Wednesday, July 30, 2008

A strong overview of a dying dollar, and the Chinese dilemma

Breaking free from dollar hegemony

By Henry C K Liu

The vast expansion of US-led globalized trade since the Cold War ended in 1991 had been fueled by unsustainable serial debt bubbles built on dollar hegemony, which came into existence on a global scale with the emergence of deregulated global financial markets that made cross-border flow of funds routine since the 1990s.

Dollar hegemony is a geopolitically constructed peculiarity through which critical commodities, the most notable being oil, are denominated in fiat dollars, not backed by gold or other species since then president Richard Nixon took the US dollar off gold in 1971. The recycling of petro-dollars into other dollar assets is the price the US has extracted from oil-producing countries for US tolerance of the oil-exporting cartel since 1973. After that, everyone accepts dollars because dollars can buy oil, and every economy needs oil. Dollar hegemony separates the trade value of every currency from direct connection to the productivity of the issuing economy to link it directly to the size of dollar reserves held by the issuing central bank. Dollar hegemony enables the US to own indirectly but essentially the entire global economy by requiring its wealth to be denominated in fiat dollars that the US can print at will with little in the way of monetary penalties.

World trade is now a game in which the US produces fiat dollars of uncertain exchange value and zero intrinsic value, and the rest of the world produces goods and services that fiat dollars can buy at "market prices" quoted in dollars. Such market prices are no longer based on mark-ups over production costs set by socio-economic conditions in the producing countries. They are kept artificially low to compensate for the effect of overcapacity in the global economy created by a combination of overinvestment and weak demand due to low wages in every economy.

Such low market prices in turn push further down already low wages to further cut cost in an unending race to the bottom. The higher the production volume above market demand, the lower the unit market price of a product must go in order to increase sales volume to keep revenue from falling. Lower market prices require lower production costs which in turn push wages lower. Lower wages in turn further reduce demand.

To prevent loss of revenue from falling prices, producers must produce at still higher volume, thus further lowering market prices and wages in a downward spiral. Export economies are forced to compete for market share in the global market by lowering both domestic wages and the exchange rate of their currencies. Lower exchange rates push up the market price of commodities which must be compensated for by even lower wages. The adverse effects of dollar hegemony on wages apply not only to the emerging export economies but also to the importing US economy. Workers all over the world are oppressed victims of dollar hegemony, which turns the labor theory of value up-side-down.

In a global market operating under dollar hegemony, the world's interlinked economies no longer trade to capture Ricardian comparative advantage. The theory of comparative advantage as espoused by British economist David Ricardo (1772-1823) asserts that trade can benefit all participating nations, even those that command no absolute advantage, because such nations can still benefit from specializing in producing products with the lowest opportunity cost, which is measured by how much production of another good needs to be reduced to increase production by one additional unit of that good.

This theory reflected British national opinion at the 19th century when free trade benefited Britain more than its trade partners. However, in today's globalized trade when factors of production such as capital, credit, technology, management, information, branding, distribution and sales are mobile across national borders and can generate profit much greater than manufacturing, the theory of comparative advantage has a hard time holding up against measurable data.

Under dollar hegemony, exporting nations compete in the global market to capture needed dollars to service dollar-denominated foreign capital and debt, to pay for imported energy, raw material and capital goods, to pay intellectual property fees and information technology fees. Moreover, their central banks must accumulate dollar reserves to ward off speculative attacks on the value of their currencies in world currency markets. The higher the market pressure to devalue a particular currency, the more dollar reserves its central bank must hold. Only the Federal Reserve, the US central bank, is exempt from this pressure to accumulate dollars because it can issue theoretically unlimited additional dollars at will with monetary immunity. The dollar is merely a Federal Reserve note, no more, no less.

Dollar hegemony has created a built-in support for a strong dollar that in turn forces the world's other central banks to acquire and hold more dollar reserves, making the dollar stronger, fueling a massive global debt bubble denominated in dollars as the US becomes the world's largest debtor nation. Yet a strong dollar, while viewed by US authorities as in the US national interest, in reality drives the defacement of all fiat currencies that operate as derivative currencies of the dollar, in turn driving the current commodity-led inflation. When the dollar falls against the euro, it does not mean the euro is rising in purchasing power. It only means the dollar is losing purchasing power faster than the euro. A strong dollar does not always mean high dollar exchange rates. It means only that the dollars will stay firmly anchored as the prime reserve currency for international trade even as it falls in exchange value against other trading currencies.

