America’s traditional stewardship of the global economy is in limbo. As president-elect Donald Trump sees it, the United States’ role in the world isn’t necessarily to lead it. Sure, the US will still engage with other countries—but only in line with Trump’s guiding principle of “America First.”
History warns that when the leader of the global order withdraws as Trump is suggesting, disaster follows. As economic historian Charles Kindleberger argued long ago, the Great Depression was “so wide, so deep, and so long because the international economic system was rendered unstable by British inability and United States unwillingness to assume responsibility for stabilizing it.”
The US eventually stepped up, leading the global economy through decades of brisk growth. And now China is signaling that it’s keen to move into any vacuum that America might leave. China is already a regional superpower; since Trump’s victory China president Xi Jinping has positioned his country as a champion of global free trade.
But closer examination of China’s finances suggests that any ambitions to assume a US-like stabilizing role in the global economy will be harder to fulfill than its leaders—and indeed most people—realize.
The core problem for China lies with how it differs now from the economy of the US during the mid-20th century. It’s similar in running enormous trade surpluses, the flip-side of which means lending its extra earnings through foreign investment. But whereas American investment benefited the world economy, on balance, China’s pattern of investment has eroded global demand—hurting in particular those countries to which it lends. Its precarious growth strategy has also burdened China’s banking system with debt now worth an alarming 250% of its GDP.
Through global interconnections, China shares its dangerous imbalances with the world—a quandary that illustrates exactly why rules of trade and capital flows should be rewritten. But in an era in which Chinese mercantilism has whipped up Trump protectionism, that hope grows increasingly dim.
The case for the new Chinese century
The US government has long used free-trade pacts—guaranteeing access to America’s 300 million consumers—to reward other countries’ cooperation with its geostrategic aims. In Trump’s view, this “globalist” policy is the crux of America’s problems. He has already vowed to ditch the Trans-Pacific Partnership, president Barack Obama’s signature multilateral trade pact. He talks about trade barriers—most infamously, the 45% tariff he has threatened to slap on Chinese imports—as both a cudgel and a solution to US joblessness. To lead his newly created National Trade Council, Trump tapped an economist known for his belief that raising tariffs and rewriting trade agreements are central to America’s economic rebirth, to bringing low-skill manufacturing operations back home. Trump criticizes the World Trade Organization and the US’s multilateral trade agreements as rigged, and threatens to run roughshod over those agreements by retaliating against what he sees as mercantilism by China, the euro zone, and Japan (among others), according to the Trump Economic Plan (pdf).
Amid this, China sure seems like a shoo-in to assume the US economic mantle. Already the world’s biggest trading nation, China is neck and neck with the US as the largest economy, in purchasing-power terms. Including Hong Kong, China roughly ties Japan as the world’s biggest creditor to other nations. (The US is its biggest debtor.)
The recent rollout of the Asian Infrastructure Investment Bank and the One Belt, One Road regional economic development plan burnished its regional leadership. Its global aspirations are apparent in China’s unexpectedly bold leadership on climate, its frenzy of bilateral trade deals, and its dogged campaign to get the yuan included in the International Monetary Fund’s reserve currency basket.
In the last month, Xi and other Chinese leaders have jetted around the planet calling for stronger global governance and praising multilateralism. “We should deepen and expand cooperation in our region,” he told the Asia-Pacific Economic Cooperation forum in Lima, Peru a few weeks ago. “Any attempt to undercut or exclude each other must be rejected.”
Expect similar soundbites from Xi in Davos next month, the first time a Chinese president and head of the Chinese Communist Party will attend the World Economic Forum’s annual gathering of corporate and political leaders. China, as one former high-ranking official put it, is on a crusade to “make globalization great again.”
The great US-Britain switch
At least one China-watching economist is skeptical. Michael Pettis, a finance professor at Peking University, often turns to history for clues to present-day puzzles. And it’s pretty clear that the place to start looking is the last time rapid globalization hit a wall: with the outbreak of World War I, in 1914.
The last globalization heyday was similar to the current one, as radical technological innovations—notably in steamships, railroads, and the telegraph—started in the 19th century to deepen crossborder trade and investment ties. Britain sat at the center of global finance, trade, and investment for more than a century. The outbreak of WWI, and the series of calamities that followed, not only upended British dominion—it also shattered the liberal world order that many at the time had assumed spread peace as well as prosperity. After the 1929 stock market crash hit, major world economies devolved into trade war, causing the nasty, global post-crash banking crisis to metastasize into the Great Depression. Then, of course, came World War II.
