China and America: the economic Odd Couple

In recent years there has been much debate among economists about the so-called ‘global imbalances’, mainly between the US and East Asia, especially China.

On one side, America has been consuming more than it has been producing, importing more than it has been exporting, and borrowing rather than relying on internal savings to pay for it all. On the other side, China has been producing more than it has been consuming, exporting more than it has been importing, and lending to the US through purchases of US government debt and other means. It is certainly odd that China, a still-developing and relatively poor country, has been effectively subsidising and keeping afloat the US, the world’s largest and richest economy.

The US-China economic relationship has assumed greater salience with the financial and economic crisis. China’s capital flows to the US allowed for low interest rates in America, which underpinned the housing boom and bust and which, in turn, triggered the broader financial unravelling. The recession has reduced both America’s trade deficit and China’s surplus, but the imbalance still exists. Many wonder if the crisis will lead to an adjustment, and in particular whether China will continue to purchase American debt and other financial assets. The recent summit of the G20 nations in Pittsburgh included a call for global economic imbalances (which are wider and more complex than just US and China) to be addressed.

In 2002, Stephen Roach began to identify the significance of the global economic imbalances, making him one of the first to do so. Roach, the former chief economist at Morgan Stanley and now the head of the investment bank’s Asia subsidiary, has long argued that the arrangement is problematic and ultimately unsustainable. Now, as the global imbalances are an important topic in policy circles, Roach has published The Next Asia, a collection of articles written between 2006 and mid-2009. The book’s title is in fact somewhat misleading: it is really more about China than Asia generally, and focuses on the economic ties between China and the US.

For many years, Roach argued that the US is the main force behind the imbalance. In The Next Asia he refers to Asia’s export-led growth as ‘a second-order bubble – in effect, a derivative of the one in US consumption’. This perspective aligns him with the so-called ‘money glut’ school of thought (1). The money-glut theorists see low interest rates in the US as the driving force behind the imbalances. Roach certainly lays a large part of the blame on the Federal Reserve under its former head Alan Greenspan. The Fed, according to Roach, was ‘led by market libertarians who condoned an insidious succession of asset bubbles and ignored its regulatory responsibility in an era of unprecedented financial engineering and excess leverage’.

This understanding leads Roach to criticise US officials for seeking protectionist trade measures against China, or demanding that China make changes, such as letting the Chinese yuan increase in value versus the dollar. The US should not scapegoat China when its own house is not in order, Roach argues, citing in particular America’s low domestic savings. If anything, the US should be thanking China, for without its large purchases of dollar-based assets, US interest rates would have to be higher to attract buyers.

When the discussion of global imbalances first emerged earlier this decade, the ‘money glut’ outlook was the predominant explanation. However, in a 2005 speech, Ben Bernanke (who became chairman of the Federal Reserve) turned the issue on its head (2). Bernanke argued that the primary cause of the imbalances was excess savings in Asia – a so-called ‘savings glut’. China in particular produces more than it consumes, and surplus funds make their way into Western capital markets. China’s state policy of pegging the yuan to the dollar – which then requires China to purchase dollar-based assets – is cited as evidence that the imbalance is the result of Chinese ‘manipulation’ rather than a natural outcome of financial flows. From this point of view, the onus for reform is on China and Asia generally, not the US, which has effectively been doing the world a service by absorbing the surplus funds.

Roach’s earlier pieces in the book are critical of Bernanke and other ‘savings glut’ theorists. In a 2006 article, he says that Bernanke’s speech ‘downplayed America’s role in fostering the problem – unchecked structural budget deficits, a plunge in the income-based savings rate of US households, and a record consumer debt binge’. Moreover, according to Roach, Bernanke’s critique failed to appreciate that China is still a developing country, one that mixes both state and private ownership and has a fragmented financial system: ‘The Fed chairman is offering advice as if China was a fully functioning market-based system – perfectly capable of achieving policy traction with the traditional instruments of monetary and currency policies. Nothing could be further from the truth.’

But as we follow the development of Roach’s arguments in The Next Asia, we find a subtle shift in his views over time. He increasingly characterises the relationship between the US and China as ‘symbiosis’ rather than pinning most of the blame on the US. Instead, he sees both countries contributing to the imbalances. The Chinese economy’s reliance on exports is one-sided and unsustainable, he argues. Roach says China is desperately in need of reforms to boost internal consumption. For example, he recommends that the Chinese state overhaul welfare assistance, providing retirement and health benefits, so that households do not undertake ‘precautionary savings’ and instead spend its income.

Roach is initially optimistic about China’s ability and willingness to carry out the kind of reforms he suggests. He gains confidence from the statement made by Wen Jiabao, China’s premier, to the National People’s Congress in March 2007, that China’s economy was increasingly ‘unbalanced, unstable, uncoordinated, and unsustainable’. But over time, as it becomes clear that China is not implementing Roach’s favoured reforms, his frustration mounts. In near-exasperation he writes: ‘There are worrisome signs that China just doesn’t get it and that it is clinging to antiquated policy and economic growth strategies.’

Roach believes the crisis has the potential to be a ‘wake up’ call for China and Asia generally. But he despairs that China’s response to the crisis appears to be more of the same: for instance, he describes China’s massive $585billion stimulus (which at 13 per cent of its GDP is more than twice the impact of the US stimulus package) as an ‘infrastructure programme’ that bolsters the existing investment in production and exports, while ‘little is being done to stimulate the Chinese consumer’.

