A neighbour underestimated

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Ceritalah by KARIM RASLAN

The buoyant statistics coming out of East Kalimantan underline the extent to which the once-poor neighbour has eclipsed Sabah. And until Sabahans can exorcise their ghosts, Indonesia will remain an untapped mirage.
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WE are living in an age of tremendous financial turmoil. Currency and equity market gyrations have dramatically altered relations between nations and entire regions. Indeed, the decline of US and European competitiveness and the attendant acceleration of Chinese wealth have been the most note-worthy developments.

What is less well-documented is the fact that these trends have also led to significant changes within South-East Asia with China’s (and India’s) hunger for natural resources driving prices ever higher.
This is most apparent on the island of Borneo.

In 2010, the GDP per capita in Sabah was RM8,450. By way of comparison, the GDP per capita in the neighbouring Indonesian province of East Kalimantan (or Kaltim) was over US$4,000 (RM12,000).



While the Kaltim statistics are inflated by skyrocketing coal, as well as oil and gas prices, the reality shows a marked increase in living standards for the province’s 3.2 million people.

In fact, Kaltim’s booming economy is also contributing to Sabah’s shortage of labour for the plantation sector.

Meanwhile, decentralisation initiatives (dubbed regional autonomy) meant that a greater proportion of the natural resource bounty was being retained locally.

Kaltim is Indonesia’s largest producer of both coal and oil/gas. At the same time there are plans to increase palm oil planting to well over 1.5 million hectares.

Balikpapan – the premier commercial hub with a population over 600,000 – is also a major transport and services hub.

The city’s Sepinggan airport (with over five million passengers a year) is Indonesia’s fourth busiest.

The buoyant statistics coming out of Kaltim underline the extent to which the once-poor neighbour has eclipsed Sabah and indeed Malaysia.

This is all the more ironic given the fact that for many decades Sabahans have felt imperilled by what they’ve perceived as waves of “desperately poor” Indonesians and Filipinos pressing at their borders.

Indeed, the control (or lack of it) of migrant workers has been an enormously controversial issue in Kota Kinabalu.

Sabah’s exponential population growth – most notably in the 1980s when naturalisation policies (covert or otherwise) were at their most pronounced – witnessed a dramatic increase from 929,992 in 1980 to 1,734,685 in 1990.

Indeed, it is arguable that Sabahans have been traumatised by the massive influx of illegals.

The state’s indigenous communities have seen their demographic and political leadership whittled away.
Unsurprisingly, they are deeply suspicious of Indonesians and Filipinos.

All this has made it difficult for Sabah to leverage Indonesia’s current prosperity despite the state’s strategic location.

Sabah has very poor connectivity with Kaltim, so much so that even the lengthy land border lacks formal road crossings.

Still, Indonesians – including Awang Faroek, Kaltim’s Governor – are lobbying hard for a link at Serudong along the Tawau/Kota Kinabalu road.

In the absence of an overland crossing, hundreds of thousands of Indonesian workers in Sabah have been forced to travel by ferry through Tawau’s meagre and unimpressive port facilities.

By way of comparison, the Entikong crossing between Sarawak and West Kalimantan has become a major thoroughfare with countless buses plying the route linking Pontianak and Kuching.

Moreover, it is estimated that some 3,000 Indonesian students are currently studying in Kuching’s many private educational institutions.

At the same time, direct flights (on local carrier, Kalstar) linking the two cities have further enhanced connectivity and opportunities for businessmen on both sides of the border.

Kota Kinabalu and Balikpapan are like step-sisters. A journey between the two cities requires an awkward and time-consuming detour through either Kuala Lumpur, Singapore or Jakarta.

The alternative is the nerve-wracking ferry from Tawau to either Nunukan or Tarakan ... neither of which are particularly attractive for tourists or business travellers.

But Kota Kinabalu remains a superb destination.

With its waterfront lifestyle, schools, hospitals and international flights, the city is poised to become a popular hub for Indonesians – from as far away as Banjarmasin, Makassar, Samarinda and Manado.

