财经观察 1692 --- All Chinas fault?

All China’s fault?

• The US financial crisis was driven by low US rates and a failure of risk management
• China’s external imbalances contributed to the problem, but did not cause it
• The Bretton Woods II system is morphing, with unclear consequences

In a recent interview with the Financial Times, US Treasury Secretary Paulson said he believed that China helped to create the global credit bubble by saving too much – and lending those savings to the United States. ‘Paulson says excess led to crisis’, by Krishna Guha, Financial Times, 2 January 2009. That put downward pressure on yields and risk spreads everywhere, he claimed, a key element of the current crisis. Our favourite news agency, Xinhua, was not going to take that sitting down. It is ‘irresponsible and untenable’, it warned, for anyone to blame China for helping to cause the global financial crisis. Since then, the local press and officialdom have been busy pushing that line. Today, we have our say.

Building Bretton Woods II

Let us start with Mr. Paulson’s case. As part of the system known as Bretton Woods II (hereafter, BW II), China and the Middle East (ME) ran large trade surpluses, and grew partly on the back of consumption in the US and other mature economies. Thanks to a mix of an undervalued currency, tax breaks, and its own competitive advantages, China’s exports boomed; so did the Middle East’s oil exports. Both regions’ currencies were pegged (or crawling-pegged) to the dollar, so there was no automatic adjustment mechanism. The revenues from these exports (as well as speculative funds moving into CNY) created a huge amount of liquidity at home, as well as super-sized FX reserves.

Beijing, Riyadh, et al. had little choice but to reinvest these savings in US Treasuries, agencies, and other foreign securities. These recycled flows made up for the US saving deficit. As a result, the argument goes, US bond yields were depressed, lowering the cost of borrowing, making US mortgages cheaper, and underpinning all other asset classes. Add a few greedy bankers and some regulatory blind spots into the mix, wait a year or two for everything to come to the boil, and we have a fully-fledged global financial crisis. (To be fair to Secretary Paulson, he has not downplayed the failure of US regulation, and we recommend reading his original comments in Appendix 1.)

Today, we examine the evidence for Paulson’s assertion. Before we get into detail, here are our 10 conclusions:

1. China did provide financing to the US during 2002-08, and clearly was (and still is) a factor in global imbalances.
2. The managed exchange rate and the People’s Bank of China’s (PBoC’s) daily FX intervention played a role in the build-up of China’s super-sized FX reserves.
3. Relative to the size of its economy, China was less imbalanced than the Middle East – but in dollar terms, it was a bigger player. Its surpluses were equivalent to about one-quarter of US borrowing over 2002-08.
4. Europe in aggregate was not a significant borrower of all this cheap financing (though some European countries clearly were). Domestic policy in some of these countries meant that they did not import the ‘surplus’ savings.
5. US short-term interest rates were set too low for too long by the Fed, which was probably the fundamental cause of the housing bubble and all the liquidity generated over 2002-08. The dollar is, after all, the world’s reserve currency.
6. Long-term US interest rates were low by historical standards after 2004. Buying of Treasuries and agency securities by China and others was likely one reason. But so were the market’s general expectations of lower inflation in the future.
7. Housing and credit bubbles developed in the US and elsewhere, but central bankers generally decided not to address them.
8. BW II has not collapsed. Instead, it is currently morphing.
9. There are important structural reasons for the emergence of ‘surplus’ savings in Asia, and these were always going to take time to change. At the same time, Beijing did make some policy choices that exacerbated the imbalances.
10. A lot of misguided consuming, banking, and regulation had to happen to turn borrowed savings into the mess we face today.

China and the Middle East did finance the US

First, let us consider flows of funds around the world. Global savings, as a proportion of global GDP, rose from a low of 20.6% in 2002 to 23.9% in 2006 and then plateaued at this higher level (a couple of percentage points above the long-run average, as we show in Chart 1).

However, we should not focus only on global savings. If a country’s high savings rate was matched by an equally high investment rate, the country would not have any ‘surplus’ savings to export. China’s (and the Middle East’s) problem was that ‘surplus’ savings – savings minus investment (S-I) – grew larger. (S-I is also equivalent to a country’s current account surplus.) In the US, the opposite occurred. China’s ‘surplus’ savings are shown in Chart 2 as the gap between the two lines. This surplus was driven not by suppressed investment, but by savings growing faster than investment.

