China's Currency

PART 2: Tequila trap beckons China


By

Henry C K Liu


PART I - Follies of fiddling with the yuan

This article appeared in AToL on November 6, 2004



China is attempting to use macro policy measures to slow its overheated economy to avoid a dreaded hard landing. Yet a hard landing may be precisely the cold-turkey medicine needed to veer China away from an addiction on export for fiat dollars not backed by any specie of value. Soft-landing is a flawed imagery because there are few economic runways long enough to land an economy plagued by speculative acceleration. Running a plane off the runway is much more dangerous than a controlled hard landing.


The term "macro policy measures" is illusive and confusing. No one knows what it means precisely, typical of many economics slogans. There is not much wrong with China's economy that cannot be cured by focusing on domestic demand stimulation through a deliberate policy of full employment with rising wages, away from low-wage exports for fiat dollars that cannot be reinvested in the yuan economy. Tinkering with interest rates and exchange rates in the context of a failed neo-liberal ideology is to miss the defoliation of monetary forests by focusing on pruning the money trees.


Neo-liberal globalization of financial markets has become a euphemism for an age of global debt bubbles. Arguably, the distinction between an economic bubble and solid fundamentals can only be perceived after the bubble bursts. So the question of a bubble can be a conceptual dilemma, like the mental phenomenon of forgetting. One does not realize something had been forgotten until after one again remembers it. Thus improving one's memory theoretically increases incidents of forgetfulness.

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Still, some useful observations can be made about the high market value of dollar assets at this juncture in the history of finance capitalism. Financial assets denominated in fiat dollars are now mostly built on debt, with sizable amounts in debts external to the US economy. Debt is not intrinsically objectionable if it is adequately collateralized by real assets, and the proceeds are invested to increase income to service the debt. But if debt is collateralized mostly by the wealth effect of speculative asset appreciation and serviced by incurring more debt, a bubble is in the making. The so-called air-ball financing, widely used in financing global telecom expansion in the 1990s, in which unrealistically anticipated future earnings were used as collateral for financing over-investments to generate those very earnings, caused the telecom bubble. A housing bubble exists because houses are being financed by full-cost mortgages at negative interest rates, banking on the continuing rise in home prices.

The making of a bubble

The size of the invisible dollar money pool created by financial derivatives is now many times (no one knows how many) the amount of M3, a money supply category accounting for the sum of all short-term liquid funds, excluding treasury bills, savings bonds, commercial papers, bankers acceptances and non-bank euro-dollar holdings of US residents. Granted, derivative notional values are not the amount at risk, as they are the underlying asset values that exist only as a notion for calculating the amount of risk to be managed. But notional values allow the contracting parties to bet on the derivative implications of virtual assets they neither own nor can safely afford.

At the end of 2002, the notional value of the dollar derivative market was $56 trillion. A 1% shift in rates would cause a $560 billion change in interest payments. A speculator with a net worth of $1 million now can bet on derivatives with a notional value of $100 million, hedging a risk of $1 million with every change in the interest rate of 1%, equaling to his entire net worth. Since risk is never eliminated but only transferred, the total risk exposure in the system is inflated by fantastic notional values. Interest payments derived from notional values can then become larger than the actual amount of the real capital in the economy.

Derivatives fit the definition of bubbles, being all air and little substance. Warren Buffet calls them, with justification, financial weapons of mass destruction. This invisible supply of virtual liquidity outside the reach of central banks supports an artificial level of asset market value detached from fundamentals. Any abrupt, premature unwinding of these private derivative contracts based on fantasy notional assets will inevitably cause drastic readjustments in asset prices in the real markets.

The pervasive securitization of debt blurs the all-important dividing line between debtor and creditor and allows an economy to borrow from itself, not just against its future, but against its current and less sophisticated debt, not for productive investment but for financial manipulation. The use of less sophisticated debt as collateral for more sophisticated debt has characteristics of a bubble. The broad disaggregating of risk to maximize transactional surplus (profit) ultimately leads to the socialization of risk (transferring unit risk onto systemic risk) while the privatization of the resultant profit remains a sacred prerequisite. The Bank of International Settlement "Lamfalussy Report" defines systemic risk as "the risk that the illiquidity or failure of one institution, and its resulting inability to meet its obligations when due, will lead to the illiquidity or failure of other institutions".

Global systemic risk is the illiquidity in one economy leading to illiquidity in other economies, through what economists call contagion. Asian financial systems are less developed in securitization and structured finance. But while Asian economies forego the benefits of the brave new world of financial engineering, they are not rewarded with any immunity from global systemic penalties which dollar hegemony imposes on the dollar economy. China, being the least developed in global finance, is highly disadvantaged by this imbalance of risk and reward.