It is worth noting that all four cities are beneficiaries of the natural resources boom and growing faster than the national average.

Indeed, other Malaysian cities such as Penang and Malacca have become adept at tapping the Indonesian demand for healthcare, education, housing and retail.

It remains to be seen whether the socio-political trauma of past decades could be overcome to allow Sabah to maximise these opportunities.

However, thankfully, some of Sabah’s leaders are beginning to recognise their neighbour’s vast potential.

Flamboyant former chief minister Datuk Harris Salleh has been a major promoter of the cross-Borneo linkages.

Last year, he undertook a highly publicised tour across Indonesian Kalimantan.

Similar sentiments are raised by Sabah Economic Development and Investment Authority CEO Yaakub Johari who confidently said: “History aside, we see Sabah acting as a conduit between an expanding Indonesia and the dynamic Northeast Asian markets.

“Enhanced connectivity whether by land, air or sea is a must.”

Until Sabah and Sabahans can exorcise their ghosts, Indonesia will remain an untapped mirage.

Malaysian Election Reform: a panel for free and fair polls

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A panel for free and fair polls

Comment by BARADAN KUPPUSAMY

 For the select committee on electoral reform to be successful, there is a need for all parties to put aside partisan politics and work for what matters most – the best interest of the rakyat.

PAKATAN Rakyat should give a chance for the Parliamentary Select Committee to be formed and do its job of investigating and suggesting changes to the country’s electoral system.

As it is, their MPs have issued numerous statements ranging from outright boycott of the select committee to agreeing to participate but on their own terms.

They want Pakatan leader Datuk Seri Anwar Ibrahim to head the panel, increase the number of Pakatan panel members from the current three or, alternatively, not to give independent MPs a place in the committee.

They also want the assurance that Prime Minister Datuk Seri Najib Tun Razak will not call for a general election before a full, complete report of the panel is published and the recommendations implemented.
 
Najib has said the reforms could be divided into immediate reforms and long term ones; immediate reforms could be implemented before the next general election.

But he has rejected outright the idea of reform first and a general election later, saying the Government reserves the right to call for a general election at any time.
 
Pakatan Rakyat is due to make known its stand on the matter soon, according to PAS deputy president Mohamed Sabu.

While Pakatan Rakyat decides, Parliament is set to debate a motion on the formation of the select committee on Oct 3, which will also include its terms of reference and possibly the members of the committee.

A parliamentary select committee, as the name suggests, is a committee of the House and tasked to deliberate on matters of concern; in this case, on election and the electoral process and submit a report to Parliament and make recommendations which can lead to changes in the relevant laws.

Select committee members must be MPs and exercise all the powers of Parliament to make inquiries, inspect documents, call experts witnesses and go on road shows around the country for evidence gathering.



They must act in a non-partisan manner as Parliament is supposed to be – that is, to act in the best interest of the rakyat.

That is why a select committee is headed by a minister of the Government of the day which has a majority in the House.

It is the Government that decides that the election system needs reforming and carries out the task of forming the select committee.

It is inappropriate for Pakatan Rakyat to demand that it head the select committee because it is the Government’s right to reserve that position for itself.

This means Anwar cannot be head of the select committee but he can be a member of the panel, if he so chooses.

Besides, such a committee has no place for an NGO leader or a civilian because parliamentary convention allows only MPs to be members of the committee.

But they can be called as experts witnesses to aid the committee in carrying out its duties which, hopefully, is the manner in which Bersih leaders will be engaged.

The Government’s right of way also includes having a majority in the select committee but that majority should be proportionate to its membership in Parliament.

Giving Pakatan Rakyat parties three places in the committee is also fair when the Government only reserves for itself five places, which is quite proportionate to the respective representation of Parlia­ment.

The only issue that Pakatan Rakyat can raise is the allocation of one place to the nine independent MPs who act as a bloc in Parlia­ment.

The independents are not true independents but former PKR MPs who defected and now stand with the Government on any issue in Parliament.

Giving them a place seems unjustified but they, too, might have a cause to present.

