Subscribe Feed (RSS)Never short a country with $2 trillion in reserves?
February 2nd, 2010 by Michael Pettis | Filed under Balance of payments, Reserves.I am traveling in DC, NY and Boston over the next few days, and between meetings and jet-lag it is hard for me to do much on my blog, but I did want to extend a short piece I wrote that was published yesterday in the South China Morning Post. This is because it is about central bank reserves, a topic that to my dismay probably generates more confused and mistaken thinking than any other topic in economics.
As many of my readers know (although I have not made any reference to it on my blog) hedge fund manager Jim Chanos recently made some headline-inducing claims about China. Chanos, a successful hedge fund manager who has made his reputation – and fortune – by identifying and shorting seriously overvalued assets, most famously Enron, seems to have read the PivotCapital piece that got a lot of attention last year, and partly as a consequence he claimed that China is undergoing a speculative bubble that makes it the equivalent of “Dubai times 1,000 – or worse”.
His claim was met with incredulity by New York Times columnist Thomas Friedman. Freidman is best known for his writings on globalization, and although I have no doubt that he is a very smart man when it comes to getting politics right, especially in the Middle East, which I believe is his area of specialty, I also have no doubt that he does not understand China much and understands almost nothing about central bank reserves and the functioning of the global balance of payment. I have read many of his articles, and so far I am pretty sure that these aren’t his strong points.
In response to Chanos’ claim Friedman made a number of very questionable statements about China. These are matters of dispute and although I think they are completely wrong, they are at least defensible. For example he says its true that there may have been risks of bubbles. ”In the last few days, though, China’s central bank has started edging up interest rates and raising the proportion of deposits that banks must set aside as reserves — precisely to head off inflation and take some air out of any asset bubbles.”
Really? I think you have to be a tad credulous to believe that the RMB 7.5 trillion lending target for 2010 and the slightly higher interest rates represents taking air out of the asset bubble. I would argue that they simply mean that the astonishing rate at which they were pumping air into the bubble has moderated slightly, to merely excessive.
He also says:
Now take all this infrastructure and mix it together with 27 million students in technical colleges and universities — the most in the world. With just the normal distribution of brains, that’s going to bring a lot of brainpower to the market, or, as Bill Gates once said to me: “In China, when you’re one-in-a-million, there are 1,300 other people just like you.”
Aside from perhaps his overestimating the quality of the education system, this is very bad statistics, and perhaps shows how easily we can get intellectually overwhelmed by large numbers. If China indeed has the same distribution of geniuses, or talent, as other countries, the fact that it has so many people won’t make it richer (and what about India?). After all if you cut China into four countries, each country will have only one-fourth the number of geniuses. Does that really mean that the four countries together are stupider? If we combine the US, Canada and Mexico into one country, its a pretty safe bet that the total number of geniuses will be more than any of the three countries currently possess, but will average intelligence rise? Can we really make the three countries richer that way (of course there may be good economic arguments for suggesting that unifying North American into a single country will make it richer, but the larger number of geniuses is not one of these arguments).
Ok, we can argue about these things, and we can agree to disagree, but where he completely blew it was, I suspect, on the one topic are where he was absolutely certain he could not be wrong.
Too bad, because he was. Friedman proposed, yet again, a common misconception over the meaning of China’s huge accumulation of foreign reserves. He argued that thanks in part to the size of the reserves it would be impossible to make money by shorting China. “First,” he warned, “a simple rule of investing that has always served me well: Never short a country with US$2 trillion in foreign currency reserves.”
Really? Friedman proposed the rule sarcastically – as both untestable and too obvious to need testing. It is so obvious that no country has ever had such high levels of reserves, so you can’t really test the hypothesis, but it’s also pretty obvious that a country with $2 trillion in reserves is in great shape. Anyone who wanted to short it must be pretty stupid, right?
But it turns out that reality is not as obvious as he imagines. Let us leave aside that the PBoC’s reported reserves are a lot more than $2 trillion, and that if correctly accounted they would be pretty close to $3 trillion. China’s foreign reserves are certainly huge. They add up to an amount equal to about 5-6 % of global gross domestic product.
But they are not unprecedented. Twice before in history a country has, under similar circumstances, run up foreign reserves of the same magnitude.
The first time occurred in the late 1920s when, after a decade of record-beating trade and capital account surpluses, the United States had accumulated what John Maynard Keynes worriedly described as “all the bullion in the world”. At the time, total reserves accumulated by the US were more than 5-6% of global GDP. My back-of-the-envelope calculations suggest that this was probably the greatest hoard of central bank reserves ever accumulated as a share of global GDP, but please check before you accept this claim.
The second time occurred in the late 1980s, when it was Japan’s turn to combine huge trade surpluses, along with more moderate surpluses on the capital account, to accumulate a stockpile of foreign reserves only a little less than the equivalent of 5-6% of global GDP. By the late 1980s, Japan’s accumulation of reserves drew the sort of same breathless description – much of it incorrect, of course – that China’s does today.
Needless to say, and in sharp rebuttal to Friedman, both previous cases turned out badly for long investors and brilliantly for anyone dumb enough to have gone short. During the early years of the Great Depression of the 1930s, US stock markets lost more than 80 per cent of their value, real estate prices collapsed, and the US economy contracted in real terms by an astonishing 30-40 per cent before recovering in the 1940s.
Japan’s subsequent experience was economically less violent in the short term, but even costlier over the long term. During the period following its astonishing accumulation of central bank reserves, its stock market also lost more than 80 per cent of its value, real estate prices collapsed, and economic growth was virtually non-existent for two decades.
The idea that massive levels of reserves are a guarantor of economic stability is, in other words, based on a profound misunderstanding both of history and of the nature of reserves. Reserves of course are not useless as an enhancer of financial stability, but their use is for very specific forms of instability. Having large amounts of reserves relative to external claims protects countries from external debt crises and from currency crises.
Great, but neither Chanos, nor even the most pessimistic Sino-analyst, has ever said that these are the kinds of risks China faces today, any more than they were the risks faced by the US in the late 1920s or Japan in the late 1980s. The risks that China faces today (and the US in the late 1920s and Japan in the late 1980s) is of excessive domestic liquidity having fueled asset and capacity bubbles, the latter requiring the uninterrupted ability of foreign countries to absorb via large and growing trade deficits. These risks include an explosion in domestic government debt directly and contingently through the banking system.
These are, very typically, the kinds of risks that threaten rapidly developing large economies, unlike the external debt and currency risks that typically threaten small economies. And reserves are almost totally useless in protecting these economies from the risks they face (and, no, no, no, reserves cannot be used to recapitalize the banks – only domestic government borrowing or direct or hidden taxes on the household sector can be used to recapitalize the banks).
In fact, it was the very process of generating massive reserves that created the risks which subsequently devastated the US and Japan. Both countries had accumulated reserves over a decade during which they experienced sharply undervalued currencies, rapid urbanization, and rapid growth in worker productivity (sound familiar?). These three factors led to large and rising trade surpluses which, when combined with capital inflows seeking advantage of the rapid economic growth, forced a too-quick expansion of domestic money and credit.
It was this money and credit expansion that created the excess capacity that ultimately led to the lost decades for the US and Japan. High reserves in both cases were symptoms of terrible underlying imbalances, and they were consequently useless in protecting those countries from the risks those imbalances posed.
We must be careful how we read history. The fact that the US and Japan had terrible decades following periods during which they had amassed levels of reserves that China has subsequently matched, and under conditions similar to those of China, does not necessarily mean that China too must have a lost decade or two. Chanos is not being crazy when he worries, but it is still an open question as to whether or not he will turn out to be right.
But the history does indicate that facile statements about central bank reserves should, at the very least, be measured against the obvious historical precedents. Chanos might still lose this debate, but Friedman has already proven himself to be hopelessly wrong.
Tags: Jim Chanos, Thomas Friedman
Brilliant. Thanks for this post.
Excellent blog today. A remaining question is the over valuation of the Renminbi, if any. Does the currency necessarily need to appreciate against the USD? In the “olden days” China would have taken our gold, and we would have had to have reduced our money supply (not increase it like we are doing now)…they would’ve inflated and we would’ve deflated, making our goods more competitively priced. This imbalance remains until the currencies are allowed to adjust?
Thanks for this post! I am not an econ guy; this really answers a few questions I’ve had about the bubble.
What a great article! I’ve read for years how China will overtake the US as the world’s largest economy. If you look carefully at the assumptions that would lead to this, it becomes a lot less certain. Great to see Professor Pettis poking holes in the China death star.
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Michael,
What do you mean when you say “and, no, no, no, reserves cannot be used to recapitalize the banks – only domestic government borrowing or direct or hidden taxes on the household sector can be used to recapitalize the banks.”
Why would a bank bailout not be “using reserves to recapitalize banks?”
Michael
Thanks for taking the time to post. By the way any clarity regarding your talk at Harvard on the 8th ?
[...] Pettis calls out Thomas Friedman on his careless economic analysis–a very entertaining read. The punchline? China, with its [...]
SV,
Pettis has answered this question so many times that he probably won’t again, but let me try. Reserves are not wealth. They represent assets on one side of the central bank balance sheet.
On the other side is matching debt. If the central bank were going to donate reserves to the banks to recapitalize them, it would create a hole in the balance sheet, and the net result would be an increase in the net indebtedness of the central bank. Since the central bank is part of the government balance sheet, this increase in net indebtedness would be exactly the same as if the Ministry of Finance borrowed money and gave it to the banks.
I have left out the fact that these dollar reserves cannot be converted into yuan by the banks without giving them right back to the central bank. The result would be no change in the central bank reserves, higher government debt levels, and recapitalized banks. You would get exactly the same result if the government borrowed money and gave it to the banks. So its the same.
Did I get it right, professor?
Hi Michael,
Interesting, the Chinese reserves issue is back and with full force.
First I would like to ask you not to deny something that I never stated. I never said that reserves are necessarily wealth. I said that they are an asset, in this case an extraordinary asset.
