China debate needs historical perspective

Central bank reserves probably generate more confused and mistaken thinking than any other topic in economics. A case in point is the recent controversy between hedge fund manager Jim Chanos and New York Times columnist Thomas Friedman, in which Friedman proposed, yet again, a common misconception over the meaning of China's huge accumulation of foreign reserves. Chanos, a successful hedge fund manager who has made his reputation - and fortune - by identifying and shorting seriously overvalued assets, most famously Enron, started the argument three weeks ago when he claimed that China is undergoing a speculative bubble that makes it the equivalent of 'Dubai times 1,000 - or worse'. Freidman, the columnist best known for his writings on globalisation, responded to Chanos insisting that it would be impossible to make money by shorting China. 'First,' he warned, 'a simple rule of investing that has always served me well: Never short a country with US$2 trillion in foreign currency reserves.' Really? Friedman proposed the rule sarcastically - as both untestable and too obvious to need testing - but it turns out that reality is not as obvious as he imagines. China's foreign reserves are certainly huge. They add up to an amount equal to about 5 per cent to 6 per cent of global gross domestic product. But they are not unprecedented. Twice before in history a country has, under similar circumstances, run up foreign reserves of the same magnitude. The first time occurred in the late 1920s when, after a decade of record-beating trade and capital account surpluses, the United States had accumulated what John Maynard Keynes worriedly described as 'all the bullion in the world'. At the time, total reserves accumulated by the US were more than 5 per cent to 6 per cent of global GDP. The second time occurred in the late 1980s, when it was Japan's turn to combine huge trade surpluses, along with more moderate surpluses on the capital account, to accumulate a stockpile of foreign reserves only a little less than the equivalent of 5 per cent to 6 per cent of global GDP. Needless to say, and in sharp rebuttal to Friedman, both previous cases turned out badly. During the Depression of the 1930s, US stock markets lost more than 80 per cent of their value, real estate prices collapsed, and the US economy contracted in real terms by an astonishing 25 per cent. Japan's experience was economically less violent in the short term, but even costlier over the long term. During the subsequent period, its stock market also lost more than 80 per cent of its value, real estate prices collapsed, and economic growth was virtually non-existent for two decades. The idea that massive levels of reserves are a guarantor of economic stability is, in other words, based on a profound misunderstanding both of history and of the nature of reserves. Reserves protect countries from external debt crises and from currency crises, but these are no more the risks faced by China today than they were the risks faced by the US in the late 1920s or Japan in the late 1980s. In fact, it was the very process of generating massive reserves that created the risks which subsequently devastated the US and Japan. Both countries had accumulated reserves over a decade during which they experienced sharply undervalued currencies, rapid urbanisation, and rapid growth in worker productivity. These three factors led to large and rising trade surpluses which, when combined with capital inflows seeking advantage of the rapid economic growth, forced a too-quick expansion of domestic money and credit. It was this money and credit expansion that created the excess capacity that ultimately led to the lost decades for the US and Japan. High reserves in both cases were symptoms of terrible underlying imbalances, and they were consequently useless in protecting those countries from the risks those imbalances posed. We must be careful how we read history. The fact that the US and Japan had terrible decades following periods during which they had amassed levels of reserves that China has subsequently matched, and under conditions similar to those of China, does not necessarily mean that China too must have a lost decade. But it does indicate that facile statements about central bank reserves should, at the very least, be measured against the obvious historical precedents. Chanos might still lose this debate, but Friedman has already proven himself to be hopelessly wrong. Michael Pettis is a professor of finance at the Guanghua School of Peking University and a senior associate at the Carnegie Endowment