Somewhere amid those decades of chaos and devastation, America emerged as the dominant world power. Its ascendancy made sense. The US surpassed Britain in its share of global output (pdf, p.6) in 1913, seizing the title of world’s top exporter (pdf, p.52) less than a decade later. By WWI, it had also become the planet’s biggest creditor.
These two facts aren’t coincidence. When a country exports more than it imports, the surplus in income from trade often flows to other countries as foreign investment. When other countries need that investment to propel their economies, this natural flow of funds is great for everybody—like in the early 20th century, for instance.
“The Great War accelerated US economic growth, along with the excess of American savings over investment, so that it began the 1920s with a huge savings imbalance, like that of China today,” Pettis writes in a blog post.
The US’s European allies needed that money to fund their war efforts. Afterward, American investment financed their reconstruction. This happened again in WW2’s aftermath, as the US took income that could have been spent domestically and shifted it overseas, investing in rebuilding Europe and Japan. In return, the US enjoyed both high yields on the money it lent and those countries’ increased demand for US goods as their economies recovered. As the US finally accepted its dual role as the engine and bankroller of global growth, it also assumed a leadership over the world’s global trade and financial order.
Good savings glut, bad savings glut
For the last few decades, China has built up huge savings surpluses like the US had nearly a century earlier. Does that signal that it’s now China’s turn to lead the global trading regime?
Probably not. In the postwar years, capital was scarce, and the US’s low unemployment rate meant there was little room left to invest productively in the American economy. America instead supplied its excess savings to countries whose factories had been razed and needed rebuilding.
Even when there’s no postwar reconstruction to fund, this is how things should work in a balanced global economy, says Dean Baker, economist and founder of the Center for Economic and Policy Research. Slower-growing countries should invest their excess savings in faster-growing poorer countries. Financing infrastructure and manufacturing in underdeveloped nations boosts productivity and raises their citizens’ standards of living—expanding global demand by more than if that savings were spent or invested domestically by mature economies.
These days there’s too much capital to go around—which is what former US Federal Reserve chair Ben Bernanke dubbed the “savings glut.” But the bigger problem is that this capital hasn’t been spent wisely. Instead of flowing to the poor countries that need the investment, much of it has gone into US government bonds. And though it’s not the world’s only chronically oversaving country, China is by far the biggest. Why has a relatively poor country been investing like crazy in low-yielding Treasurys issued by the US government? The answer happens to be the secret to the Chinese growth model.
Making a miracle
The US savings glut in the early 20th century came from the excess income generated by its ultra-fast growth. China’s results from its growth model.
This isn’t, as is widely assumed, an “export-driven” approach. Instead, China has relied on investment to fuel its rapid expansion. The money to finance this strategy came primarily from ratcheting up the country’s savings rate—the income not spent by households (as consumption) or businesses (as investment).
The Chinese government has kept interest rates on savings deposits artificially low, while simultaneously barring households and most companies from moving money out of the country. With no reliable option but to keep their earnings in Chinese state-run banks, savers supplied banks with a plentiful pool of virtually free money to loan out for investing in domestic infrastructure and factories—a surefire way to produce eye-popping GDP growth. Though these policies have lost their effectiveness in the last few years, the savings rate still hasn’t fallen much.
Until very recently, China’s central bank also prevented the Chinese yuan from appreciating against the dollar as much as it should. This makes Chinese exports cheaper for buyers abroad, while increasing the relative price of imports for Chinese consumers.
China’s internal imbalances have thrown the global economy out of whack too. Its strategy of spurring growth by boosting its citizens’ savings rate—which, again, is the same as suppressing consumption—means Chinese state-run banks persistently amass even more funds than they can lend or invest domestically. The central bank has for more than a decade invested those excess savings abroad, which drives up the relative value of those countries’ currencies again the yuan.
Normally, exchange rates would eventually balance things out. For instance, to buy Chinese goods and invest in its enterprises, traders and foreign investors buy yuan, selling their dollars (and other foreign currencies) in return. This surging demand for the yuan should drive up the currency’s value against those of its trade partners, making China’s exports pricier and, conversely, its imports cheaper. If Chinese households bought more (now relatively cheaper) foreign goods, the trade surplus would shrink.
But the Chinese government interfered with this natural adjustment process by keeping the yuan’s value against the dollar artificially low. To do this, China’s central bank (via its state-owned banking system) made Chinese exporters exchange the dollars they earned for yuan, giving them more yuan per dollar than they would have gotten on a free market. By paying more yuan than each dollar was worth, the central bank essentially subsidized exporters and foreign investors.
This exchange rate manipulation swelled China’s foreign exchange reserves to a grotesquely huge $4 trillion at their peak, with most of those dollars invested in US government bonds. China kept buying US debt due neither to investment savvy or generosity, but to suppress domestic consumption—reflected in its increased net exports—in order to keep investment powering its growth.
