China: something must burst

“I know from a common sense financial standpoint that something has to burst. When a country is losing billions and billions and billions of dollars a year and when other countries are making hundreds of billions of dollars, something is going to burst” That was businessman Trump on America’s trade deficit 27 years ago. It could be candidate Trump on the trade deficit today. The worry then, widely shared, was Japan. Now it is China. Now, as then, the worries are on the wrong side.

In the first half of the 1980s the dollar surged as a result of the Federal Reserve’s tight money to fight inflation. Partly as a consequence, Japanese imports poured into America and US companies lost market share. So pressured was America’s car industry that the Reagan administration forced Japan to agree to Voluntary Export Restraints. As the ill-fated Mr Takagi explained to John McClane in 1988’s Die Hard, “Pearl Harbor didn’t work so we got you with tape decks”

The Louvre Accord of 1985 ended this. Central banks worldwide agreed to boost their currencies against the dollar. Now, as the dollar/yen rate shifted the other way, Japanese capital poured into America buying iconic assets such as the Biltmore Hotel and the Mobil Building. There were worries about a “corporate Japanese takeover” of America.

And, in 1989, something burst but not, perhaps, what businessman Trump expected. To meet its Louvre Accord commitments the Bank of Japan brought its policy rate down from 7.44 per cent in November 1985 to 3.37 per cent in August 1987 and kept it there. This fuelled an asset price boom: in 1988 the land surrounding Japan’s Imperial Palace was said to be worth more than the whole of California. The Nikkei Stock Index rose from 22,621 in November 1987 to 38,130 in December 1989 when it accounted for more than one third of the world’s stock market capitalization.

But inflation eventually ticked up and the Bank of Japan acted. The policy rate was increased from four per cent to six per cent between March and August 1990, climbing to 8.15 per cent in February 1991. This popped the asset price bubble. By December 1990 the Nikkei was down to 23,470, reaching 17,390 in December 1992. House prices fell by two thirds and remain at that level today.

Today the worry is China. Candidate Trump frequently lambasts the Chinese for devaluing their currency. In 2014 he told the CPAC that “China, which I’ve been talking about for the last five years, yesterday, right in our face, they just devalued their currency…what they’re basically doing is saying ‘We’re really ripping you big league, nobody’s ever done it better than us, but now we’re going to really do it again’”, adding “they’re taking our jobs”

Indeed, it is true that policymakers in Beijing have tried to keep the yuan weaker against the dollar that market forces might allow. This has helped Chinese exporters. By extension it has also, some say, enabled China to buy ‘everything between Portland, Maine, and Portland, Oregon’, including Starwood Hotels and $1.2 trillion of US government debt.

But, as for the Japanese before them, this has not been a costless exercise for the Chinese.

By holding down the value of the yuan the Chinese government has held down the purchasing power of Chinese producers. This has effectively worked as a subsidy from Chinese producers, with an average GDP per capita of $14,100, to US consumers, with an average GDP per head of $56,000. If anyone should be angry about this arrangement, it should be Chinese producers.

What of concerns about China’s purchase of American assets? While some say that America is ‘hostage’ to China because of the vast debt it owes the People’s Republic, it is just as true to say that China is hostage to America for the same reason. In the event of a flashpoint between the two countries, the Chinese could dump their dollar assets, forcing US interest rates up. But the prices of China’s US bond holdings would tumble representing a capital loss for Beijing.

There is even less to worry about with tangible assets. If tension flares between America and China the Chinese owned AMC movie theatre in Inver Grove Heights, Minnesota, will still be in Inver Grove Heights, Minnesota, just as the once Japanese owned Biltmore Hotel is still there on LA’s South Grand Avenue and the Mobil Building is still at 150 East 42nd Street in Midtown Manhattan. When someone says that the Chinese have bought ‘everything between Portland, Maine, and Portland, Oregon’, remember that those things are still somewhere between Portland, Maine, and Portland, Oregon. They have not been shipped to China, only the paper claims on them have.

Finally, by pegging the yuan to the dollar Beijing has essentially been importing US monetary policy. As the US has expanded its money supply so has China. Debt, much of it bad, has increased in China to levels some analysts believe to be higher than in America on the eve of the subprime crisis. China’s empty cities, like the abandoned properties of Michigan a decade ago, are monuments to malinvestment.

Free trade benefits both parties, they wouldn’t trade if it didn’t. But trade that is distorted by tariffs, quotas, and currency manipulation, can blow up horribly. “Something has to burst”, as a man once said but, as with Japan a quarter of a century ago, it might not be the Americans who should be most worried.