Chapter 14 Chapter 12 Should the global financial crisis depend on China?

When you hear some US officials say that China is partly responsible for the financial crisis, the first reaction may be that the US is looking for a scapegoat, and China is usually their target.From some perspectives, you are right. China is often blamed for irrelevant things.However, we should also see that, as the third largest economy in the world and the fastest growing economy among all important economies, there is no doubt that China will have a huge impact on the world economy.It's also not surprising that sometimes this influence is good and sometimes it's not, which is just the way the world works.Sometimes, other countries' complaints against China may have some truth, but sometimes they just use the RMB exchange rate and China's trade surplus as a powerful means of political pressure, without understanding the actual situation of economic operation.Therefore, when some serious economists, rather than aggressive politicians, think that China has not had a positive impact on the world economy, we might as well think about whether what they say makes sense, and start from our own reality, carefully look for the problem, Make a judgment that is as objective as possible.As economists, we have a responsibility to look at issues as objectively as possible, regardless of political factors or racial and ethnic differences.

In this chapter, we analyze whether China is one of the factors that caused the global financial system chaos and then spread to the world economy.Much of the criticism ultimately falls on the saving issue.Critics argue that China is not consuming enough and saving too much.As we saw in Chapter 7, this left the domestic economy unbalanced—investment encouraged and spending power insufficient.This economic imbalance is not just a domestic problem.China cannot consume all of its "excess" savings at home, so it must export it.However, there are only a few major markets in the world capable of absorbing such a huge amount of funds, and the bond markets in the United States and Europe are the most important markets among them.

As a result, China invested its growing surplus of savings (in the form of foreign exchange reserves) in markets such as US Treasuries.But China and most Middle Eastern economies have bought too many U.S. and European bonds, pushing up market prices and driving down yields.China has provided a lot of cheap financing to the US and European markets.Lower yields have had an impact on the entire U.S. financial system.Returns on risky assets that should have high returns have fallen.As a result, people are chasing higher yields -- which means that people are willing to pay higher prices for high-risk products, pushing up risk appetite.At the household level, ultra-low mortgage rates stimulate people to buy homes; at the bank level, banks package mortgage loans into risky financial instruments with low yields.It didn't take long before things spiraled out of control. Shortly after U.S. house prices began to slide in 2006, the gigantic housing bubble began to burst, and so did the bubble in the mortgage-backed securitization market, ultimately leading to the end of Wall Street we witnessed not so long ago, and the near collapse of global financial markets. crash.

Of course, critics have not pointed the finger at China entirely.Other factors that led to the crisis also played an important role.In a speech at the end of 2008, former U.S. Treasury Secretary Henry Paulson talked about the root causes of the global financial crisis.He highlighted mismanagement of U.S. financial markets and low levels of U.S. household savings, and made clear what the U.S. needs to do to fix its financial system.In his speech he mentioned: Let's not forget a core fundamental question.Over the past few years, persistent and worsening global economic imbalances have led to massive hot money flows, low interest rates, excessive risk appetite and a frenzied search for yield.These cannot be attributed to one country alone.There is no doubt that low savings rates in the US are a big problem, but underconsumption and reserve accumulation in Asia and oil exporters, as well as structural problems in Europe, are also contributing to economic imbalances.If we only emphasize the issue of financial market regulation and avoid the global economic imbalances that have created excess global liquidity, then we will miss an opportunity to radically improve global markets and restore economic vitality.Unless a new solution is found, the pressure on global economic imbalances will continue to mount.

This statement is in fact accusing China's high trade surplus and policy of preventing the appreciation of the renminbi as laying the groundwork for the crisis.Without these conditions, the current chaos in financial markets would not have been triggered. Of course, this speech caused an uproar in China, and also set off a climax of criticizing Paulson's remarks.Xinhua refuted it, calling any remarks that blamed China for the global financial crisis "extremely absurd and irresponsible."Many Chinese officials, including Premier Wen Jiabao, have responded by blaming the crisis on failure to regulate financial markets.In fact, many Chinese are very dissatisfied with the failure of the United States to manage its own real estate market and spread the crisis to the whole world.China has also been greatly impacted, and its exports have been hit hard (in this regard, many Americans feel that Chinese exporters have made a lot of money in recent years because American consumers buy more. It sounds reasonable) .So the question is: Who is to blame for this crisis?More importantly, how do we get out of this mess?

