by Adam Tooze
V
Such talk was no doubt supposed to suggest a profound realist wisdom. But it was in fact symptomatic less of a bold or coherent new worldview than of the rather desperate mood in Washington. It was particularly rich coming from an administration whose supporters in Congress had in the name of god-given American values repeatedly tried to sabotage crisis-fighting efforts and who now demanded that the Fed should ensure the best of all possible worlds by following a nondiscretionary, automatic policy rule. The “arc of history” sonorously rejected by Trump’s security hawks had, of course, been invoked by President Obama.124 But in using that figure of speech he had referenced not deterministic neoconservative philosophies of history, but the prophetic voice of one of America’s greatest freedom struggles. There was indeed no determinacy. The question was how the arc might be beat. Even if one accepted some version of the disillusioned narrative of the world economy offered by the Trump camp, the question was how to respond. Was “America first” an adequate answer, even for America? Whatever the answer to that question, the reality that the rest of the world had to deal with was that the American electorate had put in office an erratic, narcissistic nationalist who no longer offered any commitment to upholding an international order unless it directly and immediately connected to American national interests, however those were defined. Given the size and reach of the American nation-state and its economy, this had profound global consequences.
In 2008 the United States had been at the epicenter of the crisis. Both the Bush and Obama administrations had faced the hard fact that there was little or nothing that was automatic about the functioning of the global financial system. It had taken unprecedented efforts, led by the United States and the rest of the G20, to stabilize both “America’s free political and economic system” and the world economy. In 2017 the United States was once again at the center of global concern, but this time it was uncertainty emanating from America’s erratic new government that was the key.125 And once it was framed that way, the question that Paulson had put in the summer of 2016 could not be dodged. How might the United States fare in a future financial crisis under President Trump? Would he be able to rally a concerted response? If the haggling over the debt ceiling in 2017 was anything to go by, it would again come down to a bargain between pragmatic centrist Republicans and congressional Democrats.
Of course, we can peer only dimly into the future. So what might we learn by looking to the past? If there is a question that may throw light on our future prospects it is not how Trump might have coped in 2008, or how he may cope with some future contingency, but why in 2017, when he took office, Trump did not face a global economic implosion. It may seem like a perverse question. In 2017 economic growth in the United States was steady. Unemployment was down to precrisis levels. The markets were booming. In Europe the economy was finally bouncing back. An immediate crisis was not in the cards. The real force of the question becomes apparent if we direct our attention, in conclusion, not to America and Europe, the old hub of transatlantic globalization, but to China and the emerging markets, where the future of the world economy will be decided. There the years prior to 2017 had been anything but calm.
Chapter 25
THE SHAPE OF THINGS TO COME
On January 17, 2017, as the World Economic Forum assembled at Davos to consider the implications of Brexit and Trump, China’s President Xi Jinping stepped to the rostrum to deliver the opening plenary. It was a speech widely seen as announcing China’s new role as an “anchor of globalization.”1 Eight years earlier the governor of PBoC had made headlines around the world by proposing a new Bretton Woods. That intervention staked China’s claim to be a major voice in global economic governance. In 2017 Xi no longer needed to break down the door. All he had to do was to declaim the most basic platitudes of what had once been the global consensus, reinforcing them with a bracing dose of historical materialism, a few ancient proverbs and a reassuring recitation of China’s mind-blowing growth record.2 It was exactly the message that the CEOs, investors and policy experts at Davos wanted to hear, and Xi was exactly the person to deliver it. Unlike Trump, he was clearly a sophisticated individual. He might head a Communist party, but as a “princeling” he had the reassuring air of someone born to power. Unlike Angela Merkel, Xi did not need to convince anyone of his capacity and will to act on a scale commensurate with China’s place in global affairs. His evident authority demonstrated China’s arrival not just as a major economy but as a superpower. For many across the world, particularly in Europe, China was already the economic superpower. Amid the awed sense of a historic transition, memories were short. It was easily forgotten that at Davos only a year earlier, the talk had been not of Chinese hegemony but of China’s economy unleashing a global disaster.
I
The emerging market economies had been in trouble since the taper tantrum of 2013. Two of the great economic success stories of the new millennium, Brazil and South Africa, had crash-landed. The commodity price collapse in the fall of 2014 dealt a heavy blow to exporters of oil, gas, iron ore and other raw materials. Russia and much of Central Asia were struggling under the impact of sanctions and the Ukraine crisis. Given lackluster growth in Europe and the United States, the one sustaining force in the world economy was China’s relentless growth, and in 2015 even that suddenly seemed in doubt.
On June 12, 2015, while the West was distracted by events in Greece and Ukraine, China’s stock market began to slide. From a high of 5,166, in three weeks the Shanghai Composite Index plunged 30 percent. With the state-directed “national team” of investors—companies and funds—pumping billions of yuan into the market, stock prices temporarily stabilized. But in mid-August, amid fears of a yuan devaluation, the market fell again and reached a new low just above 3,000 in September. From that plateau government intervention temporarily pushed it higher. But on January 4, 2016, the collapse resumed. By February further waves of selling took the index down to 2,737, not much more than half of its level six months earlier.