Under the accounting rules of capitalism, capital cannot exist until ownership is specifically assigned. Thus socialization of capital is a self-contradiction in term and must stay off the balance sheets of the capitalist financial system. To own assets, even a government must act as if it is a corporation, a "legal person". Thus private property and individualization are inseparable. Pension fund assets and other forms of collectively owned assets must adopt the governing characteristics of private capital in order to participate in the economic system. Such assets enjoy no prerogative to invest at less than maximum profit for the common good because in a capitalistic market economy, the ultimate definition of the common good is maximum profit.

Thus employee pension funds will invest for highest returns in companies that ship their members' jobs overseas to low-wage economies. The formula of socialization of risk in support of privatization of profit leads to the hollowing of the center - a classic definition of a systemic bubble. Yet the ownership of debt is largely socialized, dispersed throughout the global financial system, with encouragement of moral hazard, which is the lack of fear for private consequences of financial adventurism. The pleasure of excess is not limited by any excess of pleasure. Golden parachutes are provided free for financial adventurers, paid for by the public as unknowing victims through central-bank-induced inflation.

Whether or when a bubble will burst depends on a government's ability to extend its elasticity, which is not unlimited, notwithstanding US Fed chief Allan Greenspan's wizardry. Such elasticity comes from liquidity. To support the market, government increasingly needs to intervene, which in turn destroys the market. As is already apparent, the Federal Reserve is increasingly reduced to an irrelevant role of explaining the economy rather than directing it. It has adopted the role of a clean-up crew of otherwise avoidable financial debris rather than the preventive guardian of public financial health.

In a financial bubble, the monetary value of financial assets rises but the real economy itself may not be growing. But asset price appreciation is defined as growth, not inflation. Thus we have robust "recoveries" that continue to lose jobs, with the value of money protected by structural unemployment and underemployment. In the finance sector, wealth is created by escalating systemic risk exposure, known in the street now as the "Greenspan put". A writer of a put option profits by the stock at the end of the contract remaining stable, rise, or fall by an amount less than his pre-received profit or premium. Inflation and deflation have become two sides of the same coin that alternate as monetary concerns in a matter of months, through highly-manipulated markets of foreign exchange that tend to destabilize real economies via a multitude of channels, such as wealth disparity effects, off-balance-sheet creative accounting and alternating recurrences of credit excesses and crunches. Volatility has become regular market opportunities.

A few months earlier, China was blamed by Western economists for exporting deflation through an undervalued currency. Now China is being blamed for exporting inflation also through an undervalued yuan while the Chinese currency continues to be pegged to the dollar. Yet China does not have an export economy; it has a re-export economy. Most of the factors of production for Chinese exports are imported, such as capital, raw material, infrastructure systems, energy, capital equipment, design, financial services, machine parts, intellectual property licensing, offshore distribution and sales, the only exceptions being labor and raw land.

China's trade deficit widened sharply in April to $2.26 billion from $540 million in March due to the growing demand for raw materials and energy resources. That was the fourth consecutive monthly trade deficit this year. Exports rose 32% in April, compared with a year earlier, to $47.1 billion, and imports jumped 43%, to $49.4 billion. In the year's first four months, China's exports reached $162.74 billion, up 33.5% from a year ago, and imports rose 42.4%, to $173.5 billion. China incurred an overall trade deficit of $8.4 billion in the first quarter of 2004. The January-April deficit was $10.76 billion. If anything, China is importing inflation that is now at a 5.3% annual rate. Much of China's inflation comes from commodity and energy imports, the prices of which are denominated in dollars and set outside China.

The recent global commodity market bubble is not caused by real increased demand by the Chinese economy but by speculation fueled by low dollar interest rates and speculation of China's future demand based on anticipated Chinese export growth. Yet the inevitable rise in dollar interest rates will burst the commodities bubble, affecting the exchange value of the currencies of commodity-exporting nations such as Australia, South Africa and Chile. It will also torpedo the anemic US recovery and curb demand for Chinese exports. The global economy, led by super-low short-term dollar interest rate, has been sustained by carry trade, a technical term that describe a speculative strategy of borrowing short-term in low-interest money markets to invest for gain in long-term high-interest money markets, or to speculate in high-inflation sectors such as commodities. A steep fall in copper, gold and other metal prices in the final week of April 2004 suggested that the two-year boom in commodity markets might be coming to a close, except for oil, whose price is being driven by the second Iraq war and climatic factors.

Hegemony hazards

Copper and nickel each lost more than 5% of their value on April 28, 2004, accelerating a drop that began early in the month. Copper, the most widely used industrial metal, traded at $2,657 a metric ton on the London Metal Exchange, down from $3,100 in late March, having more than doubled from early 2003 until the March 2004 peak. The price collapse was described by traders as blowing off speculative "froth". Nickel, used for making stainless steel, has lost almost 40% of its value since reaching a peak of close to $18,000 a metric ton in early January 2004. The gold price was fixed in London at $386 an ounce on April 28, down from a peak of $428.20 in January 2004. Gold closed in London at $423.45 on October 22. December delivery gold was at $425.60. The growing nervousness in the metal markets stems mainly from China's moves to cool its fast-expanding economy as well as a recent rebound in the dollar, reflecting expectations of higher dollar interest rates. The rebound of the dollar has roiled metal markets because most prices are denominated in dollars and often move in the opposite direction.

