BY ANDREW SHENG AND XIAO GENG
HONG KONG – In
early February, as China celebrated the start of the Year of the Monkey, a
widely circulated hedge-fund newsletter roiled financial markets by predicting
a hard landing for the economy, the collapse of the shadow-banking system, and
the devaluation of the renminbi. Stability returned only after People’s Bank of
China Gov. Zhou Xiaochuan, in an interview with Caixin magazine, explained the
logic of China’s exchange rate policy.
But China’s
ability to maintain that stability depends on a multitude of interrelated
factors, such as low productivity growth, declining real interest rates,
disruptive technologies, excess capacity and debt overhangs, and excess
savings. In fact, the current battle over the renminbi’s exchange rate reflects
a tension between the interests of the “financial engineers” (such as the
managers of dollar-based hedge funds) and the “real engineers” (Chinese
policymakers).
Foreign
exchange markets are, in theory, zero-sum games: the buyer’s loss is the
seller’s gain, and vice versa. Financial engineers love speculating on these
markets, because transaction costs are very low and leveraged naked shorts are
allowed, without the need to hedge an underlying asset. The exchange rate,
however, is an asset price that has huge economic spillover, because it affects
real trade and direct-investment flows.
Nowadays, financial
engineers increasingly shape the exchange rate through financial transactions
that may not be linked to economic fundamentals. Because financial markets
notoriously overshoot, if the short-sellers win by pushing exchange rates and
the real economy into a low-level equilibrium, the losses take the form of
investment, jobs and income. In other words, financial engineers’ gain is real
people’s pain.
To achieve
these gains, financial engineers use the media to influence market behavior.
For example, short-sellers portray sharp declines in commodity and oil prices
as negative factors, even though lower energy prices actually benefit most
consumers — and even some producers, by allowing them to compete with their
oligopoly counterparts. It is estimated that lower oil and commodity prices
could add some $460 billion to China’s trade balance, largely offsetting the
loss in foreign exchange reserves in 2015.
Similarly,
China’s growth slowdown and the rise of nonperforming loans are being discussed
as exclusively negative developments. But they are also necessary pains on the
path to supply-side reform aimed at eliminating excess capacity, improving
resource efficiency and jettisoning polluting industries.
The real
engineers, excluding those whose judgment is clouded by personal financial
interests, should counter this influence, while refusing to succumb to the
temptation of quick fixes. Fortunately, China’s authorities have long
understood that a stable renminbi exchange rate is critical to national,
regional and global stability. Indeed, that is why they did not devalue the
renminbi during the Asian financial crisis. They saw what most analysts missed:
leaving the dollar as the main safe-haven currency for global savings, with
near-zero interest rates, would have the same deflationary impact that the gold
standard had in the 1930s.
In the face of
today’s deflationary forces, however, real engineers in the world’s major
economies have been unwilling or unable to reflate. The United States, the
world’s largest economy, will not use fiscal tools to that end, owing to
domestic political constraints. Europe’s unwillingness to reflate reflects
Germany’s deep-seated fear of inflation (which underpins its enduring
commitment to austerity). Japan cannot reflate because of its aging population
and irresolute implementation of Prime Minister Shinzo Abe’s economic plan,
Abenomics. And China is still paying for the excessive reflation caused by its
4 trillion yuan ($586 billion) stimulus package in 2009, which added over 80 trillion
yuan to its own debt.
Meanwhile, the
consequences of financial engineering are intensifying. Zero and negative
interest rates have not only encouraged short-term speculation in asset markets
and harmed long-term investments; they have also destroyed the business model
of banks, insurance companies and fund managers. Why should savers pay banks or
fund managers 1 to 2 percent intermediation costs when prospective returns on
investments are zero? A system in which financial intermediaries can increase profits
only by increasing leverage — sustainable only by increasing quantitative
easing — is doomed to fail.
Indeed, in hindsight, it seems clear that financial
engineers outperformed the real economy only with the support of superfinancial
engineers — that is, central banks. Initially, balance-sheet expansion — by $5
trillion since 2009 — provided banks with the cheap funding they needed to
avoid failure. But bank deleveraging (brought about by stiffer regulatory
requirements), together with negative interest rates, caused financial
institutions’ equity prices to fall, leading to further pro-cyclical destruction
of value through price deflation, increasing illiquidity and crowded exits.
Past
experience has taught China’s real engineers that the only way to escape
deflation is through painful structural reforms — not easy money and
competitive devaluation. The question is whether the U.S. and other
reserve-currency countries will share the burden of maintaining global currency
stability, through an agreement resembling the 1985 Plaza Accord, in which five
major economies agreed to depreciate the dollar against the yen and the
Deutsche mark. If not, why would Asia’s net lenders, especially China, continue
funding speculation against themselves?
The dollar is a safe haven, but savers in need of
liquidity still lack an impartial lender of last resort. Depositing in reserve
currencies at near-zero interest rates makes sense only if the banker is not
funding financial speculation against the depositor. But, as it stands,
financial engineers have a lot of freedom; indeed, if they are big enough, they
can’t fail or, apparently, even go to jail.
China’s Group of 20 presidency this year offers an
important opportunity to emphasize that renminbi stability is important not
only for China, but also for the global financial system as a whole. If the
dollar enters into another round of revaluation, the only winners will be
financial engineers.
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