The nearest thing we have had to a successful select committee, in recent times, was the 2004 select committee on the Penal Code and Criminal Procedure Code that was headed by Datuk Seri Radzi Sheikh Ahmad.

It heard expert witnesses and made numerous recommendations.

This eventually led to amendments to both codes in 2006 that helped to strengthen the fundamental liberties of arrested persons, among other changes.

This current committee will also see changes to the election rules and process if given a chance to be formed and conduct its work.

Therefore, it is incumbent on the Pakatan Rakyat MPs to set aside partisan politics and work together to ensure that the people get what want – a free and fair election.

Layoffs sweep Wall Street, along with low morale

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By Lauren Tara LaCapra  NEW YORK

(Reuters) - In early summer, before layoffs began sweeping across Wall Street, billboard-sized photos of employees were plastered on the walls, pillars and elevator banks of Credit Suisse Group AG's offices in the United States and abroad.

The museum-quality prints, depicting workers from administrative assistants to senior executives, were emblazoned with motivational words like "Proactive" and "Partner." By mid-July, however, the photos disappeared and the Swiss banking giant began laying off 2,000 employees.

Security guards prevented employees from taking cell-phone pictures as the posters were stripped away, according to one employee who was present.

"It sent an entirely wrong message," said an employee, who was not authorized to speak publicly. "Management literally threw away that kind of money on something so trivial, while planning to cut thousands of jobs."

A bank spokeswoman declined to comment on the internal campaign or the employee's comments.

Credit Suisse's timing illustrates the unanticipated dangers of rampant job-cutting, which tend to run in cycles on Wall Street. Employee morale often plummets at a time when survivors are asked to pick up more responsibility and customer relations can suffer as service and relationships deteriorate.



CUTTING 'MUSCLE AND BONE'

What's more, layoffs inartfully constructed can come across to shareholders as Band-Aid solutions that at best temporarily cut expenses and at worst pare away reserves of talented people.

"They finished cutting the fat and now they're into the muscle and bone," said Tim White, a managing partner who specializes in wealth management at the recruiting firm Kaye/Bassman International in Dallas.

Credit Suisse has plenty of company in its cost-cutting campaign. HSBC, Barclays PLC, Goldman Sachs Group Inc and Bank of New York Mellon Corp have announced plans to ax thousands of workers in recent months. On Thursday, Bank of America Corp Chief Executive Brian Moynihan sent a memo to senior executives outlining plans to cut another 3,500 jobs.

The planned cuts at Bank of America have pushed the number of financial sector layoffs this year to 18,252 -- 6 percent higher than in the comparable period in 2010, according to Challenger, Gray & Christmas, an outplacement firm that keeps a daily tab on layoff announcements.

Some companies began the culling earlier this year -- HSBC has already axed about 5,000 employees, with 25,000 more set to get pink slips by the end of 2012 -- and others, such as Goldman Sachs, said that cuts will come by year's end.

That is not good for morale.

BITING INTO CLIENT SERVICE

Hours have become longer, trading floors have more open seats and fresh young faces are taking over offices where high-level personnel once sat. The highest-paid people can be easy targets for layoffs now, given the cost of keeping them employed and the eagerness of younger workers to take on their roles, even at less pay, executive recruiters said.

Changes in pay structures mandated in part by the Dodd-Frank financial reform laws have exacerbated the problem.

Banks that used to pay modest base salaries supplemented by opulent stock-and-option packages that encouraged meeting short-term performance goals now are weighting compensation toward base salary.

Managing directors at investment banks have seen a typical base salary double to $400,000, said Paul Sorbera, president of Alliance Consulting. Meanwhile, 2011 bonuses are expected to fall by up to 30 percent for top earners, according to pay consulting firm Johnson Associates.

The shift erodes Wall Street's former flexibility to lower end-of-year bonuses in bad times and forces a heavier reliance on layoffs.

The danger is that client service suffers.

"Banking clients abhor relationship-manager turnover," said Heather Hammond, a senior member of Russell Reynolds' financial services practice.