Second, you used the same trick again: “…, no, no, no, reserves cannot be used to recapitalize the banks – only domestic government borrowing or direct or hidden taxes on the household sector can be used to recapitalize the banks”. Who said that it could? Friedman? Or, that is the only way you imagine how reserves could be used?
Also, as I said before your historical examples are not necessarily true. In today´s scenario there is a country with 2,4 trillion dollars of reserves and at the same time another one, the most developed of all, approaching 15 trillion dollars of debt and in a deterioration course because is unable to finance its consumers, increase its exports and instead of changing its economic model is trying to keep alive the old one. There is no precedent to this situation.
So, I just propose that, for a moment, you give up your monetarist framework, and being a specialist in China, imagine a few ways how economic policy experts would use (or are using) the reserves in China´s benefit. That exercise might help, among other things, to place the assets and capacity bobbles in China in a less important perspective.
By the way, Houhui´s explanation on how reserves in China are formed, answering my previous comment, trying to establish a one to one relationship with debt is completely wrong. There is no need to go far. Macro Economics 101 shows that this is a many to many case.
Regards,
Christopher.
Professor Pettis,
Friedman’s case about the number of smart students is correct. It is really just a special case of the idea of unlashing the human capital. Because of the change in China in the last 30 years, the human capital was unlashed and empowered. The key here is there is a huge _net change_ in the productivity of the human capital. Professor, you are at the forefront of that net change. If your students were born 30 years earlier, many may be farming the land right now. In your example of just simply combining all the people in north America, it will not result in a net change in productivity. India and other emerging markets are also benefiting from this net change and in the long run this is a very powerful force. By the way, this is also one of the reason why US has been going strong. Smart people immigrating to US resulting in a huge net change in their productivity. Just consider what would happen if US change it’s immigration policy to follow that of Japan.
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Professor Pettis,
Honestly, here is what I am stuck on. I know what I am about to say is going to sound like heresy.
What if it is the rest of the world that has a over capacity issue and China is just now unleashing the dormant capacity that it has? What if China can continue to outproduce everyone at a lower and still profitable price? Again, I know this may sound like heresy but let me elaborate.
30 years ago China’s productive capacity was lockup and dormant due to bad political structure. China’s _potential capacity_ was not part of the world’s productive capacity. In that old world, China’s production capacity was underutilized. At the same time the rest of the world’s production capacity was in balance with demand and was supported by an old price. That old price was based on an under utilized global production capacity (China’s capacity isn’t being used). Therefore, the old price is neccessary higher. This is a really important point.
Today, more and more of China’s production capacity are coming online every year. The existing productive capacity of the rest of the world that were supported by yesterday’s price is now unsustainable. However, China’s current productive capacity is supported by today’s price. Viewed this way, it is the rest of the world that has an over capacity problem. It is also interesting to note that because of lowered price, demand changed. Everyone’s quality of life improved because people every where are able to afford more at a lowered price.
Everything I said above applies to all the emerging markets (not just China) today and upcoming emerging markets in the future. Each time the production capacity of a new emerging market comes online, it is the rest of the world that has a over capacity problem!
Professor Pettis, please let me know your thoughts.
Thanks, JohnZ. That makes sense.
If your explanation is correct, the reserves do represent wealth, it’s just not the government’s. But the government can always expropriate it one way or another from the Chinese holders of that wealth–whether through taxes or monetary policy.
If what you project comes true what do you forecast is the impact on the China construction market?
@SV
Well, in China’s case foreign reserves are US bills and bonds (to a large extent).
So if they sell the bonds, then exchange it for stakes in banks at a value of X (say as cheap debt or equity), how is that a change in the net debt position?
i.e.
step 1. Sell bonds
Step 2. convert to Yuan (exchange rate is hurt)
step 3. Exchange yuan for note or other senior security in Chinese bank
step 4. Bank now “healthy”. They can probably treat the note as quasi equity /debt depending on how they structure it while still boosting the weak balance sheets.
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surely the practical issue with using the pboc’s reserves towards any kind of domestic bailout (e.g. if the pboc sold u.s. treasuries and bought chinese govt debt) is that it would necessitate abandoning the currency hedge and push the yuan through the roof. not an outcome that would help a post-bubble china methinks.
Foreign reserves can only be spent abroad, for consumption or investment. The message, if any, should be not to short dollar countries.
Great article. From another perspective, could we also say that the reserves mean nothing because they are a result of explicit dollarisation? And in the dollar zone (60+% of global economy?) the reserves are useless?
My perspective:
China’s asset and capacity “bubble” – should not be considered as such, at least not at this time, because it is justified in the context of real economic growth potential until a time that shortage/high prices of natural resources/commodities, pollution, and consequently severe world depression will diminish the current positive context.
Interesting article, thanks for the insight. Friedman’s article did seem rather flippant and casual.
But I have to say, Chanos’ investment thesis seems fundamentally broken as well. In order to short the real estate bubble, he’s going to short the infrastructure vendors (like concrete/steel producers)? Really!?
I really doubt that’s the best correlation. If the Chinese economy does slow down substantially, there’s little doubt in my mind that the government will try to spend its way out of it by throwing large amounts of money at more infrastructure development. Even if residential development disappears in its entirety, I tend to believe the infrastructure vendors will tread water reasonably well. I think you have more of a point worrying about the banks providing credit to these residential developers.
But even so, can someone pull up all the entries on this blog since Q408 breathlessly worrying about the inevitable collapse of Chinese real estate? What’s the over/under on the number of entries before said collapse actually occurs? 10? 50?
China owns 3 Tr USD
The US owns a USD-printing press
Who is richer?
Excellent post
Why can foreign reserves only be spent abroad?
Well, those who believe higher exchange rate for RMB would translate to more US manufacturing jobs should look no further than merely 4 years ago, between 2006 and 2008, RMB gained 20% against the US dollar, in the mean time, China’s trade surplus with the US also increased 20%. The problem with American manufacturing is its structurally high labor cost, a problem the manufacturing industry shares with the rest of the economy. The structurally high labor cost, contrary to what many people believe, isn’t primarily a result of labor union greed, the US fundamentally is an exceptionally inefficient country with suburban sprawl that forces everybody to commute to work everywhere, which adds huge structural cost to everybody’s standard of living. In most developed or semi-developed countries, there is an option between driving and taking public transit, in the US, the option simply isn’t there. Which means that quite often, higher wager earners like many American workers, in reality, live a life with lower standard of living than even many of their Chinese counterparts, despite the huge difference between their wages. Too much money, resources, time and attention have been wasted on maintaining so called “freedom” (nobody talks about the freedom to not have to drive everyday, thus polluting the world and wrecking one’s finances) which fundamentally weakens the competitiveness of US industry, unless that changes, I sincerely see no chance against China’s never-been-achieved-in-history economies of scale.
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Furthermore, those reserves are held hostage by China’s exchange rate policy
“But even so, can someone pull up all the entries on this blog since Q408 breathlessly worrying about the inevitable collapse of Chinese real estate?”
People started seriously talking about the U.S. housing bubble around 2003–that’s when some of the popular bubble blogs got started, for example. Lots of people (though a minority) watched in disbelief for years as the bubble got bigger and bigger. It’s hard to predict timing, but it can be fairly easy to detect the existence of a bubble once you’ve seen some.
Time for a refresher on aggregate demand, methinks.
In addition a reminder of relative value and unrealized losses would be instructive.
I see that the US’ current account deficit has fallen from 6 or more % of GDP %3. Which, let’s say roughly, a fall from $800 bln to $400 bln.
So there has been a very large, if not enormous, change, in the international balance of payments. And maybe I frequent the wrong places (current location excepted of course), but I don’t see much web financial blogsphere discussion of just what this means – or if one prefers, how other parts of the whole cloth are rippling in response.
Another thing I’ve wanted to know for a long time. How many of those $ in China’s reserves we acquired by buying dollars on the international market as part of maintaining the yuan peg?
Financial Times had a relevant article today. What is your response to it? The fact that Summers is justifying protectionism seems to bode ill for the continuation of our current trading arrangements. So, also, do all the spats that have arisen lately (Goggle, Taiwan arms sales, Obama’s meeting with the Dalai Lama). It doesn’t seem that the USA is attempting to assuage the “feelings of the Chinese people.” Here is John Plender:
Lawrence Summers, President Obama’s chief economic adviser, was indeed musing noisily in Davos about the theoretical justifications for protectionism in response to endemic excess capacity and mercantilist policies. He made no mention of China’s exchange rate peg because he did not need to.
Americans may well be tempted by the thought that protectionism could shock surplus savers into structural reform. Yet these countries have just had a huge shock because their slow response to the crisis meant they were savaged by the collapse of world trade. Their mindset nonetheless appears to remain unchanged, so the risk of deficient global demand has not gone away. When that last happened in the 1930s, the biggest surplus country was the US, which suffered a far greater loss of output than such deficit countries as the UK.
The harsh reality is that the economic power shift to Asia is conditional on the maintenance of an open trading system. As long as Asian countries continue to save vastly more than they invest, that assumption cannot be taken for granted. Those contemplating joining the financial brain drain to the region should remember that export dependency and a structural lack of domestic demand are potentially catastrophic in a protectionist environment.
Another great piece, thanks.
SV makes the point of how long the bubble warnings and denials went on in the U.S. There are definitely some big differences between the U.S. market and that of China, but the basic sauce is the same: an explosion in lending leads to over-investment and empty buildings, with just enough of a rational explanation for the deniers to make a case.
Recently, Zhang Xin,the CEO of SOHO, one of the China’s leading property developers, had this to say:
“Basically . . . our strategy is to sell everything we have. The real estate business should really be looking at rental yield; build a building and then lease it out with the rent giving a decent return. But, because of where China is with asset bubbles, people want to buy the assets regardless of whether they can be leased out or not. People just want to hold [property], even if it is empty.”
