China's Currency

PART 2: Tequila trap beckons China


By

Henry C K Liu


PART I - Follies of fiddling with the yuan

This article appeared in AToL on November 6, 2004



China is attempting to use macro policy measures to slow its overheated economy to avoid a dreaded hard landing. Yet a hard landing may be precisely the cold-turkey medicine needed to veer China away from an addiction on export for fiat dollars not backed by any specie of value. Soft-landing is a flawed imagery because there are few economic runways long enough to land an economy plagued by speculative acceleration. Running a plane off the runway is much more dangerous than a controlled hard landing.


The term "macro policy measures" is illusive and confusing. No one knows what it means precisely, typical of many economics slogans. There is not much wrong with China's economy that cannot be cured by focusing on domestic demand stimulation through a deliberate policy of full employment with rising wages, away from low-wage exports for fiat dollars that cannot be reinvested in the yuan economy. Tinkering with interest rates and exchange rates in the context of a failed neo-liberal ideology is to miss the defoliation of monetary forests by focusing on pruning the money trees.


Neo-liberal globalization of financial markets has become a euphemism for an age of global debt bubbles. Arguably, the distinction between an economic bubble and solid fundamentals can only be perceived after the bubble bursts. So the question of a bubble can be a conceptual dilemma, like the mental phenomenon of forgetting. One does not realize something had been forgotten until after one again remembers it. Thus improving one's memory theoretically increases incidents of forgetfulness.

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Still, some useful observations can be made about the high market value of dollar assets at this juncture in the history of finance capitalism. Financial assets denominated in fiat dollars are now mostly built on debt, with sizable amounts in debts external to the US economy. Debt is not intrinsically objectionable if it is adequately collateralized by real assets, and the proceeds are invested to increase income to service the debt. But if debt is collateralized mostly by the wealth effect of speculative asset appreciation and serviced by incurring more debt, a bubble is in the making. The so-called air-ball financing, widely used in financing global telecom expansion in the 1990s, in which unrealistically anticipated future earnings were used as collateral for financing over-investments to generate those very earnings, caused the telecom bubble. A housing bubble exists because houses are being financed by full-cost mortgages at negative interest rates, banking on the continuing rise in home prices.

The making of a bubble

The size of the invisible dollar money pool created by financial derivatives is now many times (no one knows how many) the amount of M3, a money supply category accounting for the sum of all short-term liquid funds, excluding treasury bills, savings bonds, commercial papers, bankers acceptances and non-bank euro-dollar holdings of US residents. Granted, derivative notional values are not the amount at risk, as they are the underlying asset values that exist only as a notion for calculating the amount of risk to be managed. But notional values allow the contracting parties to bet on the derivative implications of virtual assets they neither own nor can safely afford.

At the end of 2002, the notional value of the dollar derivative market was $56 trillion. A 1% shift in rates would cause a $560 billion change in interest payments. A speculator with a net worth of $1 million now can bet on derivatives with a notional value of $100 million, hedging a risk of $1 million with every change in the interest rate of 1%, equaling to his entire net worth. Since risk is never eliminated but only transferred, the total risk exposure in the system is inflated by fantastic notional values. Interest payments derived from notional values can then become larger than the actual amount of the real capital in the economy.

Derivatives fit the definition of bubbles, being all air and little substance. Warren Buffet calls them, with justification, financial weapons of mass destruction. This invisible supply of virtual liquidity outside the reach of central banks supports an artificial level of asset market value detached from fundamentals. Any abrupt, premature unwinding of these private derivative contracts based on fantasy notional assets will inevitably cause drastic readjustments in asset prices in the real markets.

The pervasive securitization of debt blurs the all-important dividing line between debtor and creditor and allows an economy to borrow from itself, not just against its future, but against its current and less sophisticated debt, not for productive investment but for financial manipulation. The use of less sophisticated debt as collateral for more sophisticated debt has characteristics of a bubble. The broad disaggregating of risk to maximize transactional surplus (profit) ultimately leads to the socialization of risk (transferring unit risk onto systemic risk) while the privatization of the resultant profit remains a sacred prerequisite. The Bank of International Settlement "Lamfalussy Report" defines systemic risk as "the risk that the illiquidity or failure of one institution, and its resulting inability to meet its obligations when due, will lead to the illiquidity or failure of other institutions".

Global systemic risk is the illiquidity in one economy leading to illiquidity in other economies, through what economists call contagion. Asian financial systems are less developed in securitization and structured finance. But while Asian economies forego the benefits of the brave new world of financial engineering, they are not rewarded with any immunity from global systemic penalties which dollar hegemony imposes on the dollar economy. China, being the least developed in global finance, is highly disadvantaged by this imbalance of risk and reward.

Under the accounting rules of capitalism, capital cannot exist until ownership is specifically assigned. Thus socialization of capital is a self-contradiction in term and must stay off the balance sheets of the capitalist financial system. To own assets, even a government must act as if it is a corporation, a "legal person". Thus private property and individualization are inseparable. Pension fund assets and other forms of collectively owned assets must adopt the governing characteristics of private capital in order to participate in the economic system. Such assets enjoy no prerogative to invest at less than maximum profit for the common good because in a capitalistic market economy, the ultimate definition of the common good is maximum profit.

Thus employee pension funds will invest for highest returns in companies that ship their members' jobs overseas to low-wage economies. The formula of socialization of risk in support of privatization of profit leads to the hollowing of the center - a classic definition of a systemic bubble. Yet the ownership of debt is largely socialized, dispersed throughout the global financial system, with encouragement of moral hazard, which is the lack of fear for private consequences of financial adventurism. The pleasure of excess is not limited by any excess of pleasure. Golden parachutes are provided free for financial adventurers, paid for by the public as unknowing victims through central-bank-induced inflation.

Whether or when a bubble will burst depends on a government's ability to extend its elasticity, which is not unlimited, notwithstanding US Fed chief Allan Greenspan's wizardry. Such elasticity comes from liquidity. To support the market, government increasingly needs to intervene, which in turn destroys the market. As is already apparent, the Federal Reserve is increasingly reduced to an irrelevant role of explaining the economy rather than directing it. It has adopted the role of a clean-up crew of otherwise avoidable financial debris rather than the preventive guardian of public financial health.

In a financial bubble, the monetary value of financial assets rises but the real economy itself may not be growing. But asset price appreciation is defined as growth, not inflation. Thus we have robust "recoveries" that continue to lose jobs, with the value of money protected by structural unemployment and underemployment. In the finance sector, wealth is created by escalating systemic risk exposure, known in the street now as the "Greenspan put". A writer of a put option profits by the stock at the end of the contract remaining stable, rise, or fall by an amount less than his pre-received profit or premium. Inflation and deflation have become two sides of the same coin that alternate as monetary concerns in a matter of months, through highly-manipulated markets of foreign exchange that tend to destabilize real economies via a multitude of channels, such as wealth disparity effects, off-balance-sheet creative accounting and alternating recurrences of credit excesses and crunches. Volatility has become regular market opportunities.

A few months earlier, China was blamed by Western economists for exporting deflation through an undervalued currency. Now China is being blamed for exporting inflation also through an undervalued yuan while the Chinese currency continues to be pegged to the dollar. Yet China does not have an export economy; it has a re-export economy. Most of the factors of production for Chinese exports are imported, such as capital, raw material, infrastructure systems, energy, capital equipment, design, financial services, machine parts, intellectual property licensing, offshore distribution and sales, the only exceptions being labor and raw land.

China's trade deficit widened sharply in April to $2.26 billion from $540 million in March due to the growing demand for raw materials and energy resources. That was the fourth consecutive monthly trade deficit this year. Exports rose 32% in April, compared with a year earlier, to $47.1 billion, and imports jumped 43%, to $49.4 billion. In the year's first four months, China's exports reached $162.74 billion, up 33.5% from a year ago, and imports rose 42.4%, to $173.5 billion. China incurred an overall trade deficit of $8.4 billion in the first quarter of 2004. The January-April deficit was $10.76 billion. If anything, China is importing inflation that is now at a 5.3% annual rate. Much of China's inflation comes from commodity and energy imports, the prices of which are denominated in dollars and set outside China.

The recent global commodity market bubble is not caused by real increased demand by the Chinese economy but by speculation fueled by low dollar interest rates and speculation of China's future demand based on anticipated Chinese export growth. Yet the inevitable rise in dollar interest rates will burst the commodities bubble, affecting the exchange value of the currencies of commodity-exporting nations such as Australia, South Africa and Chile. It will also torpedo the anemic US recovery and curb demand for Chinese exports. The global economy, led by super-low short-term dollar interest rate, has been sustained by carry trade, a technical term that describe a speculative strategy of borrowing short-term in low-interest money markets to invest for gain in long-term high-interest money markets, or to speculate in high-inflation sectors such as commodities. A steep fall in copper, gold and other metal prices in the final week of April 2004 suggested that the two-year boom in commodity markets might be coming to a close, except for oil, whose price is being driven by the second Iraq war and climatic factors.

Hegemony hazards

Copper and nickel each lost more than 5% of their value on April 28, 2004, accelerating a drop that began early in the month. Copper, the most widely used industrial metal, traded at $2,657 a metric ton on the London Metal Exchange, down from $3,100 in late March, having more than doubled from early 2003 until the March 2004 peak. The price collapse was described by traders as blowing off speculative "froth". Nickel, used for making stainless steel, has lost almost 40% of its value since reaching a peak of close to $18,000 a metric ton in early January 2004. The gold price was fixed in London at $386 an ounce on April 28, down from a peak of $428.20 in January 2004. Gold closed in London at $423.45 on October 22. December delivery gold was at $425.60. The growing nervousness in the metal markets stems mainly from China's moves to cool its fast-expanding economy as well as a recent rebound in the dollar, reflecting expectations of higher dollar interest rates. The rebound of the dollar has roiled metal markets because most prices are denominated in dollars and often move in the opposite direction.