‘Surplus’ savings accumulated in developing Asia (which China dominates) and the Middle East, as shown in Chart 3. The US was borrowing to finance its savings/current account deficits. The chart shows the savings ‘surplus’ as a proportion of GDP, and shows that the Middle East was more imbalanced than developing Asia in these terms. China ran a surplus of ‘only’ 11% GDP at its peak.

In dollar terms, because of Asia’s larger scale, Asia and the Middle East supplied roughly equal amounts of financing to the US. Chart 4 shows the accumulated build-up of borrowing and lending over 2002-08. Developing Asia (91% of which is China) and the Middle East each exported ‘surplus’ savings of around USD 1.4trn over this period, while the US borrowed an extraordinary USD 4.2trn. It did this mostly by issuing US Treasuries as well as agency securities, although in recent years China and other countries have also invested in US corporate debt and some equities.

Europe in aggregate did not borrow significant amounts within the BW II system (though some European countries did borrow with abandon, and Central and Eastern European countries ran deficits too). This leads to the question of why so much of these ‘surplus’ savings flowed to the US.

China, Middle East did not determine US short-term interest rates

One key reason is that the US was a key source of that liquidity in the first place. US interest rates were too low. John Taylor at Stanford University has shown that between 2002-06, the US Fed funds target rate significantly deviated, on the downside, from the rule he established for appropriate short-term rates. ‘Housing and monetary policy’, September 2007, and ‘The Financial crisis and the policy responses: an empirical analysis of what went wrong’, November 2008. We show this in Chart 5. Had the rate been higher, it would have made a big difference to house prices, Taylor believes.

A paper co-authored by Taylor and Josephine Smith outlines a theory to explain why long-term yields stayed low even when the Fed hiked the short-term rate after 2004 (a phenomenon Alan Greenspan famously termed a ‘conundrum’). They argue that the low inflation response to low rates created expectations of even lower inflation tomorrow; with long-term inflation expectations contained, the yield curve shifted downward. ‘The long end and the short end of the term structure of policy rules’, Josephine Smith and John Taylor, Stanford University, November 2007. In other words, there seemed to be a new paradigm in operation – that central banks were now so good at their game that markets believed they could control inflation.

The problem was that most folk (including the Fed) were looking at the prices of goods and services, not houses. House prices peaked in July 2006, as Chart 6 shows. US monetary policy explicitly did not take this into account, which now looks like an error of judgement. Sub-prime lending peaked during 2005-07. China’s imbalances grew large only in 2007-08, probably further fuelling the bubble once it had inflated. The liquidity from emerging markets, which was recycled back into the bond markets, probably prevented US monetary conditions from responding to the short-term rate hikes, as shown in Chart 7.

The US financial system

Not to put too fine a point on it, but the US financial system failed to mediate the incoming funds as normal constraints on bad credit risks gaining access to credit fell apart. Whether through poor mortgage lending standards, badly executed mortgage securitisation, credit rating mistakes, or internal risk management failures, risks were improperly managed and were allowed to multiply.

Some legitimate economic policy, and some more questionable

There were problems in Asia, too. Its growth model – and China’s – has clearly been imbalanced. However, there are some justifiable and structural reasons for this:

• After the Asian financial crisis, developing countries had clear incentives to run current account surpluses and build up FX reserves as a defence against a repeat of the crisis.
• High savings levels are not unusual in Asian economies, partly for cultural reasons.
• China’s own investment levels have rarely been suppressed (its current fiscal stimulus package is certainly not shy on the need for more government-driven domestic investment, which will help reduce the country’s external imbalances).
• Complaints about China’s lack of consumption sometimes miss the mark – building a social welfare system and boosting incomes will take years. In the short term, the world will have to learn to cope with some imbalances in China.

That said, there are other, less legitimate causes for China’s imbalances, which critics ignore to their peril. The semi-fixed exchange rate and the PBoC’s daily intervention in the FX markets encouraged exports, and thus the expansion of China’s external imbalances, from 2004. Without rehashing the old debate about the currency, we believe more could have been done.

There is also a problem with attributing China’s savings to cultural factors: savings increased dramatically during 2002-08, and China, we guess, did not become more ‘Chinese’ over this period. This increase in savings was likely driven partly by cyclical factors such as accumulated corporate profits, bigger government revenues, and higher wages, but also structural ones, such as the lack of a corporate dividend policy.

