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December 01, 2005

Liberating Sovereign Credit for Domestic Development Part II: China and a New International Finance Architecture
by Henry C. K. Liu

Dollar hegemony is a geopolitical phenomenon in which the US dollar, a fiat currency, assumes the status of primary reserve currency in the international finance architecture. While frequently rationalized as necessary for facilitating world trade, dollar hegemony is not benign. It inevitably contributes to increasing trade friction in the global trading system, by pushing exchange rates manipulation as the main tool of competition in export trade.

China's trading relationship with the US impacts the entire global economy materially. Much has been made about China's pegging its currency to the dollar even though the yuan is not freely convertible. Calls for upward revaluation of the Chinese yuan are heard frequently. There may be a case for arguing for higher prices for Chinese exports, if the increase is passed directly onto wages to increase domestic demand. But the logic of revaluing the yuan, or any currency, as a means of balancing trade is flawed. Exchange rate moves affect the price of both import and export, but their impact on trade balance may only result in changes in the volume of trade rather the monetary value of trade. With a stronger yuan, less Chinese goods and services may be exported to the US, but at a higher price; and more US goods and services may be exported to China at a lower price, but the trade imbalance in monetary value may remain the same after initial adjustments. Historical data suggest that US firm will take advantage of the exchange rate move to raise prices of US exports. The result may merely be higher inflation rate for the US and eventually for the global economy.

China's excessive dependence on foreign trade has significantly distorted its economic growth, as indicated by the high percentage of foreign trade to its gross domestic product (GDP), estimated to reach near 90% in 2004. China's high-growth coastal east and south depend heavily on foreign trade. The average rate of foreign trade dependence of the 12 provinces and municipalities in coastal east and south China was 74.5% in 2000 while the rate in the 19 provinces and autonomous regions in the interior central and western regions was only 10%. In 2003, Shenzhen and Shanghai scored 356.3% and 148.7% respectively. Much of this trade takes the form of low-wage assembly for re-export, and although the trend is changing toward vertically integrated manufacturing, the re-export aspect remains dominant. Some 54% of China's total exports were being traded by foreign investors.

China does not have a diversified trade market. Trade between China and its three biggest trade partners - the US, Japan and the European Union - accounts for about one half of its total. The economic performances of these major trade partners not only critically affect their trade with China, but also affect Chinese trade with the rest of the world in which China incurs a persistent, small but rising deficit. Trade between China and the US constituted 5.4% of China's GDP in 1997. The ratio climbed to 13% of the $1.4 trillion GDP in 2003 when trade volume was $181 billion with a US deficit of $124 billion. Since China incurred an overall trade deficit of $500 million in 2003, the entire US trade deficit with China was transferred to other economies outside China, mostly in developing economies. Yet the abnormally high reliance on trade with the US, with an ever-widening trade gap, is a structural cause for rising Sino-US trade conflicts. The US trade deficit with China is now the largest in the world. China alone was responsible for 53% of the increase in US non-oil trade deficit through June 2004. US imports from China are now five times the value of US exports to China, making this the most imbalanced trading relationship for the US, albeit US trade policy limiting "dual use" technology export to China also contributed to this imbalance. The relatively low growth rate of the matured economies, such as the US, EU and Japan, cannot sustain the high growth rate of Chinese export trade. Also, all three of these countries are actively engaged in using low-wage manufacturing in China for world-wide re-export, distorting Chinese export data.

Trade reliance ratio is determined by many factors, including GDP calculation, exchange rate distortions, methods of trade and trade competence of a nation. Nevertheless, one fact stands out: China's dollar-denominated trade surplus benefits the dollars economy and not the yuan economy. It contributes significantly to China's capital shortage for domestic development, siphoning needed capital to its foreign reserves.

China's import for 2004 is expected to exceed $500 billion and total trade could exceed $1 trillion, with total sales of consumer goods and capital goods reaching $1.83 trillion, which appears impressive until when it translates to only $1,306 per person. Because of high trade reliance ratio, some $330 billion of goods will fail to show up in 2004 Chinese GDP, which is expected to rise around 8% from 2003 to $1.5 trillion. The economy grew 9.6% in second quarter, slowing from 9.8% in the first quarter after the government imposed lending curbs to cool an overinvestment boom that caused power shortages, infrastructure bottlenecks and escalating inflation. The government targeted growth at 7% earlier for 2004. China will continue to import advanced technology equipment, high-tech products, basic raw materials and consumer goods, but it has a long way to go before reaching the full potential of a developed Chinese domestic market.