For the regime it was deeply embarrassing. In 2013 Xi had launched his new administration on the promise of the “China Dream.” Unwisely, party propaganda outlets had tied this directly to the fortunes of the stock market.3 Hundreds of millions of Chinese had entrusted their savings to the market. Those investments were now collapsing, just as the regime was gearing up for massive anniversary commemorations to mark the victory over Japan in 1945. The September 3 Victory Day Parade was to be a monumental event, making good on the incantation “Never forget national humiliation” and answering with the celebration of victory. Putin was the guest of honor. It was fitting that, at the same time, the yuan was gaining recognition as an international currency. In the fall of 2015, the IMF was on the point of including China’s currency in its SDR benchmark. A condition of being included in the IMF basket was that Beijing should allow the yuan to move more freely. For decades, the yuan had been a one-way bet. Against the overvalued dollar the only way was up. But when in early August 2015 Beijing liberalized currency trading, the yuan promptly plunged.
Clearly, something was very wrong, and, unlike in 2008, it was clear that the source of trouble was inside China. In years of explosive growth, supercharged since 2008 by a massive surge in credit, Chinese heavy industry had built up huge overcapacity. The real estate sector was weighed down by overbuilding. The stock market had been pumped up by “irrational exuberance” and a wave of dangerous margin lending. China had an overinflated shadow banking sector horribly reminiscent of that which had come crashing down in Europe and America in 2007–2008.4 But what worried the observers studying the Chinese scene most acutely was the huge wave of money that was exiting China at the rate of hundreds of billions of dollars per month in search of safe haven.5 Did they know something that the rest of the world did not?
The Yuan Panic of 2015: Quarterly Inflows and Outflows from China (in $ billions)
Source: Brad Setser
, “Asia Is Adding to Its FX Reserves in 2017 (China Included?),” Follow the Money (blog), August 21, 2017, https://www.cfr.org/blog/asia-adding-its-fx-reserves-2017-china-included.
For twenty years the undervaluation of the yuan had been a constant in world economic affairs. Now it seemed the tables were turned. Was China about to become just another emerging market boom gone bad, albeit the largest the world had ever seen? It was a terrifying thought and it begged a question. How could a country with a strong trade balance and huge reserves be sliding toward a currency crisis? It was eerily reminiscent of 2008, when champion exporters like South Korea and Russia had found their banks in trouble and struggling desperately for dollar funding. And the explanation was the same in 2015 as it was in 2008. Globalization operated through different channels at different levels. The visible trade channel on which countries like South Korea and China were so dominant was only one, and not the most decisive, channel for a financial crisis. An economy with a strong trade surplus, ample foreign currency reserves and an appreciating currency might well have banks, corporations and private citizens accumulating debts in foreign currencies. The need for dollar funding had been the common denominator of the South Korean, the Russian and the European banks in 2008. It made them acutely vulnerable to a shift in interest-rate differentials or a reversal in the direction of exchange-rate movements. It wasn’t the balance of trade but their corporate balance sheets that made them vulnerable. In 2008 China had not yet been fully incorporated into this logic. Its globalization was still “classic”—dominated by its trade account. It was precisely this familiar quality of China’s development and its counterpart in America’s “twin deficits” that distracted Western analysts from the massive financial tensions building up in North Atlantic balance sheets. But since 2008, as China’s breakneck modernization continued, it had become ever more integrated in financial terms.
The commercial logic driving China’s financial integration was compelling. Chinese businesses were investing like none had ever invested before. Interest rates in China were low. But thanks to Bernanke’s QE they were even lower in the dollar world. The only likely movement in the yuan was upward. Put the two together and you had the ingredients for a profitable “carry trade”: borrow in dollars; invest in yuan; repay the dollar loan from the proceeds of the booming Chinese economy at an appreciating yuan exchange rate.6 If China’s exchange regulations made it difficult to import US dollars directly, one or two further steps were added: borrow in dollars; buy commodities; use the expected receipts from the sale of the commodities as collateral to borrow in yuan; invest the yuan in China. Profit could be made three ways: on the spread between Chinese returns and dollar funding costs; on the depreciation of the dollar against the yuan; and on the likely increase in the value of the commodities, driven upward by booming Chinese demand.