This is reminiscent of Sam Zell selling Equity Office Properties Trust, one of the largest office REITs in the U.S., in February 2007 in a highly leveraged deal. Talk about selling at the top…
I don’t remember anyone here involved in real real estate calling it a bubble, but many acted as if they saw a peak. MetLife sold the now notorious Peter Cooper Village and Stuyvesant Town apartment complex for $5B in October 2006.
Sorry to be pedantic, but ‘jet-lag’!? You know DC, NYC and Boston are all in the same time-zone, right?
In my previous post above I argued it isn’t the new emerging markets nations, including China, that have excess production capacity problems. From a _price perspective_, it is the developed countries (the established players) that have excess production capacity problems. Furthermore, I argued that every time the production capacity of a new emerging market goes online, all established players will have an excess capacity problem.
Now, let’s look at the size of the excessive capacity in the developed world and it’s mirror image the size of the under utilized potential productive capacity in the developing countries. Out of the ~6 billion people in world, ~2.5 billion are still living in proverty. Thus this is a huge reservoir of potential production capacity that is still locked out of the global economy. The production cost of almost all current goods today are necessary higher than where it could be if that under utilized production capacity is released. The world still have a long way to go. Importantly, the change will be lumpy. China is a very good example of this lumpiness. Also being an optimist, I strongly hope the rate of global improvement is accelerating.
The excess capacity problem will be a recurring problem of the established nations for a long time to come. At some point China will most likely become a developed nation and will play a reverse role.
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I thank there should be some difference between US / Japan and PRC. US / Japan is a market economy while PRC is a mix of market and planned economy.
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Touching on the point re: reserves not being wealth. I am not an economist but it Seems to me there could be a difference where the reserves are accumulated as part of taxes (windfall or not) of the natural resource base (essentially, the government expropriates part of the natural resource wealth).In other words, if the government sells oil and generates $$, that is got to be wealth, why not? This is how Russia does it, and then they have the wherewithal to bail out local banks and companies. Sure, it’s a form of taxation but it feels different, more like wealth.
Glk and SV bring up interesting points related to China’s real estate backed asset market. I have a real estate brokerage in Shanghai and made a list of factors based on my experience and knowledge about the existence or non-existence of a China bubble on my blog at http://www.paulsalo.com
If the imbalances continue then the US will go protectionist because it will have no choice. As someone mentioned above, Summers was already beginning to mainstream protectionism in Davos.
There are a lot of political and cultural obstacles to unlocking the purchasing power of the gigantic Asian working class. Certainly the elite are more than happy to have a large reservoir of cheap labor, and organizations to resist that impulse are weak. I’m not optimistic.
Bubbles can go on a very long time, though.
Just for the record. Friedman isn’t such a great expert on the ME either. He lived here for a while and writes entertaining books about it, but since he speaks neither Arabic nor Hebrew his ability to understand what’s going on is quite limited.
Why hasn’t anyone questioned whether the so-called “reserves” are actually money good?
Can’t we all just admit the entire global economy is just one big Ponzi anymore.
Only one part of this piece makes me question your judgment:
“I have no doubt that [Friedman] is a very smart man when it comes to getting politics right, especially in the Middle East, which I believe is his area of specialty . . . .”
This is the guy who was the cheerleader for the Iraq invasion, who said we were going to transform the region. I would say that his Middle East expertise is about equal to his economics expertise, and all his other expertise while we’re at it. Zip. Zero. Nada. A bigger blowhard would be hard to find.
An excellent article and some eye opening responses and comments.
My understanding of govt reserves (China’s) is different, being a layman’s understanding. A company manufactures in China using local currency input, sells in USA in dollars and converts it back into local currency which is released by China’s central bank. The bank gets reserve, the company gets Yuan.
But the local currency input for manufacture in China is essentially a bank loan taken by the Chinese company. The local currency is a fiat currency generated by the central bank of China, which capitalises the Chinese bank which lends to the local company.
Now if the local company does something stupid like take excessive loans and create overcapacity, it will no longer be able to service its loan. If the local manufacturer collapses, at that time, the so called foreign currency reserve is what will prevent the Chinese banking system from collapsing.
So the so-called reserve is just another representation of successful Chinese businesses. If the Chinese business is no longer successful, the so called reserve will vanish into thin air.
The so-called reserve is also representing the enormous foreign capital investing within China. For example, Citibank gives dollars to China’s central bank, gets Yuan and invests in Chinese manufacturer.
Now if for some reason Citibank demands its money back from China – because its business in China does poorly for example – the Chinese have to give back the dollars and get back Yuan.
Similarly, if a Chinese manufacturer makes a surplus in dollars but refuses to park it with the Central bank, defaults on his local loan and decamps to Luxembourg or Taiwan (as happenned in Argentina, Brazil etc), again there will be flight of capital and depletion of the so called reserve.
At the end of the day, Chinese success depends on the successful operation of its businesses. If they over-invest and destroy capital, past success (represented by dollar reserves) will not come to its rescue. The destroyed Yuan capital will destroy an equal amount from the dollar reserve.
SillyThing, your post was the most profound. The overcapacity and overpaying is in the West. If someone else does the same thing for much less, no way you can maintain your salary level unless you do something nobody else can, or do it much much better than the poor fellow.
Salary for poor quality white workers will now come down while for good quality Asian workers will go up.
In the end, quality will matter, not the colour of one’s skin or the accent of one’s voice.
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Is it not relevant to consider the stage of development that China is at relative to the comparisons of the US and Japanese cases?
Whether looking at basic absolute/conditional convergence perspectives, or per capita metrics for infrastructure, housing, credit et al – high rates of capital stock build are not problematic if you are coming from a low base already.
Perhaps a question to address. Not a China expert so don’t know the details.
I first caught wind of the Friedman quote reading the business insider. Immediately, I started laughing out loud about the quote on reserves. I commented would you have wanted to short the US in 1929?
The shocking ignorance most people have for history and historic bubbles. It’s not hard to walk to the bookstore or even click on Amazon to order Reinhart and Rogoff’s “It’s different this time.”
It’s never different and yes, it’s always a bubble. At some point — possibly now — China will be a huge short. As always is the case with markets: When?
Thank you professor for pointing out the obvious to the uneducated.
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Michael, I am bookmarking this blog.
[...] Michael Pettis, “The idea that massive levels of reserves are a guarantor of economic stability is, in other words, based on a profound misunderstanding both of history and of the nature of reserves.” (China Financial Markets) [...]
Reinhart and Rogoff have received a great deal of press but Professor Pettis’ book on international crises, their causes, and how to manage national capital structure to mitigate the inherent volatility is a better book IMHO.
“The Volatility Machine” by Michael Pettis.
Superb – perhaps one of your most insightful.
Reserves are a chimera in China’s case; they exist only as long as they are not used.
In many ways the reserves do not exist but are the accounting identity representing how severely China has sold goods on the international market below economic value. In other words, the reserves are a record of a rather opaque but very real “loss” China has taken to date so as to realize the current levels of employment. It will be a loss that is recorded in reserves but one day will be realized.
Chanos is hunting in the right area.
This is quite an interesting article and comments, which puts our current financial situation in a little better perspective. Unfortunately, I think in a lot of ways we are a nation and race built upon ignoring the past and thinking “it will be different when we do it.” So with that said, it is not abnormal to want to bury ones head in the sand…
Mr. Pettis says, ‘If China indeed has the same distribution of geniuses, or talent, as other countries, the fact that it has so many people won’t make it richer’ But I think that that what Friedman was saying was that it makes China ‘intellectually’ richer. Which may make China richer in the monetary sense, in the long term.
BTW, China has infrastructure AND smart human capital AND better institutions. India has only smart human capital and a few good institutions. Also, the literacy rate in India is 62% while that in China is 92%.
I think that we should be very wary in making predictions about China, since it has consistently proven many wrong.
Maitreya
http://indiaschinablog.blogspot.com
Sir,
Friedman writes the same thing over and over again as if it were revealed truth. By the way his opinions about the Middle East are just as wrong as his latest stuff on China.
[...] Michael Pettis does a good job of systematically dismantling this idiotic line from Tom Friedman: [...]
> So the so-called reserve is just another representation
> of successful Chinese businesses.
Well, actually, no. Chinese exports were way down and are still down (I believe currently something like 15% from their peak) since the Lehman collapse, Sept. 2009. Meaning, since the world economy – at least temporarily – fell off a cliff.
And yet China’s reserves have grown enormously since that time. And that’s because the Chinese government has been intervening massively in foreign currency markets, buying dollars, in order to maintain the yuan-dollar peg.
Had they not (intervened), the yuan would have risen, the dollar would have fallen even more and Chinese exports would be down considerably more than ‘just’ 15%.
And what did the Chinese govt use to buy those dollars with? Freshly printed yuan.
Bucket-loads of freshly printed yuan propose inflation in China. You know as in: “real estate asset bubble”.
There is a set of procedures called ’sterilization’ – to prevent the domestic inflation caused by the printing of your own currency in order to use that to maintain a peg to some other currency.
You can probably look up sterilization (in this sense) on some Wikipedia page. It involves Central Bank operations, such as reverse repos, that are obscure to most.
How do you get jet lag when you’re traveling between three cities in the same time zone?
[...] would have shorted Japan in the 1980s.Sounds damning, but he proceeds to quote Michael Pettis, who writes:It was the very process of generating massive reserves that created the risks which subsequently [...]
[...] on China. Link to great blog post by Michael Pettis dealing with arguments about China being in a bubble. He [...]
This post has hit the economic blogs today. Here’s the Economist’s critiques with links to Felix Salmon and Tyler Cowen’s blogs which both picked up on Friedman and Pettis before the Economist. I must say that while I don’t disagree with the overall argument of this post, I too was a bit surprised by Pettis’ argument that excess credit resulted in the Great Depression.
[...] Source [...]
[...] 4, 2010 · Leave a Comment Michael Pettis offers a sharp rebuke of yet another of Tom Friedman’s idiocies and in the process makes a few invaluable points [...]
