The Wages of Neo-liberalism

PART 2: The US-China trade imbalance

Henry C K Liu

(See also Part 1: Core contradictions)

A rising US trade deficit with China has generated much heat but little light about unfair Chinese trade practices.

While sensationalized reports over movie-copyright violations are highlighted by Hollywood special interests in the popular media to draw public attention, and in the halls of the US Congress to lobby for countervailing trade legislation against China, the validity of many of the complaints of unfair trade does not survive reality checks with actual macro-data. It is similar to Wal-Mart complaining about loss from shoplifting while raking in obscene profits from shoppers at the expense of its own workers and those of its suppliers overseas. Of course shoplifters deserve to be punished, but it is not a valid excuse for Wal-Mart's global low-wage policy.

In 1950, the United States imported US$11.4 billion of goods and services and exported $12.7 billion, for a foreign-trade total of $24.1 billion, constituting a mere 7.3% of a gross domestic product (GDP) of $329 billion. There was no trade with China because of a Cold War embargo by the US. The US trade deficit for 1950 was $1.3 billion, which came to an insignificant 0.4% of GDP. It was an amount the US could easily sustain as World War II had left the country the richest and most productive economy in a war-torn world.

Also, at that time the US was the world's only creditor nation, with a gold-backed dollar serving as a reserve currency for international trade as mandated by the Bretton Woods international finance architectural regime. The gold-backed dollar with fixed exchange rates ensured that war debts incurred by US allies would be duly paid back without dilution. Thus a US trade deficit was quite necessary for restoring a world economy severely damaged by war. And the dollars that the surplus trading economies received were returned to the US to pay for war debts but not to buy US assets, as foreign-exchange and capital controls were the order of the time. The minor payments imbalance was paid with a transfer of gold holdings between the trading economies. There was no foreign-exchange market beyond government exchange windows. In that arrangement, dollar hegemony was not a serious problem, as cross-border flow of funds were strictly controlled by all governments and the US was obliged to redeem dollars with gold.

The end of the Cold War in 1991 enabled the globalization of deregulated financial markets to allow cross-border flows of funds to be executed electronically with no restrictions for most economies. Since then, a huge foreign-exchange market has grown to more than $2 trillion of daily volume around the benchmark of a fiat US dollar. The reserve-currency status of the dollar has not been based on gold since 1971, but only on US geopolitical prowess, which managed to force all key commodities to be denominated in dollars. Finance globalization since 1991 has allowed the US to become the world's biggest debtor nation, with the largest trade and fiscal deficits, financed by a fiat dollar that continues to serve as a key reserve currency for not only international trade but, more important, for international finance.

Imbalance of payments and debt bubble

Dollar hegemony emerged after 1991 to allow the US to neutralize persistent trade and fiscal deficits that otherwise would lead to an imbalance of payments between it and its trading partners by erasing the payments imbalance from its trade deficit with a US capital-account surplus.

Separate from the trade deficit, the US fiscal deficit is financed by the Federal Reserve's monetary-easing policies to increase the money supply, causing an asset-price bubble that can absorb the rising debt without altering the debt-equity ratio, causing de facto but stealth inflation, renamed as "growth". This phantom growth is touted by neo-liberal economists as the reason foreign investment is attracted to US assets. What dollar hegemony does is to transform the dollar-denominated payments imbalance of the United States into a dollar-denominated debt bubble in the US economy. Holders of US debt and assets are rewarded with high nominal returns provided by a high growth rate reflecting rising asset prices denominated in money that constantly loses purchasing power.

World trade is now a game in which the US produces dollars by fiat and the rest of the world produces things that fiat dollars can buy. The world's interlinked economies no longer trade to capture a comparative advantage; they compete in exports to capture dollars needed to service dollar-denominated foreign debts and to accumulate dollar reserves to sustain the exchange value of their domestic currencies.

To prevent speculative and manipulative attacks on their currencies, the world's central banks must acquire and hold dollar reserves in corresponding amounts to their currencies in circulation. The higher the market pressure to devalue a particular currency, the more dollar reserves its central bank must hold. This creates a built-in support for a strong US dollar that in turn forces the world's central banks to acquire and hold more dollar reserves, making it even stronger. This phenomenon is known as dollar hegemony, which is created by the geopolitically constructed peculiarity that critical commodities, most notably oil, are denominated in US dollars. Everyone accepts dollars because dollars can buy oil. The recycling of petrodollars is the price the United States has extracted from oil-producing countries for US tolerance of the oil-exporting cartel since 1973.

