Sixty years ago Tennessee Ernie Ford recorded a song titled Sixteen Tons, based on an earlier recording by country-Western songwriter Merle Travis. Tennessee Ernie’s version soon hit number one on the music charts. The song is about a coal miner trapped in the system run by coal companies before the advent of the United Mine Workers union. Miners were paid in scrip that could be used to buy goods only at the store run by the company. When the miner didn’t have enough scrip the company store acted as a payday lender, advancing scrip on credit.1 Hence, the repeated lines in the song’s chorus: “I owe my soul to the company store,” and “another day older and deeper in debt.” (Travis said his coal-miner father used that last line often.)
Americans don’t work in Chinese coal mines.2 Yet I thought of this analogy as I read Unbalanced: The Codependency of America and China by Stephen Roach, former chairman of Morgan Stanley Asia. Odd as it may seem, Americans are the coal miners and China is the company store. Americans spend every last penny to buy goods at the company store that is China, and China advances us the money to do it.
The codependency of China and the U.S.
The mechanism is a little more complicated than the simple relationship between the miner and his company store. In the case of China and the U.S., U.S. citizens buy cheap goods from companies in China. China’s central bank trades China’s own currency, renminbi (RMB), for the dollars those companies receive from Americans. Thus, China’s central bank amasses dollars. China’s foreign exchange reserves rose, according to Roach, by a factor of 300 from $11 billion in 1990 to $3.5 trillion by mid-2013.
More than a third of China’s foreign exchange reserves are held in U.S. Treasury securities. There are two views about why China holds so much in U.S. Treasury securities, even though their yields are so low. One, which is undoubtedly part of the reason and may be the entire reason, is to prevent the kind of debt crisis that Southeast Asia suffered in 1997. In that year countries like Thailand, which had been receiving regularly rolled-over six-month-maturity dollar loans from U.S. creditors, saw a sudden stop to their credit when doubts about the Thai economy and the Thai baht spiraled. This brought about a crisis that drove down the value of the baht. If Thailand had had unlimited quantities of dollar reserves to repay loans, it could have weathered the crisis. China noted this and swore that, so as never to be vulnerable to such a crisis, it would massively stockpile foreign currency reserves.
The other possible reason for hoarding U.S. dollars – and the cause of much American China-baiting – is to keep the exchange value of China’s RMB low. That way, it will be cheap for Americans to buy goods from China. This promotes China’s export strategy. It would probably be difficult to separate those two reasons; you would have had to have gotten into the minds, or the smoke-filled rooms, of the top Chinese Communist Party decision-makers. Roach’s preferred interpretation is clearly that China amassed these foreign reserves because of an all-out effort to avoid the instability from which it had suffered so much in the past. Memories for example of the instability of the Cultural Revolution of 1966-1971 were still very fresh.
Once these Chinese dollars are invested in – loaned to – the U.S. Treasury, how do they get into the hands of American consumers, who then use the “scrip” to buy goods from China?
The answer of course is that Americans borrow that scrip – or rather, that money. The massive Chinese investment in Treasury securities helps keep interest rates extremely low. This hugely increases the incentive to borrow. Then all that is needed is “collateral,” and Americans will go out and borrow to their hearts’ content and buy Chinese goods.
We know how that worked out and how good that collateral was: overvalued houses in the mid-2000s, overvalued tech stocks in the late 1990s. And Roach is afraid that U.S. policy will make that happen again. If you don’t have some other way to get those moneys that China recycled to the U.S. Treasury into the hands of consumers, then you have to inflate some new – or possibly old – “collateral.” In short, what Roach calls the “false prosperity” of American policy may consist of repeatedly inflating financial bubbles.