Quite interesting opinion piece in todays FT by Arvind Subramanian As has been predicted earlier on this blog, China is getting more and more criticized for their currency peg.
“It is time to move beyond the global imbalance perspective and see China’s exchange rate policy for what it is: mercantilist trade policy, whose costs are borne more by countries competing with China – namely other developing and emerging market countries – than by rich countries. The circle of countries taking a stand against China must be widened beyond the US to ramp up the pressure on it to repudiate its beggar-thy-neighbourism. But progress also requires that the silent victims speak up. Emerging market and developing countries must do a “Google” on China.”
Full article here: http://www.ft.com/cms/s/0/fc056484-10fb-11df-9a9e-00144feab49a.html
[...] Never short a country with $2 trillion in reserves? Thomas Friedman of the NYT gets a lesson in history and the possible bubble that China has been blowing. (tags: Chine economy global trade usa surplus deficit economics finance obama Friedman) [...]
China has the same historical problem that plagued the USSR. The GDP in the country is a fixed target, which minions of government bureacrats make happen. The decisions about where the resources go to make that happen are made by these same minions. You do not actually believe that the best and brightest run the bureaus of the communist party. Is Kim Jong IL the best and brightest in North Korea? The systems are not compatible with free markets. The economy is made up of a thousand decisions which are efficient at the micro and macro level. In the end a ruling over class will exploit the great unwashed masses. A revolutionary will come along, and poof the dialectic starts over. Maybe this is a “New Economy” where human nature, history, and risk have all been resolved.
[...] analysis of a commonly misunderstood aspect of global macroeconomics: “Never short a country with $2 trillion in reserves?“, Michael Pettis (Prof Finance at Peking U), at his website China Financial Markets, 2 [...]
Very good article. However, some things could really be different this time.
– The imbalances could eventually force the US to become protectionist. This could collapse the current export led boom in China.
– If the bubble bursts and China has a severe recession, I’d expect China’s reaction to be similar to the German people when the Weimar Republic collapsed in GD I. They have great arrogance and a sense of entitlement from their long boom. Germany boosted demand and created full employment by arming for world war, and China could certainly do the same on a much much grander scale.
– The supply of resources, particularly oil, is the primary upper limit to production and consumption today. We have already passed or will nearly pass Peak Oil. If it wasn’t for the Great Recession depressing demand, oil prices would already be in the hundreds of dollars per barrel. If China arms for war, there is likely to be greatly increased oil demand, and China will be likely to seize oil producing countries outright. And resource limitations will force China to go to war before the resources deplete below a necessary level.
– The biggest thing that is really different this time is nuclear weapons. If the US becomes protectionist and China arms for war, then WW III and the nuclear annhilation of most of the world’s population could become inevitable. This may be nature’s way of thinning the herd when population outstrips resources.
JW, the fact that China’s tiny and snail pace appreciation of the RMB during that time did not translate into immediate gains for the US is not surprising. I think that Prof. Pettis normally argues that the structual problems in China are more important than the RMB manipulation anyway (alhtough others disagree, or combine the two directly). It takes years for changes to feed into the entire system. China is expanding of course, so we could say that it is entirely expected that its surplus expands even with RMB appreciating.
The problem with this argument is that we have no comparison case. We cannot know what would have happened if China had not allowed the RMB to move. In other words, i am arguing that China’s surplus / the imbalances would have become worse without the move in the RMB during the period you describe. So your argument that the move did nothing is not necessarily true, it could well be that the move did something, but as it was so small and slow, not enough to reverse the trend. If Chinese policy makers really believed that the peg was not helping their exporters, then simply float the RMB. See what happens! If Chinese economies of scale etc are so great, then why do the exporters need the peg too?
Michael Pettis is one of my reference about China.
Almost everyone becomes a cheerleader when China economy is the theme.
Friedman is a complete moron on every subject I’ve seen him wrote about. He married money (and therefore influence) and is a soi-disant doyen.
If you want to see how much of a clown this asshat is, Google “Tom Friedman Suck On This” and watch the video.
His schtick is the smart-ass quip – but nobody ever bothers to examine whether his track record is remotely accurate. For the record, he never saw a war he didn’t like, and was a big booster of all the recent misadventures.
HE wouldn’t know a shortable market if his wife’s money depended on it.
Cheerio
GT
I think today marks a major inflection point. Between Summers remarks at Davos, NY Times editorials, Martin Wolfe’s FT piece, and the ignoring of China’s protest of the Tiawan arms deal, I think the consensus of mutual benefit has died. I suspect that this April China will be officially labeled a currency manipulator .
Silly things, your argument and elaboration on “It is the rest of the world, not China that has a overcapacity problem” is flawed after a second thought. I think most people define overcapacity as “a country produces more than it consumes” regardless of whether their dormant productivity is unleashed or not. Your remark actually equals saying that the West has been so far unable to transfer their labor from the industries where they no longer have comparative advantages. But this is more a political problem, because nobody could simply decide which country to produce what with what amount. I believe if US determines to throw all its resources to produce textile or toy, the cost and productivity advantage of Chinese goods will not be a certain.
There’s no right or wrong when arguing who has overcapacity if you think from different perspective. But I assume that every product is produced for consumption (the basic value for any economic activity), so Michael has pointed out many times, during a global contraction of demand, surplus countries must do more to deliver the necessary adjustment of the imbalance no matter what they say.
China is only 2% of global equity indexes (e.g. MSCI). So should international investors even care about a China bubble? It’s not like Japan in 1989, which was something like 50% of global market cap (it paid to underweight Japan!)
“although I have no doubt that he is a very smart man when it comes to getting politics right, especially in the Middle East, which I believe is his area of specialty”
Actually, most Middle East specialists consider Friedman kind of a joke, too. (This isn’t even an ideological thing, particularly. He’s routinely mocked by both ardent neocons and passionate anti-warriors.)
“Getting the Chinese to revalue (or float) their currency is probably critical to the U.S. achieving Obama’s ambitious SOTU goal of doubling U.S. exports in the next five years”. – WSJ
Yes. And winning the lottery is critical to my ambitious goal of retiring next year.
What can the US sell them. Let’s see, we have overcapacity to supply CDOs and Tyvek houses in remote desert areas. I’m not sure anyone will buy the Tyvek houses, but if we can get them to buy the CDOs we can increase employment on Wall Street and also wipe out their dollar reserves six months down the road.
Thanks. Very interesting article and posts. China’s policies seem to have resulted in too much investment in hard assets (real estate, plant and equipment), and therefore it has excessive capacity in those sectors, and too little investment in “soft assets” (people, education, consumer goods and services), and therefore it has insufficient capacity in those sectors.
One question, as I don’t pretend to understand economics well-enough at this level. Professor Pettis states that “And reserves are almost totally useless in protecting these economies from the risks they face (and, no, no, no, reserves cannot be used to recapitalize the banks – only domestic government borrowing or direct or hidden taxes on the household sector can be used to recapitalize the banks).” Is that because politically it would be impossible to use the reserves for those purposes or is it that the reserves are in some sense an accounting fiction and can only be tapped through increased borrowing by the government or increased taxes on the consumers/households?
[...] the rest here: Never short a country with $2 trillion in reserves? Share and [...]
Think about the Qing dynasty during the 18th century… Don’t ever short it. Or even at the start of the 19th century when it out produce the rest of the world…
Besides the influential Paul Krugman taking issue with China’s export based development model, we have this Op Ed piece by Philip Bowring…….
Who Needs Whom More?
http://www.nytimes.com/2010/02/04/opinion/04iht-edbowring.html?ref=global
“An unsustainable trade imbalance with the U.S. remains largely unaddressed despite a long U.S. recession. The West stands frozen in awe of an economy that has a grand exterior but, like the fast-growing Soviet economy of the 1950s, requires ever more capital to produce a unit of output. Meanwhile China — and some Western commentators — naively believes that a trade surplus and massive foreign exchange reserves ensure stability. Look at Japan since 1990 or the U.S. in the 1930s.
No one wants a trade war. But the U.S. is in a stronger position to wage one than a half-modernized China still relying on foreign markets and foreign companies’ technology and investment.”
Your thoughts here deserve to be shared widely.
Here is a simple explanation of why China can not use the reserves to recapitalize the domestic economy.
China’s reserves are in US dollars. They are basically IOUs from Americans. China can cash them in to recapitalize domestic markets only if somebody is willing to honor those IOUs *FOR SOMETHING THAT CHINESE PEOPLE WANT*. Unfortunately, the US is running a huge deficit (making those IOUs not worth much) and Chinese do not want anything from outside China.
Here is a simple example to explain the point further.
1. Consider two villages A and B. Some villagers in Village A produce goods and export it to village B.
2. But, instead of accepting goods manufactured by village B in return, village A accepts IOUs from village B.
3. The producers in A store the excess goods (not exported to village A and not immediately needed for consumption) with their *central bank* in return for IOUs from the central bank.
4. The central bank hands over the goods to other villagers (let’s call them investors) in return for IOUs (future payment in goods).
5. Now the central bank is armed with some IOUs from the investors, and some IOUs from village B. The producers are armed with IOUs from the central bank.
6. Unfortunately, the investors are unable to come good on their IOUs and the producers are demanding goods in return for the bank’s IOUs.
7. Now, the central bank can ask village B to honor its IOUs and pass the goods on to the producers. However, if village B produces goods that producers in village A don’t want then those IOUs from village B are of no use.
8. This causes the collapse of the economy in village A.
I hope this helps.
Tou,
In any field of science, including economics, rather a perspective is right or wrong isn’t determined by it’s popularity with most people. What determines correctness is logic and evidence. A couple of hundred years ago, the popular view is the world is flat while a minority thinks the world is round. This is why I’ve warned my perspective maybe heresy. But hey, so what
At any rate, it is too much to elaborate on the price mechanism and it’s affect on the efficient allocation of resource in this comment. I’ll just briefly say that if nations continue to produce goods unsupported by market price than the world is wasting resources and we’ll all be poorer for it. This is a fundamental and well understood idea in economics. This is also why economists support globalization.
