Stephen King: First the Chinese accumulated dollars, now everyone is joining the stampede

What caused the crisis? For some, the story is simple. It’s all about global imbalances.

The US borrowed too much and the Chinese lent too much. In an arithmetical sense, this assertion contains some truth. The US has lived with a whopping deficit on the current account of its balance of payments for countless years. The Chinese, in turn, have experienced an ever-widening surplus.

According to this thesis, China’s surplus results from the pursuit of a mercantilist exchange rate policy designed to promote Chinese exports at the expense of manufacturing jobs elsewhere in the world. China deliberately prevented its exchange rate from rising by using its trade surplus to buy dollars in the open market.

This led to a massive increase in China’s foreign exchange reserves, most ofwhich were invested in US Treasuries. US interest rates ended up lower as a result, leading to the housing boom and sub-prime crisis.

Based on this view of the world, the US economy would eventually collapse when Chinese and other foreign investors in US assets reached a point of saturation where they simply had too much exposure to the US economy. At that moment, the US would discover the folly associated with its constant borrowing from abroad. Capital inflows would dry up, domestic financial markets would tumble and the dollar would collapse.

Thatwas the theory. There is, though, one big problem. The dollar may have been weak at the beginning of the crisis but it isn’t any longer.

Through much of this year, the dollar has been in the ascendant. China’s currency, the renminbi, is struggling to keep up. Other currencies, including the euro and, most obviously, sterling, have fallen on hard times. If, then, this is a story about the unwinding of global imbalances, it’s a story that appears to have lost the plot.

I have no doubt that China’s trade surplus and its associated purchase ofUSTreasuries have played some sort of role in the crisis. But they’re not the only factors, and nor are they the most important. While it’s true that Treasury yields in the US were lower as a result of China’s behaviour, that doesn’t explain the huge boom in demand for mortgage-backed securities and their various derivatives over recent years. Everyone wanted a piece of the action. American investors bought these pieces of paper but so, increasingly, did European and emerging market investors.

Why was there such a huge demand for products which, today, are no longer trusted? One simple answer relates to our own, collective, desire to retire early with a decent nest egg of savings, a desire which required a high return on our financial investments.

Our hopes of meeting those desires were dealt a savage blow in 2000 and 2001 when equity prices collapsed.

We needed another “get rich quick” scheme. Investors looked elsewhere for assets that might have a chance of generating the returns that would keep us happy in our dotage.

For a while, mortgage-backed securities seemed to do the trick. They were safer than equities but offered a higher yield than Treasuries.

The odd thing about these investments, though, is the idea that building or buying houses will add to national wealth in the years to come.

Wealth ultimately comes from productivity gains. Those gains, in turn, hinge on advances in technology and on a more efficient allocation of global capital. While it’s true that modern houses have more advanced technologies than older houses (double glazing, for example), the big gains are, of course, seen in other areas, most obviously in computers, transportation and communications. Ultimately, house prices will tend to rise only as a consequence of these technology gains and their impact on our incomes. Over the very long term, house prices won’t rise of their own accord (as, indeed, the Japanese, with their feeble economy, have discovered over the last 16 years, a period of persistently falling land prices).

The huge investments in paper assets in recent years were ultimately used to fund investments in parts of the economy which were never likely to boost long-term growth. Even worse, to the degree that investments in housing diverted funds from other, more rewarding, areas of economic endeavour, the investments were ultimately used only to bring forward future consumption to the present. All that extra consumption required someone else to do all the producing.

It’s no surprise that children’s toys this Christmas will be mostly labelled “Made in China”.

When, at the end of 2006, the US housing market began to soften, alarm bells should have been ringing.

Afalling US housing market suggested that, perhaps, mortgage-backed securities and other, more esoteric, pieces of paper were perhaps not quite as safe as investors had previously assumed. It took a while for investors to recognise the problem.

Late last summer, though, the penny dropped. Any piece of paper linked to housing was suddenly of little worth.

Banks, though, had been dependent on the sale of these pieces of paper to raise the necessary funds to sustain high volumes of lending. If the demand for these pieces of paper collapsed, it followed that bank lending would also collapse. Everything else stems from this: shortages of credit, worries about bankruptcy, monetary hoarding, and recessionary fears. We are witnessing a catastrophic breakdown of trust within the financial system.

In fact, the only stuff that is trusted these days is cash. One of the more remarkable developments last week was a fall in the rate of interest rate on 3-month Treasury bills to below 0 per cent. In other words, people are prepared to pay the US government to look after their money, such is their anxiety about savings held in the private sector.

This kind of behaviour has long been seen in Japan, but it’s a new experience in theUSand elsewhere in the world. It also helps to explain why the dollar is so strong. In a world of tremendous uncertainty, the only cash investors want to hold is cash which has the best international liquidity. Almost anywhere in the world, dollars are acceptable as a means of exchange. It’s no surprise, then, that dollars are very popular all of a sudden.

In this new dollar stampede, there are plenty of casualties. It won’t be long before US exporters are complaining about unfair competition from abroad. Flows of private capital to emerging markets will dry up, because the desire for dollars creates a “home bias” for US banks. Emerging market currencies, in turn, will come under pressure, reducing the nest egg of dollar foreign exchange reserves which had been built up in earlier years.

Funnily enough, then, the world as awhole has decided to behave as the Chinese have been doing for the last decade or so. The Chinese have been accumulating dollars. Suddenly, everyone else also wants dollars.

In hindsight, rather than demanding the Chinese should have allowed the renminbi to appreciate, perhaps the Americans should, instead, have encouraged the Chinese to diversify their foreign assets. Rather than holding Treasuries, the Chinese might have been encouraged to buy US companies in need of a bit of tender loving care. But the opportunity to sell General Motors at a reasonable price is no longer there.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com