In recent decades, central banks of all governments, led by the US Federal Reserve during Alan Greenspan's watch, had bought economic growth with loose money to feed debt bubbles and to contain inflation with "structural unemployment", which has been defined as up to 6% of the workforce, to keep the labor market from being inflationary. Central banking has mutated from being an institution to safeguard the value of money so as to ensure wages from full employment do not lose purchasing power into one with a perverted mandate to promote and preserve dollar hegemony by releasing debt bubbles denominated in fiat dollars. (See Critique of Central Banking, Asia Times Online, November 6, 2002.)

Despite all the talk about globalization as an irresistible trend of progress, the priority for the United States in the final analysis has been to advance its superpower economic objectives, not its obligations as the center of the global monetary system. This superpower economic objective includes the global expansion of US economic dominance through dollar hegemony, reducing all domestic economies, including that of the US, to be merely local units of a global empire. Thus when the US asserts that a healthy and strong economy in Europe, Japan and even Russia and China, all former enemies, is part of the Pax Americana, it is essentially declaring a neocolonial claim on these economies.

The concept of "stakeholder" in the global geopolitical-economic order advanced by Robert B Zoellick, former US deputy secretary of state and now president of the World Bank, is a solicitation from the US to emerging economic powerhouses to support this Pax Americana. The device for accomplishing this neo-imperialism is a coordinated monetary policy managed by a global system of central banking, first adopted in the US in 1913 to allow a financial elite to gain monetary control of the US national economy, and after the Cold War, to allow the US as the sole remaining superpower controlled by a financial oligarchy to gain monetary control of the entire global economy.

With the help of supranational institutions such as the International Monetary Fund and the Bank of International Settlements, the US aims to negate national economic sovereignty with globalization of unregulated trade conducted under dollar hegemony. Unregulated trade globalization in the 21st century aims to neutralize national economic sovereignty to preempt national development financed by sovereign credit. Trade through export has become the sole operative path for national economic growth in a political world order of sovereign nation states that has existed since the Treaty of Westphalia of 1648. No national domestic economy can henceforth prosper without first adding to the prosperity of US-controlled global economy denominated in dollars.

Holy Dollar Empire
Echoing the Holy Roman Empire, the global economy has been operating as a global Holy Dollar Empire with the Federal Reserve as the Holy Dollar Emperor. Similar to the Holy Roman Empire, which disintegrated from the rise of Lutheran nationalism, this Holy Dollar Empire will eventually disintegrate from progressive centrifugal forces of a new populist economic nationalism. This new nationalism is not to be confused with regressive trade protectionism. The formation of the new Group of Five (G5 - China, Brazil, India, Mexico and South Africa) in the 2008 Group of Eight Summit in Tokyo (G8 - the US, UK, Germany, France, Italy, Japan, Russia and the European Union) is a sign of this new trend of progressive economic nationalism. The 2008 US presidential election may herald in a new populism in US history to reform the structure of US debt capitalism.

In his speech to the G5 leaders, China's President Hu Jintao said: "It is necessary to take into full account the issue of food security in tackling the challenges in energy, climate change and other fields." Apart from calling for the setting up of an UN-led international co-operation mechanism and a global food-security safeguard system, Hu said all countries should strengthen cooperation in grain reserves, a process of proven success in China but not recommended by the UN Food and Agriculture Organization, which views such scheme as a distortion of trade.

Liberation from this Holy Dollar Empire of dollar hegemony can only come from sovereign nations withdrawing from the global central banking regime to return to a national banking regime within a world order of sovereign nation states to put monetary policy back in its proper role of supporting national development goals, rather than sacrificing national development to support global dollar hegemony through wage-suppressing export-led growth.

In a world order of sovereign nation states, the supranational nature of central banking will render it inoperative, as it can be and has been used as an all-controlling device for the world's rich nation to neutralize the sovereign rights of financially weak nations. In a democratic world order, central banking is also inoperative within national borders, as it can be used by a nation's rich as a device to deny the working poor of their economic rights. Central banking, in its support of dollar hegemony, operates internationally in opposition to the economic interests of sovereign nation states and domestically in opposition to the economic rights of the working poor by discrediting enlightened economic

nationalism as undesirable protectionism.