Chinese trade reached a record high of $851 billion in 2003 with a GDP of $1.4 billion; exports rose 34.6% to $438 billion against a rise in imports of 39.9% to $413 billion. In the first eight months of 2004, China recorded a trade deficit of $950 million; exports rose 35.8% to $361 billion while imports increased 40.8% to $362 billion. The continuing increase in China's foreign exchange reserves in the face of a trade deficit means that China's domestic sector is subsidizing its export sector to the tune of its trade deficit plus its foreign exchange reserves growth. Wealth has left the yuan economy into the dollar economy.

The distributional consequences of trade on energy consumption are significant. For the US, energy consumption per dollar of GDP dropped from 17,440 Btu in 1973, year of the OPEC oil embargo, to 9,460 Btu in 2003. The drop was achieved partly by importing energy-intensive products. Unlike other developing countries such as India, South Korea and Brazil, the amount of energy consumed per dollar of GDP has decreased dramatically in China over the past two decades. Still, China consumed 35,000 Btu per dollar of GDP in 1999. With average annual GDP growth rates around 7-8% over the last decade and energy consumption growth rates somewhat lower, China has been reducing its energy intensity. This is in large part a result of government efforts to conserve energy, and the updating of industrial plant equipment. China's Energy Conservation Law entered into force on January 1, 1998. The government has promoted a shift towards less energy-intensive services and higher value-added products, as well as encouraged the import of energy-intensive products. While China ranks second in the world behind the United States in total energy consumption and carbon emissions, its per capita energy consumption and carbon emissions are much lower than the world average. In 2001, the US had a per capita energy consumption of 341.8 million Btu, greater than 5.2 times the world's per capita energy consumption and slightly over 11 times China's. Per capita carbon emissions are similar to energy consumption patterns, with the United States emitting 5.5 metric tons of carbon per person, the world on average 1.1 metric tons, and China 0.6 metric tons of carbon.

China's oil imports for the first eight months of 2004 were up 39% cent at 79.9 million tons. China is reported to be planning to invest $12 billion in the Russian energy industry, with an interest in buying parts of Yukos, the embattled Russian oil giant. China takes about 7% of its oil from Yukos, already suffered a cut to its supplies because the Russian company cannot pay transport costs in September. China is reported to be forced to prepay transportation costs to Yukos to avoid supply interruption. Much of this energy is needed only by the export sector.

China needs to activate its domestic market to balance its overblown foreign trade. The Chinese economy can benefit enormously by the aggressive deployment of sovereign credit for domestic development and growth, particularly in the slow-growth western and central regions. Sovereign credit can be used to stimulate domestic demand by raising wage levels, improve farm income, promote state-owned-enterprise restructuring and bank reform, build needed infrastructure, promote education and health care, re-order the pension system, restore the environment and promote a cultural renaissance. While exchange control continues, China can free its economy from the dictate of dollar hegemony, adopt a strategy of balanced development financed by sovereign credit and wean itself from excess dependence on export for dollars. Sovereign credit can finance full employment with rising wages in the Chinese economy of 1.4 billion people and project it towards the largest economy in the world within a very short time, possibly in less than five years. The expansion of its domestic economy will enable China to import more, thus also allowing it to export more without excessive and persistent trade gaps. Much needs to be done, and can be done to develop the full potential of China's economy, but exporting for dollars is not the way to do it.

China is in the position to kick start a new international finance architecture that will serve international trade better. China has the option of making the yuan an alternative reserve currency in world trade by simply denominating all Chinese export in yuan. This sovereign action can be taken unilaterally at any time of China's choosing. All the Chinese State Council has to do is to announce that as of a certain date all Chinese exports must be paid for in yuan, making it illegal for Chinese exporters to accept payment in any other currencies. This will set off a frantic scramble by importers of Chinese goods around the world to buy yuan at the State Administration for Foreign Exchange (SAFE), making the yuan a preferred currency with ready market demand. Companies with yuan revenue no longer need to exchange yuan into dollars, as the yuan, backed by the value of Chinese exports, becomes universally accepted in trade. Members of the Organization of Petroleum Exporting Countries (OPEC), which import sizable amount of Chinese goods, would accept yuan for payment for their oil, so will Russia. This can be done without de-pegging the yuan from the dollar and SAFE can retain it position as the exclusive window for trading yuans for other currencies without any need for new currency control regulations. The proper exchange rate of the yuan can then be set by China not based on export to the US, but on Chinese conditions.