The saving/spending divide
Chinese citizens save a very high percentage of their incomes, while U.S. households are legendary for their lack of saving. The household saving rate in China is over 30% while in the United States it is around 3-6% (this does not, however, count the U.S. taxes that fund Social Security and healthcare programs). Chinese citizens save so much because extremely hard times remain in relatively recent memory for most of them, and because the social safety net in China is so low. Roach says that China’s “so-called retirement safety net contains assets of just USD $1,690 per worker for the 257 million who were actually covered by such plans in 2010”; and China’s healthcare plan “provides benefits equaling just $30 per year for each of China’s 1.3 billion citizens.” In these areas, U.S. citizens should, and plainly do consider themselves lucky, since they’re unconcerned enough to go out and spend nearly all of the income they earn. China’s low-cost products also helped America keep the brakes on inflation.
Roach is not alone in believing that this unbalanced situation cannot continue. One would think that for China, the Western financial crisis of 2007-2009 was a wake-up call, alerting them that their export strategy was vulnerable to volatility in Western economies.
But as Roach makes plain, it was not the first wake-up call. China’s leadership, unlike that of the U.S., was anticipating the unsustainability of their strategy prior to the financial crisis. In what came to be called the “four UNs,” at a press conference on March 16, 2007, premier Wen Jiabao “warned of complacency. While conceding that all looked well on the surface, he went on to depict the Chinese economy as increasingly ‘unstable, unbalanced, uncoordinated, and ultimately unsustainable.’”
This, from Roach’s viewpoint, clearly illustrates the benefits of China’s “vertical accountability within the hierarchy of the Party” as opposed to “horizontal accountability in a multiparty United States.” Roach repeatedly stresses the fact that the United States forms no long-term strategies, and that worries him. “Strategy doesn’t come easy for a nation whose economy sits on the bedrock of the Invisible Hand. Despite the obvious warning signs of massive imbalances and the bubbles they spawned, there is a strong predisposition in the United States to resurrect the timeworn recipe of consumer-led economic growth.”
Who would have thought that a scant 20 years after the downfall of the Soviet Union proved once and for all the superiority of a free economy organized by the Invisible Hand, we would be seriously wondering if an authoritarian system doesn’t work better after all?
Roach worries that in the absence of a planned strategy, U.S. muddle-through policy – preferring to clean up after a financial mess than try to anticipate one, as was Greenspan’s stated inclination – will repeatedly inflate bubbles to keep the U.S. consumer borrowing against its China scrip, in order to recycle the money it sends to China to buy Walmart goods.
Don’t focus on China’s “undervalued currency”
Roach makes a good case that the U.S. Congress will be making a big mistake if it takes action to retaliate for what it deems China’s “currency manipulation.”
First, Roach points out that the traditional and still practiced method of accounting for the value of exports is deeply flawed. For example he says that for a “dress at The Limited that is labeled ‘Made in China,’ the Chinese value added turns out to be only about 5 percent of the sales price.”
Why is this? Because production is now so internationalized, components of a product may be made in many different countries then shipped to China to be assembled. Components for an iPhone might be made in Korea, Taiwan, Malaysia, and Indonesia and assembled in China, which thus adds only a percentage of the total value added, but to which the whole value added is attributed anyway because the resulting iPhone was exported from China. In fact, says Roach, “we can more accurately see [China] as the hub of a massive, integrated, pan-regional export machine – in effect, a proxy for a large collection of tightly connected Asian economies that provide low-cost goods to a savings-short U.S. economy.”
Roach points out that in 2012, the U.S. ran trade deficits with 102 countries. And even accounting for the trade deficit with China in the way that the accounting is still done, “Over the decade ending in 2012,” says Roach, “China accounted for 33.5 percent of the cumulative U.S. multilateral trade gap.” Surprisingly, this is less, according to Roach, than the U.S.’s 40 percent deficit with Japan over the 80s decade, in which Japan was not the hub of a pan-regional export machine as China is today.
Roach says that trying to “correct” the bilateral trade deficit with China by forcing China to revalue its currency or imposing sanctions will not work. “America’s multilateral trade deficit,” he says, “is an outgrowth of the biggest saving shortfall in history. If that saving problem is not addressed, closing down trade with one [i.e., China] of the 102 countries means that piece will simply get redistributed to the other 101.”