Let's first analyze Paulson's point of view. Only by understanding the operation of the global financial system can we understand China's role in it.As part of what is known as Bretton Woods II, China and the Middle East exported huge volumes, ran large trade surpluses, and relied in part on consumption in the US and other advanced economies for economic growth.Under the combined effects of undervalued currency, tax incentives and its own comparative advantages, China's manufacturing exports are booming unprecedentedly, as are oil exports from the Middle East.Currencies in both regions are pegged (or creep pegged) to the U.S. dollar, so there is no automatic adjustment mechanism to curb the trade surplus (under a market-oriented floating exchange rate system, the RMB and Middle Eastern currencies will appreciate, thereby inhibiting exports and encouraging imports , balance the trade account and prevent further accumulation of foreign exchange reserves. Whether the RMB exchange rate regime is "managed floating" or "manipulated exchange rate", it will be slightly different from a full floating exchange rate system - the exchange rate will remain stable and independent of market forces ).Huge export revenues (and speculative gains on the renminbi) have created a lot of renminbi liquidity in China and accumulated high foreign exchange reserves.

How did the dollar enter China's foreign exchange reserves?very simple.Under the basic expectation of RMB appreciation, Chinese exporters are obviously unwilling to hold dollars, so they sell the dollars received from exports to banks.Banks are also reluctant to hold dollars for the same reason, so they sell dollars to the sole and last buyer, the People's Bank of China, so that the dollars go into the country's foreign exchange reserves.China and the Middle East, which hold large sums of dollars, have no choice but to reinvest large amounts of foreign exchange earnings in US Treasury bonds, agency bonds and other foreign securities.Some critics argue that China should increase its purchases of oil, gold and other commodities, but that argument fails to take into account the problems of scale.In 2008, when foreign exchange reserves grew the fastest, China added 40 billion to 50 billion U.S. dollars of foreign exchange reserves every month. If China uses these foreign exchange reserves to buy oil, gold and other bulk commodities, it will have a huge impact on the market. drive up market prices.Therefore, these foreign exchange funds are eventually recycled back to the United States, making up for the savings gap in the United States.As a result, the U.S. financial market has gained a lot of liquidity.

In this environment, U.S. Treasury yields are depressed, lowering the cost of funding and making U.S. home mortgages cheaper.Americans are getting used to living with easy access to cheap loans.People started taking out loans to buy houses, and banks, sitting on a lot of cheap money, were happy to provide a lot of financing for it.Banks are also lending heavily to low-income groups as house prices soar. Banks package and restructure these mortgages into interest-paying financial products (called mortgage-backed securities), which are then sold to financial institutions such as large investment banks, insurance companies, and hedge funds.In a low interest rate environment, everyone pursues high returns.So, mixing some default-risk mortgages with the safer ones can lift bond yields a little bit, without affecting debt ratings, since most loans are still good quality (it doesn't look like the rating agencies are very clear what you are doing).The idea that these risky mortgages could go bad has been thrown out the window, especially now that many large corporations, including insurance companies, have also invested in these mortgage securities.This is risk management.It's been so peaceful for many years.One of the benefits brought about by this, which many people forget now, is that banks transfer mortgage loans to other financial institutions through this operation, and then issue more mortgage loans themselves.Even if all those loans go bad today, that still means a lot of people are getting their housing dreams.

But as we've seen so far, it's a giant Ponzi scheme.Under the condition that house prices continue to rise and people have the ability to continue repaying their loans, the problem will not appear; once the rise in house prices stops, risks will begin to be exposed.But the core features of Bretton Woods II have not yet broken down, namely the steady flow of cheap financing from China and the Middle East and the bursting of the US housing bubble.After hitting extreme highs in 2006, U.S. home prices began to fall.Some people stopped paying their mortgages, and it wasn't until the bankers suddenly realized they had created a monster.

