America's Pain, China's Gain

Investors view stock index as Chinese shares dove amid fears of an economic slowdown. (China Photos/Getty Images)

by John Delury

Originally published in The Daily Times, Ooctober 27, 2008


In their efforts to pass a bailout plan for America’s financial system, Bush administration officials invoked the spectre of the Great Depression of the 1930s. But, for most Asians, economic Armageddon is far more recent.

The Asian financial crisis of a decade ago brought banks, corporations and governments to their knees. The bonfire was sparked by the collapse of the Thai baht in the summer of 1997. Contagion soon spread across East Asia, with the ripple effects of serial currency devaluations reaching as far as Russia and Brazil. The long running “economic miracles” of South Korea and Hong Kong ended, as did surging growth in Indonesia and Thailand.

The central lesson taken from that crisis was to maintain large foreign-exchange reserves. This became a virtual article of faith among East Asian governments. Back in the 1990s, Asia’s fast-growing economies maintained small reserves, despite booming exports and foreign investment. Once the tailspin began in 1997, governments’ lack of reserves hampered their ability to rescue failed banks, forcing them to appeal to international institutions for relief.

But the International Monetary Fund’s bailout came with strings attached, including demands for more of the rapid capital market liberalisation that induced the crisis in the first place. Indeed, what the West calls the “Asian financial crisis” is known in Asia as the “IMF crisis”. The political humiliation and economic frustration of dealing with IMF imperatives confirmed the central importance of maintaining large reserves, as an issue not just of currency stability, but also economic sovereignty.

One Asian economy emerged from the 1997-1998 crisis relatively unscathed: China. There were many reasons for this, but foremost among them was that China had already amassed more than $100 billion in reserves, and refused to revalue its currency, when the crisis hit.

Since then, China has aggressively pursued a fast-growth, export, and investment heavy model of economic development. By capping the exchange rate and producing far more than it consumes, China’s reserves grew into a Leviathan, hitting the $1 trillion mark in 2005. Even after China (under pressure from US Treasury officials) let the yuan partially float in 2005, the Leviathan kept growing by about $200 billion annually. Over the past year and a half, China’s reserves skyrocketed to $1.8 trillion, far and away the world’s largest.

The Chinese state probably hasn’t sat on so much lucre since the halcyon days of the Qing Empire, when insatiable European demand for porcelain, tea and silk flooded the central coffers in Beijing with silver bullion. But the paradox is that today’s reserves are not real wealth that can be pumped back into the domestic economy. Instead, China’s reserves mostly underwrite America’s debt.

Even before Wall Street hit the skids, there was growing consensus in China that its reserves had grown far beyond what was necessary to avert another 1997-style crisis. Calls for a more diversified investment strategy intensified. Investing in US Treasuries, after all, was a sure loss-maker, given the gap between their modest yield and the steady appreciation of the yuan.

With the creation one year ago of a $200 billion sovereign wealth fund, the China Investment Corporation, Beijing positioned itself for more equity investment (although its early investments, in the Blackstone Group and Morgan Stanley, were widely criticised). Economist Andy Xie, formerly with Morgan Stanley, proposed last week that China trade its dollar assets for shares in US companies on a grand scale, challenging America to overcome its financial xenophobia in order to avert a disaster of undercapitalisation.

But many in China, from nationalist bloggers to social justice activists, advance a deeper critique of the Leviathan reserve. Why bind up Chinese capital to finance America’s debt-consumption economy, they ask, when so many needs go unmet at home? China was one of the world’s most egalitarian societies as late as 1985. Today, it suffers one of the world’s biggest gaps between haves and have-nots. Chinese-style capitalism is flaunting its defiance of one Confucius’ basic teachings — don’t worry about poverty, he warned, worry about inequality.

China’s physical infrastructure in booming central cities is undergoing radical modernisation, but the social and environmental infrastructure is falling apart, especially in the interior and for the huge rural population. For years, the central government has talked about creating “social harmony” — with a “new-type rural cooperative medical services system”, by increasing spending on education to 4 percent of GDP and eliminating school fees, and implementing “sustainable development” models.

The promises are grand, but the actions have not measured up. And the economic costs of restricted access to healthcare and education, on top of the scarcity of clear air and potable water, will be crippling in the mid- and long-term.

The challenge for China in the years to come is to divest itself of American debt, and begin investing in the health, education and environmental well being of its own people. Growing the economy at an average annual rate of 10 percent, it turns out, may have been the easy part.

John Delury is director of the China Boom Project at the Asia Society, New York.