# Ironically, as oil-producing economies benefited from a suddenly rise in the price of oil denominated in dollars, they developed a need to preserve the value of the dollar. Thus three conditions brought about dollar hegemony in the 1990s: In 1971, US president Richard Nixon abandoned the Bretton Woods regime and suspended the dollar's peg to gold as US fiscal deficits from overseas spending caused a massive drain in US gold holdings.

# Oil was denominated in dollars after the 1973 Middle East oil crisis, followed by other key commodities.

# Deregulated global financial markets began to emerge in 1991 after the Cold War, making the cross-border flow of funds routine.

A general relaxation of capital and foreign-exchange control in the context of free-floating exchange rates made speculative attacks on currencies regular occurrences. All central banks have since been forced to hold more dollar reserves than they otherwise need to ward off sudden speculative attacks on their currencies in financial markets. And dollar reserves by definition can only be invested in US assets. Thus dollar hegemony prevents the exporting nations from spending domestically the dollars they earn from the US trade deficit and forces them to finance the US capital account surplus, thus shipping real wealth to the United States in exchange for the privilege of financing US debt to further develop the US economy.

The US capital-account surplus in turn finances the US trade deficit. Moreover, any asset, regardless of location, that is denominated in dollars is a US asset in essence. When oil is denominated in dollars through US state action and the dollar is a fiat currency, the US in essence owns the world's oil for free. And the Quantity Theory of Money dictates that the more the US prints greenbacks, the higher the price of US assets will rise. And by neo-classical definition, a rise in asset value is not inflation as long as wages lag behind. Thus a strong-dollar policy gives the United States a double win while workers everywhere, including those in the US itself, are handed a double loss.

Through dollar hegemony, the US, unlike many Third World nations with similar trade and fiscal deficits, has been granted immunity from associated penalties of payments imbalance by having its trade deficit finance its capital-account surplus. But instead of reforming the fundamental structure of the US economy that creates such trade and fiscal deficits, many in the United States are seeking painless yet pointless solutions to a non-existent payments imbalance by engaging in irrational disputes over the issue of currency exchange rates of its trading partners, first Japan and Germany decades ago, and now China.

On top of this monetary scam, the US wants to push the exchange rate of the dollar further down to erode the value of the massive dollar holdings of its trading partners, as the exchange rate of the dollar affects only those who live, operate in or visit non-dollar economies. Because the Fed can print fiat dollars at will under a dollar-hegemonic regime, a dollar-denominated US trade deficit does not present a balance-of-payments problem for the United States, as it does all other countries that cannot print dollars. Thus a US trade deficit, being not a balance-of-payments problem, cannot be cured through manipulation of the exchange rate of the dollar. The solution has to come from reducing wage disparity between the two trading economies.

The numbers behind US-China trade

In 2005, US foreign trade of $3.30 trillion constituted 26% of its $12.7 trillion GDP. Exports were $1.27 trillion and imports $2 trillion, resulting in a goods-and-services deficit of $726 billion (5.7% of GDP), $109 billion more than the 2004 deficit of $618 billion.

For goods alone, exports were $893 billion and imports $1.7 trillion, resulting in a goods deficit of $782 billion, $117 billion more than the 2004 deficit of $665 billion. This meant that while the trade deficit for goods was large and growing, the US still exported goods in 2005 valued at 192.4 billion 1950 dollars, more than 15 times its export in 1950 and three times its 1950 GDP. For services, exports were $379 billion and imports were $322 billion, resulting in a services surplus of $56 billion, $8.5 billion more than the 2004 surplus of $48 billion.

The US trade deficit with China will greatly reduce if the US lifts high-tech-export restrictions to China.

For China, foreign trade in 1950 was non-existent because of the US embargo, except some memorandum trade with other socialist and non-aligned nations. For 2005, Chinese foreign trade reached $1.3 trillion (81% of GDP of $1.6 trillion), with a trade surplus of $102 billion (6.4% of GDP). About $100 billion of the Chinese trade surplus with the US went to pay for Chinese trade deficits with other countries.

These figures show that trade is now a precariously excessive portion of Chinese GDP. And without a trade surplus with the US, China would face a global trade deficit of about 6.25% of GDP, more than the United States' 5.7%.

China's addiction to trade

With any addiction, initial euphoria soon turns to agony. Chinese per capita GDP was $1,231 for 2005, while the country's per capita foreign-trade volume was $1,000. Take away foreign trade, and Chinese per capita GDP would be $231, or 63 cents a day. And that number is per capita GDP, not per capita income, which is usually lower.