The problem is that instead of dissipating, the risk that people thought would disappear invisibly in the financial system spread like a drop of ink into a basin of clear water, dragging down all loans.Because of the opaque way in which each mortgage-backed security product was structured and changed hands so frequently in the market, no one knew exactly what was in it.The lack of due diligence is staggering, but investors still trust asset ratings (a lesson from this story is not to trust asset ratings). As soon as investors discovered that there were default-risk loans in their home mortgage securities, they wanted to sell these products as soon as possible, and there were obviously no buyers in the market at this time.In today's world, the value of goods without buyers is close to zero.As a result, banks suddenly found that their multi-million-dollar mortgage-backed securities had suddenly become worthless junk.The screams of the financial crisis suddenly sounded.

What role did China play in this financial crisis?Many Chinese see China as an innocent bystander unrelated to the crisis.They believe that the United States is only putting pressure on China for political reasons.Some people abroad also believe that China's provision of cheap financing to the United States has fundamentally caused this crisis. If China hadn't bought those US treasury bonds and caused global economic imbalances, this crisis would not have happened.This view is quite popular in the United States and Europe, and even some well-known economists agree.Before in-depth analysis, let me list my basic views on this issue.Here, I try to be fair and objective.In short, I think China has played a facilitator role in this crisis, neither an innocent bystander nor an instigator.The way the Chinese economy has been linked to the world economy over the past few years means that China has indeed contributed to the crisis.Before in-depth analysis, let's look at the following conclusions: 1. The managed floating exchange rate system and the daily foreign exchange intervention of the People's Bank of China are one of the reasons for China's high foreign exchange reserves, and re-exported liquidity to the US dollar market between 2002 and 2008. 2. Relative to the size of its own economy, China's economy is less imbalanced than the Middle East - but in real dollar terms, China's economic imbalance is more serious. From 2002 to 2008, China "loaned" its domestic savings equivalent to about a quarter of total US borrowing. 3. On the whole, Europe does not borrow a lot of cheap funds from emerging market countries (with the exception of some European countries).Domestic policies in some European countries mean that they do not import "excess" savings from China and the Middle East. 4. We need to clarify the root of the problem, and the root of the problem is not in China.The Federal Reserve's long-term implementation of an excessively low short-term interest rate policy was the root cause of the real estate bubble and the surge in liquidity between 2002 and 2008.After all, the dollar is still the world's reserve currency.Through the implementation of loose monetary policy, the United States injected a large amount of dollars into China and other countries. After that, countries re-injected dollars into the US debt market. 5. After 2004, the long-term interest rate of the US dollar was lower than the historical level. China and other countries purchased US treasury bonds and agency bonds may be one reason. At the same time, the market's general expectation of low inflation in the future is also one of the reasons. 6. The real estate and credit bubbles in the United States and other economies are building up, but central banks generally ignore them.Incorporating asset prices into inflation targeting may detect problems in time.Of course, this is a later story, but this point has been overlooked by many people. 7. Bretton Woods II is not collapsing, but it is deforming. 8. There are important structural reasons for the "excess" saving in Asia, and it usually takes some time to change.At the same time, some policies adopted by the Chinese government have exacerbated the economic imbalance. 9. Massively misguided consumption, banking, and regulation have conspired in US financial markets to turn borrowed savings into the crisis it is today. Let us analyze the above viewpoints in depth. First, let's examine the flow of global funds.Global savings as a share of global GDP rose from a low of 20.6 percent in 2002 to 23.9 percent in 2006 and remained at this high level.But we should not just focus on global savings.If a country's high savings rate is commensurate with its high investment rate, there will be no "excess" savings exported abroad.The problem in China (as well as in the Middle East) is a growing "glut" of savings, ie savings minus investment (SI).The opposite is the case in the United States. Developing Asia (mainly China) and the Middle East accumulated large amounts of “excess” savings, while the US borrowed to finance its savings gap and current account deficit.Judging from the proportion of "excess" savings in GDP shown in the figure, the economic imbalance in the Middle East is