Bretton Woods II has not collapsed . . . but it is morphing

The situation shown in Chart 4 does look dangerously unstable. Indeed, many have warned in recent years that BW II was doomed to collapse, bringing economic dislocation as it did. However, the problems these folk predicted are not the ones we are dealing with today. For instance:

• BW II critics believed the US deficit would stop being financed. However, based on the latest data, it appears that China is still buying large quantities of US debt, helping to contain long-term interest rates.
• They worried about a large depreciation of the USD against the world’s managed currencies. This has not happened – and even if the USD does drop again, it is unlikely that Gulf Cooperation Council (GCC) currencies and the CNY would be allowed to appreciate against it.
• BW II critics worried that a rise in protectionism would cause the system to fall apart. This has not happened.

We do not rule out these events in the future. But for the time being, BW II is morphing, not collapsing The original framers of the BW II framework also argue it has not basically changed: ‘Will subprime be a twin crisis for the United States?’, Michael Dooley, David Folkerts-Landau, Peter Garber. They believe the framework is still largely sustainable.:

• US consumption is now contracting, putting an end to the enormous demand for China’s manufactured goods and Middle East oil. However, while this has caused the US non-oil trade account deficit to move back towards balance, the overall trade account remains in deficit. In other words, as Chart 8 shows, the US external account is not rebalancing.
• Many non-sovereign assets – whose yields were supposedly driven down by central bank buyers – have seen their yields rise. Central banks like the PBoC have shifted into short-term Treasury securities, becoming net sellers of agencies and long-term Treasuries. Given the need for low interest rates to support a recovery in US consumption, if these flows stopped (and other flows did not replace them), the US would have an additional problem. This ‘Great Normalisation’ of yields is being exacerbated by a shift towards risk aversion, which means many spreads remain elevated.

The simultaneous slump in global demand we are currently experiencing makes rebalancing difficult. The BW II system also increases the risks of protectionism if surplus countries continue to encourage exports.

The bottom line

We understand why Xinhua and other folk in China react strongly to the claim that China played a role in this crisis. They would be wrong, however, to ignore the flows of funds around the world. They should be careful about the consequences of these imbalances for global growth, and for growth in China. And they should try not to misinterpret Secretary Paulson, who in his pre-G20 comments was careful to lay the primary blame for the crisis at home (see Appendix I).

Having said that, the US is clearly the origin of this crisis. A low US policy rate environment allowed a US asset bubble to develop, and US financial markets were oriented towards amplifying the risks that this created. In sum, we agree with President-elect Barack Obama, who in his recent speech about the economy said that this was ‘a crisis largely of our own making’.

Appendix 1: Paulson’s mea culpa

Before the G-20 in November 2008, Secretary Paulson made the following comments:

“We in the U.S. are well aware and humbled by our own failings and recognize our special responsibility to the global economy. The U.S. housing correction exposed gaping shortcomings in the outdated U.S. regulatory system, shortcomings in other regulatory regimes, and excesses in US and European financial institutions. These institutions found themselves with large holdings of structured products, including complex and opaque mortgage-backed securities....

“It is also clear that our first priority must be recovery and repair. And of course we must take strong actions to fix our system so that the world does not have to suffer something like this ever again.... And to adequately reform our system, we must make sure we fully understand the nature of the problem, which will not be possible until we are confident it is behind us. Of course, it is already clear that we must address a number of significant issues, such as improving risk management practices, compensation practices, oversight of mortgage origination and the securitization process, credit rating agencies, OTC derivative market infrastructure, and regulatory policies, practices, and regimes in our respective countries. And we recognize that our financial institutions and our markets are global, but our regulatory regimes are national, so we will examine how best to improve cooperation and information-sharing to foster global financial system stability…

“But let us not forget one fundamental issue which lies at the heart of our problems. Over a period of years, persistent and growing global imbalances fueled a dramatic increase in capital flows, low interest rates, excessive risk taking, and a global search for returns. Those excesses cannot be attributed to any single nation. There is no doubt that low U.S. savings are a significant factor, but the lack of consumption and accumulation of reserves in Asia and oil-exporting countries and structural issues in Europe have also fed the imbalances. If we only address particular regulatory issues – as critical as they are – without addressing the global imbalances that fuelled recent excesses, we will have missed an opportunity to dramatically improve the foundation for global markets and economic vitality going forward. The pressure from global imbalances will simply build up again until it finds another outlet.”