Asia is brimming over with foreign exchange reserves. While that cushions the region from a replay of a 1997-98 style crisis, it presents new challenges for Asian policy makers. Particularly worrisome are the excesses of a pan-regional liquidity cycle – complete with the risks of asset bubbles as exemplified by the current blow-out in domestic Chinese equities. Authorities both in Developing Asia and elsewhere in the world need to come up with a new policy framework – before it’s too late.
Why globalisation is different this time
There is a striking twist to the current globalisation. Unlike the globalisation of the early 20th century when capital flowed from the rich countries of the developed world to the “settlement economies” such as Argentina, Australia, and Canada, the opposite is true today.
In the current globalisation, the incremental saving for the advanced economies of the developed world has been provided almost entirely by the transfer of capital from the poor countries of the developing world (including oil producers). The United States, with its massive current account deficit, is the major beneficiary of this “reverse Marshall Plan” – absorbing more than 70% of the world’s surplus saving over the past three years. With that transfer has come a huge build-up in foreign exchange reserves of the donor nations – especially those in Developing Asia.
Asia’s foreign exchange reserves
According to the latest estimates of the IMF, foreign exchange reserves in the developing economies of Asia are likely to exceed $1.8 trillion in 2007 – literally a six-fold increase from levels prevailing in 1999. Deeply scarred by the wrenching financial crisis of 1997-98 that was triggered by a paucity of such reserves, the emerging economies of Asia are collectively saying, “Never again.” But now they have subsequently erred on the side of excess reserve accumulation – quite possibly having gone too far in atoning for their mistakes of the past.
The recycling of this capital – especially from Asia to the United States – has serious complications for the emerging economies of Asia. Lacking in well-developed capital markets, it has been exceedingly difficult for countries like China to sterilize the massive purchases of Treasuries and other dollar-denominated assets that are required to maintain pegged or “crawling pegged” parities with the US dollar. As a result, excess liquidity has seeped into Developing Asia’s domestic financial systems, pushing broad money growth in this region up to a 17% annual rate in 2006 – nearly three times the pace of money creation in the developed world.
A similar overshoot has been evident in the expansion of bank credit. Here, as well, China is a particularly salient example. Despite multiple tightening moves by the People’s Bank of China over the past year, domestic bank lending was still surging at a 16.5% y-o-y rate through April – more than three percentage points faster than the pace of credit extension in early 2005. Not only does the Chinese central bank have ongoing and serious problems in mopping up the excess liquidity from incomplete forex-related sterilization, but also it continues to have great difficulty in achieving policy traction with a still highly fragmented network of branch banks.
At the same time, embryonic banking systems continue to play a highly disproportionate role in the intermediation of total credit flows in the donor countries of Developing Asia. Here again, that’s especially the case in China, where the development of a domestic bond market has lagged and the banking sector still accounts for nearly 85% of total credit intermediation. In short, Asia, in general – and China, in particular – lacks the high-quality financial-market and policy infrastructure that is commensurate with its linchpin role as the world’s major provider of surplus saving. Senior leaders in Beijing concur on the urgency to address these shortcomings in the context of China’s broader control problems. The recent surge of money and credit is indicative of the concerns that recently prompted China’s Premier Wen Jiabao to characterize the Chinese economy as “unstable, unbalanced, uncoordinated, and unsustainable.”
Asia’s expanding equity bubbles
But it is the rapidly expanding Chinese equity bubble – with the domestic A-share index up more than 160% over the past year – that is today’s most visible manifestation of China’s control problem. Nor is this an isolated occurrence in Developing Asia. India’s Sensex Index has surged over 115% over the past two years, and the Korean KOSPI is up more than 70% over the same period. Sharp gains are also evident in the region’s smaller equity markets – especially Vietnam but also Taiwan, Malaysia, Pakistan, and Indonesia.
To the extent that China is now the engine of Developing Asia, its liquidity management problems – to say nothing of trends in its currency and equity market – are emblematic of broader control problems afflicting the entire region. With limited domestic absorption, quasi-pegged currencies, and rapid accumulation of foreign exchange reserves, most of these surplus-saving economies are awash in excess liquidity. Lacking in alternative assets and, especially in the case of China, with largely closed capital accounts, domestic equities have absorbed a disproportionate share of the Asian liquidity binge. The result is a classic asset bubble – driven by the same speculative forces that have taken markets to excess for hundreds of years but, in this case, reinforced by the liquidity-prone currency regimes of surplus-saving economies.