more serious than that of developing economies in Asia. The GDP ratio of "excess" saving exceeds 20%. In terms of actual size, Asia and the Middle East provide roughly equal amounts of financing to the U.S. due to the larger economies in Asia. From 2002 to 2008, developing economies in Asia (China accounted for 91%) and the Middle East each exported US$1.4 trillion in "excess" savings, while the US borrowed as much as US$4.2 trillion.The United States mainly raises funds through the issuance of government bonds and agency bonds, but in recent years China and some other countries have also begun to invest in US corporate bonds and stock markets.On the whole, Europe did not borrow a lot of funds in Bretton Woods II (some European countries borrowed on a large scale, and countries such as Central and Western Europe also ran deficits). First of all, the United States is the main source of liquidity, and the interest rate level of the US dollar has been too low for a long time.John Taylor, a professor of economics at Stanford University, pointed out that from 2002 to 2006, the federal funds target rate (short-term benchmark interest rate used by banks to determine deposit and loan rates) was significantly lower than the normal short-term interest rate estimated according to the "Taylor rule". . "Housing and Monetary Policy", September 2007 and "The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong", November 2008, house prices and other asset prices would be very different if interest rates were higher.At the heart of the problem, according to Taylor, was a fundamental mistake by former Fed chairman Alan Greenspan.He sees only that the prices of goods and services have not risen sharply, setting lower short-term interest rates accordingly.But housing prices have been rising from 2001 to 2006, and in many areas have doubled or even tripled the original price level.U.S. monetary policy does not take house prices into account.Greenspan's logic is that asset bubbles are not the central bank's concern.If the bursting of the asset bubble has a negative impact on the economy, the Federal Reserve can respond by cutting interest rates.But that logic ignores the fundamental rule that asset prices should be determined by the market. Another problem is that even if Greenspan raised short-term interest rates (controlled by the Fed), long-term interest rates (determined by the bond market) would not rise much, meaning mortgage rates (where banks price loans based on the long-term yield curve) would not rise much either. will rise sharply.Chairman Greenspan called it a "puzzle" - he didn't understand it (but we imagine he was quite aware of the outcome).Lower mortgage rates mean mortgage costs are still low, so people will keep taking out loans to buy homes.Many have blamed China and the Middle East as key reasons, arguing that they used their large reserves to buy U.S. Treasuries, driving up bond prices and driving bond yields down. However, other explanations have been offered.An article by Taylor and Josephine Smith explains the famous "Greenspan interest rate puzzle" (the strange phenomenon that long-term interest rates remained low after the Fed raised short-term rates in 2004).In their view, this has something to do with the low inflation environment.In this environment, the market believes that the central bank can control inflation.If people expect the central bank to raise interest rates to fend off inflation, expectations for future inflation are lowered.Before the second half of 2007, commodity prices soared, and everyone began to worry about the coming of inflation, but the market atmosphere was very relaxed. The market believed that the central bank would take responsibility and quickly curb inflation. This expectation affected market behavior.As a result, long-term inflation expectations are suppressed, causing the yield curve to shift downward. "The Long End and the Short End of the Term Structure of Policy Rules", Josephine Smith and John Taylor, Stanford University, November 2007, they argue that this is the most important reason why long-term interest rates have not risen even after the Fed raised short-term rates . So, what role does China play here?Clearly, China's massive purchases of US bonds are not to blame if market expectations are driving down long-term bond yield expectations.To find out the real culprit, we might as well start with the situation in the United States. The real estate bubble in the United States began in 2001 and house prices peaked in July 2006.Subprime loan originations peaked between 2005 and 2007.China's current account imbalance and subsequent large-scale purchases of dollar securities only exploded in 2007-2008.In other words, China may have further inflated the already inflated US asset bubble, rather than being the instigator of the bubble. A key problem throughout the crisis has been the failure of the normal constraints on access to credit for bad-debt demand and the failure of the U.S. financial system to handle the inflows effectively.Whether it's non-existent mortgage lending standards, shoddy mortgage-backed securitization products, incompetent credit rating agencies, or failures in internal risk