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 Governor 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 spillovers, 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.
In order 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
oligopolistic 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 non-performing 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 US 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, so-called Abenomics. And China is still paying for the
excessive reflation caused by its CN¥4 trillion ($586 billion) stimulus package in
2009, which added over CN¥80 trillion 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 1-2% 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 super-financial 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 US 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 US dollar against the Japanese yen and the German Deutsche Mark.
If not, why would Asia’s net lenders, especially China, continue funding speculation
against themselves?
The US 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 G-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 US dollar enters into another round of revaluation, the only
winners will be financial engineers.
A version of this article appeared in Project Syndicate, 29 February 2016
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