In 2005, the per capita annual income of Chinese urban residents was 10,493 yuan, or $1,294 at the official exchange rate of 8.11 yuan to a dollar. The per capita annual income of rural residents was 3,255 yuan, or $401. In fact, in the rural interior, non-trade-related per capita GDP in 2005 was actually below overall per capita income, meaning that rural per capita income in region with no export trade had to be subsidized to the tune of $170 per capita, the gap between $401 and $231, or 47 cents a day.

The global poverty line is set at $2 per day, substantially higher than China's non-trade-related per capita GDP of 63 cents per day. Chinese policy of export-dependent growth is causing mounting social unrest with serious political implications, which the government is just beginning to acknowledge.

US per capita GDP in 2005 was $43,000, while per capita foreign trade was $11,196. Take away foreign trade, and US per capita GDP would be $31,804. Serious trade friction is unavoidable among all trading nations. But the macro-data show that the US as not greatly disadvantaged by trade with China.

The US per capita trade deficit with China in 2005 was $685, or 1.6% of per capita GDP, while the Chinese per capita trade surplus with the US was $155, or 12.2% of per capita GDP. But globally, the Chinese trade surplus was only $102 billion, putting the per capita trade surplus at $78.5, or 6% of per capita GDP. Furthermore, upwards of 70% of Chinese export is traded by foreign companies, leaving the per capita trade surplus in 2005 at around 50 cents net for China. Obviously, China is much more trade-dependent than the US, and it does not take much analysis to see that the US commands much more market power in trade negotiation with China.

With widening income disparity in China, the majority of the population would have income substantially lower than the average per capita GDP. China's overall Gini index (which measures income disparity) officially increased from 0.35 in 1990 to 0.45 in 2005, with zero being complete equality. Before 1978, China was the most equal society in the world. An unofficial survey put the Gini index at 0.6 for 2005.

According to the World Bank, the number of people living in poverty in China declined from 480 million in 1981 to 88 million in 2002, but in 2003, poverty rose again for the first time since 1978, as the ill effects of excessive export became statistically discernable.

The fault of GDP as a gauge for growth is plainly displayed in China, where double-digit GDP growth has given the country a booming economy on paper but one with widening income disparity that keeps the majority in poverty, irreversible environmental deterioration, rising moral apathy, systemic official corruption and spreading social unrest. It is hardly a picture that fits the world's second-largest creditor nation.

Dollar hegemony has not done better for the US, where the Gini index for 2005 was 0.41. A Gini index above 0.4 is considered socially destabilizing and economically inefficient.

The Cold War was won with neo-liberal trade

The Cold War was a political/military confrontation with an economic dimension. Underneath the militarization was an economic contest between the two superpowers, each providing aid to the less-developed allies within its own ideological bloc. There was little economic contact between the two separate and hostile blocs. Within each bloc, economic relations were conducted mostly through foreign aid. The name of the game during the Cold War was economic development, not trade.

Neo-liberals now regularly assert that socialism lost the Cold War to capitalism because freedom prevailed. Yet the issue was not that simple or clear-cut. It is true that governments that championed socialism, by being forced into a garrison-state mentality by hostile external forces, became their own worst enemy by depriving basic freedom to their citizens. But the assault on civil liberty during the Joseph McCarthy era did not bring down the US government and there was not much democracy in many US allies all through the Cold War. And one and a half decades later, the former socialist economies, from Russia to Poland, do not seem to fare better under market capitalism. China is an exception only because it hangs on to basic socialist commitments that the US is trying its best to dismantle.

The real Cold War was fought on the economic front between two drastically unequal adversaries. The socialist camp started out with a much lower level of development and a much higher level of poverty as a historical result of having been victims of century-long imperialist exploitation. Furthermore, the socialist camp did not have the benefit of a rich and powerful economy acting as the engine of growth, as the United States, leader of the capitalistic camp, was the only country undamaged by World War II. The socialist camp registered impressive growth both before and after World War II but began to lose momentum when the Soviet Union was drawn into trade with the capitalist camp to finance the Cold War arms race. The USSR led the socialist bloc to refuse Marshall Plan aid. COMECON (the Council for Mutual Economic Assistance) was founded in 1949 to create an economic bloc that endured until 1991. The word "trade" was not mentioned in COMECON documents.