Booming demand from China has been blamed for driving the spike in commodity prices since late 2002, with China either overtaking or approaching the US as the world's biggest consumer of materials like aluminum, coal, copper, iron ore and steel. But with fears growing of an inflationary bubble, Chinese authorities ordered banks in late April to curb their rapid rise in lending in overheated sectors. The government has also tightened capital requirements and regulatory approval for investments in aluminum, cement, real estate and steel projects. The State Council, China's cabinet, halted construction of a $1.3 billion steel mill in Jiangsu province as part of an effort to rebalance economic growth. The expansion of China's steel capacity has outstripped its electricity capacity and raw material supply. As China becomes the largest consumer of basic commodities, it would be natural, if it were not for dollar hegemony, for such commodities to be priced in yuan. Euroland consumes more imported oil than any other nation, but the price of oil is denominated in dollars. Iraq under Saddam Hussein was the only oil-exporting nation that denominated its oil in euros, and we all know what happened to Saddam.

The commodity boom of the 21 months between the last quarter of 2002 and the second quarter of 2004 was exacerbated by manipulation of hedge funds and other speculative investors in what is normally among the least glamorous segment of the financial markets, taking full advantage of negative dollar short-term interest rates at 1% between June 2003 and June 2004. An estimated $5.2 billion was raised for exploration and mine development in 2003, more than double the amount in 2002. Another $2.6 billion has been raised so far in 2004. Easy and cheap money, undirected by policy or regulations, seldom stimulates the economy in constructive ways. Markets are singularly without foresight or vision.

Central banks seldom adjust their monetary policies to prevent asset bubbles and related instabilities. The days of the central banker being the person who takes the punch bowl away when the party gets going are long gone. Central bankers now bring stronger drinks when the party slows. In the US, the Fed has served notice that it is prepared to move toward inflation targeting, as suggested by board member Ben Bernanke. Trapped by their past actions, central banks will continue to provide excess liquidity to support asset price bubbles and to mask the destructiveness of burst bubbles by unleashing new bubbles, euphemistically known as recoveries. Instability in the real economy has become a major recurring source of profit for financial institutions.

Dramatic financial shocks caused by the conflict between fixed foreign exchange rates and interest rate swings dictated by economic instability have become recurring phenomena. The Mexican currency crises of 1982 and 1994 were the mothers of international financial crises. The Asian financial crisis that began in mid-1997 had its genesis in Mexico, incubated by a decade of globalization of financial markets. The currency crises started in Mexico first in 1982, hit Britain in 1992 over ERM (Exchange Rate Mechanism), again Mexico in 1994, Asia in 1997, spreading to Russia and Latin America since and finally hitting both the EU and the US in 2000 and the deeper structural financial challenges facing the entire global economy. The crises have been the inevitable result of the Fed, the European Central Bank (ECB) and the Bank of Japan applying their unified institutional mandates of domestic price stability through domestic interest-rate policies that have destabilized the post-Bretton Woods international finance architecture. The common virus was dollar hegemony.

Lessons from Mexico

The Mexican financial crisis of 1982 set the pattern for subsequent financial crises around the world. For that reason, a thorough understanding of the Mexican financial crisis is necessary to understand what lies in wait for China.

To recycle petrodollars that the US printed by fiat to pay for sharply higher oil prices beginning in 1973, US banks had sought out select Less Developed Countries (LDCs) with acceptable political risk, meaning solidly anti-socialist authoritative governments, such as Brazil, Mexico, Argentina, South Korea, Taiwan, the Philippines, Indonesia, etc, for predatory lending. By 1980, LDCs had accumulated $400 billion in dollar debt, more than their combined GDP. This is money they cannot produce through sovereign credit as they cannot print dollars, but must earn dollars through export. This debt bubble was hailed as a miracle of free markets and effectively used as Cold War propaganda against socialist economies. If the socialist economies would only get rid of socialism and export at low wages to earn fiat dollars, they too would enjoy the prosperity of capitalism, god's gift to the poor.

The World Bank reports that after two decades of globalized prosperity, more than a billion people, or one in five living on this earth, still have to survive on less than a dollar a day and more than half of the world's population live on less than $2 a day. China bought this propaganda lock stock and barrel in 1979 with little understanding of the threat of this financial narcotic that would make the Opium War of 1840 look like a minor scrimmage.

Mexico's love affair with neo-liberalism was unraveling by the end of 1982. Neo-liberalism is a socio-economic-political ideology that rejects government intervention in the economy, focusing instead on achieving socio-economic progress through free markets, with emphasis on raising national income as measure by gross domestic product (GDP) statistics. Issues such as income-disparity, impaired national sovereignty, social injustice and environmental damage are considered necessary prices to pay for global prosperity. It is an ideology that is controversial even if successful, but it is a bankrupt ideology that fails even to deliver the prosperity it promises. The record of the past three decades shows that neo-liberal ideology brought devastation to every economy it invaded. China seems to be heading along a similar path.

Impacted by the Fed under Paul Volcker raising dollar interest rates sharply in 1979 to fight inflation in the US, Mexico by 1982 was put in a position of not being able to meet its obligations to service $80 billion in short-term dollar debt obligations to foreign, mostly US, banks out of a GDP of $106 billion at an over-valued peso exchange rate. Debt service payments reached 62.8% of export value in 1979. Exports accounted for 12% of GDP while government expenditures accounted for 11%, which included public-education expenditure of 5.2%. Mexico was paying more in interest to foreign banks than it did to educate its young. Mexican foreign reserves had fallen to less than $200 million and hot money capital was leaving the country at the rate of $100 million a day. Against this background, neo-liberal economists were claiming that poverty was being eradicated in Mexico by "free" trade, a claim they made the world over. China has been praised by neo-liberals for its poverty eradication success in the past two decades, while the reality of a collapse in public education, national health care, public housing and pension systems remains glaringly obvious.

A Mexican default in 1982 would have threatened the profitability, if not survival, of the largest US commercial banks, namely Citibank, Chase, Chemical, Bank of America, Bankers Trust, Manufacturer Hanover, etc. To negotiate new loans in the private sector for Mexico, all creditors would have to agree and participate so that the new loans would not just go towards paying off some holdout creditors at the expense of the others. Many other creditors were smaller US regional banks that had only limited exposure to Mexico and they did not want to "throw good money after bad" merely to bail out the major money center banks.

The big US banks had to lobby the Fed to step in as crisis manager to keep the smaller banks in line for the good of the system, notwithstanding that the crisis had been caused largely by the Fed's failure to impose prudent limits on the large money center banks' frenzied lending to naive Third World borrowers in the previous decade. Furthermore, the crisis was precipitated by Volcker's sudden high-interest-rate shock treatment in 1979, instead of traditional Fed gradualism that would have given the banks more time to adjust their loan portfolios. Third World economies were falling likes flies from the weight of dollar debts with floating interest rates that suddenly became prohibitive to service, not much different from private businesses in the US, except that countries could not go bankrupt to wipe out debt the way private business could in the US.

Third World borrowers had mistakenly figured, with coaching from New York international banks, that the dollars they borrowed would be easy to pay back because of double-digit dollar inflation rate. Volcker's triumph over domestic inflation was bought with the destruction of the Third World economies and the destabilization of the international financial system whose banks had acted like loan sharks in the Third World with Fed approval. The International Monetary Fund (IMF) then came in to take over the non-performing bank loans with austerity "conditionalities" forced on the debtor economies, while the foreign banks went home whole with the new IMF dollars.

As a result, Third World economies, including those in Asia, fell into a dollar debt spiral, having to borrow new dollars from the IMF to service the old dollar debts, being forced by new loan "conditionalities" to forgo any hope of future prosperity. Devaluation of local currencies to compete in export markets made dollar loans more expensive to pay back in local currency terms. Living standards kept declining while dollar debts kept piling higher, leading to even higher unemployment and more business bankruptcies. China was saved from this fate primarily because it went slow in its reform toward market economy and it resisted full currency convertibility.

US banks, while continuing to advocate neo-liberal free trade, market fundamentalism and financial deregulation, were at the same time falling into habitual dependence on government bailouts, both domestically and internationally. US taxpayers were footing the bill the Fed incurred in bailing out its constituent banks through near-limitless liquidity, which contributed to higher inflation, which in turn led to higher interest rates, which in turn intensified the Third World dollar debt spiral, in one huge vicious circle. As if that was not bad enough, dollar hegemony took it one step further. It saps not only nations with dollar debts and deficits, but also economies that earn a dollar trade surplus, by trapping all the dollars surplus in the dollar economy as captured creditors, draining capital from all non-dollar economies. Japan, Korea and China are all victims of this dollar hegemony. Japan, with the world's largest foreign exchange reserves of $850 billion, is saddled with a sovereign credit rating below that of Botswana because it incurred anti-cyclical fiscal deficits financed with sovereign credit. China will not be exempt from such a fate when it makes the yuan fully convertible at floating rates.

By the late 1980s, Mexico had temporarily resolved its dollar liquidity crisis, though not its dollar debt spiral problem, and was able to resume a Ponzi-scheme economic growth, relying to a great extent on rising foreign hot money inflows. To attract more foreign hot money inflows, the Mexican government, coached by neo-liberal market-fundamentalist economists, undertook major economic reforms in the early 1990s designed to make its markets more open to foreign hot money manipulation, to be more "efficient", and more "competitive" - neo-liberal code words for thinly disguised market neo-imperialism. It was a strategy of racing to the bottom and "if you don't smoke, someone else will" approach to export enslavement. These reforms included privatizing state-owned enterprises, removing trade barriers that protected domestic producers, banishing industrial policies, eliminating restrictions on foreign investment and reducing inflation by tolerating higher unemployment to push down already low wages and limiting government spending on social programs. Most importantly, it suspended exchange control and fixed foreign exchange rates and replaced them with free convertibility with floating rates.