Booming demand from China has been blamed for driving the spike in commodity prices since late 2002, with China either overtaking or approaching the US as the world's biggest consumer of materials like aluminum, coal, copper, iron ore and steel. But with fears growing of an inflationary bubble, Chinese authorities ordered banks in late April to curb their rapid rise in lending in overheated sectors. The government has also tightened capital requirements and regulatory approval for investments in aluminum, cement, real estate and steel projects. The State Council, China's cabinet, halted construction of a $1.3 billion steel mill in Jiangsu province as part of an effort to rebalance economic growth. The expansion of China's steel capacity has outstripped its electricity capacity and raw material supply. As China becomes the largest consumer of basic commodities, it would be natural, if it were not for dollar hegemony, for such commodities to be priced in yuan. Euroland consumes more imported oil than any other nation, but the price of oil is denominated in dollars. Iraq under Saddam Hussein was the only oil-exporting nation that denominated its oil in euros, and we all know what happened to Saddam.

The commodity boom of the 21 months between the last quarter of 2002 and the second quarter of 2004 was exacerbated by manipulation of hedge funds and other speculative investors in what is normally among the least glamorous segment of the financial markets, taking full advantage of negative dollar short-term interest rates at 1% between June 2003 and June 2004. An estimated $5.2 billion was raised for exploration and mine development in 2003, more than double the amount in 2002. Another $2.6 billion has been raised so far in 2004. Easy and cheap money, undirected by policy or regulations, seldom stimulates the economy in constructive ways. Markets are singularly without foresight or vision.

Central banks seldom adjust their monetary policies to prevent asset bubbles and related instabilities. The days of the central banker being the person who takes the punch bowl away when the party gets going are long gone. Central bankers now bring stronger drinks when the party slows. In the US, the Fed has served notice that it is prepared to move toward inflation targeting, as suggested by board member Ben Bernanke. Trapped by their past actions, central banks will continue to provide excess liquidity to support asset price bubbles and to mask the destructiveness of burst bubbles by unleashing new bubbles, euphemistically known as recoveries. Instability in the real economy has become a major recurring source of profit for financial institutions.

Dramatic financial shocks caused by the conflict between fixed foreign exchange rates and interest rate swings dictated by economic instability have become recurring phenomena. The Mexican currency crises of 1982 and 1994 were the mothers of international financial crises. The Asian financial crisis that began in mid-1997 had its genesis in Mexico, incubated by a decade of globalization of financial markets. The currency crises started in Mexico first in 1982, hit Britain in 1992 over ERM (Exchange Rate Mechanism), again Mexico in 1994, Asia in 1997, spreading to Russia and Latin America since and finally hitting both the EU and the US in 2000 and the deeper structural financial challenges facing the entire global economy. The crises have been the inevitable result of the Fed, the European Central Bank (ECB) and the Bank of Japan applying their unified institutional mandates of domestic price stability through domestic interest-rate policies that have destabilized the post-Bretton Woods international finance architecture. The common virus was dollar hegemony.

Lessons from Mexico

The Mexican financial crisis of 1982 set the pattern for subsequent financial crises around the world. For that reason, a thorough understanding of the Mexican financial crisis is necessary to understand what lies in wait for China.

To recycle petrodollars that the US printed by fiat to pay for sharply higher oil prices beginning in 1973, US banks had sought out select Less Developed Countries (LDCs) with acceptable political risk, meaning solidly anti-socialist authoritative governments, such as Brazil, Mexico, Argentina, South Korea, Taiwan, the Philippines, Indonesia, etc, for predatory lending. By 1980, LDCs had accumulated $400 billion in dollar debt, more than their combined GDP. This is money they cannot produce through sovereign credit as they cannot print dollars, but must earn dollars through export. This debt bubble was hailed as a miracle of free markets and effectively used as Cold War propaganda against socialist economies. If the socialist economies would only get rid of socialism and export at low wages to earn fiat dollars, they too would enjoy the prosperity of capitalism, god's gift to the poor.

The World Bank reports that after two decades of globalized prosperity, more than a billion people, or one in five living on this earth, still have to survive on less than a dollar a day and more than half of the world's population live on less than $2 a day. China bought this propaganda lock stock and barrel in 1979 with little understanding of the threat of this financial narcotic that would make the Opium War of 1840 look like a minor scrimmage.