To preserve dollar hegemony, exporting economies that accumulate large dollar reserves through trade surpluses are forced by the US to revalue their currencies upward, not to redress the trade imbalance, which is the result of dysfunctional terms of trade rather than inoperative exchange rates, but to reduce the value, in foreign local currency terms, of US debt assumed at previously stronger dollar exchange rates. When commodities prices rise, it reflects a defacement of all fiat currencies led by the dollar as a benchmark. When the currency of another nation rises against the dollar, it does not mean that currency can buy more; it only means the dollar can buy less than what the appreciating currency can buy. This is why commodities prices have been rising in all currencies, albeit at different rates.

The bursting of the latest dollar-denominated debt bubble created a global credit crisis in August 2007 that is beginning to cause globalized trade to contract. Exporting economies around the world are now forced to reconsider their dysfunctional strategy of seeking growth through exports for fiat dollars that are pushing the world economy towards hyperinflation, leading all other fiat currencies in a depreciation race to the bottom.

China's high trade dependency
At the top of the list of exporting economies is China's. The country in 2006 registered an unwholesome trade-to-GDP (gross domestic product) ratio of 69%, with a per capita trade value of US$1,645. In 2007, China's nominal GDP was 24.66 trillion yuan, or $3.38 trillion at then exchange rate of 7.3 yuan to a dollar. The 2007 per capita GDP for the population of 1.32 billion was 18,655 yuan, or $2,556, translating to $9,711 on purchasing power parity (PPP) ratio of 3.8. If China's exports were to be redirected towards the domestic market, the country's 2007 per capita GDP on a PPP basis would have increased by $5,384 to $15,095, even not counting any stimulant multiplying effect. Chinese household consumption remains at a record low of 37% of GDP, the smallest ratio in all of Asia, due to low Chinese wages.

China's trade surplus fell 20% year-on-year in June 2008 to $21.3 billion because of a drop in export growth. In Chinese currency terms the drop is more due to a rise in its exchange rate against the dollar. Still, it was the biggest surplus since December 2007, which totaled $22.7 billion. Export value in June was $121.5 billion, 18.2% more than a year earlier but the growth rate was nearly 10 percentage points down from the May figure. Imports totaled $100.1 billion, up 23.7% from a year earlier. China's trade surplus with the US in June totaled $14.7 billion, 5% higher than 2007. The surplus with the EU, its biggest export market, was worth $13.2 billion, up 21.2% from 2007.

Chinese exports are slowing because of reduced global growth caused by a developing US recession, while imports are rising on the back of rising commodity prices. These figures are not inflation adjusted. However, they reflect the rising exchange value of the yuan. In other words, exports have been falling more in yuan terms. The fall in exports is expected to accelerate as no market analyst of worth is projecting any quick or sharp recovery in the US economy.

Going forward, the ratio of nominal-GDP to PPP-GDP can be expected to fall as China's domestic inflation rate continues to exceed the US inflation rate. This trend will gain momentum as China attempts to use its trade surplus denominated in dollars for domestic development, which requires it to issue more yuan into the Chinese money supply. And market pressure can be expected to push the yuan down against the dollar until the Chinese inflation rate is at parity with the US inflation rate.

But a falling exchange rate causes more domestic inflation from imports denominated in dollars; and rising domestic inflation adds pressure to a falling exchange rate in a downward spiral, preventing the yuan from rising against the dollar from market forces. That is the dysfunctionality of the yuan-dollar exchange rate regime in relation to the inflation rate differentials between the two economies, when the exchange rate is set by trade imbalance denominated in dollars. This dysfunctionality is cause by the flawed attempt to use exchange rates to compensate for dysfunctional terms of trade, which has been mostly caused by wage disparity.

Stagflation danger
Li Yining, a leading Chinese economist, former president of Guanghua School of Management at Beijing University and member of the Standing Committee of the 11th National Committee of the Chinese People's Political Conference, the country's political advisory body, opined in the Second Meeting of the Standing Committee on July 4, 2008, that China is facing a pressing challenge in preventing inflation from turning into stagflation - the dual evils of high unemployment along with high inflation - if market expectation concludes that Chinese policymakers will fail to insulate the economy from the developing global slowdown that is expected to deepen next year with no prospect of a quick recovery.

Overwrought anti-inflation macroeconomic measures by Chinese policymakers may cause investors to dump shares of companies in the export sector, putting these companies in financial distress and causing foreign capital to exit the Chinese economy to cause unemployment to rise in China. As China is unhealthily trade dependent, this will hurt domestic development and curb consumer spending.