The Marshall Plan grew out of the Truman Doctrine, proclaimed in 1947, stressing the moralistic duty of the United States to combat communist regimes worldwide. The Marshall Plan spent $13 billion out of a 1947 GDP of $244 billion, or 5.4%. This translates to $632 billion in 2004 dollars, roughly the same amount as the US trade deficit in 2004. The mission was to help Europe recover economically from World War II to keep it from communism. The money actually did not all come out of the US government's budget, but out of US sovereign credit. The most significant aspect of the Marshall Plan was the US government guarantee to US investors in Europe to exchange their profits denominated in weak European currencies back into dollars at guaranteed fixed rates, backed by gold at $35 an ounce.

The Marshall Plan concretized the Bretton Woods regime of using the US dollar as the world's reserve currency at fixed exchange rates. The Marshall Plan enabled international trade to resume and laid the foundation for dollar hegemony to emerge half a century later, after the dollar was taken off gold by Nixon in 1971 and the Bretton Woods regime of restricting cross-border flows of funds was dismantled. While the Marshall Plan did help the German economy recover, it was not entirely a selfless gift from the victor to the vanquished. It was more a Trojan horse for monetary conquest. It condemned Germany's economy to the status of a dependent satellite of the US economy from which it has yet to free itself fully.

The Marshall Plan lent Europe the equivalent of $632 billion in 2004 dollars. Japan's foreign-exchange reserves alone were $830 billion at the end of September 2004. In other words, Japan was lending more to the United States in 2004 than the Marshall Plan lent to Europe in 1947. And Japan did not get any benefits, because the loans were denominated in dollars that the US can print at will, and dollars are useless in Japan unless reconverted to yen, which because of dollar hegemony Japan is not in a position to do without reducing the yen money supply, causing the Japanese economy to contract and the yen exchange rate to rise, thus hurting Japanese export competitiveness. Thus dollar hegemony has gone beyond the "too big to fail" syndrome. It has created a world of willing slaves to defend the dollar out of fear that without a strong dollar, tomorrow's food may not be available.

What the Cold War proved was the thesis of Friedrich List (1789-1846), as expounded in his Das Nationale System der Politischen Oekonomie (1841), translated as The National System of Political Economy, that once a nation (or a bloc of nations) falls behind economically in the trade arena, it cannot catch up through trade alone without government intervention.

List's German Historical School is distinctly different in outlook from the British classical economics of David Ricardo and James Mill. It argues that economic behavior and thus laws of economics are contingent upon their historical, social and institutional context. When a nation is forced to adopt the national opinion of another nation with different historical conditions as natural laws of international economics, it will always be the victim of such laws. Such views have been validated by the experience of postwar Japan and Germany, which had to pay the price of being client states of the US in exchange for trickled-down prosperity.

For the socialist camp, trading with the capitalist camp was the strategic error that caused it to expose itself unprotected to a game it could not win and that it would lose from the outset and never catch up. In that sense, neo-liberals are on target in claiming that free trade promotes capitalistic democracy, but they are dishonest in claiming that free trade is a win-win game for all participants. International free trade is only good for the hegemon, as domestic free trade is good for the monopolist. Socialism works only if development is not preempted by external trade. The World Trade Organization is a regime designed to favor the capitalist hegemon. The current anti-WTO movements around the world are early signs of a grassroots realization of this truism.

In the US, List's views evolved into institutional economics, which subscribes to the notion that government policies are central to promoting development, not market forces. List had been inspired by the views of the statesman Alexander Hamilton in the early days of the US as a nation.

The US Supreme Court under chief justice John Marshall in McCulloch vs Maryland (1819) established the principles that the federal government possesses broad "implied powers" to pass laws and conduct policies, programs and measures, and that the states cannot interfere with any federal agency. Marshall ruled that the Union and its government were created by the people, not by the states, and that the federal government is fully sovereign and "supreme in its own sphere of action" as long as it is not explicitly prohibited by the constitution. Marshall's opinion was one of the most significant decisions in the history of US constitutional law. It gave constitutional grounds for a broad interpretation of the powers of the federal government. The case became the legal cornerstone of subsequent expansions of federal power and by extension US global power centuries later.

Hamilton's idea of sovereign credit through the establishment of a national bank, as opposed to a central bank, was designed to protect by government measures the weak, infant industries in a young nation and to oppose Adam Smith's laissez-faire doctrine as promoted by advocates of 19th-century British globalization for the advancement of British imperialist interests (see Banking Bunkum: The US experience, November 16, 2002). Later, after the War of 1812, Henry Clay's American System argued for the establishment of the Second Bank of the US, protective tariffs and federal appropriations through the use of sovereign credit for "internal development" such as infrastructure.

