Global Financial Markets

Coursework

Edinburgh Napier Number: 40271739

Submission Date: 13th March 2020

Word Count: 3,000

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Table of Contents
Table of Contents 1

Introduction 2

Does the financial crisis mark the beginning of the end for the “Chimerica relationship”? 3

Why has the Chimerica relationship developed? 3

What advantages and disadvantages does the relationship bring to both parties? 3

What incentives do either side have in ending the relationship? 4

What steps are both sides taking to end the relationship? 5

What are the future economic prospects for both countries over the next decade? 6

Does the Chinese RMB need to be revalued upwards against the dollar? 8

Does the RMB need to be revalued? 8

Why has the value been suppressed? 8

Fears of another Japan 9

Potential consequences of revaluation 9

Is it in US or in Chinese interest to revalue the RMB? 10

Conclusion 11

References 12

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Introduction
Chimerica is a neologism first used by Niall Ferguson and Moritz Schularick to describe
symbiotic economic relationship of US over-consumption funded by Chinese over-saving of
the last two decades (Piatkowski, 2011).

Niall Ferguson later said that “Chimerica is the real engine of the world
economy” (Bernstein, 2009, p.2) and it is easy to see why. Today, Chimerica represents
around quarter of the world’s population (Piatkowski, 2011) and around 40% of the world’s
GDP (Fergusson & Xu, 2018). But since Trump election, the US has taken an anti-Chinese
turn (Fergusson & Xu, 2018) and is fuelling the trade war in hope to delay the world order
changing from unipolar system with the US as its centre to bipolar system with China
occupying the other pole (Leonard, 2012). Mike Pence even labelled China as trying to
advance its influence at the expense of the US and the international order (Lee, 2019).

The rise of China is largely attributed to its competitive advantage created by currency
undervaluation. Productivity-adjusted production in China is 40 percent cheaper than a
decade ago, but the consequences of the exchange undervaluation have become too big for
the world economy to bear (Ferguson & Schularick, 2009).

This report will critically discuss two main questions:

1) Does the financial crisis mark the beginning of the end for the “Chimerica
relationship”?
2) Does the Chinese RMB need to be revalued upwards against the dollar?

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Does the financial crisis mark the beginning of the

end for the “Chimerica relationship”?

Why has the Chimerica relationship developed?

During the 1970s and mainly during 1980s, progressive deregulation and globalisation of the
financial markets created a large demand for credit in the United States (Fabre, 2009). Global
savings were flowing into the country and profits soared, whilst China was beginning to
embrace foreign trade and foreign direct investment (Ferguson & Schularick, 2009), which
was highlighted by its admission to the World Trade Organisation in 2001. Since renminbi
revaluation in 1994, multinational companies started relocating the production to China to
take advantage of low labour costs (Ferguson & Schularick, 2009) and China quickly became
the largest manufacturer in the world. In order to retain the competitive advantage, Chinese
government kept buying dollars to avoid appreciation of their currency and this resulted in
growing distortion of global cost of capital. When interest rates were meant to rise by
integrating China into the world economy, they fell instead and American household
consumption went through the roof. And it was bankrolled by Chinese savings.

What advantages and disadvantages does the relationship bring to

both parties?

Ferguson & Schularick (2009) described Chimerican relationship as match made in heaven.
And it is hard to disagree when looking at the numbers: Chinese GDP quadrupled between
2000 and 2009, the US outspent its national income by 45% in the same period and goods
from China accounted for about a third of it.

For China, trade relationship with the US was crucial to the export-led growth that was
unprecedented even for emerging economies. Fabre (2009) estimates that during early 2000s,
external demand was either directly or indirectly responsible for at least 40% of China’s
growth that made China the largest manufacturing economy in the world and created tens of
millions of manufacturing jobs for the rural poor (Ferguson & Schularick, 2009). But this
made China very dependent on the US demand and limited the efficient use of resources.

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China has accumulated nearly $4 trillion reserves by 2014 (DBS Group Research, 2017) as a
result of current account surplus and currency intervention that could have been put to better
use.