Li argues that China should decelerate the pace of capital and foreign exchange decontrol within the context of an oncoming, protracted global economic slowdown to preserve the value of its huge foreign exchange reserves in yuan terms. He wants the government to avoid being misguided by the static concept of a fixed low inflation rate target of 3%. Rather, an inflation rate up to 60% of the economic growth rate should be permissible, meaning to allow an inflation rate at around 6% for a 10% growth rate.

China's inflation rate hit an 11-year high of 8.7% in February 2008 and eased to 7.7% in May, still high above the government-set goal of 3% annualized. Li points out that incoming economic data show that the Chinese economy is on a sound footing despite new challenges from abroad and at home, including the May 12 Sichuan earthquake and serious floods in the south. However, Li warned the government to avoid risks of stagflation in formulating macro policies going forward.

Li's advice is sensible. It serves no useful purpose to cause a collapse of the economy to fight inflation, as Paul Volcker did in the US in the1980s, making the cure worse than the disease. Still, Volcker was facing a 20% inflation rate in 1980, which might have justified drastic action. Yet Li should realize that under dollar hegemony, Chinese central bankers must try to keep the Chinese inflation rate target below 3% to stay on par with the dollar inflation rate target set by the US Federal Reserve, the head of the world's central bank snake. A 6% inflation rate in China would be more than triple the current inflation rate target set by the US central bank, the defender of dollar hegemony even as it allows the dollar's exchange rate to fall.

A Chinese inflation rate of 6%, as proposed by Li, would cause market forces to push the yuan down against the dollar, further exacerbating US-China trade tension and reviving protectionist pressure in the US. As China is being pressured relentlessly by the US to further revalue the yuan upward against the dollar, yuan interest rates must rise above Chinese inflation rates. At 6% interest rate for the yuan, the disparity with the dollar interest rate would cause hot money denominated in dollars to rush into China through "carry trade" to profit from interest rate arbitrage, betting on continuing Chinese government intervention to keep the yuan from falling against the dollar despite higher Chinese inflation.

With a 6% inflation rate, China will be forced to pay currency traders massive sums to defend an overvalued yuan dictated by US trade policy in contradiction of US Treasury policy of a strong dollar. That was how the Bank of England allowed itself to be broken by George Soros on Black Wednesday, September 16, 1992, when the British central bank attempted in vain to defend an overvalued pound sterling out of sync with its interest rate regime. It was also how the Hong Kong government was forced to execute its "incursion" into the equity market in August 1998 to defend the Hong Kong dollar's peg to the US dollar against market fundamentals.

China has been forced to take steps to offset the impact of the US Fed's easy money policy on the Chinese economy. The US Fed has cut the Fed funds rate target eight times since September 18, 2007 from 5.75% to 2% on April 30, and the discount rate nine times since August 17, 20007 from 6.25% to 2.25% on April 30. Although China's central bank has issued notes to absorb excess liquidity, market pressure still exists for the central bank to put more currency into circulation to add to already excessive liquidity. China's central bank has increased interest rates six times and the bank reserve ratio 15 times since 2007, but Shanghai interbank rates have increased only slightly, signaling major resistance to monetary policy.

Assistant governor Yi Gang of the People's Bank of China (PBoC), the central bank, in a speech in the 2008Y SHIBOR (Shanghai inter-bank borrowing rate) Work Conference on January 11, 2008, outlined the role of SHIBOR, introduced a year ago as a benchmark rate for money market participants. At the initial stage of the index's launching, central bank promotion is deemed necessary. But the SHIBOR, as a market benchmark, will be set by the market and all market participants. Yi asserts that all parties concerned including financial institutions the National Inter-bank Funding Center and National Association of Financial Market Institutional Investors should have a full understanding of this, and actively play a role in the operations of SHIBOR as "stakeholders", the new buzzword in Chinese policy circle, thanks to Robert Zoellick.

Yi said that "under the command economy, the central bank is the leader while commercial banks are followers. But from the current [market economy] perspective of the central bank's functions, the bipartite relationship varies on different occasions. In terms of monetary policies, the central bank, as the monetary authority, is the policy maker and regulator, while commercial banks are market participants and players. But in terms of market building, the relationship is not simply that of leader and followers, but of central bank and commercial banks in a market environment. This broad positioning and premise will have a direct bearing on how we behave. On the one hand, it requires the central bank to work as a service provider, a general designer and supervisor of the market. On the other hand, it requires market participants and various associations to cultivate SHIBOR as stakeholders and players on a leveling playground."

