01 Mar 2009
Buddy, Can You Spare a TrillionTopics:
Beijing is America’s largest foreign creditor. But how long will the Chinese continue to finance U.S. deficit spending?
In his new book, The Ascent of Money: A Financial History of the World, HBS professor and economic historian Niall Ferguson writes that the historic emergence of credit and debt was as important in the rise of civilization as technological invention. In the excerpt that follows, he explains the recently developed symbiotic financial relationship between the United States and China — “Chimerica.”
To many, financial history is just so much water under the bridge — ancient history, like the history of imperial China. Markets have short memories. Many young traders today did not even experience the Asian crisis of 1997–1998. Those who went into finance after 2000 lived through seven heady years. Stock markets the world over boomed. So did bond markets, commodity markets, and derivatives markets. In fact, so did all asset classes — not to mention those that benefit when bonuses are big, from vintage Bordeaux to luxury yachts. But these boom years were also misery years, when markets soared at a time of rising short-term interest rates, glaring trade imbalances, and soaring political risk, particularly in the economically crucial, oil-exporting regions of the world. The key to this seeming paradox lay in China.
Chongqing, on the undulating banks of the mighty earth-brown River Yangtze, is deep in the heart of the Middle Kingdom, over a thousand miles from the coastal enterprise zones most Westerners visit. Yet the province’s 32 million inhabitants are as much caught up in today’s economic miracle as those in Hong Kong or Shanghai. At one level, the breakneck industrialization and urbanization going on in Chongqing are the last and greatest feat of the Communist-planned economy. The thirty bridges, the ten light railways, the countless tower blocks all appear through the smog like monuments to the power of the centralized one-party state. Yet the growth of Chongqing is also the result of unfettered private enterprise. In many ways, Wu Yajun is the personification of China’s newfound wealth. As one of Chongqing’s leading property developers, she is among the wealthiest women in China, worth over $9 billion — the living antithesis of those Scotsmen who made their fortunes in Hong Kong a century ago. Or take Yin Mingshan. Imprisoned during the Cultural Revolution, Mr. Yin discovered his true vocation in the early 1990s, after the liberalization of the Chinese economy. In just fifteen years he has built up a $900 million business. Last year his Lifan company sold more than 1.5 million motorcycle engines and bikes; now he is exporting to the United States and Europe. Wu and Yin are just two of more than 345,000 dollar millionaires who now live in China.
Not only has China left its imperial past far behind. So far, the fastest-growing economy in the world has also managed to avoid the kind of crisis that has periodically blown up other emerging markets. Having already devalued the renminbi in 1994, and having retained capital controls throughout the period of economic reform, China suffered no currency crisis in 1997–1998. When the Chinese wanted to attract foreign capital, they insisted that it take the form of direct investment. That meant that instead of borrowing from Western banks to finance their industrial development, as many other emerging markets did, they got foreigners to build factories in Chinese enterprise zones — large, lumpy assets that could not easily be withdrawn in a crisis. The crucial point, though, is that the bulk of Chinese investment has been financed from China’s own savings (and from the overseas Chinese diaspora). Cautious after years of instability and unused to the panoply of credit facilities we have in the West, Chinese households save an unusually high proportion of their rising incomes, in marked contrast to Americans, who in recent years have saved almost none at all. Chinese corporations save an even larger proportion of their soaring profits. So plentiful are savings that, for the first time in centuries, the direction of capital flow is now not from West to East, but from East to West. And it is a mighty flow. In 2007, the United States needed to borrow around $800 billion from the rest of the world; more than $4 billion every working day. China, by contrast, ran a current account surplus of $262 billion, equivalent to more than a quarter of the U.S. deficit. And a remarkably large proportion of that surplus has ended up being lent to the United States. In effect, the People’s Republic of China has become banker to the United States of America.