This is the strategy that neo-liberals have been trying to lure China into for the past two decades, not without success, albeit the goal line has yet to be crossed. What has so far saved China is its residual commitment to socialist principles, hoping to reap the euphoria of market fundamentalism without succumbing to its narcotic addiction. Yet, every addict begins with the confidence that he/she can handle the drug without falling into addiction.

This was in essence the "Washington Consensus" solution imposed all over Asia in the early 1990s. In effect, it was a suicidal policy masked by the giddy expansion typical of the early phase of a Ponzi scheme. The new foreign investment denominated in dollars was used to provide spectacular returns on earlier dollar investment with the help of central bank support of overvalued fixed exchange rates while neo-liberal economists were falling over one another congratulating themselves on their brilliant theoretical insight and giving one another incestuous awards at insider dinners, collecting fat consultant fees from client banks and governments.

Star academics at Harvard, Massachusetts Institute of Technology (MIT), Chicago and Stanford - multiple snake heads of the academic Medusa - as well as those in prestigious policy-analysis institutions with unabashed ideological preferences that served as waiting lounges for policy wonks of the loyal opposition, busily turned out star disciples from the Third World elite who, armed with awe-inspiring foreign certificates and diplomas, would return to their home countries to form influential policy-making establishments, particularly in central banks, to promote this scandalous game of snake-oil economics. Harvard-educated Mexican president Carlos Salinas de Gortari, and Ernesto Zedillo, a Yale-educated economist who became president of Mexico in 1994, were prototypes. After totally wrecking the Mexican economy, Salinas was expelled from Mexico by his own political party. Zedillo now heads a research center on globalization at Yale.

China by now also has its army of foreign-trained neo-liberal elites, strategically placed in key government agencies and in advanced institutes attached to prestigious academic institutions such as Qinghua University. Every year, sponsored by the IMF and the World Bank, central bankers gather in Washington, housed in luxurious hotel suites served by fleets of limousines, to reassure one another of their monetary magic, communicating ever optimistic prognosis to the befuddled public through opaque press releases couched in cryptic jargon, while the global economy rots in the core. The G7, the club of rich countries, is wooing China to become a member notwithstanding that China's per capital GDP is still only $1,000 and there are still more Chinese living in poverty than the entire G7 population.

The British Example

But even G7 members were not immune to financial crisis. The exchange Rate Mechanism (ERM) crisis of 1992-93 exploded, involving a mismatch between the German mark and the British pound. The ERM was a fixed-exchange-rate regime established in March 1979 as part of the European Monetary System (EMS) to reduce exchange-rate variability and achieve monetary stability in Europe through an economic and monetary union in preparation for the introduction of a single currency, the euro, which was scheduled to be introduced two decades later on January 1, 1999 at $1.15 per euro. After falling below $0.85 in late 2000, and again below $0.84 in July 2001, the two currencies reached parity on July 15, 2002, but the euro fell again below $0.85 in late 2002. During the fourth quarter of 2003, the euro strongly appreciated against other major currencies, 10% against the dollar, 3% against the yen and 1% against the pound sterling. The nominal effective exchange rate of the euro against the currencies of 12 industrialized countries appreciated by about 4% during the same fourth quarter, leaving it at 9% above its inception level. Over the same fourth quarter, while the dollar depreciated by 6%, the yen and the pound sterling both appreciated by about 2% in effective terms.

On May 23, 2003, the euro surpassed its initial trading value for the first time as it hit $1.18, and in the last days of December 2003, the euro even climbed above $1.26, the highest to that date since its introduction. Part of the euro's strength is due to high euro interest rates. The euro traded at $1.26852 on October 24, 2004, while the euro overnight index average (EONIA) was 2.05% against a dollar ffr (Fed funds rate) of 1.75%. But a strong euro by no means spells the end of dollar hegemony. While the EU registers a greater GDP than the US, the dollar economy is still larger by far than the euro economy. This is because offshore euro-dollars are larger in amount than off-shore euros. In fact, the pool of euro-dollars is greater than the pool of dollars in circulation within the US. The major part of derivatives and securitized debts are denominated in dollars.

A unified single currency increases the economic interdependency of EU members that have adopted the euro and facilitates trade within the euro zone with less monetary friction. This works toward a unified market within the European Union. Differences in price levels within the euro zone will decrease. A unified monetary policy set by the European Central Bank does not leave much room for fine-tuning the economic situation in each individual member country, leaving fiscal policy in each country as the only way in which economic trends can be managed specifically for regional or national conditions. This is a structural problem with monetary union prior to political union. The economies of the EU may not all be "in sync", each may be at a different stage in government response to the business cycle, or be experiencing different structural inflationary pressures. Still, the euro adds liquidity to the financial markets in Europe. Governments and companies can now borrow in euro instead of their local currency and can access more sources for funds with less friction and more simplified financial engineering. Pension funds and national savings accounts can participate across national borders in a unified euro market. The EU can benefit from the super liquidity of a single currency, more than the mere sum of single liquidities of separate currencies.

The purpose of the ERM was to stabilize exchange rates, control inflation (through the link with the strong and stable deutschmark) and nurture intra-Europe trade. It was also designed to enhance European world trade in competition with the US, creating a so-called "United States of Europe" and as a stepping stone to a single-currency regime. To a similar extent, Asia can also benefit from a unified currency and free its thriving economies from the penalties of dollar hegemony.

Britain joined the ERM in October 1990 at a fixed parity of 2.95 deutschmark to the pound, an over-valued rate intended to put pressure on the British economy to reduce inflation rather than institutionalizing international trade competitiveness. This same rationale lies now behind the call for China to revalue the yuan. Unfortunately for the British people, the UK Treasury lost some 8.2 billion pound sterling defending the unsustainable exchange rate. This chosen rate, or any fixed rate required by ERM membership, proved misguided because it tried to benefit from the effect of a single currency for separate economies without the reality of a single currency within an integrated economy.

Withdrawing from the ERM released the UK economy from persistent deflation and provided the foundation for the non-inflationary growth subsequently experienced. It enabled monetary policy to be freed from the sole obsession of maintaining an inoperative exchange rate, thus contributing to economic expansion by a combination of rational monetary measures to respond specifically to British needs. While ERM countries were compelled to maintain relatively high real interest rates to prevent their currencies from falling outside the permitted bands, Britain enjoyed the freedom to benefit from lower rates to stimulate a stalling economy.

Hong Kong has been facing the same problems since the introduction of its peg to the dollar in 1983, which created a bubble in its economy dominated by the property sector and in the past seven years, since the 1997 Asian financial crisis, has been plagued with currency-induced deflation and unemployment, and will not recover from economic crisis until its currency peg to an overvalued US dollar is lifted, or until the dollar falls in value beyond its current low to induce another bubble that will inevitably burst again. What Hong Kong did was to buy monetary stability with economic instability. Waiting for an improved economy to justify an overvalued currency is like waiting for death to cure an infection. In the current international finance architecture, there is only one thing worse than an undervalued currency, and that is an overvalued currency. This is why China resists pressure to revalue the yuan while unemployment remains a serious problem.

The appropriate exchange rate of currencies at any particular time is that which enables their separate economies to sustain an interest rate regime to combine full employment of productive resources, particularly labor, with a simultaneous external balance-of-payment equilibrium. An operative exchange rate is not determined by trade balance alone. With a high rate of unemployment and excessively low wages by any standards, China has no reasons to revalue the yuan's exchange rate. What China needs is a national full employment policy with an aggressive wage enhancement strategy. An excessively high exchange rate triggers trade deficits and exacerbates domestic unemployment, which is what the strong dollar has done to the US economy.

A low exchange rate generates an excessive buildup of foreign-currency reserves and creates domestic inflationary pressures that lead to a bubble economy. Overvalued exchange rates require high domestic interest rate. Every nation needs to retain its sovereign right to adjust the external values of its currency in this unregulated global financial market, but an international finance architecture based on dollar hegemony preempts that sovereign right. To be fixated on a fixed exchange rate with free currency convertibility is to court financial and economic disaster in the current international finance architecture.

Chinese monetary conditions are full of contradictions. China has rising foreign exchange reserves, but an overall trade deficit, with a currency pegged to an overvalued fiat dollar backed by debt, while yuan interest rates have been persistently high. China's rising foreign exchange reserves now come not from trade surplus, but from domestic low wages that subsidize high return on foreign capital. China will remain an economic semi-colony until the rise in Chinese wages neutralizes the unwarranted increase in its foreign exchange reserves. For years, the US since the Clinton administration has operated on the doctrine that a strong dollar is in its national interest, using the capital account surplus to finance its current account deficit. Now domestic political pressure is forcing the US government to deal with its twin deficits and the outsourcing of not only low-wage jobs, but increasingly also high-pay jobs.

The US wants to force China to revalue the yuan upward so that the dollar can avoid further devaluation with other major currencies. But an astronomical disparity of wage levels between economies cannot be overcome by an adjustment of exchange rates. China is in a peculiar position of having a booming economy with rising unemployment. That is because the boom comes from shipping wealth out of the yuan economy into the dollar economy. What the US needs to do to reduce its trade imbalance with China is to adopt policies that encourages wage levels to rise in China. The only way to stop job outsourcing is to steadily remove low-wage manufacturing from the global system. For example, tariffs and quotas can focus on wage levels to impose countervailing fees for overseas wages below US minimum wages. Documentation of import quotas can be required to include labor cost data.

Britain's disastrous experience with the Exchange Rate Mechanism (ERM) should be a sobering lesson for China. Since, under ERM, Britain's interest rate was pegged to that of Germany through the fixed exchange rate with a freely convertible pound sterling, reduction in interest rates was not available to deal with increasing unemployment and declining growth in the UK. The fact that Britain lost independent control over pound sterling interest rates, coupled with the questionable independence of the Bundesbank from German national political pressure, was an important factor in Britain's final decision to withdraw the pound sterling from the ERM fixed-exchange-rate regime. Making the yuan freely convertible would be similarly suicidal for China under current circumstances.