According to BIS estimates, by the end of 2014, while China’s official reserves reached $4 trillion at their peak, cross-border claims against Chinese businesses had surged to $1.1 trillion, most of which was denominated in dollars and more than $800 billion of which was owed to large Western banks.7 All told, 25 percent of China’s corporate debts were in dollars, but only 8 percent of its corporate earnings. This mismatch was profitable but risky. If any one of the underlying conditions changed—interest rates, exchange rates or commodity prices—then the position could become loss making. In 2015 all three conditions changed. The Fed’s retreat from QE promised that the interest margin would soon be shifting the wrong way. The slowdown in China’s own growth and the sudden collapse in oil prices in 2014 reversed the momentum of commodity prices. Xi’s drive against corruption in China caused wealthy families to move assets out of the country. The outflow exerted downward pressure on the yuan. For those holding some part of the $1.1 billion in foreign exposure, this combination of factors was very bad news, and due to the fact that this was common knowledge it risked a stampede.8
Over the winter of 2015–2016 what threatened the world economy was, in the words of the Economist, nothing less than a “calamity.”9 The emerging market boom, which for so long had energized the narrative of globalization, had ground to a shuddering halt. Russia, Central Asia, Brazil and South Africa were already in recession. An implosion of the Chinese economy, with a plunging yuan and investors scrambling for the exit, could easily have pushed the world economy into recession. The Economist painted a horror scenario in which the funds flowing out of China and a huge glut of overcapacity amplified a global cycle of deflation, the momentum of which would have been more unstoppable than in 2008. Industrial and commodity producers would be left insolvent. At the same time, if the yuan peg broke, it would not be the only currency to devalue. Dollar carry trades across the emerging markets would unravel, provoking a general financial crisis. Western banks would not be immune.
The scenario was terrifying. Even the possibility of its unfolding was enough to spread panic. Commodity markets were intensely nervous. After falling off a cliff in November 2014, oil had stabilized in the spring of 2015 at c. $60 per barrel. But China was now the world’s largest crude importer. The prospect of a China crisis coupled with the abundant supply of shale oil from the United States and the intransigent stand of the Saudi government sent markets over the edge once more.10 Between the summer of 2015 and January 2016, prices halved from $60 to $29 per barrel. As the Saudis no doubt intended, this dealt a painful blow to the heavily leveraged US shale industry and sent ripples of anxiety through American financial markets. Even in the advanced economies propped up by quantitative easing, deflationary pressures were looming. In January 2016 the question at Davos was not how China would lead, but how it would cope. Could Beijing prevent a collapse? Would a Chinese implosion turn the jarring reversal of the fortunes in the emerging markets into a comprehensive rout? A year on, this is the global crisis that the Trump administration did not inherit. The question is, why not?
Any answer must start with the actions taken in Beijing. On the basis of its dramatic response to the crisis of 2008, the Chinese regime had a formidable reputation for effective economic policy. But in 2015 China’s initial response to the crisis was anything but reassuring. The fumbling efforts to stabilize the Shanghai stock market exposed the myth of Beijing’s omnicompetence.11 QE with Chinese characteristics was not a success. The August 2015 liberalization of foreign exchange trading was mishandled. But Beijing held its nerve. Rather than allowing the yuan to continue its slide, the PBoC stabilized a new peg. Capital controls were stiffened, but otherwise the PBoC allowed the unwinding of exposed dollar positions. If this was an adjustment of balance sheets and not a general panic, it was the right thing to do. From their peak of $4 trillion in the summer of 2014, China’s currency reserves fell by early 2017 to $3 trillion. Watching the monthly drain of tens of billions was nail biting, but eventually at the lower level reserves stabilized. To revive demand in early 2016, Beijing unleashed another credit boom and a fiscal stimulus, while at the same time it set about purging the most overexpanded heavy industrial sectors of overcapacity. Western media ordinarily known for their advocacy of market freedom could not hide their relief that Beijing’s grip had been restored. As the Economist remarked: “With capital now boxed in, much of it flowed into local property: house prices soared, first in the big cities and then beyond. Sales taxes on small cars were reduced by half. Between them, these controls and stimuli did the trick.”12 In reaction commodity prices rebounded and manufacturing surged across Asia, pulling China’s giant manufacturing capacity back from the brink. The threat of global deflation receded.
This is how the triumphalist narrative goes. China is not just another crisis-prone emerging market. Beijing is in control. A threat of crisis spawned in China that threatened to destabilize the world economy was contained by China. So far so good, one might say. But 2015 demonstrated not only that China was neither invulnerable nor omnicompetent. Even more significantly, it demonstrated that it was not autonomous. In 2008 the
question had been whether China would dump its dollar holdings and destabilize the United States. Eight years later, thanks to China’s deeper financial integration, the question was reversed. As Beijing struggled to gain a grip on its stock market and the drain of foreign exchange, the question was not whether China would dump the dollar but whether the Fed would cooperate with China’s efforts to stabilize the yuan.
For Janet Yellen and the Fed board it was a deep dilemma. The year 2015 started with the FOMC expecting to continue the process they had begun when they ended QE in December 2014. They were going to raise rates. The question was how far and how soon. After the taper tantrum of 2013 the Fed was acutely aware of the possible consequences for emerging markets.13 But with the American economy slowly moving toward full employment, they wanted to move off zero, if for no other reason than to give themselves room for maneuver when the next setback came. More generally, there was an insistent urge to “normalize.” Despite all the talk of secular stagnation, it was hard to accept that zero interest rates or the Fed’s massively inflated balance sheet should be a permanent feature of the world economy. But now blocking the path to normalization was the threat of a China crisis. In 2013 the Fed had flaunted its exclusive focus on the state of the US national economy. Could they take the same approach to China?