For the US, global savings were necessary to feed the credit consumption and financial
services firms that became a major contributor to the GDP. US firms that relocated their
production to China have enjoyed large profits but today, around one-third of Chinese
products imported to the US are part of the supply chain for US-based firms making them
vulnerable, e.g. Amazon does not manufacture any Kindle components in America(Lee,
2019).

What incentives do either side have in ending the relationship?

Number of economists have spoken out that the Sino-American relationship is unsustainable,
and more specifically, Chinese academic Shi Yinhong describes the two countries to bring out
the worst in each other (Leonard, 2012).

Garret (2013) argues that China should become less reliant on exports and rather focus on
supporting growth in domestic demand. Piatkowski(2011) supports this by highlighting that
Chinese GDP per person is below 1/10th of US which provides large scope for catching up. It
is also assumed that the American demand will not return to the levels seen before 2008 and
China should look for opportunities elsewhere (Leonard, 2012).

German Finance Minister Peer Steinbrueck came out with a prediction that the US will lose
its status as the superpower of the global financial system (Garret, 2013). Apart from supply-
chain reliance mentioned in previous section, the US is wary now that China supplies
microchips that keep cars on the road and planes in the air (Rennie, 2019). Ferguson and Xu
(2018) highlight that the Chinese determination to keep their foreign exchange reserves and
continuous intervention in the RMB exchange rate made the relationship increasingly
intolerable to the US.

However, it is highly unlikely that Chimerican divorce would be civil. Both sides will need to
realise that it would not only hurt China and the US but the entire global economy (Ferguson
& Xu, 2018).

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What steps are both sides taking to end the relationship?

Continuing the analogy from previous section, Leonard (2012) compared Chimerican divorce
to one between abusive couple who hate and need one another at the same time.

China has taken steps to lower the bilateral trade imbalance with the US (Rhode, 2019) and
by appreciating the yuan against the dollar, the US current account deficit fell by $300 billion
(Ferguson & Xu, 2018). China is mitigating against the drop in the US demand by looking
for non-western markets and investing in companies and assets outside the US (Leonard,
2012). This will likely mean slower growth but eventually be a positive move towards a more
balanced economy. Whilst looking to substitute the exports, China is beginning to resemble
the US (Ferguson & Xu, 2018). Household consumption is quickly rising to the forefront and
becoming the driving force of the Chinese economy. To stimulate domestic demand, in first 6
months of 2009, China pumped 10 trillion renminbi into domestic construction and
infrastructure (Ferguson & Schularick, 2009). And by the end of 2017, SMEs accounted for
75% of urban employment (Ferguson & Xu, 2018). Further initiatives such as ‘Made in
China 2025’ look to make China 70% self-sufficient by 2025 (Lee, 2019) in an ambitious
strategic shift from manufacturing to technology-intensive higher-value products and services
which were previously domain of foreign companies, mainly in the US.

The US started to implement more aggressive approach to commercial relations with China
(Rhode, 2019) such as confronting China’s trade policy and blocking a range of inward
investments on national security grounds that are mainly aimed at China. Lee (2019) further
backs this using example of Huawei that got excluded from 5G networks in the US, Australia
and New Zealand. Since Trump took office, US imposed tariffs of 30% on solar panels and
washing machines, 25% on imported steel, 10% on imported aluminium to widen the rift
between China and the US as some American allies were exempted from these tariffs
(Ferguson & Xu, 2018). And the US hasn’t stopped there, amid the espionage fears, it
decided to add fuel to the fire by tightening the visa rules for science and technology students
from China (Rennie, 2019). Ironically, the US is becoming more Chinese.

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What are the future economic prospects for both countries over the
next decade?

The next decade presents number of challenges for each country in its own backyard and on
the global playing field as well. China is no longer a passive lender or manufacturing factory
for the US, China has become a strategic competitor that is willing to replace the US on top
of the world leadership (Ferguson & Xu, 2018).

China has to continue moving towards more balanced economy and avoid stagnation and
deflation that happened to Japan in the 1990s as a result of moving away from export-growth
model (Piatkowski, 2011). China started importing US expertise (Tinker, 2017) to continue
reform and development of the financial sector but in doing so, the economy became reliant
on easy money and prone to bubbles (“The return of Chimerica,” 2013). But following the
burst of the stock bubble, Chinese government decided to devalue the yuan in August 2015
(Ferguson, 2015) which sparked criticism. In order to continue the growth, China has to
address the issues with ageing population and environmental pressure - 16 out of 20 most air-
polluted cities are in China (Piatkowski, 2011). One way to do this is to open the economy to
foreign and private competition that are proven to increase productivity.