While World War II catapulted the United States into superpower status within half a decade, the cost of the Cold War, which lasted four decades, led the US into a Pyrrhic victory built on recurring cycles of fiscal deficits. Before the globalization of financial markets in the 1990s, fiscal deficits produced only one penalty: domestic inflation. Keynesian deficit financing turned out to be effective in smoothing out the cursed business cycle. And with foreign trade merely a minor factor, there was no foreign-exchange-rate implication as long as the dollar was on a gold standard and the US held most of the world's gold stock. The United States was indeed hit by domestic inflation by the 1960 and the effect on the US economy was stimulant enough for government economists in the administration of president John Kennedy to conclude that with the "New Economy" the US could afford guns and butter simultaneously, and even send a man to the moon, by putting up with a little inflation.

But because the dollar was the trade reserve currency and much of the US fiscal deficit was being spent overseas in the Korean and Vietnam wars and in funding the cost of the North Atlantic Treaty Organization in Europe and US bases in Japan, South Korea and other US allies in Asia and the Pacific, the Middle East and South America, a great deal of dollars flowed overseas, putting a drain of the stockpile of gold the US was holding in Fort Knox. Enough gold left the US vault at Fort Worth, Texas, to go into foreign vaults in the same building that president Lyndon Johnson was unable to fund his Great Society programs while trapped in the Vietnam quagmire in the late 1960s.

In August 1971, Nixon was forced to take the dollar off the gold standard to stop the outflow of gold into foreign accounts, and imposed a 10% import tariff that was removed by year-end with a devaluation of the dollar by 2.25% from the exchange rate fixed by the Bretton Woods regime. Two years later, the 1973 Middle East crisis gave the Organization of Petroleum Exporting Countries an opening to raise the price of oil tenfold, from $3 to $30 a barrel. The US accepted the new oil-price regime by forcing the oil-producing nations to denominate oil in dollars. It was not difficult to convince the oil-exporting governments, as most of them did not have large enough economies to absorb all the sudden wealth, and at the time the dollar was still the world's most stable currency and the US was politically more stable than any other country, and it was immune to terrorism.

The excess petrodollars went to finance Third World borrowing at a higher rate of interest than in the US, to be repaid by dollars earned by exports. Such loans were considered safe because as the chairman of Citibank, Walter Wriston, famously pronounced: "Countries don't go bankrupt." Citibank became the world's largest bank through aggressive international lending. This was the beginning of dollar hegemony.

But dollar hegemony did not emerge full-blown until the emergence, after the end of the Cold War in 1991, of deregulated global financial markets that allow the massive cross-border flow of funds, which the Bretton Woods regime had restricted. The breakdown of that restriction in 1991 was more important for facilitating dollar hegemony than moving the dollar off the gold standard in 1971.

With dollar hegemony, the US central bank, the Federal Reserve, transforms itself from a guardian of the value of the nation's money and a lender of last resort to a ubiquitous virtual money machine that starts printing at the earliest signs of a slowing economy. After 1987, the Fed under chairman Alan Greenspan led all the world's central banks in an orgy of liquidity injection.

The US, under Robert Rubin as treasury secretary, former bond trader at Goldman Sachs, discovered that all it had to do to make money was to print more dollars; and world trade has since become a game in which the US makes dollars by fiat and its trading partners make things that fiat dollars can buy, from oil to garments, to television set and automobiles. The US kept its defense industries and research and outsourced old-economy manufacturing first to Japan and Germany, and garments and low-tech products to Asia and Mexico. Most important, the US in essence created and ran a new finance sector with junk bonds and other structured finance products that other advanced economies did not catch on to until a decade later. The US moved into finance capitalism with dollar hegemony while its trading partners were stuck in industrial capitalism.

The flawed logic of currency revaluation

The logic of revaluing the Chinese yuan, or any currency, as a way of balancing trade with the United States is flawed. This is particularly true if prices are denominated in the currency of the consumer economy, as the dollar is.

It was ironic that US treasury secretary Lawrence Summers in the late 1990s repeatedly lectured Japan not to substitute sound balanced macro-economic policy with exchange-rate or interest-rate policies, because the US did exactly that with the Plaza Accord in 1985 and with its strong-dollar policy after the 1997 Asian financial crisis.

Robert Mundell, 1999 Nobel laureate in economics, observed while attending a conference in Beijing last year that never before in history had there been a case where international monetary authorities tried to pressure a country with a not freely convertible currency to appreciate its currency. He said China should not appreciate or devalue the yuan in the foreseeable future. "Appreciation or floating of the renminbi would involve a major change in China's international monetary policy and have important consequences for growth and stability in China and the stability of Asia," Mundell said.