The reunification of Germany cracked open the structural flaw in the ERM because massive capital injection from West to East Germany had produced inflationary pressure in the newly unified German economy, leading to preemptive increases of interest rates by the Bundesbank, the German central bank. At the same time, other economies in Europe, especially that of Britain, were in recession and not prepared for interest rate hikes dictated by the German central bank. This interest rate disparity magnified the overvaluation of the pound sterling in the early 1990s. Nominal interest rate disparity between a higher yuan rate and a lower dollar rate has magnified the inflow of hot money into China, even with capital controls and limited currency convertibility. Yet, both real yuan and dollar interest rates are negative in that they are below their respective inflation rates, while both economies still face persistent unemployment problems. For China to raise yuan interest rates under these conditions is to push its lopsided economy into a tailspin.

In 1992, the ERM was torn apart when a number of currencies could not keep within these limits without collapsing their economies. On Black Wednesday, September 16, a culmination of factors allowed George Soros, hedge-fund titan, to break the Bank of England, pocketing $1 billion of profit in one day and more than $2 billion eventually. The British pound was forced to leave the ERM after the Bank of England spent $40 billion in an unsuccessful effort to defend the currency's fixed value against speculative attacks. The money went directly into the pocket of speculative hedge funds rather than helping the pound sterling. The Italian lira also left the ERM and the Spanish peseta was devalued.

Hong Kong's freely convertible currency with a fixed peg faced similar attacks by hedge funds half a decade later. After the Asian financial crisis that first broke out in Thailand on July 2, 1997, the market became less and less confident that if confronted with a choice between counter-cyclical interest rate targets and the fixed exchange rate, the Hong Kong Monetary Authority (HKMA) would necessarily choose the exchange rate. The deflation effects of the overvalued currency were causing much unnecessary pain on the population. The situation launched an open season for currency attacks that broke out predictably and repeatedly after July 1997. After the fourth major attack on the Hong Kong currency in August 1998, which required a $18 billion government "market incursion" to foil, a list of seven "technical measures" was adopted to shore up the peg's credibility, among which a convertibility undertaking would obligate the HKMA to guarantee the dollar value of the clearing accounts of all licensed banks.

This shifted currency risk from the banks to the HKMA. Now if the peg were abandoned, the government would have to make up for losses on at least some of the banks' local currency assets, a commitment enforceable by law. This technical measure substantially increased the cost of de-pegging to the government and raised the pain threshold of the inoperative peg. The economic pain has lingered for seven years with no end in sight, albeit that the recent fall of the dollar has since moderated the pain. Hong Kong's economy has not recovered; it has merely got used to the pain that has been dulled somewhat by subsidies from China. China is protected from contagion from Hong Kong by the fact that the yuan is not freely convertible.

In 1992, to curb German inflation, an increase in German interest rates was necessary, but if the Bundesbank were completely independent of German political-economic interests and behaved truly as a dominant regional central bank, it would not have adopted this policy as there were cries from all over a depressed Europe for decreases in interest rates. By adopting tight monetary policies in response to domestic inflationary pressures that followed German reunification in 1990, German short-term interest rates, which had been rising since 1988, continued to rise, reaching nearly 10% by the summer of 1992. So, at a time when Britain needed a counter-cyclical reduction in interest rates, the Bundesbank sent the interest rate upwards, plunging Britain deeper into recession through the ERM.

This was the fundamental problem with the ERM. Fixed exchange rates for a freely traded currency conflict with the interest rate levels needed by different economic conditions in separate member economies. The British interest rate pegged to that set by the Bundesbank was crippling the British economy because the UK was in a recession and required low interest rates. The prevention of an economic bubble in Germany exacerbated recession in Britain and much of Europe. Another way of looking at it is that the non-German members of the ERM were subsidizing the reconstruction of a united Germany.

Wrong move

China's economy would face a similar whiplash from the Fed's interest rate policy if the yuan were freely convertible. Even with currency control, the Fed's "measured pace" interest rate hike has forced the People's Bank of China to lift its benchmark one-year lending rate to 5.58% from 5.31% beginning October 29 to stay above China's inflation rate, which reached 5.31% in August. Such a timid interest rate increase will have no effect on the overheated export sector, but will be highly contracting for the domestic sectors. The unexpected move appeared to have been taken mostly to appease misguided US pressure. It made no economic sense.

The problem with the Fed is that while it has been a de facto world central bank for the past decade because of dollar hegemony, it does not set monetary policy for the benefit of the world, but only for what it intuitively thinks is good for the US economy. In the past decade, the Fed in fact did not even make monetary policy for the good of the US economy, only the dollar economy. Pushing China to raise yuan interest rates while the yuan is pegged to the dollar will cause problems for other economies whose currencies are also pegged to the dollar, causing interest rates in those currencies to also rise, slowing those economies and destabilizing the region and the world economy.

Anyway it is sliced, a weak dollar adds up to higher inflation in the US, which will push the Fed to raise the dollar short-term interest rate, thus threatening equity prices. To offset a crash in the equity markets, the Fed supplies more liquidity. Dollar liquidity in turn forces other central banks to supply liquidity in their own currencies, pushing global long-term interest rates down and bond prices up. This causes a boom in both bonds and stocks, casting aside the traditional formula that stocks and bonds move in opposite directions. Gravity has not gone out of fashion; it was merely temporarily postponed through acceleration. A slowdown will bring the global economy down in a crash. This is why the world is nervous over the Chinese economy slowing down.

The 1992 ERM crisis was followed by the Mexican peso crisis of 1994-95. The Fed started to raise interest rates in 1994 and sharply curtailed its own purchase of treasury bills, triggering a global bond crash and a subsequent US economic slowdown. Across the border, high dollar interest rates caused a Mexico peso crisis.

Up to the1994 crisis, neo-liberal economists were praising Mexico for doing most things right since the 1982 debt crisis. Government budget had shifted from substantial deficit to surplus, thus no longer draining Mexican private savings, albeit that the social infrastructure of Mexico was left in dire strait. With businesses privatized and tariffs low, Mexico was the poster boy of neo-liberal miracle. The inflow of hot money capital had risen from zero to 5% of GDP. But internal Mexican inflation and the fixed peso-dollar exchange rate had left Mexico uncompetitive in world trade. Mexicans were taking the speculative hot money to finance consumption rather than investment.

The Mexican boom was applauded as a miracle of neo-liberal wealth effect. The Congressional Budget Office Report on NAFTA (North American Free Trade Agreement) calmly diagnosed the Mexican situation as nothing more serious that an overvalued peso. The neo-liberal solution was to devalue the peso by 20% and let the peso then drift gradually downward in an orderly market by as much as Mexican inflation exceeded US inflation in order to keep Mexico competitive, restoring market equilibrium and all would be well. Life turned out very differently.

By December 1994, Mexico ran out of foreign exchange reserves and announced it would suspend the peso's peg to the dollar and let the market determine the devaluation of the peso. But the peso fell like a rock by far more than the 20% that neo-liberals had forecast was necessary to restore equilibrium. Speculators in the market pushed the peso down sharply and abruptly by more than 300%. Foreign exchange reserves had fallen from nearly $30 billion in March, to $5 billion when the decision to abandon the peg was made in December.

The Mexican government bet that the drawdown of reserves was a temporary shock rather than a permanent change in foreign investor/creditor demand for peso-denominated assets. Mexico's economic fundamentals, balanced federal budget, successful privatization campaign, financial liberalization, were "sound enough" in the spring of 1994 to elicit "a strong and unqualified endorsement of Mexico's economic management" from the IMF. According to the neo-liberal doctrine, the only weak link was its overvalued currency. But the market had a better take on reality. Investors/speculators saw that dollar hegemony was destroying the peso economy and everyone wanted to be out of peso.

Part of the Mexican government's strategy for retaining confidence in its stable exchange rate throughout 1994 was to replace conventional short-term borrowing with the infamous "Tesebonos", a short-term security whose principal was indexed to the dollar, as a means of retaining the funds of investors who feared bottomless devaluation. This policy did retain some $23 billion of foreign financing but it fatally increased Mexico's exposure to foreign exchange risk. What in effect happened was that $23 billion stayed in Mexico, but left the peso economy for the dollar economy. The ultimate irony was that much of the $23 billion belonged to Mexicans.

By the end of 1994, the inflow of dollar hot money to Mexico's peso economy had not resumed as expected by neo-liberal policymakers. Investors/speculators feared hyperinflation as the Mexican government frantically printed pesos to cover its peso-denominated debts. Or worse, they feared capital controls that would trap dollars in Mexico for an indefinite time, or formal default: a repeat of the 1982 crisis that international banks had not forgotten. They understood well how dollar hegemony worked.

With $5 billion in reserves, with $23 billion in Tesebono liabilities that would be converted into dollars and pulled from the peso economy as it matured, and with no one willing to lend more dollars to borrowers without dollar income, Mexico faced imminent default on its dollar debts, hyperinflation and a severe depression. Either the Mexican government would push peso interest rates sky-high to keep capital in the peso economy and strangle the Mexican economy or the Mexican government, unable to borrow more dollars, would start printing pesos to meet its obligations in both pesos and dollars and see a spiral of 1980s Argentina-style hyperinflation and depreciation. The panic began to spread in what came to be called the "tequila effect", creating instability in other developing economies in the region and beyond.

Mexico was not insolvent. As Walter Wriston of Citibank famously said in 1973, nations do not go bankrupt. Mexico was merely facing a dollar liquidity crisis. If dollar creditors had been willing to roll over Mexico's short-term dollar debts, mild contraction policies and a moderate devaluation to reduce imports and encourage exports would enable the Mexican government to pay rescheduled dollar liabilities as they came due. Mexico then would theoretically recover quickly from a short and shallow recession. But dollar hegemony prevented such a solution. Mexico was facing a dollar illiquidity it could not possibly solve because it could not print dollars.