In an article in the Financial Times following the publication of his book, Roach evaluates the crisis responses globally and concludes: ‘Far from rebalancing, an unbalanced world again appears to be compounding existing imbalances.’ (3) The Pittsburgh summit adopted the goal of ‘sustained and balanced growth’, but Roach argues that this is an empty statement that lacks an enforcement mechanism.

Roach is an astute observer of global trends, and The Next Asia is full of insights. Today, when many economists and policymakers are focused on emergency measures and financial reforms, Roach provides a useful counterweight, stressing that there are underlying structural problems that need to be addressed. And compared to those who superficially focus on the financial sphere, and pin the blame for the crisis on greedy bankers, complex financial instruments or lax regulators, his emphasis on global imbalances gets closer to the point.

But Roach goes too far when he describes these imbalances as ‘the root cause of the current crisis and recession’; they are a symptom rather than a cause. The real issue underneath the imbalances – which Roach and most other participants in the debate overlook – is the decline of productive industry in the US. As a recent report by CrossBorderCapital found, US profitability has been falling for some time, in contrast to China and other parts of Asia (4). The discussion of ‘imbalances’ usually refers to who is borrowing (the US) and who is lending (China); or who is consuming (the US) and who is not (China). But the fundamental ‘imbalance’ is between who is creating new value in productive industries (China) and who is relying on credit to cover up for a lack of dynamism (the US). Overall, the term ‘imbalance’ is too much of a euphemism for what should really be called US decline.

Roach’s calls for China to reform are also problematic. As mentioned, he bemoans China’s lack of action on the reform front, but he never seeks to try to explain this inactivity. He displays a lack of curiosity to try to find out why China never gets around to promoting consumption. It leads to no re-evaluation of China’s interests, or the barriers to reform.

There are, in fact, a number of good reasons behind China’s reluctance to change, some of which Roach himself points to, but never fully develops. For instance, the build-up of currency reserves among Asian nations was a response to the late Nineties financial crisis in that region. Countries whose debt was denominated in dollars found that it ballooned when the value of their currencies fell; in response, many Asian nations vowed ‘never again’, and built up dollar reserves and relied more on internal savings. China was not a victim of this process, but it learned from observing what happened to its neighbours, and also began loading up on dollars.

Likewise, there is a rational basis for Chinese purchases of US Treasury securities, even though there are relatively low returns from such investments. Specifically, such purchases support China’s dollar reserves and provide a relatively liquid form of investment (as opposed to foreign direct investment, such as buying assets or investing in companies, which requires a longer commitment). Moreover, there is a geopolitical dimension, which many economists overlook or downplay. China is essentially a status quo power rather than a challenger, a country that seeks to grow within the context of a US-led world order. The Chinese government is certainly aware that a drastic withdrawal of investment in the US could upset the foundation of that order, to China’s detriment.

In a recent discussion of his book on the website of Foreign Policy magazine, Roach says ‘the shift to internal demand is really Beijing’s only option’ (5). Not really. By ‘internal demand’ Roach means consumption. If the US consumer will no longer buy imports from China, then China must create new consumers at home. But this emphasis on personal consumption is myopic. As the examples of industrialising Britain and America show, profitable growth creates its own demand; in particular, from new surplus being spent on the next round of investment, or businesses buying from other businesses. In both the British and American examples, personal consumption eventually rose, but it was secondary to business consumption. In neither case did governments adopt policies to provide special boosts to personal consumption.

Indeed, when Roach calls upon China to prop up consumer spending and shift the economy away from industry and towards services, from the ‘quantity to quality dimension of the growth experience’, he sounds like he wants China to embrace the policies that the US and other Western countries have adopted to offset industrial decline. The West may need to deploy such strategies after decades of deindustrialisation, but China is still a rising industrial power, and it would be quite understandable if it ignored the West’s calls to be more like it.

It is clear that Roach disagrees with those in the US and elsewhere who blame China solely for today’s economic problems. Perhaps the most passionate passages in The Next Asia are his testimonies before Congress, where he bluntly tells American politicians they are wrong to scapegoat China: ‘By going after China, you in the Congress are playing with fire.’ And it’s also clear that his concept of ‘symbiosis’ is meant to be even-handed. But his neutral-sounding, ‘both need to look in the mirror’ framework ultimately overstates China’s problems and underestimates America’s weakness. And his assumption that the goal of economic policy should be ‘global balance’, rather than the dynamic growth of productive industry, leads Roach down the same path as the US officials he criticises – lecturing China.

Sean Collins is a writer based in New York.

Stephen Roach on the Next Asia: Opportunities and Challenges for a New Globalization, by Stephen Roach, is published by John Wiley & Son. (Buy this book from Amazon(UK).)

(1) Daniel Ben-Ami provides a very useful discussion of the different explanations for the global imbalances. See A balancing act, Fund Strategy, 17 August 2009

(2) ‘The global savings glut and the US current account deficit,’ March 2005 speech

(3) ‘An unbalanced world is again compounding its imbalances,’ Financial Times, 7 October 2009

(4) CrossBorderCapital, ‘Re-thinking emerging markets – another look at the next twenty years,’ Emerging Markets, May 2009

(5) ‘No turning back for The Next Asia,’ foreignpolicy.com, 8 October 2009