Mexico's love affair with neo-liberalism was unraveling by the end of 1982. Neo-liberalism is a socio-economic-political ideology that rejects government intervention in the economy, focusing instead on achieving socio-economic progress through free markets, with emphasis on raising national income as measure by gross domestic product (GDP) statistics. Issues such as income-disparity, impaired national sovereignty, social injustice and environmental damage are considered necessary prices to pay for global prosperity. It is an ideology that is controversial even if successful, but it is a bankrupt ideology that fails even to deliver the prosperity it promises. The record of the past three decades shows that neo-liberal ideology brought devastation to every economy it invaded. China seems to be heading along a similar path.

Impacted by the Fed under Paul Volcker raising dollar interest rates sharply in 1979 to fight inflation in the US, Mexico by 1982 was put in a position of not being able to meet its obligations to service $80 billion in short-term dollar debt obligations to foreign, mostly US, banks out of a GDP of $106 billion at an over-valued peso exchange rate. Debt service payments reached 62.8% of export value in 1979. Exports accounted for 12% of GDP while government expenditures accounted for 11%, which included public-education expenditure of 5.2%. Mexico was paying more in interest to foreign banks than it did to educate its young. Mexican foreign reserves had fallen to less than $200 million and hot money capital was leaving the country at the rate of $100 million a day. Against this background, neo-liberal economists were claiming that poverty was being eradicated in Mexico by "free" trade, a claim they made the world over. China has been praised by neo-liberals for its poverty eradication success in the past two decades, while the reality of a collapse in public education, national health care, public housing and pension systems remains glaringly obvious.

A Mexican default in 1982 would have threatened the profitability, if not survival, of the largest US commercial banks, namely Citibank, Chase, Chemical, Bank of America, Bankers Trust, Manufacturer Hanover, etc. To negotiate new loans in the private sector for Mexico, all creditors would have to agree and participate so that the new loans would not just go towards paying off some holdout creditors at the expense of the others. Many other creditors were smaller US regional banks that had only limited exposure to Mexico and they did not want to "throw good money after bad" merely to bail out the major money center banks.

The big US banks had to lobby the Fed to step in as crisis manager to keep the smaller banks in line for the good of the system, notwithstanding that the crisis had been caused largely by the Fed's failure to impose prudent limits on the large money center banks' frenzied lending to naive Third World borrowers in the previous decade. Furthermore, the crisis was precipitated by Volcker's sudden high-interest-rate shock treatment in 1979, instead of traditional Fed gradualism that would have given the banks more time to adjust their loan portfolios. Third World economies were falling likes flies from the weight of dollar debts with floating interest rates that suddenly became prohibitive to service, not much different from private businesses in the US, except that countries could not go bankrupt to wipe out debt the way private business could in the US.

Third World borrowers had mistakenly figured, with coaching from New York international banks, that the dollars they borrowed would be easy to pay back because of double-digit dollar inflation rate. Volcker's triumph over domestic inflation was bought with the destruction of the Third World economies and the destabilization of the international financial system whose banks had acted like loan sharks in the Third World with Fed approval. The International Monetary Fund (IMF) then came in to take over the non-performing bank loans with austerity "conditionalities" forced on the debtor economies, while the foreign banks went home whole with the new IMF dollars.

As a result, Third World economies, including those in Asia, fell into a dollar debt spiral, having to borrow new dollars from the IMF to service the old dollar debts, being forced by new loan "conditionalities" to forgo any hope of future prosperity. Devaluation of local currencies to compete in export markets made dollar loans more expensive to pay back in local currency terms. Living standards kept declining while dollar debts kept piling higher, leading to even higher unemployment and more business bankruptcies. China was saved from this fate primarily because it went slow in its reform toward market economy and it resisted full currency convertibility.

US banks, while continuing to advocate neo-liberal free trade, market fundamentalism and financial deregulation, were at the same time falling into habitual dependence on government bailouts, both domestically and internationally. US taxpayers were footing the bill the Fed incurred in bailing out its constituent banks through near-limitless liquidity, which contributed to higher inflation, which in turn led to higher interest rates, which in turn intensified the Third World dollar debt spiral, in one huge vicious circle. As if that was not bad enough, dollar hegemony took it one step further. It saps not only nations with dollar debts and deficits, but also economies that earn a dollar trade surplus, by trapping all the dollars surplus in the dollar economy as captured creditors, draining capital from all non-dollar economies. Japan, Korea and China are all victims of this dollar hegemony. Japan, with the world's largest foreign exchange reserves of $850 billion, is saddled with a sovereign credit rating below that of Botswana because it incurred anti-cyclical fiscal deficits financed with sovereign credit. China will not be exempt from such a fate when it makes the yuan fully convertible at floating rates.

