil (still priced in dollars), US corporations, US mineral deposits, US agricultural land, US golf courses, whatever. We already know that all the East Asian banks have accumulated reserves far in excess of what they "need" to defend their currencies. So why not simply keep many of those dollars in dollar form and buy US real assets with them?

Chinese inflation and asset bubbles

Since China does only limited sterilization, the build-up of reserves also builds up the Chinese money supply which in turn stokes inflation and speculative investment and asset bubbles (e.g. Shanghai real estate).

A bubble pop in China would indeed be a serious crisis, both for the global economy and the Chinese Communist Party. However, the bosses in Beijing have been taking measures to address this problem which seem to be working, if not totally effectually at least passingly so. Administrative measures to limit loans have been "draconian" by some estimates. The central bank has also raised interest rates and reserve requirements for banks, both of which have obstructed the growing money supply flowing into speculative investment. Plus, China uses capital controls on inflows, addressing hot money trying to take advantage of higher Chinese interest rates. None of this is perfect, of course, but it can probably continue on for some time.

In addition, if China is going to grow at 9% a year, it will need a money supply growing at a rather healthy clip. How fast a clip? That is the question -- but don't ask it of me. I'm a lowly political economist who never built a single model in graduate school.

Japan can't do it alone

If China pulls the trigger on the balance of financial terror, R&S argue that Japan is not enough to keep the thing afloat. That being said, Japan is a major player in the entire system and one largely (although not wholly) neglected in R&S's paper. Moreover, Taiwan and Korea, the #3 and #4 largest reserve holders in the world, must be part of any equation. These four countries move as a bloc and will continue to do so, looking to China for signals as to which direction and how quickly. Look at Korea's attempt to defect from supporting the dollar in 2004 and its quick scurry back to the pack as the won rose dramatically. This is not to mention the continuing security dependence of Japan, Taiwan and Korea on the United States which surely plays a part in their decisions on whether to eat up US assets or not.

Now if Bush truly blows the budget out of orbit with his crazy Social Security privatization scheme, the US may be asking for more than anybody is willing to choke down. But an analysis of the US side of the story will have to wait until tomorrow.

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