An interesting news item featured in Reuters in June captures the dilemma and the challenges that China faces in its transition to a modern economy commensurate with modern and autonomous institutional capability (more on this later, too). The brief news item is worth capturing in full to savour all that it captures about China’s complex political and social arrangements:
(Reuters)—In a burst of patriotism, China’s central bank swore loyalty to the country’s Communist leaders on Monday by vowing to “always walk with the Party”. Whereas most central banks around the world try to assert their independence from the government and politicians, China’s central bank has exercised no policy autonomy.
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The nationalistic ardour from the People’s Bank of China is the latest pledge of support for the ruling Communist Party ahead of the 90th anniversary of its founding on Friday.
“The central bank marked in Beijing today the 90th anniversary of the founding of the Communist Party with celebrations around the theme of ‘always walking with the Party’,” the central bank said in a statement on its website.
“We sang about the good of the Party; the good of socialism; the good of reforms, and the good of the great motherland,” it added.
With a central bank that is not hesitant to declare itself a faithful servant of the ruling party, it is a matter of time before financial markets demand the necessary risk premium of Chinese assets. Imagine how much more complicated would China’s economics and politics become if the US were to technically default on its debt in the first week of August. Perhaps, it is the trigger that the world needs to realize that it has been enjoying a phantom recovery post-2008.
Financial markets have not quite priced in a US debt default scenario for two reasons: it is considered extremely unlikely. A “Hollywood” or “Bollywood” type last-minute happy ending is still expected. The second reason is that it is intellectually a daunting exercise to grapple with the consequences of the default.
A default would greatly erode whatever prestige and influence the US still has. It is unlikely that the US dollar would rise due to “safe-haven” inflows. It is common sense that when a country defaults, it is much farther from being safe.
US treasury yields would rise and the US dollar would decline. China would face huge valuation losses on its US dollar reserves. Its dollar reserves are estimated to be between 60% and two-thirds of its $3.2 trillion worth of foreign exchange reserves as of the second quarter of 2011.
That, of course, is an easy prognosis. More importantly, it would intensify the internal power struggle between technocrats in the People’s Bank of China and politicians and within the political class, between reformers and those who favour the status quo policy of undervalued exchange rates supporting export-led growth. The succession battle for 2012 would intensify significantly and a geopolitical confrontation with the US would be a possibility.
Asian currencies will rise. They have to. Perhaps, this is the trigger needed for them to abandon their mercantilist policies. Some of them have, to some extent. Whether China would find the courage to let the yuan appreciate is the trillion-dollar question. China’s domestic economic momentum has been waning. A private sector gauge of activity in the manufacturing sector showed recently that the sector is contracting and not expanding. Hence, China would be reluctant to let the currency appreciate even as the US’ default considerably raises the subsidy showered on the export sector in the last three decades.
Europe would be caught out. It has stitched together a fragile package for Greece, which does not do much to address the structural growth prospects for the peripheral economies. These countries need not only to address their stock of debt and its servicing, but also ensure that debt burdens simply do not build up afresh. That requires a much weaker currency, among other things. A US default would push the euro higher. That is a clear negative for the peripheral economies near-term. However, such a default would eventually confer on the euro the exorbitant privilege that the US has enjoyed. But that would only further widen the chasm between core Europe and peripheral Europe. Hence, US’ debt default would narrow the odds on the European Monetary Union splitting into two factions if not more.
If the US manages to cobble together a last-minute compromise, it would be just that—a compromise and not an enduring solution to the problem of tackling both short-term growth slowdown and medium-term fiscal sustainability. The issues that the world faces now would come back with greater intensity in 2012. In all these sterile academic debates about fiscal stimuluses sustainability, the world has ignored the long-term growth-inflation/resource constraint trade-off. To the extent that a US default brings all the issues back above the carpet, it would actually be a welcome development.
V. Anantha Nageswaran is an independent macroeconomic and investment strategy consultant, based in Singapore. Your comments are welcome at firstname.lastname@example.org