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A Chinese Scholar on China’s Financial Security Strategy

[Editor’s Note: Economic Information, a publication under Xinhua, published a research paper on China’s Financial Security Strategy. The author, Jing Naiquan, is an Associate Professor in the Finance Department of Zhejiang University and is Director of the China Gold Investment Institute. In his paper, Jing stressed that China should insist on the managed floating exchange rate system and diversify its reserve holdings into gold. He offered the theory of the “U.S. dollar’s three privileges” and suggested that this theory be used to counter U.S. pressure on RMB appreciation and that the U.S. be asked to lift its ban on high-tech exports to China. He also outlined 13 measures to improve financial security. The following is a translation of the article.] [1]

After 30 years of the reform and opening up policy, China has realized great achievements in economic development, but has also paid a huge price for these achievements. We face many, very complicated issues, such as an economic transformation bottleneck, environmental pollution, a waste of our resources, a housing bubble, work-related disabilities, an increased gap between the rich and the poor, inflation, corruption, and international containment.

China’s current economic situation as a whole is good, but China’s economic and financial security still faces many unprecedented risks and difficulties. The large number of loans issued in the past couple of years has put too much capital into the virtual economy and has led to asset bubbles, causing the banking system to face increased risks. Inflationary pressure is clear and there is less room for monetary policy adjustments. The real estate bubble negatively impacts macroeconomic growth. International trade disputes are increasing, and pressure for RMB appreciation is intensifying.

In order to have an accurate understanding of the issues related to China’s economic and financial security in the current complicated international economic situation, we need to first analyze the main characteristics of today’s economic and financial situation.

Eight Characteristics of the Post-Crisis Era

From the macro economic viewpoint, using an in depth analysis, we can identify eight characteristics of the post-crisis international economic and financial situation. These eight characteristics present the difficulties, opportunities, and overall trends for China’s economic and financial security.

1. The trend of technological innovation and a low-carbon economy

A low-carbon economy and technological innovation have become symbols of today’s trend. They are the important goals for global economic and industrial restructuring. They have provided new opportunities and challenges for China’s economic transformation. They have also provided China’s financial sector with new services and product innovation fields.

2. Decentralization of global institutions’ discourse right. [2]

The root cause of China’s disadvantage in international trade and its many international issues is its lack of say in global institutions. As the international status of China, India, and other emerging economies increases, the discourse right within global institutions and organizations is becoming decentralized.

3. Normalization of friction and conflict in international trade

With the increase in economic and financial globalization and the expansion of international trade, international trade friction has become the norm. At present, trade friction between China and the U.S., the European Union, Japan, and other countries is increasing, which will have a negative impact on China’s exports and overall economy.

4. A pendulum cycling between inflation and deflation

The flood of U.S. dollars and the Federal Reserve’s continuous “low interest rate” monetary policy have affected the transition from deflation to inflation. Now inflation and deflation are like a pendulum (swinging from one extreme to the other). In the first half of 2009 the global economy was in deep deflation and economic recession; by the end of 2009, as the economy began to recover, the world faced obvious inflationary pressure.

5. A preference for not having the U.S. dollar as the super-sovereign currency

In 2009, the U.S. stimulus plan of over $U.S. 700 billion and the $U.S. 1.42 trillion fiscal deficit eased the U.S. recession, but the two rounds of quantitative easing with hundreds of billions of dollars have weakened the U.S. dollar. As a super-sovereign currency, the U.S. dollar is gradually losing its dominant position as a reserve currency. Because most of China’s foreign exchange reserves are in U.S. dollar assets, the preference for not using the U.S. dollar will result in direct losses to China’s foreign exchange reserves. This adds more risks and difficulties to China’s huge foreign exchange reserves and their management.

6. Asset bubbles caused by international capital investment

In recent years, once a huge amount of international hot money sets its eyes on certain assets, such as real estate, oil, or gold, the prices of these assets will bubble. Asset bubbles will lead to an irrational exuberance in a country’s economy, which seriously threatens the security and stability of the country’s economy. The U.S. subprime mortgage crisis and the Asian financial crisis are two good examples of the dangers of asset bubbles. Currently, China’s real estate market is experiencing a rapid increase in prices.

7. Losing morality in financial innovation and regulation

The financial crisis has prompted many countries’ regulatory authorities to take strict measures, but these measures are based on each country’s own national interests; they are self-serving and without consideration for their economic and financial impact on other countries. When markets are booming, financial innovation also focuses on maximizing their own interests.

8. Gold serving as monetary reserves or non-monetary reserves

During the financial crisis, gold has been highlighted. As a reserve asset, gold is used as a non-monetary reserve during normal times, but also serves as hard currency during times of economic recession, crisis, or war. China should take full advantage of gold’s dual uses to increase gold reserves and increase our financial system’s capability of handling risks.

Five Principles to Get the Current Political Situation under Control

As the economic and financial situation around the world becomes more complex and volatile, China is encountering more and more opportunities and challenges. In my view, China should always give top priority to its own national economic and financial security while dealing with international economic and financial issues. We should adhere to five principles: the political, economic, social, international, and independent principles, which are all related to national economic and financial security.