The fact of the matter is that in the US, the central bank, in addition to being a lender of last resort, has become a key market participant in the repo market (in which, effectively, stock is borrowed or lent for cash, with the stock serving as collateral) to keep short-term interest rates aligned with the Fed funds rate target set by the Fed Open Market Committee. Until proposed reforms are adopted by Congress, the Fed is not the regulator of non-bank financial institutions, be they investment banks and brokerage houses, hedge funds, private equity firms, or the recently active foreign funds.

The role of regulating the issuing of securities in the US belongs to the Security Exchange Commission (SEC), created by the Securities Act of 1933 to protect investors by maintaining fair, orderly and efficient markets while facilitating capital formation. Securities offered to the general public must be registered with the SEC, requiring extensive public disclosure, including issuing a prospectus on the offering. It is a time-consuming and expensive process.

Most commercial paper, the market that precipitated the credit crisis in August 2007, is issued under Section 3(a)(3) of the 1933 Act, which exempts from registration requirements short-term securities with certain characteristics. The exemption requirements have been a factor shaping the characteristics of the commercial paper market. Private equity firms with fewer than 15 investors and hedge funds, even though they may control billions of equity and multi billions of credit, are not regulated by the SEC.
When the Federal Reserve and other central banks have taken crisis-induced actions since August 2007 to calm markets to get market participants to believe that the financial system will continue to operating normally, market indicators, such as London InterBank Offered Rate (LIBOR), on which SHIBOR is modeled, suggest that the Fed's message has not been accepted by market participants. The LIBOR, a global benchmark, normally trades predictably at only a few basis points (hundreds of a percentage point) above the federal funds rate. It is a "traded version of the fed funds rate". As such, it's an important benchmark for determining lending rates on big corporate deals, mortgages and other lending markets.

LIBOR has been out of normal alignment with the Fed funds rate since the credit crisis began in August 2007. The Fed and the European Central Bank have already been greasing the markets by adding liquidity through reserve operations. When the credit crisis broke, one-month LIBOR was traded at an abnormally high 5.82% when the Fed funds rate target was 5.25%, a 57 basis points spread, and the Fed discount rate was cut 50 basis points to 5.75%. The Fed has since cut the fed funds rate target from 5.25% to its current 2% and the discount rate from 6.24% to 2.25%, but the spread between the Fed funds rate and LIBOR has not narrowed.

Three-month dollar LIBOR was trading at 2.75% as of July 11, 2008, 75 basis points above the Fed funds rate. It means banks are not willing to lend short-term money to each other for fear of counterparty default. Also, as part of general tightening in the current credit crisis, banks have been hoarding cash to respond to the frozen asset-backed commercial paper market. Many European banks have committed to credit lines to big issuers of this paper, and because nobody wants to take on more of that paper, those paper-issuing companies are forced to borrow from banks using their bank credit lines - making banks need more cash to build up required reserves. With more than $1 trillion of commercial paper set to come due every six weeks since August 2007 and more than $700 billion as of June 2008, banks are reluctant to tie up their reserves lending to other banks even at rates that would normally seem extremely attractive.

At present, lending and deposit interest rates are regulated in China with a floor lending rate and a ceiling deposit rate. Central banker Yi said that "[W]hen clients complain about high interest rate, commercial banks can pass the buck to the central bank because the central bank sets the interest floor. When SHIBOR matures, SHIBOR will become the culprit. Such a change bears important legitimacy, authoritativeness, and persuasiveness, and can make SHIBOR a recognized and authoritative benchmark."

Yi sees market-based interest rates coming from deregulation. But if the central bank deregulates deposit rate ceiling and lending rate floor when there is no other reliable benchmark to substitute them, the result could be worse. When is the right timing for deregulation? The answer is when a new benchmark matures. SHIBOR is an important benchmark in the process of making interest rates more market-based. An interest rate floor and ceiling are likely to exist for some period. Can the market-based interest rate transformation process start with discount rate linking with SHIBOR? In fact, discount facilities are loans. A breakthrough with the discount rate will have a far-reaching impact on market-based interest rate transformation, and provide experience for future interest rate reform, according to Yi.