At first sight, it may seem bizarre. Today the average American earns more than $34,000 a year. Despite the wealth of people like Wu Yajun and Yin Mingshan, the average Chinese lives on less than $2,000. Why would the latter want, in effect, to lend money to the former, who is twenty-two times richer? The answer is that, until recently, the best way for China to employ its vast population was through exporting manufactured goods to the insatiably spendthrift U.S. consumer. To ensure that those exports were irresistibly cheap, China had to fight the tendency for the Chinese currency to strengthen against the dollar by buying literally billions of dollars on world markets — part of a system of Asian currency pegs that some commentators dubbed “Bretton Woods II.” In 2006 Chinese holdings of dollars almost certainly passed the trillion dollar mark. (Significantly, the net increase of China’s foreign exchange reserves almost exactly matched the net issuance of U.S. Treasury and government agency bonds.) From America’s point of view, meanwhile, the best way of keeping the good times rolling in recent years has been to import cheap Chinese goods. Moreover, by outsourcing manufacturing to China, U.S. corporations have been able to reap the benefits of cheap labor too. And, crucially, by selling billions of dollars of bonds to the People’s Bank of China, the United States has been able to enjoy significantly lower interest rates than would otherwise have been the case.
Welcome to the wonderful dual country of “Chimerica” — China plus America — which accounts for just over a tenth of the world’s land surface, a quarter of its population, a third of its economic output, and more than half of global economic growth in the past eight years. For a time it seemed like a marriage made in heaven. The East Chimericans did the saving. The West Chimericans did the spending. Chinese imports kept down U.S. inflation. Chinese savings kept down U.S. interest rates. Chinese labor kept down U.S. wage costs. As a result, it was remarkably cheap to borrow money and remarkably profitable to run a corporation. Thanks to Chimerica, global real interest rates — the cost of borrowing, after inflation — sank by more than a third below their average over the past fifteen years. Thanks to Chimerica, U.S. corporate profits in 2006 rose by about the same proportion above their average share of GDP. But there was a catch. The more China was willing to lend to the United States, the more Americans were willing to borrow. Chimerica, in other words, was the underlying cause of the surge in bank lending, bond issuance, and new derivative contracts that “Planet Finance” witnessed after 2000. It was the underlying cause of the hedge fund population explosion. It was the underlying reason why private equity partnerships were able to borrow money left, right, and center to finance leveraged buyouts. And Chimerica — or the Asian “savings glut,” as Ben Bernanke called it — was the underlying reason why the U.S. mortgage market was so awash with cash in 2006 that you could get a 100 percent mortgage with no income, no job or assets.
The subprime mortgage crisis of 2007 was not so difficult to predict. What was much harder to predict was the way a tremor caused by a spate of mortgage defaults in America’s very own, homegrown emerging market would cause a financial earthquake right across the Western financial system. Not many people understood that defaults on subprime mortgages would destroy the value of exotic new asset-backed instruments like collateralized debt obligations. Not many people saw that, as the magnitude of these losses soared, interbank lending would simply seize up, and that the interest rates charged to issuers of short-term commercial paper and corporate bonds would leap upwards, leading to a painful squeeze for all kinds of private-sector borrowers. Not many people foresaw that this credit crunch would cause a British bank to suffer the first run since 1866 and end up being nationalized. Back in July 2007, before the trouble started, one American hedge fund manager had bet me seven to one that there would be no recession in the United States in the next five years. “I bet that the world wasn’t going to come to an end,” he admitted six months later. “We lost.” Certainly, by the end of May 2008, a U.S. recession seemed already to have begun. But the end of the world?
True, it seemed unlikely in May 2008 that China (to say nothing of the other BRICs) would be left wholly unscathed by an American recession. The United States remains China’s biggest trading partner, accounting for around a fifth of Chinese exports. On the other hand, the importance of net exports to Chinese growth has declined considerably in recent years. Moreover, Chinese reserve accumulation has put Beijing in the powerful position of being able to offer capital injections to struggling American banks. The rise of the hedge funds was only a part of the story of the post-1998 reorientation of global finance. Even more important was the growth of sovereign wealth funds, entities created by countries running large trade surpluses to manage their accumulating wealth. By the end of 2007, sovereign wealth funds had around $2.6 trillion under management, more than all the world’s hedge funds, and not far behind government pension funds and central bank reserves. According to a forecast by Morgan Stanley, within fifteen years they could end up with assets of $27 trillion — just over 9 percent of total global financial assets. Already in 2007, Asian and Middle Eastern sovereign wealth funds had moved to invest in Western financial companies, including Barclays, Bear Stearns, Citigroup, Merrill Lynch, Morgan Stanley, UBS, and the private equity firms Blackstone and Carlyle. For a time it seemed as if the sovereign wealth funds might orchestrate a global bailout of Western finance, the ultimate role reversal in financial history. For the proponents of what George Soros has disparaged as “market fundamentalism,” here was a painful anomaly: Among the biggest winners of the latest crisis were state-owned entities.