management, risks without proper oversight have multiplied.In other words, it is precisely because low interest rates have lowered financing costs that U.S. companies have no financing pressure, and when companies actually raise funds, no one asks them to use the funds in the way they should. We should not lose sight of the fact that Asian economies also have imbalances.There are also problems in Asia's economic growth model, and China's growth model is obviously unbalanced.However, there are also excusable structural reasons for economic imbalances: 1. After the Asian financial crisis in 1997-1998, the motivation of developing economies to pursue a current account surplus increased significantly in order to accumulate a large amount of foreign exchange reserves to resist the possible recurrence of financial crisis. 2. High savings rates are not uncommon in Asian economies, partly due to regional cultural factors and partly due to the absence of social security systems.Building a social safety net and raising incomes cannot be achieved overnight.In the short term, the world still has to learn to get used to some of the imbalances in the Chinese economy. 3. The level of domestic investment in China is rarely suppressed.If the government represses investment, the “excess” savings will be even greater (the current fiscal stimulus package unequivocally proposes a substantial increase in government-led domestic investment, which would help reduce China's external imbalances). In addition, there are other factors contributing to economic imbalances in some Asian economies, as well as in China.For these problems, we should actively face up to them instead of turning a blind eye.Exchange rate policy is one of them.At present, critics of the RMB exchange rate system sometimes overemphasize the impact of the exchange rate, but a stronger RMB cannot balance the US-China trade deficit.As we mentioned in Chapter 11, American consumers are happy to buy cheap manufactured goods, and China has a clear comparative advantage in manufacturing.On the contrary, except for high-tech products, some high-end food products, and a few other products, China does not import a lot of American goods. Still, the yuan's exchange rate is always an issue.The central government understands that the export industry can create jobs and promote economic growth, so it has been controlling the RMB exchange rate.We don't want to use the political term "currency manipulation", but it's clear that every month the central bank will step in and buy dollars to keep the yuan exchange rate at a certain level.If the central bank does not intervene in the market, day after day, the RMB exchange rate will fluctuate, and large amounts of foreign exchange reserves will not be accumulated.Although we can say that the central bank's foreign exchange intervention is a legitimate policy operation, we cannot deny the existence of government intervention.Although the appreciation of the renminbi cannot prevent the crisis from happening, it may prompt the adjustment of the imbalance to happen earlier. There is a real possibility that the borrowing situation among the "excess" saving in various regions is faltering.Indeed, in recent years many have warned that Bretton Woods II is doomed to collapse, causing much pain to the world economy.However, we believe that the prospects predicted by these critics have not become the problems we face today, such as the following: Critics of Bretton Woods II believed that (at some point) the US deficit gap would not be covered by external funding.But don't believe what you read in the newspapers. The latest data shows that China is still buying up dollar assets in large quantities, driving down long-term dollar interest rates. Critics are also concerned that the dollar will significantly depreciate the value of managed currencies around the world.But that hasn't happened yet - even if the dollar slips again, Middle Eastern currencies and the Chinese yuan are unlikely to be allowed to appreciate significantly against the greenback. Critics of Bretton Woods II also worry that the rise of trade protectionism will disintegrate the global trading system.Again, this didn't happen at all. We do not rule out the possibility that these fears will materialize in the future, but it seems unlikely to me.We have not seen a large-scale trade war start, and even under the pressure of the devaluation of the dollar, we have not seen China stop buying US bonds.In addition, the Chinese government has not allowed the yuan to appreciate significantly against the dollar.Even if these fears materialize in the future, Bretton Woods II appears to be deforming, not collapsing.The original proponents of the Bretton Woods II framework considered the system largely unchanged, see Michael Dooley, David Folkerts Landau, and Peter Garber, "Will Sub-primebea Twin Crisis for the United States?".They believe the system remains largely sustainable. What does this mean?U.S. consumption is shrinking, reducing demand for Chinese-manufactured goods and Middle Eastern oil.The US trade deficit is slowly shrinking, but at the same time, China's trade surplus is not shrinking, but is still expanding.In other