Impossible dreams drag nations down

Many countries need an economics reality check

Kevin Rafferty
01 June 2010

It is a measure of the nervous mess of world financial markets that when the Financial Times reported last week that China was reviewing its assets denominated in euros, the markets promptly plummeted; the very next day when China denied any such euro-review, there was a massive rally in equities and commodities and a sell-off of bonds.

And this occurred in the week when the Organisation for Economic Co-operation and Development forecast returns to healthy growth in the rich industrialised countries of 2.7 per cent for this year and 2.8 per cent next. Overall global growth is now expected to be 4.6 per cent after a fall of 0.9 per cent last year.

There are good reasons why the nervous Nellies should be twitchy. Looking at the real economic world of 2010, there is a lack of balance. Too many countries are pursuing the same objectives, in which they can’t all succeed. Indeed, in many cases there is an internal conflict between policies pursued inside countries. Politicians in countries as diverse as Greece, Germany and China have not realised that only in an Alice in Wonderland world is it possible for everyone to do impossible things.

China boldly chases impossible dreams. It wants to keep exports growing as the engine of economic growth and jobs, and is reluctant to see the yuan appreciate because this will make exports less competitive. Its foreign exchange reserves will continue to grow, but this makes their real value ever vulnerable to a fall in the US dollar’s value, or of other reserve assets that Beijing chooses.

The fall in the euro, from US$1.49 in November to US$1.22 today, highlights some of the difficulties over foreign exchange rates. Beijing complains it has suffered a 13 per cent revaluation against the euro this year, threatening the competitiveness of exports to euroland. If, as some currency specialists predict, the euro falls closer to parity with the dollar, Beijing’s headaches will grow.

The currency and reserves demonstrate China’s limited options. China has the biggest pile of reserves in the world, accounting for about a third of the world’s reserve assets, excluding gold. Whether they really total US$2.4 trillion or US$3 trillion, it is tempting to ask what the real profit is in such a hoard.

A few months ago, there was much talk in Beijing of diversifying out of dollars. At that time, the euro was regarded as a safer haven, apart from the creation of a new global reserve currency, say based on the special drawing right. But even an SDR-like instrument would be a proxy for the basket of currencies of which it was composed and would still be vulnerable to currency fluctuations.

The truth is that the vulnerability of the increasing reserves is part of the price to be paid for export success, and it also denies Chinese consumers the fruits of their labour, locked up in the dollar holdings.

China could diversify its holdings by buying foreign assets, such as companies or buildings. But Japan has shown that this is easier said than done, and excites foreign opposition if done on a large scale. Imagine the outcry if China bought wholesale chunks of the US. It’s also too easy to miscalculate and pay over the odds for not-such-good assets, as China and even canny operators like Singapore have already discovered.

China’s better option is to actively aim for a balanced current account most consistent with growing job creation. But that means riding the political punch of powerful exporting companies.

At least China is enjoying many of the challenges of success. It’s different with the so-called advanced industrialised economies. Indeed, if you look closely at the economic structures of the Western countries, the expression “advanced industrialised countries” is something of a euphemism for “ageing, sclerotic and unwilling to change”.

Almost all of these countries seem to have forgotten some basic principles of economics. As John Maudlin wrote over the weekend in The Big Picture blog, there are only two ways for economies to grow, either through population or productivity increases. On the first score Japan, Russia and much of the old Western Europe are all vulnerable, but don’t seem to understand their plight.

The eurozone countries have an extra problem, of being 16 different fiscal regimes roped together under a common currency. The difficulties of Britain, outside euroland, show some of the dimensions of their problem.

The new British coalition government announced a substantial £6 billion (HK$67.5 billion) spending cut to get the government’s unsustainable deficit of 11 per cent of gross domestic product under control. It may sound savage, but it is only 4 per cent of the £156 billion deficit. Another option is to raise the value-added tax to 20 per cent, but retailers have warned that this would cost 163,000 jobs, cut consumer spending by £3.6 billion over four years and risk sending economic growth into a tailspin.

Britain has its own currency and a painful escape route. It can allow the pound to depreciate towards parity with the dollar, which will make Britain more attractive as a tourist destination and boost exports, if Britain can rediscover the art of making things as opposed to making paper financial mansions in the City of London.

Greece has no such luxury, and is competing in euroland with Germany where productivity has risen 30 per cent since the euro started. Even if the euro gets a boost from depreciation, Greece and everyone else have to compete with super productive Germany. Greece’s choice is willingly to go into depression or to default on its debts and leave the euro.

There is increasing recognition that the euro is an unfortunate orphan that needs greater parental political control. But none of the countries is willing to concede the control. Greek public servants are not even prepared to accept the curbs of their own elected government.

Spare a thought for the self-righteous Germans who – conveniently forgetting that they and France encouraged acceptance of deficits by not accepting the original 3 per cent limit – are now saying that everyone should be like them. That’s the other impossible dream – that everyone can export their way to economic recovery. If China, Britain, the US and Germany are all trying to export, who is going to buy?


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