Yi touched on the relationship between SHIBOR and internationalization of the yuan. In the past, the central bank looked only at the domestic market, but now it must adopt a global perspective. Many currencies in the world have their benchmark interest rates, including LIBOR, EURIBOR, Japan's TIBOR and so forth. The launch of SHIBOR shored up transaction volume in the Chinese money market. Comparatively speaking, Shanghai's money market capacity now is much smaller than that of London and New York. But the yuan will soon become an important currency in the world, so China will steadily push ahead with yuan convertibility under the capital account.

At present, great appreciation pressure on the yuan driven by large amounts of capital influx is to a large extent due to a positive speculative outlook of China's economy and purchase of yuan-denominated assets by foreign companies and individuals. The money market is part of the financial infrastructure that will establish the role of the yuan in world markets, according to Yi.

Many existing financial products are linked to interest rates set by the PBoC. So when the PBoC adjusts interest rates, multiple factors have to be taken into account so as to balance the interests of various parties. Any move to balance interests involves different interest groups and complex situations. So a widely accepted and objective benchmark is needed, and SHIBOR can serve that need. More products, from company provident funds, public welfare funds, company trust funds to wealth management products, housing provident funds and broker depository funds can be linked to SHIBOR.

Chinese equity markets have been taking a beating in recent months. The Shanghai Composite Index fell from a peak of 6,124 in mid-October 2007 to 2,566 in early July 2008, a fall of 58%, largely due to the rising exchange value of the yuan and market pressure on yuan interest rates to rise to keep lenders from cutting off loans at negative interest rates. If the yuan becomes freely convertible and tradable, China would be receiving 3% interest on its sizable dollar reserves currently at $1.8 trillion while paying 6% interest on much larger yuan deposits.

By seeking growth through exports for dollars, China has trapped itself in an incurable mismatch between necessary domestic macroeconomic policies to assure sustainable growth and its central bank's monetary policy dictated by dollar hegemony. This mismatch is counterproductive, crisis-prone and unsustainable.

And as China liberalizes its interest rate regime and currency convertibility as advised by neo-liberal economists whose credibility has been bankrupted by unfolding events, the Chinese economy will face another financial crisis that will wipe out a good part of the export-led financial and economic gains in the last decade. All exporting economies that have abandoned capital controls since the emergence of deregulated globalization of financial markets have been regularly devastated by recurring financial crises that have imploded every decade, the last three being the 1987 market crash, the 1997 Asian Financial Crisis and the 2007 credit crisis. This latest crisis has yet to fully play out its destructiveness and there are no signs so far that US policymakers trapped in dysfunctional supply-side ideology have the economic wisdom and the political dexterity to prevent it from turning into a global depression.

China was relatively spared in the 1997 Asian Financial Crisis largely due to its then cautious pace of opening up its financial sector to global market forces reacting to dollar hegemony. This time around, China can only insulate itself from this pattern of global financial crises by making a concerted effort to shift its exports to the domestic market and to reduce substantially its trade dependency from the current near 70% to below 30% in a planned manner and on an orderly schedule. Exports should be returned by policy to an augmentation role in the economy, supporting domestic development, which should be the main focus of economic growth. The domestic sector should no longer be made to sacrifice to support the export sector. Exports should support domestic development, not act as a parasite on domestic development.

Breaking free from dollar hegemony
A first step in this redirection of policy focus on domestic development is for China to free itself from dollar hegemony. This can be done by legally requiring payment of all Chinese exports to be denominated in yuan to stop the unproductive role of exporting for dollars that cannot be spent domestically without incurring
heavy monetary penalty. Such a policy affects only Chinese exporters and can be implemented unilaterally by Chinese law as a sovereign nation, without any need for international coordination or foreign or supranational approval.

Importers of Chinese goods around the world will then have to acquire yuan from the Chinese State Administration for Foreign Exchange (SAFE) to pay for imports from China. The yuan exchange rate and Chinese export prices can then be coordinated according to Chinese domestic conditions. Import prices denominated in yuan can then be more rationally linked to Chinese export prices. Foreign trade for China then will benefit the yuan economy rather than the dollar economy. There will be no need for the PBoC to hold dollar reserves.

China's economic growth since 1980 has been driven by export of low-price manufactured goods with a dysfunctionally low wage scale. To correct the imbalance of trade that has been giving China trade surpluses of dubious financial or economic benefit, China needs to raise wages, not to revalue its currency. Raising Chinese wages to the level of other advanced economies will redress the current inoperative terms of international trade that now benefits only the dollar economy to benefit the Chinese yuan economy.