words, the US's external economic imbalance problem is being resolved, and its dependence on external financing has been reduced.However, China's economic imbalance has not been resolved, and China's export income is still increasing; in the first four months of 2009, China's trade surplus continued to expand. Chapter 10 has analyzed the reasons in detail.Therefore, China is still a big buyer of U.S. bonds, but unlike its previous investment strategy of buying U.S. agency bonds, the State Administration of Foreign Exchange currently only buys short-term government bonds.Currently, only a handful of countries are still interested in long-term U.S. Treasuries, including China. You may ask, how is this possible?If the US trade deficit narrows, won't China's trade surplus decrease accordingly?Well, it would be true if there were only China and the US in the world.But that's not the case, let's not forget that the influence of the Middle East is also very large.As shown in Figure 12-7, the huge trade surplus in the Middle East has tended to balance in 2008, and there will even be a trade deficit in 2009, which can be described as a significant change.This is mainly because oil is the main export commodity in the Middle East, which has been greatly affected by the sharp drop in international oil prices, resulting in a sharp decline in its trade surplus.As a result, there is no longer a large "excess" savings in the Middle East that needs to be invested in overseas markets. China, on the other hand, does not have such problems as a commodity importer.In fact, as a commodity importer, China has suffered the exact opposite of the Middle East - imports have suddenly become cheaper, meaning that China's trade surplus has climbed again in recent months.As of April 2009, China's trade surplus was 30 percent higher than in the same period in 2008, leaving China with more "excess" savings to invest in the US and elsewhere.But at the same time, China's capital account inflows have decreased, and more Chinese households and businesses are happy to hold dollars rather than convert foreign currencies directly into renminbi.Therefore, the increase rate of China's foreign exchange reserves is not as large as in 2008. Regional current account balances in 2008-2009 show the global flow of “excess” saving and borrowing.The trade surplus in the Middle East largely disappeared, the U.S. trade deficit narrowed, the European Union was little changed, and the trade surpluses of developing Asia (mainly China) rose slightly.Is this Bretton Woods III? In some ways, this could be described as a new kind of global economic imbalance — and it could just as well be given a new name.This new imbalance is naturally strongly bilateral, with China continuing to provide financing to the United States while the Middle East no longer undertakes this task.In addition, the nature of the U.S. economic imbalance has also changed. It is no longer the negative household savings rate that leads to the U.S. savings deficit, but a large government fiscal deficit. By the end of 2009, the U.S. fiscal deficit may easily exceed 10% of GDP.China's investment behavior also began to change after the collapse of Lehman Brothers in the third quarter of 2008, and it gradually sold off its holdings of US agency bonds (bonds of Freddie Mac and Fannie Mae).While China is still buying U.S. bonds, the purchases are mostly concentrated in short-dated debt while selling long-dated debt.This means that China is no longer the factor that restrains long-term interest rates in the United States.The Fed itself is also acting aggressively to keep mortgage rates below where they would be without action. Therefore, it can be said that the embryonic form of Bretton Woods III has been embodied.But in other respects, the old system remains the same.China is still buying US bonds and has not diversified its investments.Some people say that China should actively diversify its investment targets beyond the US dollar.But that’s not feasible because few other markets have the capacity and liquidity to absorb such huge amounts of money.Some argue that China should buy oil or other commodities -- but it only takes a few billion dollars to buy oil prices much higher.And, at least dollar bonds pay interest, while oil and gold do not.In addition, no matter which object China invests in, there are investment risks.At present, China holds a large number of US dollar bonds. As long as the investment portfolio or the US dollar depreciates, it will directly lead to the depreciation of the assets held by China.It's like jumping out of a frying pan and into a fire.Moreover, the US has been financing its "excess" consumption with the "excess" savings of other economies.And likewise, China is consuming its "excess" savings on the "excess" consumption of the US (a feature that will again help China's export industries in 2010, supplying them with substantial demand).Therefore, there is still a reciprocal relationship between China and the United States. So, for the most part, I think Bretton Woods II is here to stay.China will still provide substantial financing for the deficits of the US and Europe, but it is clear that doing so is risky.