If Chinese exports are paid in yuan, China will have no need to hold foreign reserves, which currently stand at more than $480 billion. And if the Hong Kong dollar is pegged to the yuan instead of the dollar, Hong Kong's $120 billion foreign-exchange reserves can also be freed for domestic restructuring and development. Chinese trade surplus would stay in the yuan economy. China is on the way to becoming a world economic giant but it has yet to assert its rightful financial power because of dollar hegemony.

There is no stopping China from being a powerhouse in manufacturing. Many Asian economies are trapped in protracted financial crisis from excessive foreign-currency debts and falling real export revenue resulting from predatory currency devaluation. The International Monetary Fund (IMF), orchestrated by the US, has come to the "rescue" of these distressed economies with a new agenda beyond the usual IMF conditionalities of austerity to protect Group of Seven (G7) creditors. This new agenda aims to open Asian markets for US transnational corporations to acquire distressed Asian companies so that the foreign-acquired Asian subsidiaries can produce and market goods and services inside Asian national borders as domestic enterprises, thus skirting potential protectionist measures. The United States, through the IMF, aims to break down the traditionally closed financial systems all over Asia. This system mobilizes high national savings to finance industrial policies to serve giant national industrial conglomerates with massive investment in targeted export sectors. The IMF, controlled by the US, aims at dismantling these traditional Asian financial systems and forcing Asians to replace them with a structurally alien global system, characterized by open markets for products and services and crucially, for financial products and services. The focus is of course on China, for as US policymakers know: as China goes, so goes the rest of Asia.

Trade flows under neoliberal globalization in the context of dollar hegemony have put Asian countries in a position of unsustainable dependency on foreign, dollar-denominated loans and capital to finance export sectors that are at the mercy of saturated foreign markets while neglecting domestic development to foster productive forces and to support budding domestic consumer markets. In Asia, outside the small elite circle of well-heeled compradores, most people cannot afford the products they produce in abundance for export, nor can they afford high-cost imports. An average worker in Asia would have to work days making hundreds of pairs of shoes at low wages to earn enough to buy one McDonald's hamburger meal for his family while Asian compradores entertain their foreign backers in luxurious five-star hotels with prime steaks imported from Omaha. Markets outside of Asia cannot grow fast enough to satisfy the developmental needs of the populous Asian economies. Thus intra-region trade to promote domestic development within Asia needs to be the main focus of growth if Asia is ever to rise above the level of semi-colonial subsistence that will inevitably translate into political instability.

The Chinese economy will move quickly up the trade-value chain, in advanced electronics, telecommunications, and aerospace, which are inherently "dual use" technologies with military implications. Strategic phobia will push the US to exert all its influence to keep the global market for "dual use" technologies closed to China. Thus "free trade" for the US is not the same as freedom to trade. Increasingly, the world's nations will all procure their military needs from the same global technology market. Depriving any nation access to dual-use technology will not enhance national security as the deprived nation can easily shift to asymmetrical warfare which is more destabilizing than conventional armament.

Still, China will inevitably be a major global player in the knowledge industries because of its abundant supply of raw human potential. Even in the US, a high percentage of its scientists are of Chinese ethnicity. With an updated educational system, China will be a top producer of brain power within another decade. World leaders in high-tech, such as Intel and Microsoft, are actively pursuing cross-border R&D wage-arbitrage in Asia, primarily in China and India. As China moves up the technology ladder, coupled with rising consumer demand in tandem with a growth economy, global trade flow will be affected, modifying the "race to the bottom" predatory competitive game of two decades of globalization among Asian exporters to acquire dollars to invest in the dollar economy, toward trade to earn their own currencies for investment in domestic development.

