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Taking hype about China with a big pinch of saltGrowth and size are not enough for fundamental changes in the global financial landscapeBy GUNTER DUFEY22 November 2011The avid reader of articles on international financial affairs is being fed a rich diet of speculative articles regarding the hyped-up changes that the rise of China’s economy is supposed to bring to the international monetary system. No doubt, potential for change exists as the Chinese economy, with its 1.3 billion hard-working and ambitious people, catches up with the more developed world, simply by being subjected to fewer policy mistakes - mistakes that have held the economic performance of that country back for decades, if not centuries.But is growth and size enough for fundamental changes in the global financial landscape? Caution is called for!It is true, China currently confronts a serious problem of diversifying its excessive foreign exchange reserves. Why it makes sense to accumulate hard-earned resources in huge liquid ‘reserves’ abroad is rarely addressed in this context. But then, the confusion starts in earnest: with China having 90 per cent of its balances in US Treasuries, analysts, in trying to highlight the (wrong) dilemma, bandy about alleged US$271 billion in reserve losses presumed to have accrued during the 2003-2010 period.How is that number arrived at? A dollar is a dollar is a dollar. If the number was only expressed in RMB, then it might make possibly sense for identifying opportunity losses. But real losses? Will these dollar holdings not buy as many Boeing planes, Caterpillar tractors, MS Windows systems (oops - MS sold only one copy to the PRC), and chicken feet from the United States?If one takes into account US inflation, which is quite moderate, one also has to take into account that Boeing planes and Caterpillar tractors get a bit better every year.When looking at the future role of the RMB in the international financial system, many academic writers forget to properly take into consideration the complete calculus of institutional investors when deciding where to hold liquid balances. Like China, such investors look for safety, liquidity and preserving value. But are these characteristics to be found in the RMB markets - offshore or onshore?Currently, this is clearly not the case. Onshore RMB are simply not accessible due to China’s currency control regime. Offshore RMB deposits in Hong Kong and other places are available and have given rise to a great deal of excitement among pundits from academia and fee-earning bankers, but the realities are not favourable for investors to park institutional funds in such deposits.The return is minimal and purely dependent on expectations of a sufficient appreciation of the RMB relative to the USD, which has not happened so far, and may happen to a much lesser extent, given China’s politics and domestic inflation rate. Anybody with the experience of cash management at MNCs will recognise that no one would risk his/her career on putting other people’s money in an asset class that exists only due to a peculiar constellation of Chinese political machinations.But let’s look ahead and speculate that the ‘Long March’ towards free convertibility of the RMB would ultimately arrive at its destination. How would the RMB stack up against the USD and others? Textbooks tell us that the volume of trade is an important determinant for private transactors to keep a ‘working’ balance for convenient settlement in that currency. Clearly, given the PRC’s economic size and role in the volume of international trade, the currency would be attractive for keeping balances.
However, this is only part of the story: as anybody who ever tried to run international settlement accounts knows, one is always confronted with unexpected receipts and disbursement requests. This is why everybody holds positive balances in spite of the fact that such balances yield virtually nothing, but have to be funded with the capital resources of the institution concerned; balances are expensive and need to be minimised!This means for a currency to be attractive, there have to be very efficient opportunities to borrow or invest funds for short periods safely and efficiently in order to minimise idle balances at the end of the business day.In short, currency systems compete in terms of an efficient money market, with many players and instruments, subject to reasonable prudential supervision. For China to offer facilities that can compete with the US’s is a long way off. There are other fundamental issues that have a bearing on the relative competitiveness of a fully convertible RMB against the alternatives. One has to do with a frequently overlooked practical aspect: the RMB business day ends long before the working day of other financial systems.Fundamental issuesIndeed, operating in the US time zones, one can adjust RMB balances only with a delay of one day! This aspect of time zone, plus the inefficiencies of the Japanese financial markets severely limited the role of the JPY as an international currency, defined as one that is used by transactors from third countries; despite the JPY being fully convertible for over 30 years now and its value has been on an upward trend towards the EUR and USD.There is another fundamental issue with the RMB as an international transaction currency: do you really want to have your working balances kept in a jurisdiction, where property rights have not been held in high esteem for centuries? There is something called ‘sovereign risk’ that goes well beyond sloppy fiscal policy currently afflicting Southern Europe. Now, it must be recognised that when it comes to international reserve assets of central banks as well as long-term investments by private asset managers, the considerations that govern the management of working balances abroad are more relaxed.Liberalised Chinese financial markets, governed by a decent legal system and rules of corporate governance may well attract a portion of the world’s savings. But that is different from playing a role as an international reserve asset comparable with, or superior to the USD. Such a role is not for the home country of the currency to usurp; it is decided by others who find a currency and its financial market environment sufficiently attractive to entrust their hard-earned savings.Thus, the world, including China, is stuck with the USD. In this respect, the so-called US balance of payments deficit is a chimaera: nobody knows exactly how much is due to excess US consumption and how much is due to the fact that in a constantly growing world, official and private investors find US financial markets the (relatively) best place to store a significant part of their ever growing savings. Interest rates on US bonds do not support the argument that investors are very concerned with the risks of a US ‘default’, pundits’ musings and even rating agencies’ prognostications notwithstanding.There is a final issue that muddies the debate regarding China’s reserves: investment in ‘real’ assets is simply not the answer! Buying productive assets requires expertise in managing such assets in a foreign environment. Chinese executives have shown to be very competent at managing productive assets in the unique PRC environment with its politicised decision-making, non-existent intellectual property rights and a surplus of eager hands coming from the countryside; many foreign investors in China have underestimated Chinese business acumen to their detriment.
Whether those skills will work outside of China, however, is more than doubtful. The experience so far does not support such a view. What special capabilities do PRC business entities have in running mining operations in Australia, when even local management has difficulties coping with the Australian regulatory regime and an entrenched culture of difficult unionism?Such questions are never addressed by writers who advocate foreign direct investment as a solution for China’s international reserve policy challenges. The solution to that issue has to be found in a drastic change in China’s political economy: stop subsidising US consumption and do something for the average Chinese citizen who is still enduring a living standard of less than 10 per cent of other Asians, such as the Japanese and Singaporeans. Such a policy change would be good for the Chinese - not so good for the Unites States, a fact that seems to escape many US members of Congress. But that is a different story . . .The writer is professor emeritus of the University of Michigan, Ann Arbor; he is teaching now at Nanyang Technological University/NBS Singapore
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