Crisis Was Made in China

By Alan Wood

EVERYBODY knows the global financial crisis and recession are the fault of the US and its extreme capitalism, or so Kevin Rudd and a lot of others would like us tothink.

Unquestionably, the behaviour of US financial institutions, including banks, investment banks, hedge funds and those who ran them, as well as of ratings agencies, investment advisers and others, makes them entirely legitimate targets of criticism.

The Group of 20's focus on reform, more effective regulation and transparency, and dealing with issues such as poor incentive structures and institutions judged too big to fail is an essential response to fatal flaws in deregulated markets.

And for now the concentration on fiscal and monetary policy responses aimed at restoring financial stability and restarting economic growth is the right one.

But viewing the crisis as largely a phenomenon made in America is wrong and dangerous. It could encourage behaviour that sets up the world for the next financial crisis.

The fallacy of this view was exposed in a speech by US Federal Reserve chairman Ben Bernanke, then a member of its board, in March 2005. The title of his speech was The Global Savings Glut and the US Current Account Deficit.

Bernanke noted that in a US economy that appeared to be in generally good shape, there was one aspect of its economic performance that was worrying economists and policymakers in the US and elsewhere: its large and growing current account deficit and the associated build-up in its foreign debt, seen as likely to precipitate an international currency crisis.

A widespread view, Bernanke said, was that this primarily reflected economic policies and other economic developments within the US. He challenged this conventional wisdom. Bernanke's explanation was lengthy, but the crux of it was what he called a remarkable reversal in the flows of credit to developing and emerging market economies, a shift that had transformed those economies from borrowers on international capital markets to large net lenders.

In the mid-1990s most developing countries were still large net importers of capital. In 1996, emerging Asia and Latin America borrowed about a net $US80 billion on world capital markets. However, in July 1997 a run on the Thai baht triggered the Asian financial crisis of 1997-98.

The response of the countries hit by the collapse of capital flows as foreign investors rushed for the exits, such as Thailand and South Korea, and of others, notably China, that escaped the worst effects of the crisis but worried about future ones, was to build up a large war chest of foreign exchange reserves to protect them from the risk of future investor panics and sudden capital flight.

Significantly, reserves also rose because China (and others) followed a development strategy of export-led growth based on an undervalued exchange rate, which required foreign currency inflows to be quarantined in official reserves.

This strategy, along with domestic reforms, was impressively successful in driving high growth and satisfying the crucial political imperative of finding jobs for the millions of Chinese migrating to the industrial cities. But for the world's balance of payments to balance, other countries had to run current account deficits.

The equilibrating mechanism was the flow of these excess savings into the financial markets of the US, Britain, Australia and other countries. The funds were invested in financial and other assets, but predominantly in US Treasury bonds.

Then deregulated financial markets intermediated them to the wider economy. First it was equity markets that soaked up the funds, then housing markets as households borrowed and leveraged their way into a housing bubble. And a mountain of increasingly opaque and risky financial derivatives were built on top.

So the root of the problem, Bernanke argued, lay not in the US but in the savings glut in countries in Asia, dominated by China, and in the traditional surplus countries, Germany and Japan.

This glut is the problem that ultimately has to be fixed.

Instead of blaming the US, we could legitimately say it all started in the policies of savings glut countries, with China the most high profile one.

Recently, perhaps partly to deflect attention from this, China's central bank governor Zhou Xiaochuan set a hare running by suggesting a solution was to replace the US dollar as the world's reserve currency with an internationally issued and managed one, the International Monetary Fund's special drawing rights.

Not surprisingly, the US is not taking any of this discussion very seriously, nor is anyone else apart from a UN committee. The American attitude has not changed much since Richard Nixon's treasury secretary John Connally told the Europeans in 1971 that the dollar is "our currency but your problem".

Right now the country for which it is the biggest problem is China, with its $US2 trillion in foreign exchange reserves, about 70 per cent of which is estimated to be assets denominated in US dollars, including lots of US government paper. Fears have been voiced that China could precipitate a new crisis by selling off its reserves or simply by not buying any more US Treasuries, but it won't, despite large losses and grumbling by Premier Wen Jiabao. China is locked in because the alternative is to precipitate the US dollar collapse it is so anxious to avoid.

A critical question is whether the global crisis will trigger behaviour that will help, through time, to unwind the global imbalances that are its root cause. Households in the US, Australia and elsewhere are deleveraging and saving more, and China is shifting to boosting domestic consumption and taking other measures, such as health and welfare reforms, that should reduce pressure on Chinese households to save.

And if the new post-crisis global financial architecture makes countries in Asia more relaxed about current account deficits and borrowing, then the world can begin to establish a more rational, and sustainable, financial structure.

This is one in which rich countries with rapidly ageing populations do the saving and invest in developing countries with younger, more rapidly growing populations and better investment opportunities.

But so far China still seems wedded to a strategy of export-led development, while in the US its necessary response to the global crisis is increasing its fiscal deficits and public debt, actions that will take time to unwind. In both China and the US, the adjustments needed will be painful, unpopular and resisted.

A good starting point would be to recognise that the worst financial and economic crisis since the Depression is not a simple morality play with Made in America stamped on it.