Asian economies will find in China a preferred alternative trading partner, possibly with more symbiotic trading terms, providing more room to structure trade to enhance domestic development along the path of converging regional interest and solidarity. The rise in living standards in all of Asia will change the path of history, restoring Asia as a center of advanced civilization, putting an end to two centuries of Western economic and cultural imperialism and dominance.

The foreign-trade strategies of all trading nations in recent decades of neoliberal globalization have contributed to the destabilizing of the global trading system. It is not possible or rational for all countries to export themselves out of domestic recessions or poverty. The contradictions between national strategic industrial policies and neoliberal open-market systems will generate friction between the US and all its trading partners, as well as among regional trade blocs and inter-region competitors. The US engages in global trade to enhance its superpower status, not to undermine it. Thus the US does not seek equal partners as a matter of course. With economic sanctions as a tool of foreign policy, the US has been preventing, or trying to prevent, an increasing number of US transnational companies, and foreign companies trading with the US, from doing business in an increasing number of countries deemed rogue by Washington. Trade flows not where it is needed most, but to where it best serves the US national security interest.

Neoliberal globalization has promoted the illusion that trade is a win-win transaction for all, based on the Ricardian model of comparative advantage. Yet economists recognize that without global full employment, comparative advantage is merely Say's Law internationalized. Say's Law states that supply creates its own demand, but only under full employment, a pre-condition supply-siders conveniently ignore. After two decades, this illusion has been shattered by concrete data: poverty has increased worldwide and global wages, already low to begin with, have declined since the Asian financial crisis of 1997, and by 45 percent in some countries, such as Indonesia.

Yet export to the US under dollar hegemony is merely an arrangement in which the exporting nations, in order to earn dollars to buy needed commodities denominated in dollars and to service dollar loans, are forced to finance the consumption of US consumers by the need to invest their trade surplus dollars in dollar assets as foreign-exchange reserves, giving the US a rising capital account surplus to finance its rising current account deficit.

Furthermore, the trade surpluses are achieved not by an advantage in the terms of trade, but by sheer self-denial of basic domestic needs and critical imports necessary for domestic development. Not only are the exporting nations debasing the value of their labor, degrading their environment and depleting their natural resources for the privilege of running on the poverty treadmill, they are enriching the dollar economy and strengthening dollar hegemony in the process, and causing harm also to the US economy. Thus the exporting nations allow themselves to be robbed of needed capital for critical domestic development in such vital areas as education, health and other social infrastructure, by assuming heavy foreign debt to finance export, while they beg for even more foreign investment in the export sector by offering still more exorbitant returns and tax exemptions, putting increased social burden on the domestic economy. Yet many small economies around the world have no option but to continue to serve dollar hegemony like a drug addiction.

Japan provides the perfect proof that even a dynamic, successful export machine does not by itself produce a healthy economy. Japan is aware that it needs to restructure its domestic economy, away from its export fixation and upgrade the living standard of its overworked population and to reorder its domestic consumption patterns. But Japan is trapped into helplessness by dollar hegemony.

Japan sees its sovereign credit rating lowered by international rating agencies while it remains the world's biggest creditor nation. Moody's Investor Service downgraded Japanese government bonds by two notches recently to A2, or one grade below Botswana's, not to mention Chile and Hungary. Japan has the world's largest foreign-exchange reserves: $819 billion in July 2004; the world's biggest domestic savings: $11.4 trillion (US gross domestic product was $11 trillion in 2003); and $1 trillion in overseas investment. And 95% of its sovereign debt is held by Japanese nationals, which rules out risk of default similar to Argentina. Japan has given Botswana, where half of the population is infected with the AIDS virus, $12 million in grants and $102 million in loans.

Why does the New York-based rating agency prefer Botswana to Japan? The Botswanan government budget is controlled by foreign diamond-mining interests to protect their investment in the mines. Botswana does not run any budget deficit to develop its domestic economy or to help its poverty-stricken people. Thus Botswana is considered a good credit risk for foreign loans and investment. Japan, on the other hand, is forced to suffer the high interest cost of a low credit rating because its responsive government attempts to solve, through deficit financing, the nation's economic woes that have resulted from excessive focus on export. Dollar hegemony denies a good credit rating even to the world's largest holder of dollar reserves.

