America: First time among equals
It's not a fair fight, the currency war between the US and China - but it's more evenly matched than most of us has ever seen. And as we saw in yesterday's sharp fall in the dollar, it has the potential to cause the rest of the world a lot of trouble.
Whether in the economic arena or the political one - it's been a long time since the US could pick on someone its own size. When it comes to a currency war, China's peculiar economic system lets it come pretty close.
The US spends as much on national defence every year as the rest of the G20 combined. That speaks to its unique geopolitical standing. Its economic firepower stems not just from its position as the world's largest economy but the "exorbitant privilege" of having the world's reserve currency.
As Martin Wolf argued in yesterday's FT [registration required], that means America will win this currency war - because it has a limitless capacity to print dollars. But China also has some unique weapons at its disposal - which America would not have, if the shoe were ever on the other foot. It can withstand the dollar onslaught for a lot longer than anyone else.
Why? Because there is no other country with a large economy - but a communist financial system. True, foreign banks have come to China in the past decade. True, they now have a new financial regulatory and supervisory authority that looks a bit like the FSA. But that is where the similarities end. Most banks are state-owned and all of them are still very much state-controlled.
This means that China can resist more upward pressure on its exchange rate, for a longer period of time, than any other government in the world, because it has a greater capacity to neutralise the impact on the domestic economy.
Sorry, this is complicated. But trust me, it's important.
In a normal Western financial system, governments can't hope to absorb large inflows of capital and hold down their currency and keep control of domestic interest rates. If they intervene to prop up the dollar (and keep their own currency cheap), that raises their foreign reserves, which in turn would usually push up the domestic monetary supply and create inflation. They can raise interest rates to tackle that problem, but that tends to make the inflow problem even worse, by making the country that much more attractive to foreign investors.
That is basically the dilemma being faced by Brazil, some of Central and Eastern Europe, and most of the emerging Asian economies. Thanks to loose monetary policy in the US and elsewhere, investors are flooding their economies with cash, in search of higher returns.
As I mentioned last week, this could do a lot of damage to their economies. In that sense, they are already victims in this battle to re-balance the global economy: some more innocent than others.
In Brazil, which has a flexible exchange rate, the government has put a tax on capital inflows, with only modest success. Where exchange rates are controlled (primarily Asia), there's been massive intervention to stop the currency going up - some of it even larger, as a share of their economy, than China's.
All of them try to "sterilize" those interventions, selling assets into the market to mop up the cash and prevent it turning into inflation. But there's a limit to what they can do. In a normally functioning financial system, building up hundreds of billions of dollars of reserves will massively distort asset prices and financial activity in the domestic economy, even if you prevent the immediate hit to inflation.
Which brings me to China and its repressed financial system. America would be quite happy for China's inflation rate to go up instead of its exchange rate: domestic inflation ought to make Chinese exports less competitive in the US, just as a change in the nominal exchange rate would.
But of course, that's exactly what the Chinese don't want. So, like most countries that intervene in exchange market, it tries to sterilize those flows. Here is where the repressed financial system comes in handy: not only can it require the banks to buy an enormous amount of low-interest government bonds, but it can also instruct them to hold a lot more cash in reserve at the central bank.
According to Nick Lardy, a renowned expert on the Chinese financial system at the Petersen Institute for International Economics, in the first half of 2008 alone, a three-percentage point increase in this reserve ratio forced banks to deposit an extra RMB1.3 trillion with the central bank. From 2002 to 2008, the authorities raised the reserve ratio 21 times, taking the rate from six to 17.5% (eat your heart out, Basel III).
Of course, the banks don't like this. But they don't get a choice. They can also comfort themselves with the knowledge that the money they're losing on all these forced investments in low-yield investments is at least partly offset by the profits they make on their domestic deposit accounts, which all receive interest rates far below the rate of inflation.
That low rate of return on savings is the government's doing as well, and for economists, it is the hallmark of a repressed financial system. It's a massive "stealth tax" on household savings, the proceeds of which accrue to banks, the government and, in China's case, exporters.
As Nick Lardy and others have argued, this is not safe or sustainable for China's economy. It pushes savings into the black economy, and adds to the problem of global imbalances because Chinese households are not benefiting as much as they should be from the nation's growth, and they have to save a lot more to feel secure.
But when it comes to China, we know that the unsustainable can continue for a very long time. We found out this week that China's foreign exchange reserves had risen by $194bn in the three months to September - one of the biggest increases on record (see chart below). At least $100bn of that was due to purchases of foreign exchange. (For reference, then the Bank of Japan intervened, to such acclaim, last month it spent about $25bn.)
As we saw yesterday, the longer this war continues, the greater the collateral damage will be for other economies, caught in the crossfire. And the more it will come home to the US administration that we really are living in a new world.