It then fell upon the US, which could print dollars at will, to provide a rescue package totaling $40 billion that Mexico could draw on to contain its dollar liquidity crisis. The Bill Clinton administration, whose chief economic official had invented dollar hegemony, was prepared to act, but US domestic politics stood in the way. Conservatives and liberals united to oppose the rescue package for different ideological reasons. Patrick Buchanan called the Clinton rescue package a gift to Wall Street: "Not free-market economics [but] Goldman-Sachsonomics." Ralph Nader urged the Congress to reject the support package and to demand that Mexico raise wages. Columnists in the Wall Street Journal demanded that support be provided only if Mexico first returned the peso to its pre-December parity.

Mexico's devaluation of the peso in December 1994 precipitated another crisis in the country's financial institutions and markets that caused an abrupt collapse of a "booming" economy that had not benefited Mexico as much as the dollar economy. Within Mexico, most of the meager benefits went to the elite comprador class at the expense of the general population, particularly the poor, but even the middle class who had no dollar income. International and domestic investors/speculators, reacting to falling confidence in the peso, sold Mexican equity and debt securities to buy dollars with which they could buy back what they sold at a fraction of the selling price.

Foreign-currency reserves at the Bank of Mexico, the nation's central bank, were insufficient to meet the massive demand of speculators seeking to convert pesos to dollars. In response to the crisis, the US organized a financial rescue package of up to $40 billion from the US, plus another $10 billion from Canada, the IMF and the Bank for International Settlements (BIS). The multilateral rescue package was intended to enable Mexico to avoid defaulting on its dollar debt obligations and thereby overcome its short-term dollar liquidity crisis and to prevent the crisis from spreading to other emerging markets through contagion. It was not to help a Mexican economy hemorrhaging from a bankrupt monetary policy, one that allowed foreign and domestic speculators to collect their phantom Ponzi peso profits in real dollars. The Mexican rescue package in 1995 created moral hazard for international banks on a global scale.

In the weekend before Mexico's pending dollar default, the US government took the lead in developing an emergency rescue package. The package put together by the Fed under Alan Greenspan and the Treasury under Robert Rubin, a former co-chairman of Goldman Sachs and a consummate bond trader, included short-term currency swaps from the Fed and the Exchange Stabilization Fund (ESF), a commitment from Mexico to an IMF-imposed economic austerity program for $4 billion in IMF loans, and a moratorium on Mexico's principal payments to foreign commercial banks, mostly US, with Fed regulatory forbearance on resultant bank capital adjustments that affected bank profits. It also included $5 billion in additional commercial bank loans, additional dollar liquidity support from central banks in Europe and Japan and pre-payment by the US to Mexico for $1 billion in oil and a $1 billion line of credit from the US department of agriculture.

The ESF was established by Section 20 of the Gold Reserve Act of January 1934, with a $2-billion initial appropriation. Its resources have been subsequently augmented by special drawing rights (SDR) allocations by the IMF and through its income over the years from interest on short-term investments and loans, and net gains on foreign currencies. The ESF engages in monetary transactions in which one asset is exchanged for another, such as foreign currencies for dollars, and can also be used to provide direct loans and guarantees to other countries. ESF operations are under the control of the secretary of the treasury, subject to the approval of the president.

ESF operations include providing resources for exchange-market intervention. The ESF has also been used to provide short-term swaps and guarantees to foreign countries needing financial assistance for short-term currency stabilization. The short-term nature of these transactions has been emphasized by amendments to the ESF statute requiring the president to notify Congress if a loan or credit guarantee is made to a country for more than six months in any 12-month period. Short-term currency swaps are repurchase-type agreements through which currencies are exchanged. Mexico purchased dollars in exchange for pesos and simultaneously agreed to sell dollars against pesos three months hence. The US earned interest on its Mexican pesos at a specified rate.

It was Bear Stearns chief economist Wayne Angell, a former Fed governor and advisor to then Senate majority leader Bob Dole, who first came up with the idea of using the ESF to prop up the collapsing Mexican peso. Bear Stearns, a Wall Street giant, had significant exposure to peso debts. Senator Robert Bennett, a freshman Republican from Utah, took Angell's proposal to Greenspan and Rubin. Both rejected the idea at first, shocked at the blatant circumvention of constitutional procedures that this strategy represented, which would invite certain reprisal from Congress.

Congress had implicitly rejected a rescue package that January when the initial administration proposal of extending Mexico $40 billion in loan guarantees could not pass. The chairman of the Fed advised Bennett that the idea would only work if Congress's silence could be guaranteed. Bennett went to Dole and convinced him that the whole scam would work if the majority leader would simply block all efforts to bring this use of taxpayers' money to a vote. It would all happen by executive fiat. The next step was to persuade Dole and his counterpart in the House, Speaker Newt Gingrich. They consulted several state governors, notably then Texas governor George W Bush, who enthusiastically endorsed the idea of a bailout to subsidize the border region in his state. Greenspan, who historically opposed bailouts of the private sector for fear of incurring moral hazard, was clearly in a position to stop this one. Instead, he used his considerable power and influence to help the process along when key players balked. Moral hazard infected not only the banking system, but also the political system making a mockery of the constitution. Few in Washington were prepared to be reminded that it was this kind of systemic corruption in the name of the common good that had brought down the Roman Empire.

The peso bailout would lead to a series of similar situations in which influential private financial institutions knowingly got themselves into future trouble in order to maximize their short-term profit, vindicating the moral-hazard principle predicting that market participants will take undue risks in the presence of bailout guarantees. As Thailand, Indonesia, Malaysia, South Korea and Russia stumbled into financial crisis, culminating in the collapse of hedge fund giant Long-Term Capital Management (LTCM), which played key speculative roles in precipitating the crisis by achieving fantastic returns to begin with, Greenspan moved to increase dollar liquidity to support the distressed bond markets. At the helm of LTCM was yet another former member of the Fed board, former vice chairman David Mullins, to plead for help from his former Fed colleagues.

When New York Fed president William McDonough helped coordinate a bailout of LTCM, Greenspan defended McDonough before a congressional oversight committee. Reflecting on all the corporate welfare being doled out to prop up bad private-sector institutional investments worldwide, Bill Clinton appointee Alice Rivlin, the able former congressional budget director, observed "the Fed was in a sense acting as the central banker of the world". During Clinton's first term, Greenspan had handed the president a "pro-incumbent-type economy" and was rewarded with a seat next to the first lady in Clinton's televised State of the Union address and a third-term appointment as Fed chairman. Crony capitalism was in full swing in the temple of free market.

Historically, the US and Mexican economies have always been closely integrated in a semi-colonial relationship. In 1994, the US supplied 69% of Mexico's high-value-added imports and absorbed about 85% of its low-wage labor-intensive exports. US investors have provided a substantial share of foreign investment in Mexico and have established numerous manufacturing facilities there to take advantage of low wages and unregulated labor and environmental regimes. Also, the US has served as a large market for illegal Mexican immigrant labor in its underground economy and farm sector, which has grown to be a sizable foreign-currency earner for Mexico. Mexico has long been the third-largest trading partner of the US, accounting for 10% of US exports and about 8% of US imports in 1994. The Maquiladora assembly industry concentrated on the Mexican side of the US-Mexico border was hailed by neo-liberals as a model of successful free trade, instead of the sweatshop hell it actually was.

In 1994, under newly installed president Ernesto Zedillo, a Yale-educated economist, Mexico entered the North American Free Trade Agreement with the US and Canada. NAFTA, conceived as a regional economic counterweight to the EU, further opened Mexico to foreign investment and bolstered investor interest on the hope that with NAFTA, Mexico's long-term prospects for stable economic development were likely to improve, at least for the benefit of foreign investors. NAFTA, as negotiated and signed in December 1992 by the administrations of Mexican president Carlos Salinas de Gortari and US president George H W Bush, and as amended and implemented by the Salinas and Clinton administrations in 1993, did not offer Mexico any significant increase in access to the US market. Rather, Mexico was blackmailed into signing NAFTA to prevent Mexican businesses from being bankrupted wholesale by sudden waves of pending US protectionism.

Mexico was also advised by neo-liberals to adopt an exchange rate system intended to protect foreign investors who could exchange their peso earnings for dollars at the Mexican central bank at an overvalued rate. In 1988, the nominal exchange rate of the peso had been fixed temporarily in relation to the dollar. However, because the inflation rate in Mexico was greater than that in the US, a peso nominal depreciation against the dollar was needed to keep the real exchange rate of the peso from increasing. With the nominal exchange rate of the peso fixed, the real exchange rate of the peso appreciated during this period. In 1989, this fixed-exchange-rate system was replaced by a "crawling peg" system, under which the peso-dollar exchange rate was adjusted daily to allow a slow rate of nominal depreciation of the peso to occur over time.

In 1991, the crawling peg was replaced with a band within which the peso was allowed to fluctuate. The ceiling of the band was adjusted daily to permit some appreciation of the dollar (depreciation of the peso) to occur. The Mexican government used the exchange rate system as an anchor for an unsustainable economic policy, ie, as a way to reduce inflation through shrinking the economy, to force a politically destabilizing fiscal policy, and thus to provide a comfortable climate for foreign investors who managed to carry home the same dollars they brought in via a short circuit, while leaving only their peso holdings behind that the Mexican central banks had promised to guarantee as fully convertible at an over-valued fixed exchange rate despite predictable unsustainability. The key difference between the peso and the yuan is that the yuan is not freely convertible.