The Asia-Pacific trading system has been structured to serve markets outside of Asia by providing low wage manufacturing. This enables the US to consume more without inflation and without raising domestic wages. All the trade surpluses accumulated by the Asian economies have ended up financing the US debt bubble, which is not even good for the US economy in the long run. Low-price imports allow the US to keep domestic wages low without dampening consumer power and contribute to a rising disparity of both income and wealth within the US where purchasing power comes increasingly from debt supported by capital gain rather than rising wages. The result is that when the equity bubble of inflated price-earning ratio finally bursts, wages are too low to keep the economy from crashing from a collapse of the wealth effect.

After thoroughly impoverishing the Asian economies by making possible financial manipulation of crisis proportions, dollar hegemony now works to penetrate the remaining Asian markets that have stayed relatively closed: notably Japan, China and South Korea. Control of access to its markets has been Asia's principal instrument for its sub-optimized trade advantage and distorted industrial development. This strategy had been practiced successfully first by Japan and copied in various degree of success by the Asian Tigers. Protectionism will survive in Asian economies long after formal accession by these economies to the World Trade Organization (WTO).

Once free from dollar hegemony, China can finance its domestic development without foreign loans and capital. The Chinese economy then will no longer be distorted by excessive reliance on export merely to earn dollars that by definition must be invested in dollar assets, not yuan assets. The aim of development is to raise wage levels, not to push wages down to achieve predatory export competitiveness. Yet export under dollar hegemony requires keeping wages low, a prerequisite that condemns an economy to perpetual underdevelopment. Terms such as "openness" need to be reconsidered away from the distorted meanings assigned to them by neoliberal cultural hegemony. The contradiction between globalizing and territorially-based national social and political forces is framed in the context of past, present and future world orders.

Globalization is not a new trend. It is the natural policy for all empire building. Globalization under modern capitalism began with the British Empire, marked by the repeal of the Corn Laws in 1846, five years after the Opium War with China, and two years before the Revolutions of 1848. Great Britain embarked on a systemic promotion of free trade and chose to depend on imported food, which gave a survivalist justification to economic empire. France adopted free trade in 1860 and within 10 years was faced with the Paris Commune, which was suppressed ruthlessly by the French bourgeoisie, who put to death 20,000 workers and peasants, including children. Despite a backlash movement toward protective tariffs in Britain, Holland and Belgium, the global economy of the 19th century was characterized by high mobility of goods across political borders. As Europe adopted political nationalism, international economic liberalism developed in parallel, until 1914. World War I, the 1929 Depression and World War II caused a temporary halt of free trade. The US "Open Door" policy for pre-revolutionary China, proclaimed by John Hay in 1899, was part of a globalization scheme to preserve US commercial interests by preventing the partition of China by European powers and Japan, after the US became a Far Eastern power through the acquisition of the Philippines. The Open Door policy was rooted in the most-favored-nation clause in the unequal treaties imposed on China by Western imperialist powers.

Like the United States now, Britain was a predominantly importing economy by the close of the 18th century. Despite the Industrial Revolution's expanded export of manufacturing goods, import of raw material, food and consumer amenities grew faster in value than export of manufacturing goods and coal. The key factor that sustained this trade imbalance was the predominance of the British pound, as it is today with the US dollar and its impact on the trade finance. British hegemony of sea transportation and financial services (cross-currency trade finance and insurance) earned Britain vast amounts of foreign currencies that could be sold in the London money markets to importers of Argentine meat and Canadian bacon. International credit and capital markets were centered in London. The export of financial services and capital produced factor income that served as hidden surplus to cushion the trade deficit. To enhance financial hegemony, the British maintain separate dependent currencies in all parts of the empire under pound-sterling hegemony. This financial hegemony is now centered on New York with the dollar as the base currency. When the Asian tigers export to the United States, all they get in return are US Treasury bills and corporate bonds, not direct investment in Asia. Asian labor in fact is working at low wages mainly to finance the expansion of the dollar economy.

Market fundamentalism, a modern euphemism of capitalism, is thus made necessary by the finance architecture imposed on the world by the hegemonic finance power, first 19th-century Great Britain, now the United States. When the developing economies call for a new international finance architecture, this is what they are really driving at. Foreign-exchange markets ensure that the endless demand for dollar capital by the poor exporting nations will never be met. British economist John A Hobson identified the surplus of capital in the core economies and the need for its export to the impoverished parts of the world as the material basis of imperialism. For neo-imperialism of the 21st century, this remains fundamentally true.