A trade deficit reflects the structural deficiency embedded in a country's trade, monetary and exchange-rate policies. In 1975, the US had a trade surplus of $12.4 billion. By 1987, it had incurred a trade deficit of $153.3 billion, which was widely but mistakenly attributed to an overvalued dollar. The effects of the 1985 Plaza Accord to devalue the dollar by negotiation shrank the trade gap temporarily, but a lower dollar enabled the US economy to grow faster than those of its trading partners, and by 1991 the US trade deficit began rising again as finance globalization allowed the trade-deficit dollar to return to reinvest in US assets. Trade began to be linked with international finance.

With the development of a deregulated global financial market, the world financial architecture began to operate under the rules of dollar hegemony. The growth in the US was concentrated mostly in the deregulated financial sector, where the US was unquestionably the leader in innovation. The growing capital-account surplus made the growing trade deficit benign as the balance-of-payments problem was transformed into a US debt bubble.

The 1997 financial crisis in Asia sent local currencies plummeting, making Asian goods drastically cheaper. Yet China was the only Asian nation that did not devalue its currency. By that year, the US trade deficit had hit $110 billion, and heading higher. But net capital inflow to the US after July 1997 exceeded $100 billion, at 7.2% of GDP. The 2004 $666 billion trade deficit was equal to $784 billion in 1997 dollars, more seven times what it was in 1997. Surely that geometric increase was more than a foreign-exchange problem.

The White House Council of Economic Advisers reports that in 2004 the United States registered the world's largest net capital inflow at $668 billion (70% of world total), while Japan had the largest net capital outflow at $172 billion, followed by Germany at $104 billion, then China at $69 billion, Russia at $60 and Saudi Arabia at $52 billion. In 1995, developing Asian countries had net inflows of $42 billion, but had net outflows of $93 billion in 2004. China had $2 billion of net capital outflows in 1995, $21 billion of net outflows in 2000, and $69 billion in net outflows in 2004.

In 1995, developing and emerging-market countries as a whole received $84 billion in net capital inflows. A sudden reversal of capital flows to Indonesia, South Korea, Malaysia, the Philippines and Thailand from a net inflow of $93 billion in 1996 to a net outflow of $12 billion in 1997 represented a swing of $105 billion, or 11% of their pre-crisis GDP. In 2000, they experienced $91 billion in net outflows. In 2004, they experienced $367 billion in net outflows. While these countries remained net recipients of foreign direct investment (FDI) inflows, they became large net purchasers of foreign reserve assets made primarily by their central banks. This represents a capital outflow because the dollar inflows had to be absorbed by domestic debt to be invested abroad rather than within these countries.

The value of global foreign reserves, held primarily by central banks, rose from roughly $1.5 trillion to $3.9 trillion between 1995 and 2004, a 160% increase in a period when the value of global GDP increased by roughly 40%. Global reserves increased by more than $1.3 trillion in 2002-04 alone. Three countries accounted for nearly 60% of this reserve increase: Japan, China, and South Korea.

With $69 billion in net outflows, China was the world's third-largest net capital exporter in 2004. While China receives substantial foreign investment, it experiences even larger capital outflows because of foreign-reserve accumulation by its central bank that results from its foreign-exchange regime. Foreign direct investment (FDI) into China in 2004 totaled more than $153 billion in new agreements, up by one-third over 2003. Utilized FDI (the amount actually invested during the year) also surged to a record high of almost $61 billion, rising 13.3% over 2003.

As China's reserves have risen in recent years, its capital-account balance has moved toward larger deficits and its current account toward larger surpluses. In 2004, China's current-account surplus was equivalent to 4% of GDP, and is likely to have exceeded 6% of GDP in 2005. At the end of September 2005 it was $769 billion, with $58 billion added in the third quarter.

China's reserves have increased because of its rising current-account surpluses, net private capital inflows, and tightly managed pegged-exchange-rate system. To maintain this peg, China's central bank has purchased large amounts of foreign-currency assets in recent years. Even after modifying its exchange-rate peg last July, linking the yuan to a basket of currencies rather than the US dollar alone, China's foreign reserves have continued to rise, passing $800 billion by the end of 2005, and may rise to $900 billion or $1 trillion by the end of 2006. Between 2000 and 2005, China's foreign reserves increased by more than $600 billion. But this is not surplus national wealth, but a reflection of deficiency in social-security funding caused by market reform.

Neo-liberals argue that with a stronger currency, the global purchasing power of China's currency would rise, raising its income in global terms and consumption share, and thus reducing its rate of domestic saving. Yet under current terms of international trade, a higher exchange rate translates directly into a lower domestic wage scale for any economy heavily dependent on export, further reducing domestic consumption. China's social-security funding deficiency is being mistaken for a high saving rate.

