By: David A. Smith
[Continued from yesterday’s Part 1.]
In politics, never retreat, never retract, never admit a mistake.
As we saw in yesterday’s Part 1, judging by the report in Bloomberg Business (January 14, 2016) and a similar article and editorial in the Economist’s January 16 issue, something is badly awry in Chinese fiscal and monetary policy, and while such news doesn’t capture headlines or trigger reactions the way building artificial islands does, economics and finance matter, because the nation that cannot fund its industry and its citizens will be wracked with many more problems than just its international posture.
More important than poll numbers, because they can vote with their feet and their money
Among the many benefits of capitalism, workforce mobility is too little remarked, perhaps because when Marx was writing, workforces had to go to factories rather than the reverse; but in an information economy, where value chains can be discorporated, talent goes where it maximizes its life quality, and that is a complex equation involving both economic and non-economic factors. Controlled economies can sometimes produce huge quantities (real or reported) of tangible goods, but in this pursuit they sacrifice everything to do with quality of life. This works as a starting point when people are extremely poor and tangible goods are directly beneficial in extending healthspan, but once a country achieves a large middle-class, they start demanding more than tractors and concrete blocks – and that a totalitarian country cannot deliver.
While China’s not totalitarian, it is autocratic, and it’s been trying both to harness the markets and dictate to them.
B. A China that trades cannot sustain its ‘political trilemma’
China’s economy is in an awkward adolescence:
I’ll grow up eventually … won’t I?
It’s a combination of:
· A developed-world industrial capacity that depends on (x) importing resources from foreigners and (y) exporting finished products to foreigners.
The awkwardness comes from China’s schizophrenia toward foreigners: charming and extroverted when it comes to commerce, fearful and introverted when anything touches society.
I can never agree with me
The contradiction can never be resolved so long as China holds to it insularity, because markets are places where people tell each other the truth, and that truth is expressed in the price not only of goods and services, but also of the currency with which they are traded.
Pick no more than two
What Xi is running up against is what international economists call the trilemma, or the impossible trinity. It says that a country can’t have all three of the following things at once:
1. Flexible monetary policy
2. Free flows of capital.
3. Fixed exchange rate.
They fight one another.
How dare you say I’m inflexible
The Eurozone likewise found out about these problems in the context of Greece, Cyprus, and other capital havens, where stapling a weak economy with lax fiscal controls and questionable collection practices resulted in investors piling in to Greek-issued Euro-denominated bonds, and running up the spreads on those bonds to heroic levels. In fact, if one has fixed exchange rates, then one has only two choices to hold it up:
1. Tight capital controls, a preferred approach of dictators. (Which is why it’s one of the infallible leading indicators of a tyrant ruining his or her economy, such as the late Hugo Chavez did to Venezuela.)
January 29, 2016: Venezuelans queuing for groceries … of which there are scarcely any
2. The Central Bank makes it a policy of sustaining the desired exchange rate by buying or selling contrary to the market. This works only if the central bank has effectively infinite reserves of the foreign currency it will need to buy.
Most nations – Western ones, anyhow – have opted for the first two goals: free flows of capital and flexible monetary money. They have done so because tight capital controls don’t work in a democracy, which Greece found out to its shock, and because they believe that economic growth follows from those two things, and also because when your currency floats in the global markets, your nation is constantly pricing and repricing its goods and services.
AHI blog posts on China and on foreign investment in US housing
The ultimate in ‘this time it’s different, Jul 18, 2011: 2 parts, Monopoly SOEs
A little learning is a dangerous thing, October 27, 2011: 2 parts, Hukou system
Capital’s bolt hole, December 22, 2011: Influx of money into New York residential
Old before rich? May 2, 2012, 2 parts: Economy like India, age pyramid like Japan
Ex-mittances, August 17, 2012: French capital buying Manhattan condo’s flats
A theory of China’s cities and housing, August 23, 2012: 7 parts. Read this one first.
Just outrunning the currency bears, September 24, 2012: Dollar as ‘least bad’ currency
China’s whistling tea-kettle, November 9, 2012: Flight of private capital
Runaway money train, July 22, 2013 4 parts: Monetary policy out of control
Urbanization, meet displacement, June 13, 2014: Chinese buying Australian homes
Live-in safety deposit boxes, February 10, 2015: Using apartment as bolt holes
For that reason, global currencies in the IMF’s ‘reserve basket’ are members of a club, one that China was keen to join, and in October China did:
“Christine, does this mean I’m in the club?”
Xi seems to realize that he paid a high price for the honor of having the Chinese yuan included in the International Monetary Fund’s basket of reserve currencies along with the dollar, the euro, the yen, and the British pound.
Aside from dues and initiation fees, clubs have rules, and President XI is just now discovering what they mean:
To be included in the basket, China had to demonstrate that the yuan was “freely usable.” That forced it to lower some investment barriers—enabling the capital flight now bedeviling the leadership.
Funny thing about club rules, isn’t it?
You do not talk about capital controls, ever
They have consequences.
As soon as China started allowing free (or at least freer) flows of capital, it was inevitable that it would have to give up on one of the other two objectives.
If it wanted to keep the yuan from falling, it would have to raise interest rates higher than is good for the domestic economy, essentially giving up on setting an appropriate monetary policy.
Or, if it wanted to set interest rates as it pleased, it would have to allow the yuan to sink.
For President Xi, reversing course to exit from the IMF basket of currencies would have been an unthinkable loss of face. But the alternatives are … unpleasant.
[Continued tomorrow in Part 3.]