The US, on the other hand, has to focus on rebuilding their savings and strengthening the
financial system that caused the longest recession since the Great Depression (Fergusson &
Xu, 2018). Piatkowski (2011) argues that future development of the US lies in addressing the
long-term fiscal problems, low quality of basic education and military overstretch. The US
has been fighting on many fronts for too many years and as Kim (2016) put it, the US “pivot
to Asia” cannot last due to astronomical costs.

The Sino-American tension is reminiscing of Cold War, but whilst Soviet Union was an
ideological rival, China is a commercial one as well. Bilateral trade between US and China is
$2bn a day compared to $2bn a year in case of Soviet Union (Rennie, 2019). And whilst both
Xi and Trump want to avoid market disruptions (Rhode, 2019), the propaganda on either side
as evidenced by US film poster Death by China displayed below is not helping.

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2008 financial crisis was meant to mark the end of Chimerican relationship but in 2017, the
US trade deficit with China climbed to its highest level on record (Ferguson & Xu, 2018). It
looks like the relationship is certainly turning sour but both sides realise that they need each
other so the global economy can prosper.

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Does the Chinese RMB need to be revalued upwards

against the dollar?

Does the RMB need to be revalued?

Chinese renminbi (RMB) has become the second most used currency in global trade and
finance in the world (Hu, Li, Yang & Chao, 2016). Hu et al (2016) argue that stable exchange
rate is desirable to attract foreign investment and limit local capital going abroad. However,
common perception is that the RMB is undervalued but the numbers range from 0 to 50
percent (Ferguson & Schularick, 2009). These estimations are mainly based on labour costs
and Ferguson and Schularick (2009) support this with a statistic from 2008, when the Chinese
wages were 4% of the US rate, but the productivity was 20% of the US rate. On the other
hand, DBS Group (2017) argues that the assumption that China pursues a weak currency
policy might be wrong when considering mid-2014 oil prices plunge when euro and yen fell
by over 20% but dollar and yuan took off. In fact, between 2005-2017, RMB appreciated by
48% in real inflation-adjusted terms. Considering the average USDRMB exchange rate went
from 8.192 in 2005 to 6.831 in 2009, it had very little effect on the amount of trade surplus
that continued to expand (Peng, Liou, Yang & Yang, 2018). Athukorala and Yamashita (2009)
explain this by China’s role as the final assembly centre for global production.

Why has the value been suppressed?

It was in China’s interest to set a weak exchange rate for the RMB. By pegging it against the
US dollar at the rate of 8.7RMB per US dollar in 1994 and not moving it until 2005, China
has managed to create an unfair advantage in world trade (Peng et al., 2018). Since
productivity gains were not reflected in the exchange rate, Chinese economy was attractive to
foreign investors and production was relocated to China to exploit the lower costs (Ferguson
& Schularick, 2009). China is able to manipulate markets and distort the competition, as there
is a lack of separation between political and economic agencies (Lee, 2019) and it is clear
that China is looking after its own interest first even if it is at the expense of other market
participants. Lastly, China will be looking to assert its influence on global financial market

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and one way of doing so is keeping the value low to make assets priced in yuan more
attractive.

Fears of another Japan

Traditional emerging economies tend to run trade deficits and rely on foreign loans to pay for
excess imports until the flow of funds dries up at which point currency reserves kick in (DBS
Group, 2017). However, China was running trade surpluses for more than 2 decades and their
net debt was negative which meant their foreign reserves were constantly increasing,
reaching nearly 4 trillion dollars in 2014 (DBS Group, 2017).

China fears they would follow the fate of Japan if yuan appreciated rapidly against the dollar.
Frankel (2015) discusses the conspiracy theory that the US deliberately sabotaged Japanese
economy at the Plaza in 1985. Most common version is that devaluing the dollar against the
yen made the yen too strong and priced Japanese manufacturing out of world markets.

