Why China wants a well-deserved “tax break”

• Source: Global Times
• [22:35 August 05 2009]
• Comments

By Stirling Newberry

The fear in international markets now, with appetite for risk returning to markets, is that the dollar will tumble.

If that happens, then China, as the holder of dollars, might suffer from another “Shanghai Surprise,” a brutal sell-off of assets, and a shock to the large holdings of dollars. China is not alone in this fear: Japan’s next government is likely to diversify out of the dollar as well.

The latest round of fears was sparked by US Treasury Secretary Tim Geithner’s refusal to promise no tax increases on families making less than $250,000. For other nations watching US fi scal progress, this was hopeful, but in Washington this was seen as breaking a promise, which Ruth Marcus of the Washington Post called “toxic” to Obama’s reelection hopes.

Suddenly dollar holders were back to watching the administration do damage control as Press Secretary Robert Gibbs backtracked on Geithner, but then had to backtrack himself on paying for healthcare reform. Which was it, they thought? Will the US pay for domestic programs with taxes, or hope to borrow again?

For countries trapped in the dollar as a reserve currency, it was another stomach turning moment out of many.

But how did China get into this trap? Because in the 1990s being short of dollars exposed developing nations to the potential of a financial crisis if investors fled. Under Bill Clinton, the policy of the US government was dollar drought. In 1997 and 1998, even healthy economies were caught in what came to be called the Asian Panic.

George W. Bush, however, had different priorities. He wanted a massive tax cut for the upper brackets of Americans, and a war in Iraq. He did not want to pay for this with spending cuts, nor with inflation, but by devaluing the dollar. His advisors, like Alan Greenspan and Ben Bernanke, told him, correctly, that if the US printed dollars, then other nations, particularly developing nations, would have to buy.

Some countries, such as Saudi Arabia, could raise the price of the goods they sold. That’s why the price of oil kept going up. Although the dollar was getting weaker, and hurting Saudi dollar holdings, they had a knob that they could turn. Other countries, like China, didn’t have this option and so had to buy dollars, but coundn’t raise their products’ price.

In 2000, according to the IMF, the industrialized nations and the developing nations had roughly equal foreign exchange: slightly more than half a trillion dollars. By 2009, developing countries held double the developed countries: 1.5 trillion for developed countries, and 3 trillion for developing countries.

Developing countries basically stopped buying dollars in early 2004, while developed nations accelerated their purchases. With smaller GDPs, that meant that far more of their national effort went to buying dollars, and developed countries have been hit far harder by the devaluation of the dollar. They had to buy to protect against currency crisis, and keep their currency close to the dollar to avoid competitive disadvantages and attract investment.

In effect, the dollar devaluation became a tax on developing countries for access to the US market, and to global investment. US companies moved industrial production to developing countries, but in return, those countries had to finance US consumers with higher oil prices, and reserves fixed in US Treasuries.

The other side of the tax was paid by US manufacturing workers, who lost their jobs and benefits. The people who collected the tax were US banks, with large illusory profits, and the US government in pursuit of its war in Iraq.

US consumers and bankers grew fat, and now, there are increasing calls to put them on a diet. The holders of dollars want someone else’s stomach to do the heavy lifting for a change.

So if you want to know why China, Russia, and other developing countries are agitating to move off the dollar as the world’s reserve currency, and realize that for the last 10 years, they have paid a tax, and for the last fi ve, a tax that has been more on them than on developed nations.

When Zhou Xiaochuan, the governor of China’s central bank, pushes for a global currency that is more distributed, Americans should recognize what motivates him: he, and China, and other developing nations, want a tax cut.

The author is a US macroeconomist specializing in the study of currency basis and financial volatility. He can be reached via stirling.newberry@gmail.com