By the way, I do agree that China is manipulating the RMB exchange rate and therefore is distorting the market price to a degree. By most estimates the RMB exchange rate distortion is around 15-25%. On the other hand the average income of an American is 10X or 1000% higher than a Chinese! This is also true for other developing nations. So the question is which is the main driving force at work? Is structural reform and the mass liberation of productive capacity of human capital in developing nation the main force? Or is it the 15-25% exchange rate distortion of RMB?
Frankly, I think China should revalue the RMB already! Considering the forces at work, it would not make much of a difference to China’s growth path. It will also help address the inflation and asset bubble concerns in China.
I’ve try to define over capacity base on market price and drawn my conclusion from that. I think the over capacity issue lies with developed nations. This over capacity issue will persist even if the RMB exchange rate isn’t distorted. Furthermore, we’ll see more over capacity issues over time as more developing nation’s productive capacity comes online as a result of structural reforms.
I’d love to hear the professor’s view.
[...] – Never short a country with $2 trillion in reserves [...]
[...] – Never short a country with $2 trillion in reserves [...]
[...] – Never short a country with $2 trillion in reserves [...]
[...] Posted by Chauncey on February 4, 2010 Never short a country with $2 trillion in reserves?. [...]
@ Dave Chiang
Priceless comment. Laughed out loud. Thanks for that
[...] Michael Pettis tells us why Thomas Friedman is wrong, wrong, wrong about China. As he says, “although I have no doubt that he is a very smart man… I also have no doubt that he does not understand China much…” [China Financial Markets] [...]
[...] here: Never short a country with $2 trillion in reserves? Share and [...]
[...] Den ene – professor Michael Pettis – underviser på Peking Universitet, og han har på sin blog ydmyget førnævnte Thomas Friedman, og han har bl.a. påpeget idiotien i at hævde, at 27 mio. studerende [...]
There’s a lot of misunderstanding in this discussion arising from the use of the word “can’t” (as in “…reserves cannot be used to recapitalize banks”). My kids have the same problem – they say “I can’t do it!” when they mean “It’s really difficult”, or “I don’t want to”, or “I’d have to give up something else I really like in order to do it”. It’s not a case of a technical impossibility but of an undesirable option.
China CAN very definitely use it’s reserves, both resource reserves and foreign exchange reserves (not all of which are in dollars), for any purpose that money will buy. All these reserves are convertible in the marketplace into dollars, euros, yen, yuan or any other currency, and currency is fungible: someone somewhere will take it in exchange for another currency or goods or services.
There are many reasons why the Chinese gov’t doesn’t WANT to use its reserves to bail out its banks (just like there are many reasons why the U.S. gov’t doesn’t WANT to default on its debt – though it most certainly CAN), and among those reasons the most commonly discussed are: 1) the very serious immediate investment losses that would result, and 2) the effect on the value of the yuan and the subsequent deleterious effects on Chinese international trade (among other things). Both are classic international asset liquidation outcomes, and highly probable.
The fact that, in the face of world trade contraction and deflation, the Chinese gov’t has intentionally expanded credit and money supply and worsened the banks’ loan portfolios in the process, is evidence ipso facto that concern about bank balance sheets has not been its top priority up to the present.
This should be no surprise. Every “developed” country in the world has “zombified” their banks (a la Japan) with subsidies and interest-free loans to sustain balance sheets overloaded with bad loans. Re-capitalization (slowly, slowly, maybe over decades) is theoretically part of “our plan”, but you’ll notice it wasn’t the first, second, or third steps we took.
So far, the Chinese have done a stunningly successful job of reprising in a short time the development of “developed” countries (which have always had their gov’ts underwriting and managing economic progress), so why be surprised if they also imitate our patented “boom-bust-bailout” cycle? Maybe they will come up with a “superior way” to handle this than our model but, with all respect, so far they appear better imitators than innovators in mercantile and capitalist economics.
This doesn’t mean Mr. Friedman is right (he’s an entertainer, not a serious economist). I believe Dr. Pettis is correct in projecting that China WON’T (as opposed to CAN’T) use its reserves for bailouts, mostly because if they ever do need to bail out their banks they now have observed first-hand over the last two years many, many examples in the “developed” world of creative options for conducting bailouts even when you have no reserves at all!!
[...] reserves provide protection against the wrong sort of crisis. The risks China faces today are asset and capacity bubbles reminiscent of Japan in the 1980’s and America in the 1920’s when those countries had China-sized foreign reserves. We all know how their bubbles finished. [...]
Here’s a better investing rule for Tom Friedman: never take the long leg against Jim Chanos.
Menomnon, I agree that while in the past Chinese reserves represented successful exports (dumping?) recent dollar reserve accumulation is due to excess liquidity injection in the local money markets. i.e. over leverage. I think sterilisation usually refers to a reverse repo of locally injected currency (Yuan) after buying dollars from inflow (FDI)to prevent excess local liquidity.
Andrew P, I agree with your viewpoint about wars started by China. Alarming but possible.
India is the most likely target for aggression. This will be coupled with a tie up with Pakistan which will ditch USA. Roads and gas lines will probable be built from China to Baluchistan, areas of India occupied Kashmir necessary for this will probably be taken over by force. In addition, Iranian gas and oil pipelines will probably also be negotiated (with or without gunboat diplomacy). China will probably also use Iranian connections to destabilise and split Iraq, taking over the Shia areas of Iraq as a Chinese protected area outside of US interest. Oil reserves of Basra and surrounding areas will be the target.
I expect an aggressive move from China in November 2010, after the Shanghai fair is over and the Chinese and global economy weakness gets exposed. They will probably occupy Indian Kashmir areas required for a major road building activity to link with Pakistan.
If Indian spooks minitor these discussion boards, please take note.
Forward air bases built in Tibet recently, coupled with the fast train link are almost certain to mean an invasion of Kashmir, South Tibet (Arunachal Pradesh) and Sikkim. Increased Maoist insurgency within India and increased insurgency in North East signal a Nepali style Maoist takeover of West Bengal, North East states of India by China supported Maoist elements.
Regarding education, Chinese have a 400 million population of highly skilled people. India has about 50 million people with high skills, growth of which has recently stalled because of talent paucity.
There is no competition.
@JW:
Well seen, this is an often overlooked phenomen in the USA, the great distances: Fly over country. Therefore, the traffic infastructure and dense population of ancient states as China or Europe are huge pros of these countries, because traffic would be the first victim of „running out of fuel”..
wbr Stuff
BTW: China with only one coast try this to overcome with their dams.
[...] – MarketWatchArgentina’s reserves and its debts: Central Bank robbery – EconomistNever short a country with $2 trillion in reserves? – China Financial MarketsGreece’s sovereign-debt crunch: A very European crisis – [...]
Michael, I often see charts showing the massive fx reserves in emerging markets to demonstrate high(er) EM savings rates. If reserves aren’t wealth (and I can’t think of an argument that beats yours that they aren’t) are they SAVINGS?
Initially, it seemed to me reserves are savings are only to the extent they can be invested in the local economy (i.e., requiring conversion back to local currency and the process JohnZ describes above). But if China, for example, uses its dollars to buy US companies, earns USD returns in excess of the cost of sterilization (maybe a big if), and the net returns let the PBOC expand the domestic monetary base and thus the funds investable domestically, why isn’t that wealth? If your reserves are a growing asset that lets you expand your liabilities (domestic money) and increase investment? Leaving aside for now how good those investments might turn out to be or whether more investment is such a good thing for China.
Maybe we shouldn’t expect Tom Friedman to know what he’s talking about when it comes to monetary economics and central banking. But what about PIMCO?
I very recently heard the head of EM local fixed income markets call the Chinese growth story “very durable” because (1) the govt understands that they need 9-10% GDP growth to maintain social stability and prevent unrest; and (2) it has two trillion dollars of reserves, so “a very deep wallet to make that happen”. I think we’ve disposed of point (2) multiple times here, and point (1) seems to me to mean only that we’ll never have reliable data/statistics as long as it’s true.
On Russian bank bailouts: I think Russia is actually DE-capitalizing its banks more than recapitalizing, as it shifts more and more credit risk on to state-owned banks by forcing them to bail-out ’strategic’ non-financial companies.
Russia has either been drawing down its Reserve/Well-being Funds (but not central bank reserves) or not sterilizing dollar inflows in order to provide ruble liquidity to banks. (The rubles created in exchange for foreign currency natural resource flows are usually collected right back in taxes and put in the Reserve/Well-being Funds, sterilized via the budget). The banks use the extra rubles to lend to corporates (it’s the nonfinancial corporates the govt is bailing out, I think). And state-owned banks have played a big role in bailing out foreign creditors by refinancing dollar loans w/ ruble loans, the proceeds of which the corporate borrowers use to buy dollars and pay-off foreign creditors. So the fact that reserves come from natural resource wealth doesn’t seem to change the basic process JohnZ lays out. What am I missing?
Does Friedman forget he’s talking about China’s stock market, a discounting machine whose price already has factored in the brainpower? Given the global exuberance on this market, even more so in China when you look at the bubbly Shanghai composite index, the most optimistic scenario is probably priced in. Anything short of that and the market drops, even if the outcome is still really good.
It would be extraordinary for a high growth emerging economy not to have any busts – remember all the booms and bust the U.S. went through in it’s high growth phase. In the modern world though, China’s leader probably follow Japan, slower pain but more over the next 20 years than if it just let’s market discipline correct all the imbalances in a quick crash that it can bounce back from tremendously in a few years, like in the Great Depression before the policy mistake of tightening led to a double dip in 1938.
Check out my blog, where I have a lot of commentary like this.
“Never short a developing country who has a 2 trillion foreign exchange reserve.”