By the late 1980s, Mexico had temporarily resolved its dollar liquidity crisis, though not its dollar debt spiral problem, and was able to resume a Ponzi-scheme economic growth, relying to a great extent on rising foreign hot money inflows. To attract more foreign hot money inflows, the Mexican government, coached by neo-liberal market-fundamentalist economists, undertook major economic reforms in the early 1990s designed to make its markets more open to foreign hot money manipulation, to be more "efficient", and more "competitive" - neo-liberal code words for thinly disguised market neo-imperialism. It was a strategy of racing to the bottom and "if you don't smoke, someone else will" approach to export enslavement. These reforms included privatizing state-owned enterprises, removing trade barriers that protected domestic producers, banishing industrial policies, eliminating restrictions on foreign investment and reducing inflation by tolerating higher unemployment to push down already low wages and limiting government spending on social programs. Most importantly, it suspended exchange control and fixed foreign exchange rates and replaced them with free convertibility with floating rates.

This is the strategy that neo-liberals have been trying to lure China into for the past two decades, not without success, albeit the goal line has yet to be crossed. What has so far saved China is its residual commitment to socialist principles, hoping to reap the euphoria of market fundamentalism without succumbing to its narcotic addiction. Yet, every addict begins with the confidence that he/she can handle the drug without falling into addiction.

This was in essence the "Washington Consensus" solution imposed all over Asia in the early 1990s. In effect, it was a suicidal policy masked by the giddy expansion typical of the early phase of a Ponzi scheme. The new foreign investment denominated in dollars was used to provide spectacular returns on earlier dollar investment with the help of central bank support of overvalued fixed exchange rates while neo-liberal economists were falling over one another congratulating themselves on their brilliant theoretical insight and giving one another incestuous awards at insider dinners, collecting fat consultant fees from client banks and governments.

Star academics at Harvard, Massachusetts Institute of Technology (MIT), Chicago and Stanford - multiple snake heads of the academic Medusa - as well as those in prestigious policy-analysis institutions with unabashed ideological preferences that served as waiting lounges for policy wonks of the loyal opposition, busily turned out star disciples from the Third World elite who, armed with awe-inspiring foreign certificates and diplomas, would return to their home countries to form influential policy-making establishments, particularly in central banks, to promote this scandalous game of snake-oil economics. Harvard-educated Mexican president Carlos Salinas de Gortari, and Ernesto Zedillo, a Yale-educated economist who became president of Mexico in 1994, were prototypes. After totally wrecking the Mexican economy, Salinas was expelled from Mexico by his own political party. Zedillo now heads a research center on globalization at Yale.

China by now also has its army of foreign-trained neo-liberal elites, strategically placed in key government agencies and in advanced institutes attached to prestigious academic institutions such as Qinghua University. Every year, sponsored by the IMF and the World Bank, central bankers gather in Washington, housed in luxurious hotel suites served by fleets of limousines, to reassure one another of their monetary magic, communicating ever optimistic prognosis to the befuddled public through opaque press releases couched in cryptic jargon, while the global economy rots in the core. The G7, the club of rich countries, is wooing China to become a member notwithstanding that China's per capital GDP is still only $1,000 and there are still more Chinese living in poverty than the entire G7 population.

The British Example

But even G7 members were not immune to financial crisis. The exchange Rate Mechanism (ERM) crisis of 1992-93 exploded, involving a mismatch between the German mark and the British pound. The ERM was a fixed-exchange-rate regime established in March 1979 as part of the European Monetary System (EMS) to reduce exchange-rate variability and achieve monetary stability in Europe through an economic and monetary union in preparation for the introduction of a single currency, the euro, which was scheduled to be introduced two decades later on January 1, 1999 at $1.15 per euro. After falling below $0.85 in late 2000, and again below $0.84 in July 2001, the two currencies reached parity on July 15, 2002, but the euro fell again below $0.85 in late 2002. During the fourth quarter of 2003, the euro strongly appreciated against other major currencies, 10% against the dollar, 3% against the yen and 1% against the pound sterling. The nominal effective exchange rate of the euro against the currencies of 12 industrialized countries appreciated by about 4% during the same fourth quarter, leaving it at 9% above its inception level. Over the same fourth quarter, while the dollar depreciated by 6%, the yen and the pound sterling both appreciated by about 2% in effective terms.

On May 23, 2003, the euro surpassed its initial trading value for the first time as it hit $1.18, and in the last days of December 2003, the euro even climbed above $1.26, the highest to that date since its introduction. Part of the euro's strength is due to high euro interest rates. The euro traded at $1.26852 on October 24, 2004, while the euro overnight index average (EONIA) was 2.05% against a dollar ffr (Fed funds rate) of 1.75%. But a strong euro by no means spells the end of dollar hegemony. While the EU registers a greater GDP than the US, the dollar economy is still larger by far than the euro economy. This is because offshore euro-dollars are larger in amount than off-shore euros. In fact, the pool of euro-dollars is greater than the pool of dollars in circulation within the US. The major part of derivatives and securitized debts are denominated in dollars.

