Thursday, June 26, 2008

What cannot go on...

Imballanced trade is, in the long run, unsustainable. It is also bad for the U.S., as we have argued extensively in Trading Away Our Future. It costs the U.S. jobs, future comparative advantage, and future debt payments.

Until very recently, China has had the best of all worlds from a mercantilist perspective. The Chinese government borrowed domestically at low interest rates, lent the money to the United States at higher interest rates, made money on the investment, sustained a non-market exchange rate, and subsidized its exporters.

A recent Reuters article suggests that the system of 'sterilizing' dollars earned from foreign trade is beginning to crumble on the edges. In particular, the decline of the dollar, combined with below-inflation interest rates in the U.S., and higher interest rates in China are conspiring to generate losses on the Chinese investment portfolio.

China's central bank used to make a tidy profit in managing foreign exchange inflows. When Chinese interest rates were lower than in the United States, the People's Bank of China made money every time it sold bills at home and invested its forex reserves in debt across the Pacific -- its own carry trade.

But that soured over the past year as Beijing raised rates and the U.S. Federal Reserve slashed them. The economics were further undermined by the yuan's faster appreciation against the dollar.

China's losses may be running to about $15 billion a month, or 5 percent of GDP on an annualised basis, Goldman Sachs economists Hong Liang and Eva Yi calculated.

The losses are not huge, compared to more than two trillion dollars worth of reserves. China's response has been to emphasize increased reserve requirements for Chinese banks, a strategy that is better financially.

Brad Setser's recent blog suggests that China now has less company at the task of supporting the dollar. Rising energy costs have led some East-Asian countries to begin drawing down reserves and selling dollars.

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