Before 1994, Mexico's strategy of adopting sound monetary and austere fiscal policies appeared to be having its intended effects of making foreign capital feel secure while producing the unintended effect of steadily hollowing out the Mexican economy. Inflation had been steadily reduced by the fixed exchange rate of the peso, government social spending was down to reduce the budget deficit, and foreign direct investment was increasing. Moreover, unlike in the years before 1982, most foreign capital was flowing to Mexico's private sector that yielded higher returns rather than as low-interest loans to the Mexican government in 1982 to finance budget deficits.

Although Mexico was experiencing a very large current account deficit, both in absolute terms and in relation to the size of its economy, neo-liberal policymakers did not consider it an immediate problem. They pointed to Mexico's large foreign currency reserves, its rising exports, and its seemingly endless ability to attract and retain foreign investment. They had hoped to copy the US strategy of using a capital account surplus to finance its current account deficit. But they forgot that unlike the US, Mexico cannot print dollars and that even though the dollar is the world's reserved currency for trade, it is still a US currency, not a world currency. They were in fact ignorant of the danger of dollar hegemony to Mexico. This attitude ignored the fact that true wealth was leaving Mexico through the turning of peso assets into dollar assets, masked by a Mexican stock market bubble fueled by an overvalued peso.

Yuan's Peso Parallels

Though the conditions surrounding the yuan are not totally congruent with those surrounding the peso, there are similarities between the yuan in 2004 and the peso in 1994, with the exception that China's currency is not freely convertible. Prior to the 1994 crisis, Mexico's foreign exchange reserves kept growing in ratio to the Mexican GDP similar to the China's rise in foreign exchange reserves in ratio to its GDP. For both economies, the rise in foreign exchange reserved was caused by the inflow of hot money. The rise in China's foreign exchange reserves is actually an ominous indicator of real wealth leaving the yuan economy into the dollar economy, as it was for Mexico up to the 1994 peso crisis. Mexican GDP in 2002 was $920 billion compared to China's $1 trillion. Mexican per capita GDP was $9,000, nine times that of China's, because of Mexico's smaller population. Following a 6.9% growth in 2000, Mexican real GDP fell to 0.3% in 2001, with the US slowdown the principal cause. This could also happen to China. With a sharp fall in interest rates to stimulate and a rise of the peso of 5% against the dollar, the inflation rate in Mexico was unable to fall below 6.9%. Foreign direct investment reached $25 billion in 2001, of which $12.5 billion came from the purchase of Mexico's second largest bank, Banamex, by Citigroup.

Reality finally unmasked this faulty neo-liberal theory by late 1994. Mexico's financial crisis was the inevitable outcome of the growing inconsistency between its monetary and fiscal policies, its over-dependence on export for dollars to sustain growth and its false sense of stability based on its exchange rate peg to a fiat dollar. Partly because of an upcoming presidential election, Mexican authorities were reluctant to take action in the spring and summer of 1994, such as reducing the inconsistency between interest rates and the fixed value of the peso. This structural policy inconsistency was exacerbated by the government's response to several economic and political events that created investor concerns about the likelihood of a currency devaluation, such as the issue of large amounts of short-term, dollar-indexed tesobonos. By the beginning of December 1994, Mexico had become particularly vulnerable to a financial crisis because its foreign exchange reserves had fallen to $12.5 billion while it had tesobono obligations of $30 billion maturing in 1995.

A country can respond to a dollar current-account deficit in four ways:

Attract more foreign capital denominated in dollars. The US does not need to do this because of dollar hegemony, but Mexico, which could not print dollars, was forced to attract more foreign capital denominated in dollars with a Ponzi scheme of paying old capital with new capital.

Use dollar foreign exchange reserves to cover the deficit. The US can do this by printing dollars, the reserve currency of choice, but Mexico could not print dollars, only pesos, which put more pressure on the peso-dollar exchange rate.

Tighten monetary and/or fiscal policy to reduce the demand for all goods, including imports, shrinking the economy.



It was obvious that Mexico was experiencing a large current-account deficit financed mostly by short-term portfolio capital, a euphemism for hot money, which was vulnerable to a sudden reversal of investor confidence. Nevertheless, neo-liberal policymakers in both Mexico and Washington, while acknowledging that the peso was overvalued and the existing exchange rate was unsustainable, were undecided about the precise extent to which the peso was overvalued and if and when financial markets might force Mexico to take action. Estimates of the overvaluation ranged between a benign 5%-20%.

Moreover, Fed and treasury officials under Greenspan and Rubin did not foresee the magnitude of the crisis that eventually unfolded. The IMF was oblivious to the seriousness of the situation that was developing in Mexico and, for most of 1994, did not see a compelling case for a change in Mexico's exchange rate policy. In the period prior to July 1997, when the Asian financial crises broke out first in Thailand, the IMF was praising South Korea and most other Asian economies for their continuing growth and sound exchange rate policies. Even after financial contagion was in full force, the IMF kept releasing complacent prognoses of the temporary nature of the crisis. The IMF diagnosed the crisis as a passing liquidity crunch, denying its structural causes, particularly dollar hegemony.

The objectives of the US and IMF rescue packages for Mexico after the December 1994 devaluation and the subsequent loss of market confidence in the peso were (1) To help Mexico overcome its allegedly short-term liquidity crisis and; (2) To limit the adverse effects of Mexico's crisis spreading to the economies of other emerging market nations and beyond. No effort was directed at restructuring fundamental neo-liberal policy faults, or to admit that localized isolation is empty hope in a globalized system.

Many US observers opposed any US financial rescue to Mexico. They argued that tesobono investors should not be shielded from financial losses on moral hazard grounds, and that neither the danger posed by the spread of Mexico's crisis to other nations nor the risk to US trade, employment, and immigration was sufficient to justify such a bailout.

The Bank of Mexico, the central bank, doubled the interest rate on short-term Mexican government peso notes, called cetes, from 9% to 18%, in an attempt to stem the outflow of dollar. However, despite higher interest rates, investor demand for cetes continued to lag. Investors were demanding even higher interest rates on newly issued cetes because of their perception that the peso would be subject to progressively larger devaluation by rising interest rates. It was a classic vicious circle.

Options available to the Mexican government at this time included:
1) Offering even higher interest rates on cetes.
2) Reducing government expenditures to reduce domestic demand, decrease imports, and relieve pressure on the peso.


Devaluing the Peso.

All three options would lead to increased downward pressure on the peso and the economy. The only workable option, exchange control in the form of restrictive capital flow, was not considered by the Harvard-Yale-trained Mexican central bankers, nor encouraged by US advisors. It was not until 1998, when Malaysia successfully adopted exchange controls, that some born-again market-failure fundamentalists led by MIT economist Paul Krugman grudgingly acknowledged it as a legitimate option.

From the perspective of the Mexican authorities, the first two choices were unattractive in a presidential election year because they could have led to a significant downturn in economic activity and could have further weakened Mexico's banking system. The third choice, devaluation, was also unattractive since Mexico's success in attracting substantial new dollar investment to feed its Ponzi scheme depended on its commitment to maintain a stable exchange rate. In addition, a stable exchange rate had been an essential ingredient of longstanding policy agreements among the government, labor and business, and these agreements were perceived as ensuring economic and social stability. Also, the stable exchange rate was considered a key to continued reductions in the inflation rate by orthodox neo-classical economics. Ironically, typical of all Ponzi schemes, success was fatal because it accelerated unsustainability.

Rather than adopting any of these highly visible options, the government chose, in the spring of 1994, to increase its issue of tesobonos quietly as a political expediency to help the ruling Institutional Revolutionary Party (PRI) win the coming election. Because tesobonos were dollar-indexed, holders could avoid losses that would otherwise result if Mexico subsequently chose to devalue its currency. The government promised to repay investors an amount, in pesos, sufficient to protect the dollar value of their investment. Tesobono financing in effect dollarized Mexican sovereign debt and transferred foreign exchange risk from investors to the Mexican central bank and government and to provide a short-term liquidity solution that would exacerbate long-term structural problems.

Tesobonos proved attractive to domestic and foreign investors. However, as sales of tesobonos rose, Mexico became vulnerable to a financial market crisis because many tesobono purchasers were portfolio investors who were very sensitive to changes in interest rates and related risks. Furthermore, tesobonos had short maturities, which meant that their holders might not roll them over if investors perceived (1) An increased risk of a government default or; (2) Higher returns elsewhere. Market discipline operated like a pool of frenzied sharks cycling around the scent of financial blood.

Nevertheless, Mexican authorities viewed tesobono financing as the best way to stabilize foreign exchange reserves over the short term and to avoid the immediate costs implicit in the other alternatives in an election year. In fact, Mexico's foreign exchange reserves did stabilize at a level of about $17 billion from the end of April through August 1994, when the presidential elections came to a conclusion. Mexican authorities expected that investor confidence would be restored after the August election and that investment flows would return in sufficient amounts to preclude any need for continued, large-scale tesobono financing.

After the election, however, foreign investment flows did not recover to the extent expected by Mexican authorities, in part because peso interest rates were allowed to decline in August and maintained at that level until December. During the autumn of 1994, it became increasingly clear that Mexico's contradictory mix of monetary, fiscal, and exchange-rate policies needed to be adjusted. The current account deficit had worsened during the year, partly as a result of the strengthening of the economy related to a moderate pre-election loosening of fiscal policy, including a step up in developmental lending in the domestic sectors, which was considered by market fundamentalists as a big no-no.

Imports had also surged as the peso became further overvalued. Mexico had become heavily exposed to a run on its foreign exchange reserves as a result of substantial tesobono financing. Outstanding tesobono obligations increased from $3.1 billion at the end of March to $29.2 billion in December. Also, between January and November 1994, US three-month treasury bill yields had risen from 3.04% to 5.45%, substantially increasing the attractiveness of US government securities. In the middle of November 1994, Mexican authorities had to draw down foreign currency reserves to meet the demand for dollars.