I fixed it for Freidman. The per capita reserve of China is nothing compared to the U.S. in the 1920s or Japan in the 1980s. Per capita export of China also ranks below many more developed countries. The U.S. was the richest and most developed country in the world before the Great Depression. So was Japan in the 1980s. Today’s China ranks maybe the 90th among 140 nations in terms of per capita income.
The concept that foreign exchange reserve is not really wealth is difficult to understand. Why? Think this way: if China slowly converted her paper reserve into gold, then China obviously accumulated wealth, right?
By the way, 30-50% real estate in Shanghai and Beijing were probably bought by foreigners (Chinese-Americans, etc). These two markets do not represent Chinese real estate markets in general. I am really curious what Chanos will short in China.
Right let’s see if I can get this straight as it seems like a very important concept to understand. China’s foreign reserves are netted out on it’s central bank balance sheet by a corresponding debt. How has this happened?
First thing that happens is China produces widgets that America likes and sells them profitably to. In return the widget maker is given US dollars which he sells and purchases Yaun with. The important point here is that because the widget which was created by labor has been made profitably it results in a net increase in demand for Yaun which would normally cause the Yaun to rise and assuming the US does not do better in it’s trade with any other countries the $US dollar would be inclined to fall.
The China central bank notices from it’s elevated perch that the profitable manurfacturers are driving up the value of the Yaun putting the breaks on it’s economic growth. In order to prevent the Yaun from rising it sells Yaun and buys US dollars. But since it did not make anything in a profitable way it must create a corresponding debt on the other side of the ledger or print money to purchase the $US.
There you have it. I think.
Of course there are other processes occurring at the same time. Such as money formation at the regional banks in the form of debts and credits to fund the manufacturers expanding factories. Artificially low interest rates to tax effectively tax savers and help capitalize banks. And using similar methods to the federal reserve to expand it’s balance sheet and encourage lending as part of it’s fiscal stimulus measures.
An excellent post, Michael. Massive periods of excesses in the money supply and easy credit are most often followed by problems to match those excesses. China has a short window of opportunity to correct.
I suspect China will not only raise interest rates, but consider another currency revaluation. I expect the RMB to raise 10% against the dollar in 2010.
ps don’t people realize that Michael is based in Beijing? There will be jet lag.
BBC interview with M. Pettis here:
“Could there be a trade war between China and the West?”
http://www.bbc.co.uk/worldservice/business/2010/02/100204_china_trade_buslness.shtml
Layconomist,
Your example is hopelessly confused. No need to use villages, goods and IOUs. Let’s talk about what really happens…it’s not that hard to understand.
Chinese exporters sell to US consumers for dollars. China, through the PBOC and SAFE (State Agency of Foreign Exchange), controls the Yuan by being the only market agent for that exchange, currently pegging the Yuan at 6.83 for every dollar. So for every $1 tendered, the exporter gets 6.83 RMB deposited into his bank account.
PBOC takes the dollars, transfers them to CIC or some other investment entity, and invests them back into vehicles in the west, typically treasuries. They could sell the dollars in the world market for some other currency. They could buy physical assets with the US dollars. But China has to date, bought principally US Government debt.
Back home in China, the PBOC must effectively print more RMB to cover the deposit, increasing the money supply. If they want to offset the inflationary effects of that increase, they issue sterilization bonds which they require the banks to buy. They were pretty much doing so up until 2008 when they stopped.
So, are these foreign exchange assets wealth? Probably not the right question to ask. Clearly, the reserves are an asset that China, as a country, can use to project its influence on the international stage. But that asset comes at the expense of improving Chinese citizen’s lot at home. If the increase in RMB supply is not sterilized, then inflation will eat away at the value of those deposits the exporters and hardworking laborers have stuck at the banks. If the sterilization bonds are issued, then the government is essentially directly borrowing those deposits from their citizens to “invest” overseas.
FX reserves are an asset, just like anything else. However, they represent a redistribution of income/wealth. China is sort of rearranging its national balance sheet. So the Chinese consumer cannot enjoy the fruits of his labor as much as he should because his cash is stuck in low yielding deposits and some of the foreign goods he would like to buy are prohibitively expensive because of the undervalued RMB and also the import duties on foreign goods. Try to buy a REAL set of Ping golf clubs, or a foreign produced car, or imported perfume, foreign vitamins, or foreign makeup or foreign wine here.
As long as you have a pliant population, who you can feed a constant flow of propaganda that their country is well off, the government is working hard for them and tomorrow will be better than today, then they tolerate the hidden costs and the forced savings.
[...] Never short a country with $2 trillion in reserves? Michael Pettis. I’m a bit late to this, which is a must read. [...]
[...] the article here: Never short a country with $2 trillion in reserves? Share and [...]
Seatrus, you are still missing Pettis’s point. It doesn’t matter if the reserves are converted into gold, slowly or quickly, or into anything else. They still aren’t net wealth. If you borrow $100 and buy $100 of gold, you are not richer. Your assets have gone up by $100 and your liabilities have too. That is what happened to the central bank. They borrowed money and used it to buy dollars.
And yes, Pettis lives in Beijing, and so unless I have been terribly mistaken all my life, travelling from there to New York, Boston and DC involves changing time zones and incurring jet-lag.
[...] China: Never short a country with $2 trillion in reserves? – China Financial Markets [...]
I cannot believe how many smart people believe reserves can be used to recapitalize banks. Even Willem Buiter. They cannot!
I agree with Hua Qiao and Silly Things.
Why are we even sure that China has been selling without profit? The very labor situations that we so disapprove of, are the reason why they can make profit on each of their transaction. And the leverage that domestic consumption that China’s population gives it, is unparalleled especially if we were comparing China and Japan. Also, we are safely discounting the political situation in the country which enables it to mobilise huge resources and make politically difficult decisions. I would refer anyone interested in the topic to go through The Economist’s special report on China published 2 months ago, and the fact that 35% of China’s reserves are not in USD. They are in Euro, Yen and other currencies. Also, the cover of The Economist was interesting with uncle Sam and Mao Zedong sharing a bed with arms on the sides and rose on the bed! Intriguing.
TR, the key here is that China did not borrow the money. Suppose China has $1000 surplus with the U.S.A. The Chinese balance sheet will look like this:
Asset: $1000
Liability: 0
PBoC then buys U.S. treasury bills worth $1000
Asset: $1000(treasury bills)
Liability: 0
PBoC then PRINTS and issues RMB$6800, ignoring the cost of printing,
Asset: $1000(treasury bills) + $RMB6800(newly printed cash) – $RMB6800(distributed cash)
Liability: 0
THE ABOVE IS THE KEY: wealth is indeed created when $6800 NEW RMB is created.
PBoC then issues bonds worth RMB$6800
Asset: $1000(treasury bills) + $RMB6800(cash)
Liability: $RMB6800(bonds)
PBoC then converts $1000 treasury bills to cash, and buys gold that is worth $1000.
Asset:$1000(gold) + $RMB6800(cash) – $1000(cash that used to by gold)
Liability:$RMB6800(bonds)
Eventually, the U.S. government pays back the treasury bills and PBoC pays back the bonds:
Asset: $1000(gold) – $1000(cash) + $1000 (cash that the U.S. government paid back)
Liability: 0
Seatrus, no, no, not at all. If a Chinese exporter has a $1000 dollars he earned from selling goods abroad, this has nothing to do with the PBC’s balance sheet. Their balance sheet will be zero assets and zero liabilities. But since the exporter has to sell the dollars to the PBC. the PBC will borrow RMB and buy dollars. In that case it has dollar assets matched with RMB liabilities, and its net wealth will be zero. Either you really don’t understand central bank transactions, or you assume that there is only one entity in China, the government, and everything any Chinese owns is really owned by the government. Unless this is true, the profit of the exporter is not the reserves of the PBC.
Correction: the last 2 steps were wrong, here is the corrected version:
PBoC then converts $1000 treasury bills to cash, and buys gold that is worth $1000.
Asset:$1000(gold) + $RMB6800(cash)
Liability:$RMB6800(bonds)
Eventually, the PBoC pays back the bonds:
Asset: $1000(gold)
Liability: 0
Seatrus, you are making the mistake of presuming that the PBOC and forex earners are one and the same. The PBOC has to “borrow” the money from various companies.
I am sure Prof. Pettis will be able to explain this clearer and more effectively, but – As a fairly simple description: In order to buy their forex (which is legal requirement for most companies) the PBOC has to give them RMB in exchange, this present huge liquidity surges in the domestic market which would create inflation (and thus real exchange rate appreciation) – socially damaging. Hence the PBOC has to mop up the excess RMB by selling bonds / increasing reserve requirements for the banks (both of which are a form of borrowing). The PBOC doesn’t start off with the asset as in your example, they get the forex in exchange for RMB.
[...] Never short a country with $2 trillion in reserves? Share and [...]
[...] Never short a country with $2 trillion in reserves? [Pettis skewers Friedman - opines on Chanos] #china $$Close [...]
[...] enormous reserves of about 5-6 percent of global GDP should be reassuring, but as Michael Pettis explains the risk that threaten large developing countries are quite different from those smaller countries [...]
[...] Pettis, of China Financial Markets, says that the conditions in China are eerily similar to conditions in the United States right [...]
Argentinian President Cristina Fernandez de Kirchner is trying to achieve the opposite result to China – she has succeeded in reducing US Treasury holdings of the Argentine Central Bank (in return for a non-transferable Argentine government bond) in order to utilize the funds generated from sale of the US bonds to balance its budget deficit. IMHO this is inflationary for the Peso, not sure what it does to Dollar/Peso.
Professor Pettis, I would like to hear your thoughts on Argentina. I was very impressed wiht the dynamism of Buenos Aires on a recent visit, and it seems to me that they escaped the vices of western banking practices during the ten years of default, and that their economy (and those of their neighbors) are well placed to grow at a faster rate than the rest of the world over the next decade.
“Why can foreign reserves only be spent abroad?”