Investors, for their part, tend to view cost-cutting as a short-term solution that fails to address fundamental issues relating to capital, strategy and the ability to endure through hard economic times.

At Credit Suisse, some senior jobs have been consolidated as executives have been escorted toward early retirement with offers of bonus bridges and other payments, sources familiar with the matter say.

Managing directors in businesses that have missed revenue targets have been told to reduce millions of dollars' worth of headcount expenses, according to a managing director who received such a request. In some areas, including operations, legal and technology, more work is being outsourced and mid-level employees are being replaced by consultants.

"People are leaving resumes on the printers, hoping someone picks it up," the Credit Suisse employee said.

Some sources believe that banks are repeating their typical hiring strategy: Cutting staff levels too deeply in bad times only to rush out with open checkbooks when markets recover.

"When people are getting hired, fired, hired, fired, every two years, it's very difficult to run a business," said Conrad Ciccotello, a finance professor at Georgia State University who has studied the issue. "There is precious human capital destroyed in vicious boom-and-bust cycles that is costly to replace."

(Reporting by Lauren Tara LaCapra; Editing by Richard Chang and Jan paschal)

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Friends for all seasons - priceless

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People who are friends in good and bad times are priceless

Monday Starters - By Soo Ewe Jin

THE MAS-Air Asia alliance remains very much the talk of Corporate Malaysia. In the many analyses so far, the recurring theme seems to be about how erstwhile enemies are going to work together as friends.

My colleague used the Sun Tzu quote, “Keep your friends close, and your enemies closer,” to lead off the cover feature on the deal in StarBizWeek on Aug 13. Somewhere in the story, there is this quote by Tony Fernandes: “You don’t have to be an enemy forever, life is too short.”
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Actually, there is not that much that separates the corporate world and politics as far as alliances are concerned.

In politics, it is said that there are no permanent friends, only permanent interests. Politicians are fond of referring to their adversaries as “strange bedfellows” but will not hesitate to climb into the same bed if it suits their interests.

In the world of high-finance, bitter rivals can easily sleep on in the same bed, so long as it is good for the bottom line.

For some business people, however, friendship is not a word that exists in their vocabulary. Many good friends who go into business together learn the hard way that years of friendship count for nothing once the business issues get into the way.



A friend told me once that he will never hire me, or ask me to be his business partner, simply because he values our friendship too much.

I once met a man at a hospital as he was dying. He told me how he had pursued wealth and success at any cost. If a family member or close friend went against him, he would not spare them any mercy.

“But look at me now. I do not have long to live. But if I recover, I will surely be a different person. I will seek the forgiveness of those I have hurt. I will forgive others. I will give back to society. I will try not to be so nasty to people,” he said.

I was there to bring him a message from a former business partner who was somehow not able to bring himself to see him personally. He told me to tell him that he did not hold anything against him and to wish him well.

Tears came to his eyes. “I wish he would come and tell me this personally. I have done so much harm to him and his business. But he still thinks of me and is concerned for me.” I told him, “I hope and pray that you will both meet up and forgive each other.” They never did. He died one week later.

I was thinking about friendship this past week after a friend posted on his Facebook this simple reflection: “It has been said that everlasting friends go long periods of time without speaking and never question the friendship. These friends pick up like they just spoke yesterday, regardless of how long it has been or how far away they live; they don’t hold grudges. They understand that life is busy and know that you will always love them.”

Whether we want to admit it or not, sheer numbers of acquaintances in itself is no reflection of the number of real friends we have. Just ask anyone previously in a high position who has retired and he will tell you about the sense of “abandonment” that one feels sometimes.

Suddenly, no one is free for lunch or for teh tarik, one such person told me recently.

This is not to say that it is not possible to have real friends within working relationships. But it can only come about if we are genuinely concerned about the person, and not just the title he or she holds.

And the test of that friendship will come when you are going through a difficult journey, and he is there for you.
● Deputy executive editor Soo Ewe Jin is thankful for friends, near and far, new and old, who bring that special touch into his life, through good and bad times.

