How the US and China should deal with the global downturn

By Ronald McKinnon

As always, I am amazed by how much analytical ground Martin Wolf covers in each column; “Why agreeing on a new Bretton Woods is vital” is no exception. Let me first pick up on one point: the number of countries involved in the negotiation.

The original Bretton Woods agreement was essentially bilateral, and negotiated between the British Treasury (Keynes) and the US Treasury (White) in 1943-1944, with Canada sometimes acting as an umpire.

The post-war General Agreement on Tariffs and Trade cum World Trade Organisation negotiations were manageable and quite successful as long as they were also mainly bilateral – the eastern European bloc versus the US – with Most Favoured Nation treatment extended to most other countries.

Developing countries did have a marginal say. The old GATT exempted them from the requirement to reciprocally reduce their own tariffs. This was disastrous for them, and fortunately is being phased out under the new WTO.

But the latest Doha round of the WTO could not be concluded at all, in part because too many emerging markets, India, China, and Brazil among them, were recalcitrant in the face of American and European agricultural protectionism.

In reforming Bretton Woods on the monetary cum exchange rate side, strictly limiting the number of negotiators to the most financially prominent countries is a necessary (but certainly not sufficient!) condition for success.

Who are they? In Asia, China and Japan. In Europe, the European Central Bank representing the eurozone, with whom the UK might want to be affiliated. In North America, just the US, with Canada possibly again acting as umpire.

Once these four groups agree on a set of rules for restoring exchange rate stability, aligning interest rates, and reducing trade imbalances among themselves, the other smaller economies in the world system would benefit enormously.

But other countries outside the “big four” need not bind themselves to the same set of rules, except to carry forward the existing obligation to maintain current-account currency convertibility under the current IMF agreement.

To discuss what monetary and fiscal reforms the big four should negotiate amid the great global economic crisis would require a book length declamation. Below, I focus on how just the US and China should deal with the global downturn.

China and the US: Partners for Managing the Global Economic Crisis?

What had been mainly a financial crisis with a seizing up of interbank and commercial bill markets, is now spreading with full force to the real economy.

Consumption and investment spending in the industrial centre of the world economy is falling, with even sharper downturns­ coupled with currency crashes­ in economies producing primary products on the periphery. Although less severely impacted by the global downturn than the American or European economies, China’s high-growth economy is slowing more than most analysts expected.

Beyond making every effort to unblock credit markets, what is the best way to mount a global counter cyclical policy?

Though China and the US are an unlikely duo to mitigate the current economic crisis, they have good reasons to cooperate.

Both have strong vested interests in ameliorating a global downturn while preserving the foreign exchange value of the dollar. Trade between them is huge, but extraordinarily unbalanced. China is the largest creditor of the US, nervously holding nearly $2,000bn in foreign exchange.

The large US trade deficit in manufactures with China (and east Asia more generally) has contracted the US manufacturing base and inflamed American politics by throwing red meat to the protectionists. A cooperative economic programme that addresses the near-term global macro crisis on the one hand, and the festering China-US trade imbalance on the other, is feasible and highly desirable.

The collapse of the US housing bubble in 2007-2008 is the proximate reason for the worldwide spread of the credit crisis. Aggregate demand in the global economy is declining because of the retrenchment in US household spending, which is necessary to reduce the US trade deficit.

Because the Federal Reserve overreacted by cutting interest rates too much, the flight of hot money from the dollar up four months ago worsened the seizing up of credit markets in the US. When counterparty risks are acute, the huge US interbank markets are further impaired because of a shortage of prime collateral in the form of US Treasury bonds.

As foreign central banks, such as the People’s Bank of China (PBC), intervene to buy dollars to prevent their currencies from ratcheting upward, they invest the proceeds disproportionately in US Treasuries and so incidentally worsen their shortage in private US financial markets.

But China also has domestic financial problems including a banking squeeze. Because of ultra low US interest rates and American “China bashing” to appreciate the renminbi, the deluge of hot money inflows into China had forced the PBC to buy dollars in the foreign exchange market to prevent the renminbi from ratcheting up sharply.