A unified single currency increases the economic interdependency of EU members that have adopted the euro and facilitates trade within the euro zone with less monetary friction. This works toward a unified market within the European Union. Differences in price levels within the euro zone will decrease. A unified monetary policy set by the European Central Bank does not leave much room for fine-tuning the economic situation in each individual member country, leaving fiscal policy in each country as the only way in which economic trends can be managed specifically for regional or national conditions. This is a structural problem with monetary union prior to political union. The economies of the EU may not all be "in sync", each may be at a different stage in government response to the business cycle, or be experiencing different structural inflationary pressures. Still, the euro adds liquidity to the financial markets in Europe. Governments and companies can now borrow in euro instead of their local currency and can access more sources for funds with less friction and more simplified financial engineering. Pension funds and national savings accounts can participate across national borders in a unified euro market. The EU can benefit from the super liquidity of a single currency, more than the mere sum of single liquidities of separate currencies.

The purpose of the ERM was to stabilize exchange rates, control inflation (through the link with the strong and stable deutschmark) and nurture intra-Europe trade. It was also designed to enhance European world trade in competition with the US, creating a so-called "United States of Europe" and as a stepping stone to a single-currency regime. To a similar extent, Asia can also benefit from a unified currency and free its thriving economies from the penalties of dollar hegemony.

Britain joined the ERM in October 1990 at a fixed parity of 2.95 deutschmark to the pound, an over-valued rate intended to put pressure on the British economy to reduce inflation rather than institutionalizing international trade competitiveness. This same rationale lies now behind the call for China to revalue the yuan. Unfortunately for the British people, the UK Treasury lost some 8.2 billion pound sterling defending the unsustainable exchange rate. This chosen rate, or any fixed rate required by ERM membership, proved misguided because it tried to benefit from the effect of a single currency for separate economies without the reality of a single currency within an integrated economy.

Withdrawing from the ERM released the UK economy from persistent deflation and provided the foundation for the non-inflationary growth subsequently experienced. It enabled monetary policy to be freed from the sole obsession of maintaining an inoperative exchange rate, thus contributing to economic expansion by a combination of rational monetary measures to respond specifically to British needs. While ERM countries were compelled to maintain relatively high real interest rates to prevent their currencies from falling outside the permitted bands, Britain enjoyed the freedom to benefit from lower rates to stimulate a stalling economy.

Hong Kong has been facing the same problems since the introduction of its peg to the dollar in 1983, which created a bubble in its economy dominated by the property sector and in the past seven years, since the 1997 Asian financial crisis, has been plagued with currency-induced deflation and unemployment, and will not recover from economic crisis until its currency peg to an overvalued US dollar is lifted, or until the dollar falls in value beyond its current low to induce another bubble that will inevitably burst again. What Hong Kong did was to buy monetary stability with economic instability. Waiting for an improved economy to justify an overvalued currency is like waiting for death to cure an infection. In the current international finance architecture, there is only one thing worse than an undervalued currency, and that is an overvalued currency. This is why China resists pressure to revalue the yuan while unemployment remains a serious problem.

The appropriate exchange rate of currencies at any particular time is that which enables their separate economies to sustain an interest rate regime to combine full employment of productive resources, particularly labor, with a simultaneous external balance-of-payment equilibrium. An operative exchange rate is not determined by trade balance alone. With a high rate of unemployment and excessively low wages by any standards, China has no reasons to revalue the yuan's exchange rate. What China needs is a national full employment policy with an aggressive wage enhancement strategy. An excessively high exchange rate triggers trade deficits and exacerbates domestic unemployment, which is what the strong dollar has done to the US economy.

A low exchange rate generates an excessive buildup of foreign-currency reserves and creates domestic inflationary pressures that lead to a bubble economy. Overvalued exchange rates require high domestic interest rate. Every nation needs to retain its sovereign right to adjust the external values of its currency in this unregulated global financial market, but an international finance architecture based on dollar hegemony preempts that sovereign right. To be fixated on a fixed exchange rate with free currency convertibility is to court financial and economic disaster in the current international finance architecture.

Chinese monetary conditions are full of contradictions. China has rising foreign exchange reserves, but an overall trade deficit, with a currency pegged to an overvalued fiat dollar backed by debt, while yuan interest rates have been persistently high. China's rising foreign exchange reserves now come not from trade surplus, but from domestic low wages that subsidize high return on foreign capital. China will remain an economic semi-colony until the rise in Chinese wages neutralizes the unwarranted increase in its foreign exchange reserves. For years, the US since the Clinton administration has operated on the doctrine that a strong dollar is in its national interest, using the capital account surplus to finance its current account deficit. Now domestic political pressure is forcing the US government to deal with its twin deficits and the outsourcing of not only low-wage jobs, but increasingly also high-pay jobs.

