Column : The US?s expansionary monetary policy

Chinese economist Xu Hongcai alleges that the US has a unique ?wealth-generating mechanism? since it has the exclusive privilege to increase money supply of dollars, the world?s reserve currency. He contends that an expansionary monetary policy by the Fed, subsidises the US to the detriment of other countries, particularly China. It?s a widely known fact that China has now become the production base for US manufacturing. A lesser known fact is that China has also become the de facto banker to the US. The US uses dollars to purchase cheap goods from China and, in turn, China exchanges these dollars with US Treasury bills. This process forms a bilateral circulation of commodities and currency.

The circulation of goods and dollars between China and the US is operated through the financial markets since a significant percentage of China?s savings is transferred to the US through its investment in Treasury bills. Currently, China holds $1,150 billion of Treasury bonds and notes. If Taiwan and Hong Kong are included, that figure rises to $1,440 billion. To get a sense of how big that number is, India, in comparison, holds $40 billion of US Treasury instruments, which is about R2 lakh crore. In other words, China has lent about 25 times more money than India. The US has used this money, in part, to successively purchase goods from China and suppress domestic inflation. In the last decade, the US has increased its external borrowing since it has an unsustainably large fiscal and current account deficit. Last year, the US government spent $1,550 billion more than it earned and it imported $634 billion worth of goods more than it exported. To pay for both of them, it has resorted to external debt since the US saves little as a country.

To finance its fiscal and current account deficit, the US has a ?free meal? at the expense of other countries. This unique wealth transfer mechanism happens through dollar depreciation. To understand how dollar depreciation benefits the US on its external debt, consider the following example. Let?s say I borrow $100,000 today for two years, which at the current exchange rate of $/R 44.00 would be worth R44 lakh. Suppose, in 2013, when the dollar debt has to be returned, the $/R exchange rate depreciates to 39.00, I have to pay back only R39 lakh. It is the same ?free-lunch? that companies like Reliance are hoping to have by issuing long-dated dollar bonds. For example, Reliance raised $1.5 billion (around R6,600 crore) in October 2010 from its bond issuance denominated in US dollars, of which $1 billion matures in 10 years and the remaining $0.5 billion in 30 years. If the $/R exchange rate depreciates big-time in the next decade, which seems pretty likely, the company will gain substantially from the reduced value of debt. A similar windfall, but on a much more massive scale, is accruing to the US government. To fund its external borrowing, it follows an expansionary monetary policy by increasing money supply and buying back its own debt. This has resulted in a large supply of dollars in the world economy, which should, in the long-run, cause significant dollar depreciation.

So, what can be done by China to offset the free meal that the US seems to be serving itself, by taking advantage of the reserve currency status enjoyed by the US dollar. First, China should let go of the artificially low exchange rate of the renminbi (RMB). China could accelerate the internationalisation of the RMB by allowing it to appreciate, even though it might hurt its exports in the short run.

Second, China needs to gradually get rid of its dependence on the US economy by shifting its economic strategy from export-driven to domestic demand-driven. Third, China needs to stop being a banker to the US and diversify its foreign currency assets. It should ease capital controls for its residents and businesses so that the private sector can play a stabilising role. Most importantly, China needs to gulp its ego and seek India?s assistance in reforming the international monetary system. India stands to lose if the US continues with its policy of flooding the market with dollars, even though considerably less than China. Therefore, it may be a ?win-win? proposition for India to cooperate with China. If they were to come together, they would have sufficient clout to make the US act more responsibly and block the US from monetising its debt. The future leaders of the global economy need to get their act together to call the bluff of the incumbent. Else, the US will continue to take advantage of this unique wealth transfer mechanism to have its free meal.

The author, formerly with JPMorgan Chase, is CEO, Quantum Phinance