US panics over Asia's new investment bank, embarrasses itself - financial strategist

SS: But still, we see a lot of panic around this venture – at least, among the American officials. Why do you think that is?

MP: In my opinion, Washington has way overreacted and has turned what was probably not a very important initiative into a huge embarrassment for Washington. I think they’ve just completely mishandled this whole process. I think they mishandled it because they overestimated its importance, like a lot of other people.

SS: So you don’t think China’s Development Bank can really take over the leading role from World Bank or IMF?

MP: No, that’s impossible. There are two problems: first, there’s a problem of currency. Tremendous constraints on the use of the currency, and there’s no way for foreign central banks to acquire large amounts of renminbi. That’s not going to happen until there’s been a significant change in the domestic growth model – and that should take, at least, from 10 to 20 years. But the other thing that people don’t understand is that the role of the Bretton Woods instruments is underpinned by the ability of any country in the world to buy unlimited amounts of U.S. assets, including U.S. government bonds. China doesn’t allow foreigners to buy local government bonds. If China is willing at some point to allow enormous amounts of money flowing into the country, driving the trade account into deficit – then it will play a major role in the international financial architecture. But until then, I think it won’t… and quite frankly, I don’t think the U.S. will much longer, either. I think the cost of maintaining the system is way too high. In my guess, in 10 years, the U.S. will be trying to prevent that from happening, too.

SS: I still want to talk about some major establishments, including the China’s Development Bank. I’ve read an opinion in New York Times, that the institutions backed by the U.S. had not met the growing demands for roads, railroads and pipelines in Asia. Will the new Bank be able to do that? Do you think the China’s Development Bank would be able to do that?

MP: The problem in development…every time we have a new development bank, whether it’s the Asian development bank or World Bank, national development banks – they all point to the same problem. There’s way too much savings in the world, and in certain parts of the world, there’s demand for savings, for infrastructure investment, for example. So how do you match the two? In principle, it’s easy to send the money over, but we’ve always had two big problems with development: first off, you can send the money over, but it’s not clear that the money is always wisely spent. Secondly, we know that developing countries with a significant external debt burden end up running what we call “financial distress costs”. At some point, the growth begins to slow, and then, very often, they run into payment difficulties. No one has really figured out how to solve those two problems. So, if the new AIIB – the Asian Infrastructure Investment Bank is able to develop a new way of controlling development finance, that would be great. But so far, I don’t think there’s any clear idea of how that’s going to happen.

SS: While the U.S. warned its friends not to join –some of America’s closest military allies in the region, Australia and South Korey, have signed up for China’s Development Bank. Is China’s growing clout stronger that U.S. pressure at this point?

MP: I think the U.S. opposition to AIIB made absolutely no sense. I think the way they presented that opposition made the possibility of a huge embarrassment very high – and I think that’s exactly what happened. So, it’s not very clear to me, why they opposed it so strongly. There’s one theory – because of the close relationship with Japan. The Japanese opposition to Bank was quite strong, I don’t know if that’s true or not. But that’s the only rational reason I can think of. Otherwise, the opposition to the bank, simply, to me, made no sense at all. I don’t see why Washington made it such an important aspect of its relationships in Asia – it just didn’t make sense.

SS: Speaking about U.S. policies towards China’s Development Bank – former U.S. Secretary of State Madeleine Albright said: “The bottom-line is – we screwed it up” – and that’s a direct quote. Would you agree?

MP: Yes.

SS: But do you agree in the way she meant it – meaning Washington undermined itself by failing to allow a bigger voice for China in World Bank and IMF?

MP: Yes. Countries like China, countries like India, clearly deserve a much bigger role in the global financial architecture, in the governance of the global financial architecture. We have this huge problem of inertia, where nobody is willing to give up what they already have. So, if you look, for example, at Europe – Europe is way over-represented. The U.S. is over-represented, and we do need to have a recycling of the governing structure; but inertia’s a very powerful thing. In 1920s, for example, when the U.S. has been the largest economy in the world for 5 decades, but it was in the 1920s when it first started playing a central role in global governance. You saw many of the same things – the U.S. refused to join the League of Nations, it undermined the London Conference of 1933 – basically, because there was this tremendous disagreement between what the U.S. perceived as its correct role and what the Europeans were willing to allow. I think we’re seeing the same replay, and unfortunately, these things always end up with undermining of existing institutions. So we’re going to see more of this, this is not the end of the story.

SS: Do you think China will allow the U.S. to play a role in its AIIB, If U.S. decides to join the project?