True, the surprise strengthening of the dollar over the past four months has provided a respite from continual renminbi appreciation. But just the expectation that the renminbi is likely to be higher in the future impedes private capital outflows from financing China’s huge trade surplus­ and so further tightens credit conditions in the US and Europe.

From the inordinate build up of China’s official foreign exchange reserves, Chinese money growth had been excessive and led to too much inflation­, some of which leaked out into the rest of the world.

In trying to sterilize the domestic monetary consequences of the rapid build-up of official exchange reserves, the PBC has had to impose high reserve requirements on its commercial banks. But having to hold renminbi reserves on deposit with the PBC impedes the commercial banks lending to the private sector.

To deal with the global crisis, how should the US and Chinese governments proceed?

First, the US should stop China-bashing in several dimensions. In particular, the PBC should be encouraged to stabilize the renminbi/dollar exchange rate at today’s level­, both to lessen the inflationary overheating of China’s economy and to protect the renminbi value of its huge dollar exchange reserves.

Since July 2008, the dollar has strengthened against all currencies save the renminbi and the yen, and the PBC has stopped appreciating the RMB against the dollar. So now is a good time to convince the Americans of the mutual advantages of returning to a credibly fixed yuan/dollar rate.

There is a precedent for this. In April 1995, Robert Rubin, then US Treasury secretary, ended 25 years of bashing Japan to appreciate the yen­ and announced a new strong dollar policy that stopped the ongoing appreciation in the yen and saved the Japanese economy from further ruin.

But this policy was incomplete because the yen continued to fluctuate, thus leaving too much foreign exchange risk within Japanese banks, insurance companies, and so forth, with large holding of dollars. This risk locks the economy into a near zero interest liquidity trap.

Second, after the PBC regains monetary control as China’s exchange rate and price level stabilize, the Chinese government should then agree to take strong measures to get rid of the economy’s net saving surplus that is reflected in its large current account and trade surpluses.

This would require some combination of tax cuts, increases in government expenditures, increased dividends from enterprises so as to increase household disposable income, and reduced reserve requirements on commercial banks.

Then, as China’s trade surplus in manufactures diminishes, pressure on the American manufacturing sector would be relaxed with a corresponding reduction in America’s trade deficit. Worldwide, the increase in spending in China would offset the forced reduction in U.S. spending from the housing crash.

Again, there is an important historical precedent. In the great crisis of 1997-1998, most east Asian countries depreciated their currencies, with Indonesia, Korea, Malaysia, Philippines, and Thailand, whose currencies were attacked, suffering economic slumps. Fortunately, China alone kept its dollar exchange rate stable, but it did face a potential deflationary slowdown.

However, in March 1998, premier Zhu Rongji announced his famous trillion dollar fiscal expansion to be spread out over the next four years or so. This avoided an economic downturn in China by sustaining domestic aggregate demand, and east Asian neighbours recovered faster because they could more easily export to China.

Now, China is a much bigger actor on the world stage. So, with the slump in spending in the US and elsewhere, China should step in with a big new fiscal expansion, which it is well placed to do because of its huge trade surplus that should be reduced anyway. China’s public finances are now very strong with a surge in tax revenues, and the old bad loan problem with its banks has been largely corrected as enterprises­, both state-owned and private­, are now very profitable.

In contrast, the US public finances are in a mess. The pre-crisis fiscal deficit is still with us. In addition, the government has taken on huge new contingent liabilities from bailouts of innumerable financial institutions that will hamstring the federal budget for years to come. Thus, any new US fiscal stimuli, or big new spending programs not covered by tax increases, should be out of the question. Even if implemented, they would wind up increasing the trade deficit.

In summary, a negotiated fiscal expansion in China (and possibly in other trade-surplus countries such as Germany and Japan) with a formal end to China bashing so as to secure the yuan/dollar rate as the quid pro quo, would seem to be the most promising way of mitigating a global slowdown.

Ronald McKinnon is professor of international economics at Stanford University. An earlier version of this article appeared in the Shanghai Securities News, September 24, 2008 (in Mandarin)

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