The dangers of zero-sum surpluses
What does this have to do with China’s case for leading the global trade regime? Its mercantilist model—with its reliance on trade surpluses—doesn’t jibe with the collectively beneficial trade system that the world needs. It also is incompatible with fostering global prosperity. Chinese household consumption—a force of demand that should be powering the global economy—still generates what is among the smallest shares of a national GDP ever recorded.
In fairness to China, it has shrunk its surplus from 10% of GDP in 2007 to around 3% in 2015, notes CEPR’s Baker. But while China is certainly not the only country propping up growth by relying on other countries’ demand, it’s by far the biggest.In a savings-glut world, even a small surplus run by a country of China’s size requires imposing massive deficits—and the debt and unemployment that come with them—on other trading partners. And that’s not exactly a winning quality in a global trade regime leader.
China could change its growth model to winnow down its export surpluses. In fact, in many ways, it has. The government has given up most of its old methods of suppressing household consumption. An explosion of shadow banking in the last seven years has granted citizens fairer returns on their savings, undermining the government’s interest-rate repression. And in the last two years, as the economy slowed, people have been spiriting their money out of China, driving down the yuan’s value. Nowadays, the central bank is selling off its dollar reserves in order to keep the yuan stable, not buying Treasurys like it used to.
Still, China’s trade surplus has persisted, a sign that increasing household demand for imports will require more government effort than simply winding down old policies. As Pettis argues, the chief challenge is shifting wealth from the state and corporate sectors to households—a transition that’s proving politically difficult. Letting investment drop, making more wealth available to households, would drag down GDP growth, causing mass layoffs and the related threat to Communist party legitimacy. Plus, the diminished international stature that might accompany slower growth seems unlikely to suit Xi’s nationalistic zeal.
There’s an even bigger hurdle, though: China’s enormous debt burden.
China’s debt-management secret weapon
Incentivizing workers to subsidize companies by oversaving has “fueled what will one day probably be seen as the largest investment misallocation spree in history,” says Pettis.
Cheap money invites wasteful investments, and as Chinese economic growth inevitably slowed, its companies took out more loans to pay off old ones. This has gone on for long enough that China’s debt is now equal (by a conservative estimate) to 250% of its GDP—among the highest debt-to-GDP ratios anywhere on the planet. Its non-financial private sector is now using around one-fifth of its income to pay off debt, according to the Bank for International Settlements.
Because investments in its businesses aren’t generating the return they should in the form of increased output, China must borrow ever-rising sums in order to hit the government’s target GDP growth of 6.7% annually. With outstanding debt already totaling around 250% of GDP, reaching that target, by Pettis’ calculations, now requires adding between 40% and 45% of GDP to that amount each year. That amounts to roughly $5 trillion in the last year or so.
Whereas its surplus used to create the engine of investment-fueled growth, China’s surplus has now become a crucial “debt-management tool,” he says, funding economic activity that would otherwise have to be paid for with loans.
The more income from its trade surplus China brings in, the less it has to borrow to reach the government growth target. Raising its trade surplus by one percent of GDP keeps it from having to take on between 10% and 15% of GDP more in loans, calculates Pettis. With China’s pile of debt now at a level that’s perilously close to a financial crisis—that offsetting surplus income counts for a lot. And if the government is to restructure the economy so that it averts financial fiasco, that trade surplus “provides the country’s leaders with crucial breathing space” to do so, says Pettis.
A good chunk of that breathing space comes from the huge trade surplus China runs with the US right now. If Trump keeps his word and raises trade barriers, China will have a hard time hitting its 6.7% GDP growth target. If Pettis is right, that means it will either have to bump up its borrowing to even more extreme levels, or find another country on which to foist the goods it currently sells to the US.
The result of all of this is that China’s need to maintain its trade surplus will likely have more of a role in dictating how states cooperate on trade and capital rules than Xi’s grand “free trade” rhetoric. Even to those uncomfortable with a giant authoritarian country assuming leadership of the global economy, this shouldn’t necessarily come as good news. Without a superpower to manage a global system of rules, the “modern world economy falls apart occasionally,” argue economists Peter Temin and David Vines.
“A hegemonic country has the power to help countries cooperate with one another for the maintenance and, when needed, the restoration of prosperity,” they write in The Leaderless Economy. “When no country can or will act as hegemon, a world crisis erupts.”
Trump’s promised retreat, China’s ambitions, and the reasons why it probably can’t fulfill them—it all suggests the unnerving possibility that this eruption is already underway.