Rising domestic demand through higher wages is essential for China's future growth. But dollar hegemony makes it impossible for China to move in this direction by siphoning domestic savings into useless foreign reserves.

Causal dispute over current and capital accounts

There is sharp disagreement among economists about the causal relationship between current account and capital account. It is an idle dispute about where a circle starts.

Market bears tend to see changes in the capital account as following passively changes in the current account. Market bulls tend to see causation running from the capital account to the current account, confident that the United States could run a huge trade deficit without any collapse in the foreign-exchange value of the dollar because foreigners have no choice but to sell their domestic currencies to buy US assets, supplying dollars for the US to buy foreign goods. The problem arises when many in the US are no longer happy with further selling of US assets to foreigners, or loss of jobs to outsourcing. But if the US capital-account surplus shrinks, the current-account deficit will re-emerge as a classic balance-of-payments problem.

Most US journalists, and almost all politicians, line up with the dollar bears in fixating on the trade deficit rather than on the capital surplus. And they blame that deficit on China as the newest scapegoat that carries a great deal of residual hostility from Cold War days and even from century-old racial prejudice.

According to the China-bashers, the US is a victim of Chinese mercantilism, notwithstanding that mercantilism involve the quest for gold, not fiat currencies. As they tell it, China has kept its currency undervalued to promote export-led growth. To back this assertion they point to China's rapid buildup of foreign-exchange reserves, which are really loans to the US to balance its trade deficits, notwithstanding the fact that the exchange rate has been in effect for more than a decade, that China withstood temptation to devalue the yuan after the 1997 Asian financial crisis, and that fixed exchange rates were a US idea at Bretton Woods when the United States was a creditor nation.

Furthermore, the US current-account deficit represents 1.6% of global GDP, while the current-account surplus for all the countries in emerging Asia without Japan accounts for only 0.5% of global GDP. Oil-exporting countries also account for a surplus of 0.5% of global GDP. Japan's surplus is almost as large, 0.4% of global GDP.

To correct the trade imbalances, if that's the game, would require much more than a revaluation of the Chinese yuan. The rapid rise in reserves accumulation was due only in part to trade, with the bigger contribution came from capital transactions, accounting for 29% of China's foreign reserve growth. Currency speculating accounted for 37%, betting that the yuan will be revalued upward to please irrational demands from Washington. Hedge funds engage in "carry trade" to borrow low-interest yen to buy dollars to send to China, accumulating Chinese sovereign debt denominated in yuan and contributing to the pileup of dollars in the People's Bank of China (PBoC), the central bank. The political intervention by Washington in Chinese monetary policy over rising Chinese reserves is driving an increase in dollar holdings by China.

Of course $800 billion of foreign reserves is no small number. But it is not anywhere big enough to fund what the US wants China to do to open up its financial market further. Because China cannot print dollars, it must keep enough dollars on hand, at least $500 billion, to meet routine foreign-transaction needs, given the size of the Chinese economy, its money supply and the import needs of its export sector.

A wholesale opening of China's financial sector as demanded by the US would require China to cure the massive non-performing-loan problem in the Chinese banking system as defined by the Bank of International Settlement (BIS). This is a structural problem that arose from shifting from a regime of national banking to central banking. This task is ultimately going to cost upwards of $1 trillion (see China: Banking on bank reform, June 1, 2002). Making the yuan freely convertible will require upwards of $500 billion to ward off speculation. Add it all up, and China needs foreign reserves on the scale of $2 trillion to implement financial liberalization. It is less than halfway there and will not reach the necessary target if current US policy on China prevails.

The US trade deficit finances the US capital-account surplus in the form of foreign (Chinese) purchase of US Treasuries with dollars that the PBoC purchased from China's export sector with Chinese sovereign debt denominated in yuan. What China earns is a meager commission on the foreign profit from Chinese export trade. And because of tax preference granted to foreign capital and export earnings, China's foreign-financed export sector has managed to externalize its social and environmental costs to the domestic sector. Such negative externalities are about to come due soon.

With a stronger yuan against the dollar, Chinese sovereign debt denominated in yuan will buy more dollars from China's export sector, which means each yuan will buy more US Treasuries. This will reverse the historical interest-rate disparity between the yuan and the dollar and cause a halt to the carry trade of borrowing low-rate dollars to invest in high-rate yuan asset and stop the flow of dollars to the PBoC to buy more US Treasuries. So revaluation of the yuan will not help the US.

