Financial effects of reset in US-China ties

Alok Sheel | Updated on May 10, 2020

No challengers: No currency can match the market depth of the US dollar

Would China’s withdrawal from the US bond market and/or a runaway expansion of the Fed balance sheet weaken the dollar?

The US and China are not just the two largest economies in the world separately, but have also for long been in a ‘co-dependent relationship’. China realised the danger of excessive reliance on US demand in a world turning its back on globalisation, and so it is consciously trying to change its growth model. The country now relies more on domestic consumption, is saving less and has balanced its current account.

The US, on the other hand, despite President Donald Trump’s bluster, has done little to change its own counterpart model. Its dissaving has decreased slightly, but its current account deficit (CAD) is still an outsized 2.5 per cent of GDP.

Distancing China

The US has a growing income and wealth disparity problem, with its middle class thinning out as real wages at the lower end stagnate. China is a very efficient mass producer, and that enables the US to import cheap Chinese goods that have enabled its lower middle class to maintain its quality of life through Walmart, Best Buy and the like.

But the global financial crisis (GFC), and its political outcome, Donald Trump, signalled the beginning of a revolt against these disparities. Trump’s solutions, however, only tend to magnify the underlying problem, because they ignore old lessons of trade theory and new lessons of global value chains.

The danger of the US cutting off China from its trade has increased with the political spat over Covid-19. This would entail the US CAD shifting to imports from other countries at higher cost. There would be a net welfare loss to the US, although this is an opportunity for countries like India. As in the past, India is not positioned to grasp it, unlike other countries in East Asia, such as Vietnam.

The US could try and shift to domestic production and create jobs — something Trump is trying to do. For this policy to succeed, the US would need to either import cheap migrant labour (defeating the domestic job creation agenda) or cut itself off from international trade, as there are more efficient producers out there in Asia.

Monetary policy

Income inequality in the US was exacerbated by financialisation of is economy. Much of the income of the richer Americans now comes not from productive investment but rather from financial markets, from which the lower middle class is excluded.

Easy monetary policy, beginning with the ‘Greenspan Put’, has propped up financial markets. Even as it reflated asset markets, the liquidity overhang did not result in runaway consumer price inflation, as an open, globalised economy cushioned supply shocks.

The Federal Reserve was able to keep market interest rates low because the US was able to finance big fiscal and CADs over extended periods on account of the large external demand for what is effectively the global reserve currency. Other countries run such deficits at their own peril, as they would be quickly penalised by markets. These markets had a Chinese angle, because Chinese export surpluses funded a large proportion of US deficits through the purchase of treasury bonds.

As the Chinese withdraw, QE would become the chief instrument of US monetary policy, with the Fed mopping up the excess supply of treasuries from the market to keep interest rates within the policy band. That the US Fed seems to have already embraced this ‘Modern Monetary Theory’ is reflected in its bloated balance sheet, and the interest paid on excess reserves (IOER) of depository institutions, rather than the overnight Fed Funds Rate, becoming the effective Fed policy rate. Would China’s withdrawal from the US bond market and/or a runaway expansion of the Federal Reserve balance sheet weaken the mighty dollar?

Currency anchor

The dollar’s strength rests ultimately on non-economic factors, like the pound sterling in the past. According to the IMF, the last global financial crisis was supposed to have been caused by the disorderly unwinding of global imbalances, with the dollar weakening on account of sustained domestic and external deficits.

The crisis did occur, and US deficits were also one of its ultimate causes, but the dollar only strengthened as a result. The dollar has become a bellweather currency, weakening when global growth and confidence is high, and strengthening at the first signs of darkening clouds.

Any rival reserve currency would need to surmount the inertia factor, as no currency can match the market depth of the US dollar. It is like trying to replace Microsoft Windows. You need a market-maker on a colossal scale to make this shift away from the dollar. The euro was supposed to play this role, but the odds were always stacked against ageing economies.

The other possible candidate, the Chinese renminbi, faces an even bigger inertia challenge than the euro, as it lacks soft power, and its hard power still cannot match the techno-military might of the US.

For the student of history, gold still remains the most likely candidate in the long run to replace the dollar. The problem runs deeper than just US deficits which are also the counterpart of the bottomless global demand for the US dollar. It lies in the concept of fiat currency itself. It has been around for less than half a century. History tells us that there is a moral hazard in giving policy-makers the discretion to issue fiat currency without a nominal anchor. Sooner or later, they will kill the golden goose.

And this is exactly what is happening. Gold has played the role of nominal anchor through much of recorded history.

The way sovereigns are expanding deficits and debt, and the alacrity with which central banks are accommodating them since the GFC, and now in the wake of the Covid-19 pandemic, arguably leaves one with bleak hope for the future of fiat currencies. Whether the world would return to the tried and tested nominal anchor, or some other, is arguable. But buying more gold at the next sharp drop to diversify asset portfolios might not be a bad idea.

The writer is RBI Chair Professor, ICRIER

Published on May 10, 2020

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