The US wants to force China to revalue the yuan upward so that the dollar can avoid further devaluation with other major currencies. But an astronomical disparity of wage levels between economies cannot be overcome by an adjustment of exchange rates. China is in a peculiar position of having a booming economy with rising unemployment. That is because the boom comes from shipping wealth out of the yuan economy into the dollar economy. What the US needs to do to reduce its trade imbalance with China is to adopt policies that encourages wage levels to rise in China. The only way to stop job outsourcing is to steadily remove low-wage manufacturing from the global system. For example, tariffs and quotas can focus on wage levels to impose countervailing fees for overseas wages below US minimum wages. Documentation of import quotas can be required to include labor cost data.

Britain's disastrous experience with the Exchange Rate Mechanism (ERM) should be a sobering lesson for China. Since, under ERM, Britain's interest rate was pegged to that of Germany through the fixed exchange rate with a freely convertible pound sterling, reduction in interest rates was not available to deal with increasing unemployment and declining growth in the UK. The fact that Britain lost independent control over pound sterling interest rates, coupled with the questionable independence of the Bundesbank from German national political pressure, was an important factor in Britain's final decision to withdraw the pound sterling from the ERM fixed-exchange-rate regime. Making the yuan freely convertible would be similarly suicidal for China under current circumstances.

The reunification of Germany cracked open the structural flaw in the ERM because massive capital injection from West to East Germany had produced inflationary pressure in the newly unified German economy, leading to preemptive increases of interest rates by the Bundesbank, the German central bank. At the same time, other economies in Europe, especially that of Britain, were in recession and not prepared for interest rate hikes dictated by the German central bank. This interest rate disparity magnified the overvaluation of the pound sterling in the early 1990s. Nominal interest rate disparity between a higher yuan rate and a lower dollar rate has magnified the inflow of hot money into China, even with capital controls and limited currency convertibility. Yet, both real yuan and dollar interest rates are negative in that they are below their respective inflation rates, while both economies still face persistent unemployment problems. For China to raise yuan interest rates under these conditions is to push its lopsided economy into a tailspin.

In 1992, the ERM was torn apart when a number of currencies could not keep within these limits without collapsing their economies. On Black Wednesday, September 16, a culmination of factors allowed George Soros, hedge-fund titan, to break the Bank of England, pocketing $1 billion of profit in one day and more than $2 billion eventually. The British pound was forced to leave the ERM after the Bank of England spent $40 billion in an unsuccessful effort to defend the currency's fixed value against speculative attacks. The money went directly into the pocket of speculative hedge funds rather than helping the pound sterling. The Italian lira also left the ERM and the Spanish peseta was devalued.

Hong Kong's freely convertible currency with a fixed peg faced similar attacks by hedge funds half a decade later. After the Asian financial crisis that first broke out in Thailand on July 2, 1997, the market became less and less confident that if confronted with a choice between counter-cyclical interest rate targets and the fixed exchange rate, the Hong Kong Monetary Authority (HKMA) would necessarily choose the exchange rate. The deflation effects of the overvalued currency were causing much unnecessary pain on the population. The situation launched an open season for currency attacks that broke out predictably and repeatedly after July 1997. After the fourth major attack on the Hong Kong currency in August 1998, which required a $18 billion government "market incursion" to foil, a list of seven "technical measures" was adopted to shore up the peg's credibility, among which a convertibility undertaking would obligate the HKMA to guarantee the dollar value of the clearing accounts of all licensed banks.

This shifted currency risk from the banks to the HKMA. Now if the peg were abandoned, the government would have to make up for losses on at least some of the banks' local currency assets, a commitment enforceable by law. This technical measure substantially increased the cost of de-pegging to the government and raised the pain threshold of the inoperative peg. The economic pain has lingered for seven years with no end in sight, albeit that the recent fall of the dollar has since moderated the pain. Hong Kong's economy has not recovered; it has merely got used to the pain that has been dulled somewhat by subsidies from China. China is protected from contagion from Hong Kong by the fact that the yuan is not freely convertible.

In 1992, to curb German inflation, an increase in German interest rates was necessary, but if the Bundesbank were completely independent of German political-economic interests and behaved truly as a dominant regional central bank, it would not have adopted this policy as there were cries from all over a depressed Europe for decreases in interest rates. By adopting tight monetary policies in response to domestic inflationary pressures that followed German reunification in 1990, German short-term interest rates, which had been rising since 1988, continued to rise, reaching nearly 10% by the summer of 1992. So, at a time when Britain needed a counter-cyclical reduction in interest rates, the Bundesbank sent the interest rate upwards, plunging Britain deeper into recession through the ERM.