Then as now, the international economy rested on an international money system. Britain adopted the gold standard in 1816, with Europe and the US following in the 1870s. Until 1914, the exchange rates of most currencies were highly stable, except in victimized, semi-colonial economies such as Turkey and China. The gold standard, while greatly facilitating free trade, was hard on economies that produced no gold, and the gold-based monetary regime was generally deflationary (until the discovery of new gold deposits in South Africa, California and Alaska), which favored capital. William Jenning Bryan spoke for the world in 1896 when he declared that mankind should not be "crucified upon this cross of gold". But the 50-year lead time of the British gold standard firmly established London as the world's financial center. The world's capital was drawn to London to be redistributed to investments of the highest return around the world. Borrowers around the world were reduced to playing a game of "race to the bottom" to compete for capital.

The bulk of economic theories within the context of capitalism were invented to rationalize this global system as natural truth. The fundamental shift from the labor value theory to the marginal utility theory was a circular self-validation of the artificial characteristics of an artificial construct based on the sanctity of capital, despite Karl Marx's dissection that capital cannot exist without labor - until assets are put to use to increase labor productivity, it remains idle assets.

Mergers and acquisitions became rampant. Small business capitalism disappeared between 1880 and 1890. Workers and small businesses found that they were not competing against their neighbors, but those on other sides of the world, operating from structurally different socioeconomic systems. The corporation, first used to facilitate the private ownership of railroads, became the organization of choice for large industries and commerce, issuing stocks and bonds to finance its undertakings that fell beyond the normal financial resources of individual entrepreneurs.

This process increased the power of banks and financial institutions and brought forth finance capitalism. Cartels and trusts emerged, using vertical and horizontal integration to eliminate competition and manipulate markets and prices for entire sectors of the economy. Middle-class membership was mainly concentrated in salaried workers of corporations, while working class members were hourly wage earners in factories. The 1848 Revolutions were the first proletariat revolutions in modern time. The creation of an integrated world market, the financing and development of economies outside of Europe and the rising standards of living for Europeans were triumphs of the 19th-century system of unregulated capitalism. In the 20th century, the process continued, with the center shifting to the US after two world wars.

Friedrich List, in his National System of Political Economy (1841), asserted that political economy as espoused in England at that time, far from being a valid science universally, was merely British national opinion, suited only to English historical conditions. List's institutional school of economics asserted that the doctrine of free trade was devised to keep England rich and powerful at the expense of its trading partners and that it had to be fought with protective tariffs and other devices of economic nationalism by the weaker countries. List's economic nationalism influenced Asian leaders, including Sun Yatsen of China, who proposed industrial policies financed with sovereign credit. List was also the influence behind the Meiji Reform Movement of 1868 in Japan. Alexander Hamilton, by proposing the US Treasury using tax revenue to assume and pay off all public debts incurred by the Confederation in his 1791 Report on Public Debt, through the establishment of a national bank, provided the new nation with sovereign credit in the form of paper money for development.

The current breakdown of neoliberal globalized market fundamentalism offers Asia a timely opportunity to forge a fairer deal in its economic relation with the rest of the world. The United States, as a bicoastal nation, must begin to treat Asian-Pacific nations as equal members of an Asian-Pacific commonwealth in a new world economic order that renders economic nationalism unnecessary.

China, as potentially the largest economy in the Asia-Pacific region, has a key role to play in shaping this new world economic order. To do that, China must look beyond its current myopic effort to join a collapsing global export market economy and provide a model of national development in which foreign trade is reassigned to its proper place in the economy from its current all-consuming priority. The first step in that direction is for China to free itself from dollar hegemony and embark on a domestic development program with sovereign credit.

Henry C. K. Liu

Henry C. K. Liu was born in Hong Kong and educated at Harvard University, US, in architecture and urban design. His interest in economics and international relations started when he participated in interdisciplinary work on urban and regional development as a professor at the University of California Los Angeles, Harvard and Columbia. He is currently chairman of a New York-based private investment group.

Copyright © 2005 Henry C. K. Liu

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