The danger for the dollar is not that China might sell US Treasuries of which China is already too big a holder to sell without suffering substantial net loss in the market. The danger is that the US sovereign debt rating is now dependent on the credit rating or soundness of Chinese sovereign debt.

If the Chinese economy hits a stone wall, as it will when the US debt bubble bursts and Chinese export to the US falls drastically, Chinese sovereign debt will lose credit rating, causing yuan interest rates to rise, causing more hot money into China, causing the PBoC to buy more US Treasuries, forcing dollar interest rates to fall and more hot money to rush into China, turning the process into a financial tornado that will make the 1997 Asian financial crisis look like a harmless April shower. This happened to Japan, but with foreign trade constituting only 18% of GDP in 2003, Japan was able to contain the deflation domestically. Still, the impact of protracted Japanese deflation on the global economy was substantial. With China, where foreign trade hovers above 81% of GDP, with an economy already highly concentrated on the coastal regions and unbalanced with little breadth and depth, a financial crisis will transmit beyond its borders quickly. This is the real danger for dollar hegemony.

Surging capital inflows can be a double-edged sword, inflicting unwelcome and destabilizing side-effects, including a tendency for the local currency to gain in value above market fundamentals, undermining export competitiveness, and give rise to inflation. Capital inflows cause a buildup of foreign-exchange reserves held by the central bank, releasing local currency to expand the domestic monetary base without a corresponding increase in production, causing too much money chasing after too few goods, the classic cause of inflation. This creates an undesirable situation of the currency being worth more externally and being worth less internally, setting a perfect opportunity for attack on the currency by hedge funds. This is the situation facing China today and the problem will turn into a crisis as soon as the yuan becomes freely convertible.

Under dollar hegemony, capital flow is mainly denominated in dollars. Despite all the talk about the euro as an alternative reserve currency, the euro is still just a derivative currency of the US dollar, like all other currencies. To ease the combined threat of external currency appreciation and domestic inflation, central banks must implement what is known as the "sterilization" of capital flows. In a successful sterilization operation, the domestic component of the monetary base (bank reserves plus currency) must be reduced to offset the reserve (dollar) inflow, at least temporarily.

For the situation of external currency depreciation and domestic deflation, like the Japan experience, the reverse needs to be done. In theory, this can be achieved in several ways, such as by encouraging private investment overseas, but this option appears to have been blocked by US protectionism. Another way is to allow foreigners to borrow local currency from the local market, but this would invite currency attacks from unruly hedge funds. The classical form of sterilization under dollar hegemony, however, has been through the use of open market operations, that is, buying or selling US Treasury bills and other dollar-denominated instruments to adjust the domestic component of the monetary base. The problem is that, in practice, such sterilization can be difficult to execute and sometimes even self-defeating, as an apparently successful operation may raise or lower domestic interest rates and stimulate even greater undesirable dollar capital inflows or outflows.

The ability to sterilize has an inverse relationship with the degree of international capital mobility. If capital is highly mobile, attempts at sterilization will prove futile, because they can be rapidly overwhelmed by renewed inflows, particularly if the Fed continues to issue more dollars by lowering the Fed funds rate. Because of dollar hegemony, the United States is the only country that needs no sterilizations, as all inflows and outflows are in dollars. While sterilization may be useful temporarily for non-dollar economies, it cannot work for long if the capital inflows persist, because sterilization can deal only with the effect rather than the underlying cause of shocks to the system. The same is true with exchange-rate manipulation.

Also, the scope for classical open-market operations may be severely restricted by the instruments available, particularly in developing countries, including China, which are unlikely to have well-developed financial markets. Issuing a large stock of securities in an attempt to mop up the inflowing liquidity places a heavy debt-service burden on the government or central bank. It can lead to deterioration in the fiscal or quasi-fiscal balance, such as state-owned enterprises. For a central bank, operating losses can occur when the funds it raises are invested in foreign assets, which earn prevailing dollar interest rates often lower than rates the central bank must pay on the bills it has sold. Large-scale losses can even lead to the need for a recapitalization of the central bank or defaults.

In a worst-case scenario, the building up of a central bank or Treasury balance sheet may also expose it to greater credit risks, making the whole system more vulnerable to a sudden reversal in capital flows. This is more likely where much of the capital inflow is in the form of short-term portfolio investment, known as hot money, which can be reversed much more quickly and easily than foreign direct investment.

Next: China's internal debt problem

Henry C K Liu is chairman of a New York-based private investment group. His website is HenryCKLiu.com.

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