This low-wage-driven growth has distorted the progressive purpose of Chinese socialist society by reintroducing many of the pre-revolution socio-economic defects commonly found under market capitalism, such as income and wealth disparity, market-induced chronic unemployment, inequality of opportunities, collapsed social safety nets resulting from privatization of the part of the economy best handled by the public sector, rampant corruption from a collapse of societal morals and excessive influence of money in the political process, uneven regional development and environmental deterioration of crisis proportions.

The current export-led growth of China can be expected to be seriously hampered by a protracted slowdown in the importing economies. Despite China's image as an export juggernaut, the country's per capita merchandise export in 2006 was $1,655, some $135 lower than global per capita merchandise export of $1,780. This is because Chinese wages are substantially lower than the average of all export economies, while the prices of raw material are the same for all buyers in the global market.

A fall in world demand for exports would hit China harder than other export economies by pushing already too low Chinese wages further down just to keep Chinese export factories running. Also, since China's trade dependency has increased steadily over time, importing inflation through the export sector to the domestic sector, China's economy would be hit proportionally harder by a downturn in exports than it was during previous global recessions, unless current policy to reduce trade dependency is accelerated.

Exports are measured by gross revenue while GDP is measured in value-added terms. The rules of input-output macroeconomics requires import inputs to be subtracted from exports in value-added terms, and then conversion of the remaining domestic content into value-added terms by subtracting inputs from other domestic sectors to avoid making the denominator for the export ratio much bigger than GDP. Normally, this would reduce the export-to-GDP ratio. But China's domestic input is excessively low due to low wages and rents, tax subsidies and weak environmental regulations. Thus such input adjustments have little impact on the trade-to-GDP ratio.

In recent years, China has been shifting from exports with a high domestic content, such as toys, to new export sectors that use more imported components, such as steel and electronics, which accounted for 42% of total manufactured exports in 2006, up from 18% in 1995. Domestic content of electronics is only a third to a half that of traditional light-manufacturing sectors. So in value-added terms, exports have increased less than gross export revenues. This is not a comforting development because it turns the export sector into a re-export sector, benefiting the domestic economy even less.

China's current-account surplus amounted to 11% of GDP in 2007. This means its entire GDP growth was from the export sector, and its economy produced far more than it consumed domestically. This surplus production was shipped overseas for fiat dollars that cannot be spent in the yuan economy while Chinese workers could not afford the very products they produced at low wages. Thus under hegemony, while China has become the world's biggest creditor nation, it suffers from shortage of capital needed by its still undeveloped economy, particularly in the vast interior, and has to depend on foreign capital even in the coastal regions when the export section is located. In recent years, Chinese policy has encouraged higher domestic consumption, yet since 2005, net exports have contributed more than 20% of GDP growth.

Some analysts have suggested that China's GDP growth would stay at 9% from strong domestic demand. Yet this demand comes mostly from severe income disparity. China's exports to other emerging economies are now bigger than those to the US or the EU. Asia and the Middle East accounted for more than 40% of China's export growth in 2007, North America for less than 10%. But Chinese trade with other emerging economies was at a deficit, with China importing more, such as oil and other commodities, than the oil-exporting small economies could absorb in the way of low-price Chinese goods for their small populations, while poor emerging economies cannot buy more from China because they do not have sufficient dollars. If Chinese exports are denominated in yuan, trade with these poor economies would explode with balance because their exports to China can also be denominated in yuan to pay for imports from China denominated in yuan.

Export for dollars presents for all exporting countries a problem of diminishing returns because of dollar hegemony. For China, it is a problem of crisis proportions. Since global trade is denominated in dollars, China's economy faces a capital shortage despite its new role as the world's biggest creditor nation. China is forced to accept foreign direct investment, which accounts for over 40% of GDP, despite the country's chronic trade surplus and huge foreign exchange reserves of upwards of $1.8 trillion and growing. Weaker export growth could lead to a sharp drop in foreign direct investment because exporters would need to add less capacity.

While over half of all foreign direct investment in China is in infrastructure and property, such investment is still mostly related to exports, facilitating expatriate managers' housing, foreign company offices in commercial buildings, power plants to supply export factories and highways linking production areas with shipping terminals. Only sovereign credit can redress China's problem of uneven regional development caused by excessive dependence on foreign investment.

Henry C K Liu is chairman of a New York-based private investment group. His website is at

Original article posted here.

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