On November 15, 1994, in response to US domestic economic conditions, the Fed raised the federal funds rate by three-quarters of a percentage point to 5.5%, raising the general level of dollar interest rates and further increasing the attractiveness of US bonds to investors. By late November and early December, poor economic performance spilled over to political incidents that caused apprehension among investors regarding Mexico's political stability. These concerns were compounded on December 9, when the new Mexican administration revealed that it expected an even higher current account deficit in 1995 but planned no change in its exchange rate policy. This decision led to a further loss in confidence by investors/speculators, increased redemptions of Mexican securities, and a significant drop in foreign exchange reserves to $10 billion. Meanwhile, Mexico's outstanding tesobono obligations reached $30 billion, all coming due in 1995. However, Mexican government officials continued to assure investors that the peso would not be devalued.

On December 20, Mexican authorities sought to relieve pressure on the exchange rate by announcing a widening of the peso-dollar exchange rate band. The widening of the band in effect devalued the peso by about 15%. However, the government did not announce any new fiscal or monetary measures to accompany the devaluation - such as raising interest rates. This inaction was accompanied by more than $4 billion in losses in foreign reserves on December 21. A day later, on December 22, Mexico was forced to float its currency freely and it ran out of reserves to support the peg.

The discrepancy between the stated exchange rate policy of the Mexican government throughout most of 1994 and its devaluation of the peso on December 20, along with a failure to announce appropriate accompanying policy measures, contributed to a significant loss of investor confidence in the newly elected government and growing fear that default was imminent. Consequently, downward pressure on the peso continued and turned into a rout. The crisis is known as "The December Mistake". The peso crashed from the official rate of three pesos to the dollar to a market rate of 10 to the dollar in the space of a week, and sold for up to 30 pesos at times in some regions. By early January 1995, investors/speculators realized that Mexico's reserves could not meet tesobono redemptions and, in the absence of external assistance, Mexico might default on its dollar-indexed and dollar-denominated debt.

As 1994 began, signs were visible that Mexico was vulnerable to speculative attacks on the peso and that its large and growing current account deficit and its exchange rate policy might not be sustainable. However, neo-liberal economists generally thought that Mexico's economy was characterized by "sound economic fundamentals" and that, with major economic reforms of the past decade along Washington Consensus lines, Mexico had laid an adequate foundation for economic growth in the long term.

In reality, Mexico was exporting real wealth and importing hot money with the help of a flawed central bank policy that was attracting large capital inflows and held substantial foreign exchange reserves derived from foreign debt. Concerns about the viability of Mexico's exchange rate system increased after the assassination of presidential candidate Luis Donaldo Colosio in the latter part of March and the subsequent drawdown of about $10 billion in foreign exchange reserves by the end of April. Persistent rumors continue to circulate even today that Colosio, a Salinas protege, was shot on the orders of Salinas himself because Colosio was turning populist in his election campaign, threatening to undermine the legacy of Salinas's neo-liberal agenda.

With the assassination of Colosio, neo-liberal candidate Ernesto Zedillo Ponce de Leon became president and continued neo-liberal policies for six more years. Just after the Colosio assassination, US treasury and Fed officials promptly, albeit temporarily, enlarged longstanding currency swap facilities with Mexico from $1 billion to $6 billion. These enlarged facilities were made permanent with the establishment of the North American Financial Group in April. Mexican foreign exchange reserves stabilized at about $17 billion by the end of April 1994.

The infrastructure of politics is the economic institutions founded on political ideology. The infrastructure of neo-liberal politics is the institution of privatization. Harvard-educated Carlos Salinas de Gortari, in pursuing a neo-liberal agenda, put emphasis on privatization. In the final years of his term, Salinas pushed the NAFTA. Unfortunately, Salinas's version of privatization, not unlike privatization programs everywhere else, primarily took the form of a giveaway of state assets to his family members, friends and political associates. In Mexico, since most state assets were controlled by the ruling party, this giveaway had the effect of dissipating the economic resources for political patronage that had been a major source of political power of the ruling PRI, while having only modest results in terms of effective real investment. This happened also to the Kuomintang in Taiwan and to the ruling political parties in post-Soviet Russia. It will also happen to the Chinese Communist Party as China implement its privatization program.

In addition, the Salinas regime revived political violence to levels not seen since the early days of the PRI, which culminated in the assassination of Colosio and Francisco Ruiz Massieu, secretary general of the PRI. The last year of Salinas's term began with the Zapatista uprising in Chiapas. The passage of NAFTA has not had the expected dramatic positive effects. The final indignity of the Salinas regime came shortly after the installation of his successor, Ernesto Zedillo Ponce de Leon, who was immediately forced to devalue the peso. Salinas, as he left Mexico with huge foreign debts, was forced to leave the country in disgrace, though not in personal poverty.

Zedillo's term was largely devoted to institutionalizing neo-liberalism in Mexico, establishing a new institutional framework for presidential elections, including an independent Federal Election Institute (IFE) that allots disproportionate influence to special-interest groups through political campaign financing and media spending. A media-oriented US-style campaign based on sophisticated image management produced Vicente Fox Quezada of the National Action Party (PAN), the former president of Coca-Cola Mexico and a prince of the globalization culture, as the president of Mexico. Mexican politics typifies the politics of globalization, particularly in relation to NAFTA. Economic management by the PRI shifted from the populist policies of the administrations of Echeverría and Portillo to the neo-liberal agenda of Miguel de la Madrid, which was a dismal failure.

The accumulated per capita GDP growth through the period 1983-1999 was 0.32% in Mexico, while it was 180.9% in the more pragmatically managed economy of South Korea. Yet, Korea became a basket case after the 1997 Asian crisis. In spite of the vaunted sophistication of the neo-liberal model and the Ivy-league-trained technocrats administering it, Mexico was subject to recurring major financial shocks, the most traumatic being the currency crises of 1982 and 1994. Twenty years of empirical evidence of failure to deliver on promises of economic stability, growth and trickle-down prosperity should be sufficient to suggest that there is something wrong with the theory. Yet this worn-out, discredited neo-liberal theory has been invading China in ways exponentially more destructive than the SARS virus.

Obsessive compulsive export
In addition to reduced government spending and reliance on the free market, neo-liberal orthodoxy has also promoted a single-minded focus on global competition and export-driven economic development. Export cannot possibly be but a small part of any large economy such as Mexico, China or the US. It may work for special situations like Hong Kong and Singapore, whose models are totally irrelevant to a large economy like China. Yet the advice of Hong Kong tycoons is given disproportionate weight in the high council of the Chinese economic policy establishment. The preponderance of the export sector will distort domestic politics that will have adverse effects on national development policy formulation. This is where real reform is needed in China.

It has been estimated by Mexican economists that 20-25% of the Mexican population owe their livelihood to US-Mexico trade. This group crosses class, regional and even ideological lines. The fate and well-being of vast regions of the Mexican south and east are as directly connected to the US as Tijuana and Monterrey. The same applies to the coastal regions of China. It is not a rich-poor divide. There are Mexican magnates whose wealth and power are not directly linked to US connections except as part of a vibrant total economy. And there are millions of destitute Mexicans whose meager livelihood depends almost entirely on their association with "el otro lado" (the other side).

The same is true in China. It is not a left-right split. Many on the Mexican left see interaction with the US as powerful levers to transform the country toward a modern economy. Many free-market conservatives in Mexico see US neo-liberal influence as a deadly menace. The 6% of the Mexican population that is involved in export manufacture is dominated by large-scale enterprises whose owners at least are doing very well. However, workers in both export and domestic sectors have not been touched by much progress. The economy of Mexico remains polarized into extremes of wealth and poverty, with 4% of the population owning half the nation's wealth and more than 40% living in poverty. China is faced with similar trends. Mexico cannot solve its problems through export. It needs to develop its domestic economy. But dollar hegemony prevents Mexico from taking the route. The same is true for China.

Neo-liberal orthodoxy in the context of dollar hegemony prevents non-dollar economies from focusing on domestic development through the application of sovereign credit. Increasing government participation in the domestic economy in ways that promote social well-being and ecological sustainability is an alternative that have not been adequately explored. A major feature of this participation would include an industrial policy focusing on the development of industries with the greatest capacity to contribute to balanced and sustained economic growth. It would also include augmenting the government's capacity to provide essential physical infrastructure in areas such as housing and transportation, and social infrastructure in areas such as education, public health and social services. And it would promote sustainable agricultural self-sufficiency as well as patterns of growth that are sensitive to the specific needs of a nation's distinctive geographical regions and cultural heritage. The lopsided emphasis of neo-liberal economics that look almost exclusively to export-driven growth based on predatory competition in the global market is no way to solve problems of poverty.

A new entrepreneurial class that can compete internationally and work in an interdependent world economy is an asset to any nation. But the promotion of this class cannot be allowed to lead to the official disregard for the backbone of the Chinese political economy, which remains the agricultural sector and the peasants who work in it. China cannot become a rich economy by being an unjust economy, by simply moving wealth from the masses to the few.

Salinas bet his presidency on NAFTA. While NAFTA won, Salinas lost. This should be a dire warning to the Chinese Communist Party, which at long last is officially debating on ways to strength its mandate and ability to rule. Salinas and his PRI lost power because neo-liberal economics serves only part of the population, even when it is well managed. And it was badly managed by Salinas. Zedillo was able to restore a modicum of stability, with considerable help from Clinton's bailout. His economic policy continued to follow neo-liberal orthodoxy and he stabilized the peso, at a high cost to Mexico. Finally, he lost control of the government to the opposition in the historic election of July 2000.

On August 1, 2000, dissidents in Mexico's traditional ruling party, angered by its first presidential election defeat in 71 years, formally petitioned for Zedillo's expulsion. Five moderately influential factions in the PRI also demanded the expulsion of Zedillo's predecessor, Salinas, accusing both of undermining the PRI through neo-liberal, free-market economic policies. Shocked by unaccustomed defeat, the PRI was torn apart by internal power struggles between pro-Zedillo technocrats, mainly US-educated economists, and the "dinosaurs" old-style PRI politicians closely associated with nationalism.