This was the fundamental problem with the ERM. Fixed exchange rates for a freely traded currency conflict with the interest rate levels needed by different economic conditions in separate member economies. The British interest rate pegged to that set by the Bundesbank was crippling the British economy because the UK was in a recession and required low interest rates. The prevention of an economic bubble in Germany exacerbated recession in Britain and much of Europe. Another way of looking at it is that the non-German members of the ERM were subsidizing the reconstruction of a united Germany.

Wrong move

China's economy would face a similar whiplash from the Fed's interest rate policy if the yuan were freely convertible. Even with currency control, the Fed's "measured pace" interest rate hike has forced the People's Bank of China to lift its benchmark one-year lending rate to 5.58% from 5.31% beginning October 29 to stay above China's inflation rate, which reached 5.31% in August. Such a timid interest rate increase will have no effect on the overheated export sector, but will be highly contracting for the domestic sectors. The unexpected move appeared to have been taken mostly to appease misguided US pressure. It made no economic sense.

The problem with the Fed is that while it has been a de facto world central bank for the past decade because of dollar hegemony, it does not set monetary policy for the benefit of the world, but only for what it intuitively thinks is good for the US economy. In the past decade, the Fed in fact did not even make monetary policy for the good of the US economy, only the dollar economy. Pushing China to raise yuan interest rates while the yuan is pegged to the dollar will cause problems for other economies whose currencies are also pegged to the dollar, causing interest rates in those currencies to also rise, slowing those economies and destabilizing the region and the world economy.

Anyway it is sliced, a weak dollar adds up to higher inflation in the US, which will push the Fed to raise the dollar short-term interest rate, thus threatening equity prices. To offset a crash in the equity markets, the Fed supplies more liquidity. Dollar liquidity in turn forces other central banks to supply liquidity in their own currencies, pushing global long-term interest rates down and bond prices up. This causes a boom in both bonds and stocks, casting aside the traditional formula that stocks and bonds move in opposite directions. Gravity has not gone out of fashion; it was merely temporarily postponed through acceleration. A slowdown will bring the global economy down in a crash. This is why the world is nervous over the Chinese economy slowing down.

The 1992 ERM crisis was followed by the Mexican peso crisis of 1994-95. The Fed started to raise interest rates in 1994 and sharply curtailed its own purchase of treasury bills, triggering a global bond crash and a subsequent US economic slowdown. Across the border, high dollar interest rates caused a Mexico peso crisis.

Up to the1994 crisis, neo-liberal economists were praising Mexico for doing most things right since the 1982 debt crisis. Government budget had shifted from substantial deficit to surplus, thus no longer draining Mexican private savings, albeit that the social infrastructure of Mexico was left in dire strait. With businesses privatized and tariffs low, Mexico was the poster boy of neo-liberal miracle. The inflow of hot money capital had risen from zero to 5% of GDP. But internal Mexican inflation and the fixed peso-dollar exchange rate had left Mexico uncompetitive in world trade. Mexicans were taking the speculative hot money to finance consumption rather than investment.

The Mexican boom was applauded as a miracle of neo-liberal wealth effect. The Congressional Budget Office Report on NAFTA (North American Free Trade Agreement) calmly diagnosed the Mexican situation as nothing more serious that an overvalued peso. The neo-liberal solution was to devalue the peso by 20% and let the peso then drift gradually downward in an orderly market by as much as Mexican inflation exceeded US inflation in order to keep Mexico competitive, restoring market equilibrium and all would be well. Life turned out very differently.

By December 1994, Mexico ran out of foreign exchange reserves and announced it would suspend the peso's peg to the dollar and let the market determine the devaluation of the peso. But the peso fell like a rock by far more than the 20% that neo-liberals had forecast was necessary to restore equilibrium. Speculators in the market pushed the peso down sharply and abruptly by more than 300%. Foreign exchange reserves had fallen from nearly $30 billion in March, to $5 billion when the decision to abandon the peg was made in December.

The Mexican government bet that the drawdown of reserves was a temporary shock rather than a permanent change in foreign investor/creditor demand for peso-denominated assets. Mexico's economic fundamentals, balanced federal budget, successful privatization campaign, financial liberalization, were "sound enough" in the spring of 1994 to elicit "a strong and unqualified endorsement of Mexico's economic management" from the IMF. According to the neo-liberal doctrine, the only weak link was its overvalued currency. But the market had a better take on reality. Investors/speculators saw that dollar hegemony was destroying the peso economy and everyone wanted to be out of peso.

Part of the Mexican government's strategy for retaining confidence in its stable exchange rate throughout 1994 was to replace conventional short-term borrowing with the infamous "Tesebonos", a short-term security whose principal was indexed to the dollar, as a means of retaining the funds of investors who feared bottomless devaluation. This policy did retain some $23 billion of foreign financing but it fatally increased Mexico's exposure to foreign exchange risk. What in effect happened was that $23 billion stayed in Mexico, but left the peso economy for the dollar economy. The ultimate irony was that much of the $23 billion belonged to Mexicans.