Thursday, September 30, 2010

Capital controls to call the Chinese bluff?

China's persistent currency manipulation to keep the renminbi under-valued has been one of the biggest global economic concerns for some time now. This has acted as an effective export subsidy cum import tariff, a job sucking machine, that has served to artificially boost China's export competitiveness vis-a-vis developed economies and other competing emerging economy exporters.

Any efforts at direct action by way of sanctions and coercing China into revaluing its currency, besides being legally untenable, is bound to fall short politically. In the circumstances, Daniel Gros proposes capital controls on Chinese purchases of US debt through reciprocity arrangements,

"The US (and Japan) could easily prevent the Chinese Central Bank from continuing its intervention policy without breaking any international commitment. The US and Japan only need to invoke the principle of reciprocity and declare that they will limit sales of their public debt henceforth to only include official institutions from countries in which they themselves are allowed to buy and hold public debt... the Chinese authorities would just be told that they can buy more US T-bills Japanese bonds only if they allow foreigners to buy domestic Chinese debt... in contrast to the area of trade, there are no legal constraints on the impositions of capital controls."

This would leave the Chinese government without avenues for investing its massive reserves. The euro option looks unlikely given the current risks associated with those assets and the possibility that euro members would retaliate with their own reciprocity arrangements. For the same reason, in the absence of meaningful currency alternatives, any threat to dump its dollar reserves would leave China with no alternative but store its reserves as cash deposits. And given the investments in scale required to manage the massive reserves, the possibility of Chinese investments in US private assets look remote.

In any case, as Paul Krugman has vociferously argued, any Chinese hair-trigger fire-sales of its trillion dollar hoard of US Treasuries would actually rebound on China and generate a win-win outcome for the US. Such forced sales and capital flight would knock the value of Chinese investments by both lowering the prices of those assets and leading to the depreciation of the dollar (unless the Chinese step in with even more dollar purchases, leaving them with the problem of finding a source to invest them or risk leaving them under the cushions!). And, the resultant depreciation of the dollar would end up increasing the competitiveness of US exports.

As Daniel Gros says, any US imposition of a reciprocity arrangement, with the attendant possibility of drying up of the Chinese channel to finance US deficits, would constitute a test of the US commitment to rein in its burgeoning deficits and massive public debt. This would also be the most effective strategy to call the Chinese bluff and ensure that the chimera of Chinese boycott of US debt is quietly buried.


sai prasad said...

By undervaluing and selling the chinese are giving their goods at lower prices.

Secondly, the competitiveness so earned, would waste away very rapidly the moment the prices increase. The only fear that others should have is the damage that this would do to their own industry in the meantime and the unemployment that its cir=tizens would face. If they have the ability to absorb both of these, then they are only getting goods cheaper.

If they cannot, then the step that you suggest seems to be good. However, such restriction on purchase of debt might also fall short politically.

gulzar said...

yes sir, i agree that the cheap exports are a form of Chinese subsidy transfer. but the problem is what you raised with the second point - they cannot absorb the competition from cheap Chinese exports.

let us take the other emerging and developing economies. the cheap Chinese exports are directly competing with the other emerging economy exports and both destroying jobs and stifling domestic industrial development there. in other words, it is classic beggar-thy-neighbour policy.