And yet there are reasons why this seemingly elegant, and quintessentially Chimerican, resolution of the American crisis has failed to happen. Part of the reason is simply that the initial Chinese forays into U.S. financial stocks have produced less than stellar results. There are justifiable fears in Beijing that the worst may be yet to come for Western banks, especially given the unknowable impact of a U.S. recession on outstanding credit default swaps with a notional value of $62 trillion. But there is also a serious political tension now detectable at the very heart of Chimerica. For some time, concern has been mounting in the U.S. Congress about what is seen as unfair competition and currency manipulation by China, and the worse the recession gets in the United States, the louder the complaints are likely to grow. Yet U.S. monetary loosening since August 2007 — the steep cuts in the federal funds and discount rates, the various auction and lending “facilities,” the underwriting of JPMorgan’s acquisition of Bear Stearns, and, most recently, the shift to “quantitative easing” — has amounted to an American version of currency manipulation.
In the first phase of the crisis, between mid-2007 and mid-2008, the dollar depreciated roughly 25 percent against the currencies of its major trading partners, including 9 percent against the renminbi. Because this coincided with simultaneous demand and supply pressures in nearly all markets for commodities, the result was a significant spike in the prices of food, fuel, and raw materials. Rising commodity prices, in turn, have intensified inflationary pressures for China, necessitating the imposition of price controls and export prohibitions and encouraging an extraordinary scramble for natural resources in Africa and elsewhere that, to Western eyes, had an unnervingly imperial undertone. Only the “flight to safety” of foreign investors into dollars in the latter part of 2008 and the dramatic slowdown of the world economy reversed the dollar’s decline and ended the commodities boom. By the end of 2008 it was plain for all to see that China could not avoid a significant economic slowdown in the event of an American recession. Maybe, as its name was always intended to hint, Chimerica is nothing more than a Chimera — the mythical beast of ancient legend that was part lion, part goat, part dragon.
Perhaps, on reflection, we have been here before. A hundred years ago, in the first age of globalization, many investors thought there was a similarly symbiotic relationship between the world’s financial center, Britain, and continental Europe’s most dynamic industrial economy. That economy was Germany’s. Then, as today, there was a fine line between symbiosis and rivalry. Could anything trigger another breakdown of globalization like the one that happened in 1914? The obvious answer is a deterioration of political relations between the United States and China, whether over trade, Taiwan, Tibet, or some other as yet subliminal issue. The scenario may seem implausible. Yet it is easy to see how future historians could retrospectively construct plausible chains of causation to explain such a turn of events. The advocates of “war guilt” would blame a more assertive China, leaving others to lament the sins of omission of a weary American titan. Scholars of international relations would no doubt identify the systemic origins of the war in the breakdown of free trade, the competition for natural resources, or the clash of civilizations. Couched in the language of historical explanation, a major conflagration can start to seem unnervingly probable in our time, just as it turned out to be in 1914. Some may even be tempted to say that the surge of commodity prices in the period from 2003 until 2008 reflected some unconscious market anticipation of the coming conflict.
One important lesson of history is that major wars can arise even when economic globalization is very far advanced and the hegemonic position of an English-speaking empire seems fairly secure. A second important lesson is that the longer the world goes without a major conflict, the harder one becomes to imagine (and, perhaps, the easier one becomes to start). A third and final lesson is that when a crisis strikes complacent investors it causes much more disruption than when it strikes battle-scarred ones. For the historical record shows that the really big crises come just seldom enough to be beyond the living memory of today’s bank executives, fund managers, and traders. The average career of a Wall Street CEO is just over twenty-five years, which means that firsthand memories at the top of the U.S. banking system do not extend back beyond 1983 — ten years after the beginning of the last great surge in oil and gold prices. That fact alone provides a powerful justification for the study of financial history.
From The Ascent of Money: A Financial History of the World by Niall Ferguson. Reprinted by arrangement with The Penguin Press, a member of Penguin Group (U.S.A), Inc. Copyright © Niall Ferguson, 2008.