Will China lose control over currency expectations
China’s equity bubble underscores a new and worrisome feature of its policy regime – a loss of control in setting currency expectations. By succumbing to the pressures of Washington-led China bashing, the renminbi has become a one-way bet to the upside versus the dollar. With the US Congress now more likely than ever to enact WTO-compliant, veto-proof sanctions on China, most market participants have concluded that a large upward adjustment in the Chinese currency seems more and more likely as the only way to avoid a protectionist endgame.
The result has been a dramatic acceleration of hot-money inflows banking on a path of sharp RMB appreciation – in stark contrast with fixed currency expectations anchored by the once solid peg. This shift in expectations has amplified the trends noted above – leading to an accelerated pace of foreign exchange reserve accumulation, continued rapid growth in money and credit, and spillover effects in China’s domestic equity market. What Stanford professor Ronald McKinnon once labelled “conflicted virtue” – high-saving economies acquiring dollar-based claims on their creditors – is now in danger of becoming increasingly vicious (see McKinnon’s remarkably prescient 2005 book, Exchange Rates Under the East Asian Dollar Standard: Living with Conflicted Virtue, MIT Press).
How Asia can escape the policy trap
So what should be done to enable China and the rest of developing Asia to get out of this policy trap? In my view, a lasting resolution needs to satisfy three conditions: First, China needs to be more aggressive in taking actions to reduce surplus saving. That can only occur through a significant increase in domestic private consumption – a clear objective of China’s 11th Five-year Plan unveiled over a year ago. The sooner the consumption share of Chinese GDP starts to rise, the import share of this open economy will follow – reducing China’s trade deficit, a key component of its massive current-account surplus. China knows full well what it will take to boost domestic private consumption – namely, policies that establish and solidify a social safety net (i.e., pensions and social security) and thereby reduce the overhang of fear-driven, or precautionary, saving.
Consumer cultures – especially for nations lacking in safety nets – don’t spring to life over night. The increasingly destabilizing financial signals currently coming out of China make it very clear that the time path of this transition now needs to be shortened by an accelerated pace of investment in safety-net institutions.
Second, the United States needs to own up to the role it is playing in triggering destabilizing conditions in China and elsewhere in Developing Asia. The problem here is America’s unprecedented saving shortfall – a net national saving rate that averaged just 1% of national income over the 2004-06 period. The more the US relies on surplus savers from China and other Asian economies to fund its consumption-led growth, the more the destabilizing pressures of bilateral trade tensions will come into play – in economic, financial, and geopolitical terms. Relief of these tensions will require the US Congress to give up the ghost of promising a beleaguered American middle class that a bilateral RMB currency fix is the answer to all their problems. As I have stressed ad nauseum, it’s hard to be optimistic on this count. Unfortunately, there is no way out of the Asian trap if the US doesn’t disarm it.
Third, Asia, in general, and China, in particular, need to establish a new policy anchor. As I noted recently, I don’t think it is an accident that China’s interplay between foreign exchange reserve accumulation and its equity market became increasingly destabilizing in the aftermath of the dismantling of the RMB-dollar currency peg in July 2005. This single action, in conjunction with intensified pressure from Washington to do far more on the currency front, is the genesis of the hot-money inflows that are driving China’s foreign exchange reserves, domestic liquidity, and equity prices to excess. Chinese authorities need to be very direct and firm in re-establishing an explicit and transparent policy anchor – whether it is a price target, a money and credit target, or even a new currency target. With over $1.2 trillion in official currency reserves, China clearly has the ammunition to punish those who want to bet against a new policy target. With speculators increasingly eager to jump on the one-way RMB appreciation bandwagon, China may well need to take such actions in order to re-establish a credible policy anchor in the eyes of market participants.
The rest of Developing Asia is very much beholden to the China fix. Linked to the real side of the Chinese economy through an increasingly integrated pan-regional supply chain, it is virtually impossible for the rest of Asia to decouple from any pressures that might affect the performance of China’s trade engine. Similarly, the fate of the RMB could well hold the key to currencies elsewhere in Developing Asia. If the Chinese currency moves sharply to the upside, other Asian currencies – with the possible exception of the Japanese yen – should be quick to follow. Conversely, if China reverts to more of a quasi-stable RMB, currency adjustments elsewhere in the region are likely to be stymied – thereby putting the onus on improved US saving as the main mechanism for a US current account adjustment.
The Chinese equity bubble, in conjunction with mounting protectionist pressures in the US Congress, suggests that Asia’s current policy regime could be nearing a flashpoint. It is up to China and the rest of Developing Asia to put proactive policies in place that will enable it to escape this trap. Unfortunately, any such a resolution could well be for naught if Washington-led China bashing doesn’t back away from the brink.
By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley’s Global Economic Forum