Roach sums up by saying “the United States’ multilateral trade imbalance is not made in China. It is made at home, by a nation seemingly incapable of saving. … [T]rying to eliminate the Chinese piece of a massive U.S. trade deficit would accomplish little other than shifting one piece of the trade gap to others.”
China’s export boom was created largely by multinationals and foreign direct investors
Also, the idea that China succeeded with its export strategy by subsidizing its domestic companies is incorrect, according to Roach. “Contrary to general perceptions of rapidly growing indigenous Chinese producers enjoying state subsidies in the form of cut-rate financing, a cheap currency, and other forms of nontariff protection,” he says, “the bulk of China’s export impetus has come from subsidiaries of Western-owned companies.”
Most of China’s export growth was powered from the outside, largely through joint ventures of Western companies with Chinese firms. China has been second only to the U.S. as a destination of foreign direct investment, says Roach. “And with good reasons: Production and assembly in China provides an immediate and important efficiency solution for high-cost producers in the West. Down the road, it also positions multinationals to tap domestic demand in the world’s most populous market.”
What has to happen
China and the U.S. are locked in a codependency. But in this codependency one of the partners, at least, is about to make major changes. If the other doesn’t change accordingly, there will be a serious disruption. Asks Roach, “Can codependency between the United States and China endure without mutually compatible strategies?”
He puts it starkly: “The American and Chinese economies are both now at critical junctures, with one very important problem in common: Their successful growth recipes of the past are not sustainable. China has taken its producer model to excess, and America has done the same with its consumer model. … Both the United States and China are in urgent need of strategic realignments.”
China knows that its citizens must evolve to become consumers, because the export model will not last – not least because its trading partners in America and Europe cannot, by means of an unending series of inflated asset bubbles to fund borrowing, sustain their consumption; but also because competitors are arising among other developing countries that can produce more cheaply at the same or higher levels of productivity. To sustain its growth China needs its domestic market to expand; it needs to become no longer a nation only of savers and producers, but a nation of spenders and consumers.
This will break the cycle of codependency that has been the hallmark of the China-U.S. trade relationship in at least the last 20 years. To prosper, and to help China prosper, the U.S. must put the brakes on its spending binge and reduce its saving deficit. It needs to become no longer a nation only of spenders and consumers, but a nation of savers, producers, and exporters.
Roach believes that China’s inevitable turn toward consumerism, as its citizens feel more prosperous and stable and its safety net is put in place, is an opportunity for America – “a basis for its long-term resurgence.” “The United States offers a product line that would sell very well in the Next China,” says Roach, “especially motor vehicles, aircraft, appliances, pharmaceuticals, and sophisticated machinery.”
This is all quite relevant for financial advisors. The high investment returns of recent past decades deluded many U.S. workers who were within sighting distance of retirement into believing that investments would take care of them – investments in their home, hot stocks, or some other pie-in-the-sky lottery ticket. Now the likely prospective investment returns are much lower than in the past, for a variety of reasons. This, combined with China’s rebalancing, is an opportunity for a return to reason, a return to saving and production from a binge of spending and consumption.
Rather than focusing on clients’ investment returns and on producing some magical “optimum” that their clients can go on dreaming will relieve them of the necessity to save, advisors should move the focus back to saving. There can be little doubt that Americans will need to save much more than they have in recent decades. Focusing on that is much more important than focusing on their investments and the returns that they hope and wish and dream those investments could provide.
Michael Edesess, a mathematician and economist, is a visiting fellow with the Centre for Systems Informatics Engineering at City University of Hong Kong, a principal and chief strategist of Compendium Finance and a research associate at EDHEC-Risk Institute. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler. His new book, The Three Simple Rules of Investing, co-authored with Kwok L. Tsui, Carol Fabbri and George Peacock, has just been published by Berrett-Koehler.
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