MP: I think China would almost certainly welcome the U.S. joining, and my guess is that at some point the U.S. will probably play some kind of role. What I want to stress, and this is what I wrote about quite extensively last week, is that there’s a long history of these institutions, and there are two facets of this history that reoccurs. First, in the early stages we vastly overestimate the importance of the institution, and then, later on, within 5, 6, 7 years, the institution stops playing an important role, and I would be very surprised if this time was any different. A lot of noise about something that at the end of the day is probably not going to make a huge amount of difference. They were rarely do.

SS: But at this point, this institution, the China Development Bank, is just one part of Chinese economic dominance that’s growing in the region. But for countries that sided earlier, like Australia and South Korea, it does seem that Chinese economic dominance is becoming more appealing that the American dominance? Would you agree with that – and if yes, then why?

MP: I would say, again, if you look back on the history, we’ve had several periods of what seemed like “rising powers” – the U.S. in 1920s, Germany in the 1930s, the Soviet Union in 1950s and 60s. People forget that most analysts thought that by the end of the century the Soviet Union would be the world’s dominant economy and leading technological player. In 1980s everybody knew that Japan would be the dominant economy of the world. The problem in every single case, including the U.S. in 1920s, is that we base that on projections from a period of tremendous growth, but very unbalanced growth, and if you look at all of the cases that I’ve mentioned – and I can mention many more – in every single case, they were followed by one or two decades of very difficult, very painful adjustment. During that period, you get a whole bunch of institution changes. So, whether or not China becomes the world’s largest economy in the next 20 years, it’s almost a certainty that the China that emerges at the end of this period is going to look very different that the China today. It will have a different set of priorities, different institutional structures, different everything. So, what I always caution my clients is: let’s be very careful about how we project the future, because so far, historically, we’ve seen this movie many-many times, and we always get the ending wrong. I see no reason why we’re going to get the ending right this time.

SS: Now, Michael, in his State of the Union address this year, President Obama took a hardline stance against China, saying “China wants to write the rules for the worlds’ fastest growing region. That will put our business into disadvantage. We should write these rules”. What do you think – does the U.S. have the clout to write these rules? Should the U.S. be doing that? Can it do that?

MP: I think, in the 1940s and 1950s, when the U.S. represented nearly 50% of the relevant global economy, it was able to do a number of things simply because of its’ sheer size and because of its ability to export dollars through the Marshall plan. I don’t think any country today is big enough to do that, and in fact, one of the things that strikes me is that there’s a small but growing awareness within the U.S. that the costs of maintaining this global system now exceeds the benefits. So, I’m sort of in a funny position in which I believe that 10 to 20 years from now, the dollar will no longer be the dominant reserve currency. Not because it’s replaced by the renminbi or by the Euro, but rather because the U.S. itself will try to force changes in the global governance so that foreign central banks stop acquiring U.S. dollars. Now, how that happens – that’s going to be very-very complicated. There’s talk about striking the role of SDR which is the basked currency issued by the IMF. That might be one way of doing so, but the world has become much too complicated for us to have a single system run by a particular country or group of countries, and I don’t think that’s going to work.

SS: But what’s wrong with cooperation? For instance, there’s an underlined assumption that the Chinese-led system is inherently bad for the U.S. Does that mean that U.S.-backed system is bad for China? Why can’t the two just cooperate?

MP: Well, I think it’s in their best interests that they cooperate, but I think, for all of the noises, the amount of cooperation has actually been quite strong. My worry though is that we’re moving into the world in which it’s not going to be China-led or America-led, Europe-led or anything else like that. I think it has become much too complex, and there’s no country large enough to impose a consistent set of rule. Remember, we’ve only twice before had something that we could speak of as a coordinated global regime for trade and capital flows. That was, once, under a Great Britain, when its dominance of finance was complete, and, later on, after 1944, under the United States. It’s very rare to get this kind of system out of cooperation. This is an exception – not the rule. So, it’s not clear to me that we going to move from one global system to another global system. What I suspect is going to happen is that we’re going to move from one global system to, quite frankly, a very uncoordinated and much more difficult set of financial and economic relationships.

SS: In a system that you’re describing, that will be much more diverse and complicated, can you really ignore China? I mean, the U.S. own project in Asia region, which is a Trans-Pacific Partnerships excludes China. Can you ignore China, if you’re involved in a region?