1. The Principle of Political Stability

International politics is the concentrated expression of the interests between countries. We should give top priority to China’s overall interests. When we play a game with developed countries, we should pick the options in both political and economic policies that are best for China.

2.  The Principle of Economic Equality

Conflicts in international trade are becoming more common. While we insist on trade equality and reciprocity without initiating any trade conflicts and disputes, we are not afraid of conflicts and disputes. Once trade conflicts and disputes occur, we should resolutely fight for the economic benefits that conform to our country’s status.

3. The Principle of Social Harmony

The social harmony principle mainly refers to the harmony and stability of China’s own society and its relationship with other countries. It includes three areas: the harmonious and stable development of China’s own society, the harmonious and stable development of the countries with close ties to China, and the harmonious and stable development of relationships between China and other countries. Harmony has different levels. It is an ultimate goal but also a path and a process. The first concentric circle is the harmony and stability based on China’s overall interests; the second concentric circle is the harmony and stability of the countries about which China cares the most when it adjusts its policies; and the third concentric circle is the interests of other countries.

4. The Principle of International Collaboration

With the development of globalization, China has gradually stepped onto the world stage. China’s problems have become the world’s problems, and vice versa. China’s domestic fiscal and monetary policies affect other countries’ policies, and China is also affected by other countries. Thus, we should consider our national financial security issues from an international perspective so as to make China’s domestic policies consistent with its foreign policies.

5. The Principle of Monetary Independence

The principle of independence mainly refers to the independence of China’s national monetary policy. In the current international economic and financial situation, upholding the independence of our domestic monetary policy is an important prerequisite for China in striving for steady and rapid economic development, and a key protection mechanism for China to resist international economic shock.

The Financial Safety Valve – a Managed Floating Exchange Rate

The managed floating exchange rate system is China’s economic and financial safety valve. When the Chinese economy faces a great deal of pressure from home and abroad, China can regulate the exchange rate and moderately loosen restrictions on capital accounts to alleviate this pressure. Exchange rate adjustment and capital account liberalization are thus the two components of the “safety valve,” which can appropriately adjust the economic and financial pressures and shocks that China faces in certain periods of time. This can help China avoid the dramatic impact of international idle funds and prevent an excessive influx and outflow of international hot money, thereby protecting the stability of the financial system. It allows China to maintain the independence of its monetary policy and safeguard China’s politics and economy as it deals with the developed countries.
Release the Pressure on RMB Appreciation – “Three Privileges of the U.S. Dollar”

The “three privileges of the U.S. dollar” is a new theory I proposed in the academic area. Since the U.S. still plays a decisive role in the international political and economic arena, most of the influence on China that comes from the international economic and financial world is from the U.S. The dollar gives the U.S. more privileges than other countries in three areas.

First, the U.S. fair price privilege. China suffers a disadvantage as a result of this U.S. privilege in that it does not obtain a real equal amount of U.S. dollars in exchange for its exported goods and services. In theory, when people export goods and services in exchange for U.S. dollars, the trade should be fair. The goods and services we export involve resource consumption and cheap labor and are sold at a low price. However, when the U.S. exports its capital or technology-intensive goods and services to us, it does not consume many resources, yet it has a high added value and a high profit margin. From this point of view, the U.S. dollar we earn is discounted. This is the risk of receiving fewer dollars.

Second, the U.S. reserve privilege. China is at a disadvantage when it deposits its U.S. dollars in electronic form at U.S. banks (also known as a mirror account in international financial settlement). Currently, China deposits most of its U.S. dollars in electronic form at several international banks in New York. It carries the risk that, in case of an electronic system collapse such as the 9-11 terrorist attacks, China may lose its U.S. dollar reserves. There is also the risk of loss if hackers break into the bank’s network. During war or other special times, such as World War II, the Korean War, and the Iraq war, the U.S. froze the U.S. assets of its enemy countries. So there is also the risk of having our electronic accounts frozen.

Third, the U.S. realization privilege. China is at a disadvantage when it exchanges its U.S. dollar debt for equity assets and physical assets. China’s current U.S. dollar reserves are used primarily to buy equity assets such as U.S. bonds, U.S. organization bonds, U.S. corporate bonds, and U.S. stocks. The biggest problems with these financial assets are the depreciation of the dollar and the losses resulting from China’s lack of discourse right and pricing power in international trade and finance. In theory, we should be able to purchase any equivalent physical assets with U.S. dollar reserves, but, in reality, out of political and military considerations, the U.S. government sets lots of export restrictions on high-tech products, energy, advanced weapons, and other important goods. These restrictions weaken China’s realization of the privilege of its U.S. dollar debt and add the risk of being unable to fully realize its U.S. dollar debt.

The “three privileges of the U.S. dollar” carry risks with different timings: in the long term, the U.S. dollar has a fair pricing risk. In response to such risk, China needs to adjust the structure of its export industries, transforming them from labor and resource-intensive products to technology and capital intensive products. We should shorten the production chain and increase added value. In the medium term, the U.S. dollar has reserve risks. This requires us to optimize the structure of foreign exchange reserves and increase gold reserves. In the short term, the U.S. dollar has a realization risk. To deal with that risk, China needs to adhere to an independent monetary policy and a managed floating exchange rate system.