Williamson (2011) argues that the appreciation of the yen hasn’t caused the long period of
stagnation in Japan. Following the appreciation, asset prices rose sharply but the Bank of
Japan did not adjust its policy quick enough (Obstfeld, 2010). Williamson (2011) goes on to
blame the banks that pretended to be solvent after the bubble burst and deprived the growth
generating enterprises of capital.

Potential consequences of revaluation

Revaluation upwards against the dollar can result in a loss of competitive advantage for
China. If the costs of production rise, the foreign investment may slow down or even stop as
exporting from China to US and Europe may become too expensive.

On the other hand, revaluation upwards can help China on its way to more balanced economy
as the focus would shift from exports to domestic market demand as imports would become
cheaper (Morphy, 2005).

Interesting point raised by Williamson (2011) was the potential effect of revaluation on
Chinese agriculture. Agriculture forms the most peasant income and therefore it is very

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sensitive to drops in prices that would inevitably result from revaluation. Since the income
distribution is already high, this is highly undesirable outcome.

Is it in US or in Chinese interest to revalue the RMB?

It is needless to say that the US has most to gain from revaluation of the Chinese RMB.
Because of the de-facto fixed exchange rate, the dollar wasn’t able to devalue against the
RMB despite astronomic trade deficits (Ferguson & Schularick, 2009). As such, economic
growth has to be stimulated in domestic markets through fiscal and monetary policies, such
as spending on infrastructure and expansion of money supply respectively. Appreciation of
the yuan means depreciation of the dollar. When currency is devalued, exports become more
attractive to foreign markets and therefore demand does not have to depend on domestic
consumption only. Therefore, export can once again be a substantial contributor to the US
economic growth.

China, on the other hand, could also benefit from the appreciation of the yuan. Due to the
amount of reserves held in US dollars, Chinese are very dependent on policy choices of the
US as that is the main determinant of the value of the USD (Ferguson & Schularick, 2009).
At present, China holds about $3 trillion in currency reserves that could be used to boost the
domestic use should the revaluation be allowed (Williamson, 2011). Hu et al. (2016) suggest
that the side effect of the People’s Bank of China’s constant currency intervention may be a
further rise in the inflation rate which has already been quite high since 2010.

There is, however, a common interest in revaluation of the yuan for both, the US and China.
Both countries are interested in reducing the bilateral trade deficit (Ferguson & Xu, 2018) on
the road to reduce the friction between the two superpowers. Since 2008, China have made
concessions to keep the mutually beneficial relationship going but by depreciating yuan
between 2014-16, it sent a clear signal that it is not ready to let the yuan float with the market
forces.

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Conclusion
The symbiosis of Chimerican relationship was built on mutual advantages that each side
brought to the table. China was allowed to grow their economy through exports and the US
had access to cheap credit from Chinese savings. In the process of overdosing on debt,
America allowed China to overtake them as the world’s biggest manufacturer and China is
set to overtake the US in terms of GDP by 2027.

The 2008 financial crisis was meant to mark the beginning of the end of this relationship, and
for a while it even looked like it. RMB appreciated against the dollar, US current account
deficit fell by $300bn and both countries focused their stimulus plans on domestic recovery.
But as soon as the markets started recovering, the US trade deficit with China climbed to its
highest level on record in 2017.

But the relationship transitioned from trade partners to strategic competitors, where China
wants to replace the US as the world leader and the relationship is becoming more and more
unsustainable. Resulting trade war may impact the whole world but both sides are aware that
they will need to work together in some shape or form. Garret (2013) summed this up as:
“few global problems can be solved by the US or China alone. And few can be solved
without the US and China together”.

The fate of the relationship will also depend on the Chinese actions in relation to the
exchange rate of the RMB. Economists estimate that the RMB is undervalued by 0-50 per
cent. Following the decline of Japan and its lost decade following the yen appreciation, China
is trying to keep the RMB stable and despite making some concessions, the RMB remains
very much a managed currency.

The revaluation upwards would certainly benefit the US, however, there are arguments that
suggest China could also reap benefits of the RMB appreciation. Maybe one day, yuan will
move freely with the market forces, but today, China is not willing to risk further widening of
social inequalities that could result from revaluation as this could further fuel the aspirations
of its citizens for emergence of democracy (Piatkowski, 2011).

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