MP: No, of course not. Of course not. China is the second largest economy in the world, it’s the largest trading economy in the world, it really doesn’t make sense to exclude any economy of that size. I don’t really think that the purpose is to exclude China – I don’t think anyone is dumb enough to think that that’s possible. I think what’s happening is that in large part, the 2007-2008 crisis made it very clear how unstable our existing system had become. We haven’t figured out what the alternative is – yet. I think, we’re seeing a lot of different initiatives from a lot of different places in an attempt to organize an alternative to the existing system. My worry is that we’re not going to get an organized alternative. My worry is that we’re going to get a very disjunctured system in which there isn’t a clear set of rules that govern trade and finance. At its worst… we all know, in 1920s and 1930s, what an uncoordinated world looks like – and it’s a very scary thought. So, I think, somehow we have to figure out how to shift from an American-dominated system to a well functioning system, and we don’t know how to do that yet.

SS: Well, China wants the IMF to label the Yan a reserve currency – IMF director Christine Lagarde actually said it’s not the matter of “if” but “when”. How long will it take for this to happen, what do you think? And would that actually destabilize the system that you were just describing even further, or on a contrary?

MP: No. It will actually be good for the system. My guess – and this is just a guess, I have no better information than you do – my guess is that in the next year we’re going to see some sort of an agreement in which the renminbi or the Yuan becomes part of the SDR and in exchange, China opens up its capital account a little more. So, I think we’re moving in that direction. But I don’t think the changes are going to be significant. Remember that there’s this perception that China might become the largest economy of the world, and if it does, naturally its currency will become the dominant reserve currency – but there’s no historical evidence to back that up. The U.S. was the largest economy in the world rougly in the 1860s, and the dollar was a very minor currency until after WWI - nearly 50 years later. The reason is because a rapidly growing U.S. would actually not have benefited if foreign central banks have acquired a lot of dollars. I think China’s in the same position. I think there are many people in China who think that having renminbi as a major reserve currency is positive for China. But I’m not sure they always understand the costs.

SS: You know, everyone’s been the China’s economic slowdown, and the U.S. is also trying to keep China in check – however, doesn’t the slowdown in China have serious implications for the whole world at this point?

MP: I’m not sure what you mean by “the U.S. is trying to keep it in check” – I think, geopolitically, there certainly are conflicts, but economically, it’s pretty well understood in the U.S. and everywhere that rapid growth in China, rapid growth in Russia, rapid growth in Europe is net positive for the world. So, I think there’s a lot more cooperation economically, than people think. Now, what are the implications of Chinese slowdown… First off, let me tell my personal believe – I think it is almost impossible that growth rates under President Xi from 2013-2023 exceed the rate of 4% on average. In other words – we have long way to go before the slowdown stops. Many people will say – “well, if you’re right, that’s a disaster”. No, it’s not a disaster at all. In 1990 had you predicted that Japan would grow at 0% for 20 years – nobody would have believed you, but they would say that would be a disaster for the world, and in fact that wasn’t. If President Xi manages rebalancing correctly, and so far I believe that he has done as good job as we can expect, but if he manages it correctly, what we will see is household income – that is the income of ordinary Chinese people – will grow much faster than GDP for the first time, maybe 5% or 6%, which is great,that would leave everyone very happy. As for the rest of the world, I would say, if you are a producer of hard commodities – copper, iron; unfortunately that includes Russia – I think that Chinese rebalancing is going to be very painful, because I think, commodity prices have a long ways to go. But, overall, for the rest of the world, I think a smooth Chinese adjustment is actually positive, not negative.

SS: Tell me something: the much-talked about “pivot to Asia” that President Obama’s Administration undertook – is it justified and does it bring any economic gains to the U.S.?

MP: No. American foreign policy has always been characterized, and I’m sure I don’t need to tell Russians this, has always been characterized by a degree of paranoia, which frankly is unnecessary. Asia is going to develop the way Asia develops – there are a lot of problems within Asia; as you know, relationships among the major countries, ranging from Russia to Japan to India have not always been very favorable, and I think those problems have to be worked out over the next ten to twenty years. In my personal opinion – and of course, I don’t speak for the U.S. government – the smartest role the U.S. can play is the minimal role possible. It should withdraw as much as it can and focus primarily on the economic side; but, historically, the U.S. tends to get overly involved politically, and I suspect, it will continue to do so.

SS: Michael, thank you very much for this wonderful interview. We were talking to Michael Pettis, Beijing-based economist and financial strategist, talking about what China’s growing role could mean for the global financial order, and if Yuan has a potential to take on the dollar as the world’s reserve currency. That’s it for this edition of Sophie&Co, I will see you next time.