Well, they *can* theoretically be spent inside China. The CB buys something and the seller accepts US bonds as payment. Then the seller uses these bonds as payment and they have started to circulate. However, this can be done perfectly with yuan. Foreign reserves have nothing to do with the ability to stimulate a domestic economy.
Think about household work. A family wants to increase the activity between its members. A poor family can do this as easily as a rich one. If the members want “money” to keep score who has produced more and who has consumed more, they can just write tickets worth something. There is no need to use external money for internal payments.
OK, now I know what you guys argued for:
Suppose an exporter has $1000 surplus.
At the beginning,
PBoC’s balance sheet looks like this:
Asset: RMB$6800
Liability: RMB$6800
Exporter:
Asset: $1000
Liability: 0
The exporter then exchanges $1000 with PBoC:
PBoC:
Asset: $1000
Liability: RMB$6800
Exporter:
Asset: RMB$6800
Liability: 0
So the surplus ends up in the hands of the exporter in the form of RMB cash. So the currency reserve represents wealth accumulated by Chinese exporters. PBoC can still buy gold on the international market, and prints more RMB for the liability.
How exactly can you short a country that does not allow its shares to be shorted ?
http://chanakyapuri.blogspot.com/
China Announces 105% Tariffs on Chickens in Retaliation for US Steel and Tire Tariffs.
This all started with tires, and the irony of tires is US manufacturers did not even want protection. Obama started this illegal protectionist trade war.
[...] Never short a country with $2 trillion in reserves? (ChinaFinancialMarkets) [...]
China is doomed. Not because they are building too many high rises, which is very American i might add.
They are simply doomed because their main competitive advantage is….drumroll ….. their marginal cost of labor.
Now I will admit, it is an astoundingly massive advantage right now. So big that we ship t-shirts 5000 miles to be sold at walmart. Pretty steep.
However, as technology (a.k.a. productivity) increases, this decreases the relative advantage of cheap labor. No surprises there, right? We have already seen this in the auto industry, as the % of assembly (labor) workers needed per car has dropped every year for the last 80.
Unless the Chinese economy evolves (I’m not saying that it won’t), 10% growth will be a dream. How much are the Chinese natural innovators? I haven’t the foggiest – but making bottom of the food chain widgets cheaply is NOT the path to per capita prosperity, but you WILL get some damn gaudy nominal GDP numbers. As I see it, it IS the path to being the low wage, low skill factory that sees its advantages reduced as machines continue to replace man on the factory floor.
I’m not saying that China won’t run hot for another 5 or 10 years. What I am saying is that to my simple eyes, cheap labor ain’t gonna make you rich for ever.
We will send you Greenspan or Bernanke if you need them, they will think of something.
Another rule for consideration:
Don’t buy and hold a country that loans out 28% of GDP in a year to achieve only 8.7% growth.
Thanks to Hua Qiao for the clear explanation of how China’s foreign reserves have been generated. It’s amazing how something quite simply can be made so complex. I think THAT is the biggest conspiracy.
[...] Michael Pettis, “The idea that massive levels of reserves are a guarantor of economic stability is, in other words, based on a profound misunderstanding both of history and of the nature of reserves.” (China Financial Markets) [...]
Never short a country with $2 trillion in reserves?
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Never feel the need to refute a statement from Friedman
The best book I have ever read on trade, globalism, and understanding current accounts is by Jane Jacobs; “Cities and the Wealth of Nations”. Michael has the same pragmatic, almost simple, analytical style that Jacobs used. It is the best way to approach and understand complex economic structures and problems.
Jacob’s book came out in the mid 80s and it helped me to prosper through the Japanese ascendency and then avoid their crash. She also aptly explained and predicted the coming collapse and then disappearance of the Soviet Union. Not a small accomplishment and yet still, because she is not credentialed, most economists are either irritated by her or cheerfully ignore her thesis.
Basically he views were based on understanding that the reality and geographic boundaries of economic growth and decline may not and often are not the same thing as political geographic boundaries and the currency that is part of the political boundary. Jacobs makes a good case that cities are the true economic unit and often cities straddle political boundaries and thereby currency, in terms of their reach and “empire”. To Jacobs, every city is a distinct “Athenian League” around 450 BC. Those political economic units which most accurately reflect the realities of the city unit within that political boundary are the most useful in terms of supplying data to come to useful economic analysis or models. Otherwise the currency that is political orientated will mask “transactions of decline” of a city waning, or not correctly reflect cities that are growing. “Transactions of Decline” can go on for decades before they are correctly appreciated, given the political government size. intent, or power. That was the state run statis USSR economy, a “transaction of decline” and I propose that is what China’s trade policy is today.
This is what I mean when I say China’s reserves do not truly exist, certainly not in the size that reflects the utility of 2 trillion US $, but are the buildup or the “score keeping” of this massive transaction of decline.
The other lesson one gets from history is usually such a massive transaction of decline realization results in comparable security chalenges or conflict of the hard power type.
Scharfy
While I don’t agree with you that China is doomed, your notion that a country with a labor cost advantage should not add more capital is something I have thought about greatly.
Those of us who studied Marx will recall that the core of his thesis was that labor should be paid the “value” of their output. Wages less than the value of output constitutes exploitation by the bourgeois capitalists. As competition erodes profits, capitalists seeking to improve productivity replace workers with machines, increasing the unused labor supply and driving down wages, resulting in further exploitation. In a perfectly competitive market, however, machines can only be acquired for their inherent value (PV of cash flows from the investment=0). Thus, there is a cycle of increased pressure to squeeze more profits out of labor since machines can only return a normal return.
Is there an element of irony here that it seems China is descending down the same road? As the economy has grown, household income, household savings and consumer spending has not kept pace with that growth.
I am reminded of Jonathon Anderson’s intriguing piece (The Myth of Chinese Savings)which asserts that China’s huge capital spend has been a world wide “market share play”. Add more machines/infrastructure to increase productivity to drive the cost curve down in order to maintain or increase global market share.
Cheap capital and an ability to squeeze even cheaper per unit labor provides the opportunity for a sustained competitive advantage as long as the demand is there. In a world of contracting demand, will this strategy be a black hole for China?
How ironic if China’s action produce a “Marx like” cataclysm. I am no Marxist (that’s probably apparent) but I think there are elements of his core argument that are being repeated in China. Key an eye on this.
Wow, what an amazing blog post! I’m very impressed by the depth of the research involved. Nice work. One thing to say: Time for some EDZ baby.
Short Copper also. China has trillions of tons of hidden copper reserves. To read more, check out http://joeshareholder.blogspot.com/2010/02/how-to-play-coming-copper-plunge.html.
Seatrus, am still not sure entirely of your balance sheets / conclusions.
In Accounting terms, not all of the 1000USD earned by the exporter is wealth, as a very very high portion of it probably goes into paying the costs of making / processing / buying the exports. Let’s not get into profit margins! but you see the point. An asset on the balance sheet (the 1000USD) is not the same as wealth on the capital account (Profit / retained earnings.)
The RMB peg which is paid for by the govt, (central bank) allows for large quantities of sales (meaning a large trade surplus), but depending on margins (remembering Chinese importers have to use an undervalued currency to purchase raw materials / partially processed goods) this is by no means wealth. The cost of doing the peg and sterilization is borne by the PBOC, but seriously complicates / limits monetary policy in China.
Also CHina reserves are not only earned by exporters. There are also FDIs etc. See the quarterly fuss in sorting out Hot Money inflows / outflows for example.
Seatrus, i think i maybe just lost my post, so sorry if this comes up twice
it basically made the point that in Accounting terms, the 1000USD earned by the exporter is indeed an Asset, but still not ALL wealth. There is a difference between Asset and Profit (Wealth). Depending on the final profit margin, the vast majority of the 1000USD (or exchanged 6800RMB) will have to go towards covering the costs of the export in question. Anything left can indeed be counted as wealth (retained earnings / profit) and added to the company’s Capital Account.
Hua Qiao
“The Myth of Chinese Savings” – excellent read. Does not offend ones common sense a bit.
China finds itself asking a unique question -” What are we going to do with all this stuff?”
For now it seems content to subsidize the west, but perhaps a slow move off the “peg” may be in order. A soft landing towards a China that exports less is probably in the best interests of both nations.
I am not optimistic this is what shall occur. It is policy in the west to fuel debt-based consumption until the bitter end.
Accordingly, China seems to be willing to fuel these insane imbalances to keep the factories humming.
It is reassuring to know that bureaucrats everywhere can mangle policy, regardless of language or ethnicity.
Cheers.
[...] The U.S. current account deficit has shrunk only marginally from six per cent of gross domestic product (GDP), while East Asian economies continue to register persistent BOP surpluses despite falling exports, and accumulate foreign exchange reserves. [...]
For anyone interested, here’s the Paul Krugman piece Jim Chanos referred to several times in his talk about China at LSE – including as the best article about developing countries he’s ever read.
http://media.ft.com/cms/b8268ffe-7572-11db-aea1-0000779e2340.pdf
[...] As we’ve noted before, with all this talk of growth, there is speculation that GM wants to build a new greenfield manufacturing facility in China. Such a move would radically increase The General’s stake in sustained, long-term growth in China. If Chinese growth were only temporary, GM could merely reallocate excess capacity at its Antewerp plant to fulfill the temporary demand. Either way, with GM the biggest player in what is turning out to be the biggest automobile market, let’s hope these numbers do not reflect yet another bubble. [...]
bcg_81 Before he became a journalist, Krugman was a mighty fine economists and deserved that Nobel. His work on understanding Sterling post-Soros is also worth a read as he developed the idea of a “soft” option strike around pegged currency levels and the dynamics, when viewed stochastically, that will likely play out.
[...] Never short a country with $2 trillion in reserves?: Michael Pettis, China Financial Markets. [...]
bcg_81:
Very interesting Krugman paper, thank you.
