By staff reporter Zhang Hong
From Caijing Online

In light of the worst financial crisis since the Great Depression, global governments have taken unprecedented measures in the hope of reviving the financial system and supporting the world economy, pledging to do more until the desired results are reached. But wait a minute. Could these measures, that while in the short term seem necessary for stabilizing the markets, turn out to do greater harm in the future?

The imbalance between Chinese and US economies, at least, is one problem at risk of being aggravated.

A recognized cause of the current crisis is the unjustifiably high leverage in the U.S. of both financial institutions and households. This was fueled by the illusion of ever-growing profits, new leverage-incorporated financial instruments allowed to be removed from the balance sheet, and a continuous supply of easy money due to loose monetary policies and affluent funds flowing in from high-saving and surplus countries such as China and India.

This unsustainable financial ecosystem tumbled as the housing bubble burst. As assets took turns to devalue, the higher you were leverages, the greater loss you sustained. In response, institutional and individual investors both rushed to de-leverage, a trend that in turn accelerated the markets’ meltdown.

Domestically, asset prices plunged as their holders eagerly dumped them on one hand; on the other hand refinancing cannot be satisfied because of soaring risk premiums and lenders’ extreme cautiousness. Investors also sold off their overseas assets and pulled money back home, resulting in the dollar's appreciation.

As credit and money markets clogged up, the FED, being the lender of last resort, had a crucial role to play. It creatively came up with the unconventional policy tool of buying commercial papers from firms and consumer loans from banks to inject cash into the dried-up financial system. As a result, its balance sheet dramatically swelled, with total assets of 2.1 trillion dollars, almost 2.5 times larger than a year earlier.

With the Federal fund rate at a historical low of 1 percent, the Fed was speculated to bring the rate down to zero in the coming year if market conditions do not thaw. In that case, the Fed can simply continue to print cash without worrying about affecting interest rates, a behavior that will inevitably lead to inflation.

Equally important, the FED has accepted considerable risky assets as collateral that were not eligible before. That means, in the future when the FED has to sell these assets as a means of withdrawing liquidity from the market, it might have to accept discount prices because of the unfavorable quality. And the gap between the sale and purchase prices will be the “extra” base money lingering in the economy, also causing inflation.

While the Fed plays the role of lender of last resort, the US government has become a borrowing agent, because it is probably the only entity able to finance the market before confidence returns. In essence, through Bush's introduction of the 700-billion Troubled Asset Relief Program as well as other commitments, and the expected 500-billion dollar stimulus plan by the incoming Obama administration, the government is increasing its own leverage to help with the private sector’s de-leverage.

The result will be the greater indebtedness and fiscal deficit of the US government. By the end of November, the US government had accumulated a debt of 10.7 trillion dollars, very likely to surpass the newly elevated cap of 11.3 trillion dollars next year. According to Citi’s forecast, the fiscal deficit for 2009 could reach 9 percent of the GDP, or approximately 1.2 trillion dollars.

Who is going to finance the US government, after all? China seems to stand in the line.

The latest statistics showed that, by the end of September, China became the US government's no.1 creditor, holding 585 billion dollars of US treasuries.

As long as China’s foreign exchange reserve continues growing due to the double surplus in the current and capital accounts, US treasuries -- supposedly safer than others – will still be part of the additional reserve. Evidence shows that the amount of US treasuries acquired by China increased monthly in the third quarter, the September increment even larger than the growth of the reserve.

Therefore, it is clear that the imbalance will remain as China continues to finance US deficit. In doing so, China has to bear the risks of future dollar devaluation, US inflation, and the liquidity problem of US treasuries.

Meanwhile, in a bid to stabilize the economy, the Chinese government has revoked the policies used to correct the trade imbalance, including repeatedly raising the tax rebate rates for export goods, heavy investment, big-scale interest-rate cuts, and the suspected intentional depreciation of the yuan. While it’s understandable that the Chinese government wishes to ease pressure on exporters, these moves could result in an even greater trade surplus and foreign exchange reserve, further aggravating the external imbalance.

The optimistic scenario is that the US economy will recover soon and again energize China’s export sector. Otherwise, missing the chance for structural reform to beef up domestic consumption, China is doomed to become more vulnerable to external shocks in the future.