At present, we should be careful of the “U.S. dollar trap” and enhance our strategic awareness of financial security. First, facing the U.S. pressure on RMB appreciation, we should argue logically about the risks that China bears by holding U.S. dollars and the resulting unequal value between the U.S. dollar China holds and the U.S. dollar that the U.S. holds. Examples of this inequality include the various restrictions the United States sets forth on high-tech product exports, which effectively lower the real value of the U.S. dollars that China holds and give the U.S. a “hidden excess income” directly from the pricing. In its smooth economic development period, the U.S. promoted the free capitalist economic system and was against other countries’ “exchange rate intervention.” When other countries have a trade surplus, however, the U.S., by applying political and economic pressure, forces these countries to appreciate their currencies. The depreciation of U.S. dollars gives the U.S. direct “visible excess profit” in its pricing.

Thirteen Suggestions in Response to the Current Situation

Based on an in-depth analysis of the new situation that China faces in the post-crisis era, I propose the following thirteen policy measures:

1. Keep the big picture of China’s overall national interests in mind. Policy adjustments must be based on political stability; the introduction of any new economic and financial policies must aim at both political and economic gain.

2. Adjust industrial structure. We should take the lead to develop low carbon, green, environmentally friendly industries; eliminate backward industries; increase service industries; accelerate the development of cultural and creative industries; shorten enterprises’ value chain; and increase business value.

3. Strengthen scientific and technological innovation. We need to increase investments in technology, use science and technological innovation as the core driving force for industrial structural adjustments, and increase tax and financial credit supports for high-tech, capital-intensive, and cultural and creative industries.

4. Take control of international discourse right. China should actively participate in international agencies and organizations with an open mind and actively expand the scope of China’s discourse right according to the shift in global power and China’s political and economic strength.

5. Establish agencies for settling trade disputes. We should integrate different sectors’ resources, comprehensively consider the five principles, establish standing institutions to deal with international trade disputes, and develop response plans for disputes.

6. Perfect the country’s financial risk early warning mechanism. We should classify, rate, and comprehensively manage risks according to changes in the international financial situation; establish an early warning system and mechanism against hot money; and provide management plans for the nation’s policy-setting departments to deal with unexpected financial risk.

7. Lead the way to internationalize the RMB. In the process of participating in the restructuring of China’s discourse right in international trade and finance, China should fully leverage its U.S. dollar holdings to prepare for the internationalization of the RMB. We need to steadily promote cross-border settlement of RMB settlement and exchange, further expand and accelerate the construction of an offshore RMB and Chinese bond market, establish a regional adoption of the RMB in Asia, and promote the internationalization of the RMB step by step.

8. Establish China’s authoritative, inter-bank lending rate system in accordance with international practice. Learning from London interbank interest rates, LIBOR; Singapore interbank rates, SIBOR; New York interbank rates, NIBOR; and Hong Kong interbank rates, HIBOR, we should establish our own Beijing interbank interest rate, BIBOR.

9. Optimize the foreign reserve structure. Currently, the huge U.S. debt forces the U.S. government to implement an inflationary policy to dilute its debt. Since China has to buy U.S. Treasury bonds to maintain RMB exchange rate stability, this increases the risk to China’s foreign exchange reserves. China should view the safety of foreign exchange reserves as its top priority and increase the gold reserves in its foreign exchange structure in a dynamic, continuous, step by step, and low-key way.

10. Upgrade the financial regulatory system. We should establish a perfect financial regulatory system to serve the overall national interest; perfect the financial regulation system; integrate and coordinate banking, securities, insurance, and other financial institutions; and reduce systemic risks in international financial markets.

11. Diversify foreign exchange reserves. We need to maintain the RMB’s stability, while keeping monetary policy flexible. Our foreign exchange reserve management should reflect the principles of safety, liquidity, and profitability. We need to diversity foreign reserve usage. For example, we should increase investments in developing countries, increase our support and aid to underdeveloped countries, and avoid trade barriers by investing directly in the U.S. and its allies.

12. Actively expand the range of imports of high-tech products and promote an international balance of trade. Hu Xiaolian, Deputy Governor of the People’s Bank of China (China’s Central Bank), said we should actively promote an international balance of trade and safeguard our national financial security. We should use the “three privileges of the U.S. dollar” theory when negotiating with the U.S., use the RMB exchange rate as a bargaining chip, and force the U.S. to increase the types and quantities of high-tech products (U.S. companies) are allowed to export to China to achieve a dynamic balance in international trade.

13. Encourage theoretical innovation by domestic economists. The nation should establish a reward system for China’s top economists, using its own financial resources, to encourage Chinese economists to break through in the field of economic theory based on China’s specific situation and create China’s own theory of economics, thereby enabling the establishment of Chinese economists’ discourse right in the global economic field.

[1] Xinhua, “Enhancing and Strengthening Our Nation’s Financial Security Strategy,” May 31, 2011.
[2] Quite often the discussions mention a term 话语权, which is translated as “discourse right.” It means the power to lead public opinion.