Complementing “Silly Things” remarks on capacity, just take a look at this Bloomberg´s article: Brazil May Tax Ore Exports, Seeks More Steel Plants (Update1)
http://www.bloomberg.com/apps/news?pid=email_en&sid=arMKC2sjneIc
And for those that still don´t understand how the asset “foreign reserves” can be used in an advantageous way just take a look at this Globe and Mail article “China builds stakes in Canadian mining companies ” at
http://www.theglobeandmail.com/globe-investor/china-builds-stakes-in-canadian-mining-companies/article1460614/?service=email.
And also, this other Bloomberg article: China Becomes Oil ETF´s No. 4 Holder, Buys SPDR Gold (Update1)
http://www.bloomberg.com/apps/news?pid=email_en&sid=aZ9O4lrutUCc
The world has been bundled up with a suicidal bomber who is trapped with dynamites but does not want to die, and the only deadth wish is that CCP will run China forever.
The challenge will be the effort of entire world particularly the US and China to defuse the bombs together, and to unwind the bundle whose culprit is “globalization”.
The US is a very sick tiger, and China is a paper tiger made up with $3T worthless paper.
bcg_81
I had forgotten about that paper by Krugman. His opening lines are even more relevant to day as they were in 1994:
“Once upon a time, Western opinion leaders found themselves both impressed and frightened by the extraordinary growth rates achieved by a set of Eastern economies. Although those economies were still substantially poorer and smaller than those of the West, the speed with which they had transformed themselves from peasant societies into industrial powerhouses, their continuing ability to achieve growth rates several times higher than the advanced nations, and their increasing ability to challenge or even surpass American and European technology in certain areas seemed to call into question the dominance not only of Western power but of Western ideology. The leaders of those nations did not share our faith in free markets or unlimited civil liberties. They asserted with increasing self-confidence that their system was superior: societies that accepted strong, even authoritarian governments and were willing to limit individual liberties in the interest of the common good, take charge of their economies, and sacrifice short-run consumer interests for the sake of long-run growth would eventually outperform the increasingly chaotic societies of the West. And a growing minority of Western intellectuals agreed.
The gap between Western and Eastern economic performance eventually became a political issue. The Democrats recaptured the White House under the leadership of a young, energetic new president who pledged to “get the country moving again–a pledge that, to him and his closest advisers, meant accelerating America’s economic growth to meet the Eastern challenge.
The time, of course, was the early 1960s. The dynamic young president was John F. Kennedy. The technological feats that so alarmed the West were the launch of Sputnik and the early Soviet lead in space. And the rapidly growing Eastern economies were those of the Soviet Union and its satellite nations.”
bcg-81
Thankyou for that link. Literally found myself laughing at how historical parallels. Krugman seemed so impartial and scientific. I have only known him as a quasi-liberal talking head. Interesting stuff, to say the least.
[...] Never short a country with $2 trillion in reserves?: Michael Pettis, China Financial Markets. [...]
[...] furious about Friedman’s article and nail down the argument with a convincing piece (See Article from China Financial Market). Pettis argues that China’s 2 Trillion+ reserve is no doubt huge in terms of the percentage [...]
Mao Yushi, chairman of the Unirule Institute of Economics in Beijing was quoted as saying (in an article that points bask to this blog) …
“Overcapacity is a severe problem in China. It’s only going to get worse in the next few years because the government wants growth, and growth currently can only come from investment, not consumption. Investment turns into capacity. If you stop investing, the whole economy goes down. The more you invest, the more capacity there is, the less consumption there is compared to the investment. It’s a vicious cycle. There are two things the government should do to stop the cycle, but it has been doing exactly the opposite. One would be to reduce taxes. However why would the government do that? Who doesn’t like money? The second one would be to increase private investment, but you have “guojin mintui” (the advance of state-owned enterprises and the retreat of the private sector). State-owned enterprises (SOE) are so lucrative. Who wants to let go of that money?”
http://www.forbes.com/2010/02/11/china-bubble-mao-ha-renminbi-beijing-dispatch.html
A Chinese farmer once said to me: “In China, when you’re a one-in-a-million officer, there are 100 other people just like you.”
[...] Never short a country with $2 trillian in reserves – China Financial markets [...]
Here’s a visual of Friedman’s thought:
http://whoisioz.blogspot.com/2010/02/thomas-friedman.html
I apologize for not responding to any of these comments, but the number of meetings I had, and the jet-lag (and yes, travelling from Beijing to NY does involve changing time zones), made it almost impossible for me to get on line for more than a few minutes at a time. At any rate it seems to me that the debate went on very well without me.
For those who have troble seeing what the constraints are for using reserves, I have written about it often on my blog and will no doubt write about many more times. The key is to understand that the central bank has a balance sheet, and so to work out the balance sheet effect of any use of the reserves.
Ah, but how to profit from this anomaly? Only if you are part of a very special club perhaps?
to michael pettis,
hello sir,i am an indian & regular follower of this blog. i know very little about economics & its theories. still its such a pleasure to go through your blogs as well as the debate that follows. its really an enriching experience. most of the times many arguements go over my head, as i am not familiar to these theories. still i am learning slowly.
i really like with the convictions & authority you put your theories. kudos to you. keep up your good work sir.
ashutosh.
Welcome back Professor!
and a happy Chinese New Year!
In a global sense, I very much agree with Silly Things in overcapacity lies in the developed nations, once the global market start to price in the massive educated labour force from developing nations, e.g. China and India in particular, the phenomena will become more obvious. However, this is based on the assumption of free-global market and reasonable liquidity of trading medium (i.e. Currency).
At the same time, I believe the inflation (I believe it exists) in China is nowhere as severe as this article describes.
My personal understanding of TRUE asset bubble can only occur when :
1. the current level of this country’s technology is fully implemented in the economy, and there has no other spaces for value add.
2. the existing labour force in the country has reached their reasonable productivity level (reasonable = compare to other societies).
3. The Bubble-Asset price is way bigger (e.g. over 3 times) than the (replacement cost of those assets + associated labour costs).
Once all three conditions are satisfied, the true asset bubble can be formed – example of Japan in 90s.
Without any of these conditions are fully satisfied, all “asset bubble” can just be a result of temporary asset mis-allocation, those ‘asset bubble’ caused recession may last for 1-2 years. Nothing like Japan’s lost decade.
However, in a situation of an incapable-government in setting up relatively-efficient economic structure, all countries can go through long-lasting recession. But that is not a economic issue, but a political issue.
[...] I read a fascinating post by Michael Pettis connecting phenomenal run-ups in foreign reserves with fundamental economic imbalances that lead to [...]
Professor Pettis,
Many discussions of overcapacity are framed from the view of “excess over what is produced and what is consumed domestically”, as you’ve mentioned.
Unfortunately, this view really butchers the #1 sacred cow in economics: efficiency.
Consider what the consequence is if a country, any country not just China, holds back production even through it has the capacity to profitably produce more? The end result are:
- Foreign corporations, that otherwise would be uncompetitive, will continue production due to reduced competition.
- All consumers in the world will necessary pay a higher price for goods and services due to reduced competition. Consumers are forced to subsidize the uncompetitive businesses.
- Global economic growth (GDP growth) will necessary be lower.
- Resource will be severely mis-allocated. This is especially serious for the mis-allocation of human resource in the world.
Everyone looses in the long run.
In the short run, major changes do have a very real human cost dimension. Therefore it is understandable and correct for governments of developed nations to soften the shock. However, viewing overcapacity from “excess over what is produced and what is consumed domestically” misleads the analysis and will lead to significant inefficiencies.
A country is an economic actor like a business enterprise. I think the measure of overcapacity for a country should be the same as a business. Overcapacity should be measured by price and profitability of production.
Lastly, a good test of my argument is the prediction that we’ll see more over capacity issues as more and more poor nations unlocked their human capital and join the world economy. About half of the world’s 6 billion people are still living in poverty. There is still a very long road ahead!
[...] Then I’d point you to Thomas Friedman’s NY Times column of 12 Jan 10, titled Is China the next Enron? (he argues it isn’t). After Friedman, head straight to Michael Pettis’s excellent rebuke, Never short a country with $2 trillion in reserves? [...]
[...] diskuterede vi livligt her på bloggen, om Kina var en boble eller ej. Jeg citerede et par tunge drenge og fandt synspunktet mere end godtgjort. Det kinesiske mirakel er lavet af [...]
Here’s another hypothesis on how Chinese reserves will/ are (?) helping recapitalize their banks:
Chinese bank (state controlled entities) take positions on metals like copper, other commodities in Shanghai. Overseas, Chinese institutions buy these commodities and push the prices up. This in turn pushes up prices domestically (within China). Chinese government instituions book profits both overseas as well as within China.
They don’t have to worry about loosing elections because of inflation… this can go on for quite a while.
[...] Michael Pettis replies: If China indeed has the same distribution of geniuses, or talent, as other countries, the fact that it has so many people won’t make it richer. [...]
[...] Michael Pettis replies: If China indeed has the same distribution of geniuses, or talent, as other countries, the fact that it has so many people won’t make it richer. [...]
Thanks for the great input!
It would be helpful if data is presented as to how much of China’s $3 trillion reserve is earned from trade surplus, which is China’s wealth, and how much of it is foreign investment which is owned by foreigners and temporarily parked in China.
The country with the biggest real bubble never get to notice the bubble. Rose colored eyes baby, I bet the professor is one of those who missed the subprime bubble that is the root cause of the global economic depression.
The US will collapse first because it has the biggest bubble in the world– the bailout bubble, the mother of all bubbles.
[...] Never short a country with $2 trillion in reserves? [...]
[...] by Michael Pettis (a professor at Peking University’s Guanghua School of Management, “Never short a country with $2 trillion in reserves?”) are telling, particularly that huge foreign exchange reserves are not a sure shot solution for [...]
[...] by Michael Pettis (a professor at Peking University’s Guanghua School of Management, “Never short a country with $2 trillion in reserves?”) are telling, particularly that huge foreign exchange reserves are not a sure shot solution for [...]