Under Salinas, who ruled from 1988-1994, and Zedillo, whose six-year term ended in December 2000, Mexico firmly embraced the free market. Many state enterprises were sold off, its borders opened to trade and Mexico adopted the neo-liberal economic policies of fiscal and monetary discipline promoted by the IMF. PRI dissidents opposed Salinas's and Zedillo's economic and social policies as contrary to the PRI's basic populist and paternal spirit. They criticized the privatization of banks and state firms, and hikes in taxes. They blamed the traitorous policies of Salinas and Zedillo for the victory of Vicente Fox, of the conservative National Action Party (PAN) who became Mexico's first non-PRI president in seven decades. Reformist leaders within the PRI led to the marginalization of the PRI in Mexico. Reformist leader within the Kuomintang led to the marginalization of the GMD in Taiwan. A similar fate may await the Chinese Communist Party as it moves China toward more market and political reform.

At the end of June 1994, a new run on the peso was under way. Between June 21 and July 22, foreign exchange reserves were drawn down by nearly $3 billion, to about $14 billion. In early July, Mexico asked the Fed and treasury to explore with the central banks of certain European countries the establishment of a contingency, short-term swap facility. That facility could be used in conjunction with the US-Mexican swap facility to help Mexico cope with possible exchange rate volatility in the period leading up to the August election.

By July, Fed had concluded that Mexico's exchange rate probably was overvalued and that some sort of adjustment eventually would be needed. However, US officials thought that Mexican officials might be correct in hoping that foreign capital inflows could resume after the August elections. In August, the US and the BIS established the requested swap facility, but not until US officials had secured an oral understanding with Mexico that it would adjust its exchange rate system if pressure on the peso continued after the election. The temporary facility incorporated the US-Mexican $6 billion swap arrangement established in April. At the end of July, pressure on the peso abated, and Mexican foreign exchange reserves increased to more than $16 billion. Significant new pressure on the peso did not develop immediately after the August election, but at the same time, capital inflows did not return to their former levels.

The Fed and the treasury did not foresee the serious consequences that an abrupt devaluation would have on investor confidence in Mexico. These included a possible wholesale flight of capital that could bring Mexico to the point of default and, in the judgment of US and IMF officials, require a major financial assistance package. IMF officials thought that Mexico's sizable exports meant there was no need to adjust the foreign exchange policy. They did not foresee the exchange rate crisis and, for most of 1994, did not see a compelling case for a change in Mexico's exchange rate policy. The IMF completed an annual review of Mexico's foreign exchange and economic policies in February 1994. The review did not identify problems with Mexico's exchange rate policy. This pattern of IMF complacency was repeated in Asia and Latin America throughout the rest of the decade.

Whereas the 1982 rescue package would turn out to be just the beginning of a protracted process of managing Mexico's excessive indebtedness, including several concerted debt rescheduling exercises, a debt buyback and the 1990 debt reduction agreement negotiated under the terms of the Brady Plan, the 1995 rescue package worked better, largely because of widespread moral hazard. After the 1982 rescue package, Mexico received support from the Fed and the treasury on three other occasions, but always in the form of interim financing while other workouts were concluded.

The difference between the 1982 and 1995 packages is that while the former was followed by a decade of living in "exile" from the international capital markets, the latter was successful in quickly restoring market access. The difference in outcomes is related to the size of the financial package and its medium-term quality, but the fundamental difference was the market's expectation that the Fed was by 1995 fully committed to crisis resolution through added liquidity. In 1995, the financial rescue package was designed to be large enough, plausibly to solve Mexico's dollar liquidity crisis. In 1982, the package was large enough to avoid a Mexican default but for the next six years the country had to go from one rescheduling exercise to another, with the uncertainty of whether the country would be able to meet its obligations always lurking on the horizon. Success in the 1995 package was not applicable to correcting Mexico's fundamental debt problem. Much of the liquidity provided by the Fed actually came from the Asian central banks.

In 1995, after the Federal Reserve started to hike interest rates in 1994 and sharply curtailed its own purchase of treasury bills, triggering the Mexico peso crisis and a subsequent US slowdown, the Bank of Japan initiated a program to buy $100 billion of US treasuries. China bought $80 billion. Hong Kong and Singapore bought $22 billion each. South Korea, Malaysia, Thailand, Indonesia and the Philippines bought $30 billion. The Asian purchase totaled $260 billion in 1994-97, the entire increase in foreign-held US dollar reserves. These recycled dollars from US trade deficits pushed down long-term dollar rates from 7.37% in 1994 to 6.67% in 1997, narrowing the spread to less than a point between 30 year Treasuries and the ffr at 5.82%. The flood of recycled foreign-owned dollars together with low long-term dollar interest rates pushed up stock prices in the US despite the Fed raising ffr targets, forming part of what Greenspan referred to as "irrational exuberance".

When will we learn?
The Mexican crisis of 1994 raised throughout the world a number of questions about the sustainability, and even the merits, of the market-oriented reform process in developing economies. Understanding how events unfolded in Mexico during the early 1990s continues to be fundamentally important to assess the mechanics of currency crises. It is of particular importance to debates on appropriate policy for China at this juncture. The Asian financial crises of 1997 were evidence that the lessons from Mexico had not been learned. Capital account liberalization has been a central aspect of trade liberalization for the past two decades. Such unregulated markets for currency, debt and capital have fueled the flow of hot money with highly destructive force. The collapse of the peso, the IMF structural adjustment (which includes austerity, including cuts in agricultural supports) were entirely predictable; and each had the immediate effect of slashing living standards and wage levels drastically, and increasing debt burdens.

The steady fall of the dollar versus the yen and deutschmark in the first quarter of 1995, in the Asian currency crisis of 1997, during the Russian ruble collapse and debt moratorium of 1998, and most recently, the sustained collapse of the dollar versus the yen that began in October 2003 were all part of the recurring pattern of dollar-interest-rate-induced instability. On the fixed income front, the most dramatic shocks were the global bear market in bonds in 1994, and the dramatic widening in credit spreads in the summer/early fall of 1998.

Each of these crises though unique, shared some similar characteristics. First, each crisis was largely unanticipated by the market, with the forward markets providing no indication of the impending upheaval. Second, going into each crisis, over-confident investors took on highly leveraged long positions in currencies, bonds, or spread products that were soon to come under heavy speculative attack. In each case, investors tended to embrace a number of specific investment themes or paradigms to justify their investment strategies. They were all proved wrong by reality.

When a relatively large share of investors embraced the same or a narrow range of investment themes, the commonly shared set of beliefs became the market's conventional wisdom. But once a crisis hit and the prevailing accepted wisdom shattered, investors were forced to liquidate their highly leveraged positions. In each instance, the unwinding of those highly leveraged positions accentuated the magnitude of the currency or fixed-income bond market crisis.

Similar to the dollar overshoots of 1985 and 1995, the 1994 global bear market in bonds also proved to be a transitory event, thanks again to liquidity provided by central banks. But while the dollar-crisis episodes represented dramatic overshoots at major turning points in the dollar's long-term trend, the 1994 global bond market sell-off now seems to be simply an interruption of a long-range rally in global bonds fueled by ever-expanding liquidity, although substantial losses were incurred during the sell-off. Going into 1994, many highly leveraged bond funds had taken on huge long-duration positions in several key markets after riding the 1993 bull market in global bonds, and probably believed that additional hefty returns could be enjoyed in 1994 by maintaining those leveraged long positions. They evidently ignored the fact that leading indicators of global economic activity were already turning up strongly from increased liquidity, making those positions extremely vulnerable if there was even a slight shift in accommodative monetary policy.

The Federal Reserve's rate hike in February 1994 was the catalyst for investors to unwind their highly leveraged long positions, triggering a major sell-off in bond markets around the globe. Global bond yields rose by 200-300 basis points on an average over the first three quarters of 1994. By the fourth quarter of 1994, bond yields managed to stabilize and then begin to fall steadily in 1995. By late 1995, bond yields had returned to their pre-crisis levels, pushed down by central bank monetary easing, i.e. more liquidity.

This pattern of collapse followed by stabilization and then recovery from added liquidity was not too dissimilar from the pattern of the dollar's collapse in early 1995. In both crisis episodes, the collapse stage took place over a three-six month period, followed by a period of stabilization that lasted about three months and a recovery period that took place over a three-12 month period. This pattern is the direct result of central banks changing short-term interest rate targets on the latest economic data, while spiraling upward with ever-expanding money supply. This is the equivalent of a sailing captain zigzagging cleverly to respond to shifting wind patterns while sailing straight towards a gigantic whirlpool of debt fueled by excess liquidity.

The 1998 credit-spread crisis shares a number of similar features with the 1994 bond market crisis. As in the 1994 crisis, hedge funds in 1998 took on aggressive highly leveraged long positions, this time in spread product, evidently believing that credit spreads would continue to narrow. Unfortunately, Russia's decision on August 26 to engineer an effective default on its dollar debt obligations led to a complete reassessment of credit risk by global investors/speculators. Fear that default risk might increase and spread worldwide led to a mad scramble for dollar liquidity. Quality spreads in the US corporate bond market widened dramatically and stood at recession levels. The yield spread between Baa corporates and US Treasuries widened to levels not seen since the 1990-91 recession. If such wide spreads should endure, US corporations would be less willing to borrow and therefore would likely curtail investment spending plans, which would clearly dampen US growth prospects.

The 1987 stock market recovery proceeded along the same path as the 1994 bond market crisis and the 1995 dollar crisis. Following the 1987 stock market crash, prices stabilized at their new lower levels until early 1988. Over the course of 1988, equity prices recovered, and by the spring of 1989 moved above the 1987 highs on the strength of massive increase in liquidity by the Fed. With such a dismal a record, it is pure arrogance for US monetary policy wonks to give advice to China.

Next: Futures Imperfect for China