Op-Ed Contributors

Debate: Forex Reserves

(China Daily)
Updated: 2010-08-02 08:08

Yao Yang

'Smart power' is what China needs

Professor Joseph Nye's article contains factual statements that we Chinese have to swallow and respect despite feeling hurt by his arrogance when he talks about US military and economic strength. We live in an interdependent world, in which we will probably harm ourselves if we take unilateral action aimed at harming another side.

Of course, the US would be hurt if China were to "sell" the $900 billion worth of US Treasuries it holds. But then the "sale" would hurt China, too, because it would wash away the value of its $2.4-trillion foreign reserves, most of which is believed to be in dollar-denominated assets.

China is caught in a dollar trap. A major part of China's $1.4 trillion exports is conducted in dollars. The greenback is the favored medium of currency even in Sino-Japanese trade, accounting for up to 60 percent of the transactions. So, for now, maintaining a "balance of financial terror" with the US seems to be the only option open to China.

China has accumulated huge foreign reserves because of its high domestic savings rate. In recent years, national savings, that is, the sum of savings coming from households, enterprises and the government have accounted for half of the country's GDP. About 80 percent of those savings is absorbed by domestic investment, leaving the rest 20 percent, or 10 percent of the national GDP, as China's net savings, most of which is held in the form of official foreign reserves.

So, why does China save so much? Chinese households save a lot, 37 percent of their disposable income, to be exact. But the government saves as much as the households. In the last decade, the central and local governments have spent 30 to 50 percent of their revenues on roads, buildings, public utilities and equipment. Chinese enterprises are even more thrifty, pumping virtually all their retained profits back into the economy.

This "savings glut" is a combined result of China's large reserves of labor and its integration into the world economy. Currently, China occupies the highest point of demographic dividends, that is, the benefit of large amounts of labor supply. Today, one working person in China needs to take care of only 0.4 non-working person, the lowest ratio in the world. The abundant labor supply - China has to create 24 million jobs to absorb new workers each year - means more savings.

But demographic dividends are not likely to last long in China. Most predictions show China will lose its demographic advantage by 2025. That may sound far off, but it's not that far if we consider the issues confronting the US today. The US government's debts have grown to more than $10 trillion, and there is no sign of the growth slowing down, at least not in the coming decade.

Ironically, China's savings are helping finance those US debts. For this, if not for anything else, Nye and other Americans should feel grateful to the Chinese people. Even without this courtesy, Nye should have questioned the sustainability of the American model of extravagant consumption built on debts. A debt is a debt, that is, the debtor is obliged to pay back someday.

Today, China holds its savings in US Treasuries; but there will soon come a day when China's savings decline and the Chinese people begin to consume more. What will the US government do then?

For Nye, the answer must be "continue", because "America's military and economic strength reinforces confidence in the dollar as a haven". If China stops recycling the dollar, other emerging countries or oil rich countries will. This is one kind of power the US enjoys, but not the kind Nye usually promotes.

What I am more worried about, however, is how China will find room for improvement amid this seeming inevitability. Nye incidentally reveals a secret held by some American elites: an undervalued yuan is good for the US because it provides Americans cheap goods and cheap finance to buy those cheap goods.

One of the immediate actions China can take to deal Nye and his likes a blow is to allow the yuan to rise against the dollar. My colleagues at Peking University, Xu Dianqing and Li Xin, working in collaboration with some American experts on an international project, have found that a moderate revaluation of the yuan against the dollar, say by 10 percent, will have only a minor effect on China's exports and GDP.

China could expedite the process of internationalizing the yuan to escape the dollar trap, too. One way of doing this is to issue yuan-denominated debts to countries in which the yuan is already strong and, at the same time, issue yuan-denominated bonds in Hong Kong to create an offshore yuan bond market. With $2.4 trillion in reserves, it is not difficult to build confidence in the market. This is what US Secretary of State Hillary Clinton calls "smart power".

The author is professor and director of Peking University's China Center for Economic Research.

(China Daily 08/02/2010 page9)