Malaysia still in pursuit of full independence

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Still in pursuit of full independence

Global Trends By MARTIN KHOR

Fifty-four years after Merdeka, Malaysia, like other developing countries, is still fighting for full independence in a globalised world which has grown more complex and crisis-laden.

THE Merdeka season is a good time to ponder over what independence means to Malaysia and the other developing countries that are still battling to overcome the disadvantages that the colonial era brought.
The problems of governance in a developing country, 54 years after independence, are still as complex or even more so when compared with the immediate post-colonial days.

In that first phase of independence, the developing countries were preoccupied with domestic battles – how to install domestic political processes and how to chart new economic strategies to get out of the shadow of colonial influence.

Most countries tried to shake loose from the control of foreign-owned mining and plantation companies, banks and retailers, by boosting their domestic public and private enterprises.

However, they were over-dependent on a few export commodities for a long time.

In the social sphere, there was the monumental battle to provide jobs, build up housing, schools and health systems, besides reducing poverty.

Today, many developing countries like Malaysia have succeeded, to a significant extent, to break the foreign-ownership grip on the economy and to diversify from commodities to resource-based processing, boosting manufacturing and property development.



While some countries remain poor and dependent on foreign aid, other middle-income countries have broken through into the development sphere.

Indeed, countries like Malaysia are now worried about being stuck in the “middle-income trap”.

They are no longer so competitive in the labour-intensive industries like textiles and electronics assembly because lower-wage countries have entered the scene, yet they find it difficult to break through into higher value-added sectors and activities, in order to upgrade their economic status.

While the colonial grip on their economies has loosened, the middle developing countries are now caught in the complex web of global inter-dependence, in which they have become significant players but are still not able to call the shots, nor equitably participate in decision-making.

The dependence of immediate post-colonialism is now replaced with the inter-dependence that comes with globalisation. In good times, the country soars with the world economy.

But in bad times, the domestic economy is at the mercy of rapidly falling exports and foreign-capital outflows, as the 1998-99 Asian crisis and the 2008-09 “global great recession” showed.

With the United States and Europe caught in a deflationary situation, the next few years will be another great challenge.

Will the middle developing countries sink with the major players, or break free to chart their own course?
The answer will probably be in between.

But “decoupling” from the crisis in the rich countries can properly be achieved only if there are vision and action plans, including national economic restructuring and greater regional collaboration.

Intense inter-dependence is also evident in the physical world, where the environment worldwide is collapsing because the pursuit for economic growth did not take into account resource depletion and pollution.

The science of climate change and the recent radiation from damaged nuclear plants both reveal that emissions in one part of the world affect health and life in other parts.

Global solutions are thus necessary, but negotiations to find them are bogged down by basic issues of North-South equity and the need for balance between the imperative for environmental protection and the immediate needs for development.

International negotiations are also stuck in the area of economics.

The World Trade Organisation’s Doha talks have stalled because of the unreasonable demands made by major developed countries on the big developing countries.

Despite the G20 Summits, the world is further away today from global solutions to the financial crisis than in 2008-09 when concerted actions were agreed upon to stimulate a recovery.

It appears that the US, Europe and Japan, all former colonial countries, are now afraid that their mastery over the global economy is being challenged by China, India and some other developing countries – Asean included.

The middle developing countries like Malaysia are no longer one-sidedly dependent on their former colonial masters.

But in the web of an inter-dependent and globalised world, they are still in the mode of responding to initiatives and policies of the major developed countries, or to the unfolding situation.

They do not yet have the power or confidence to initiate and coordinate their policies and take the initiative to put forward solutions to global problems.

But they now have the growing capacity to do

Fifty-four years after Merdeka, the world is still an imbalanced one, and our country is building more stepping stones towards full independence.

It must join other developing countries to get a full voice and a fair share in the benefits of the global economy.

In this complex globalised economy, the developing countries’ battle for independence continues.

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 The true meaning of independence
 Reviving our winning ways   

Capital controls: From heresy to orthodoxy

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THINK ASIAN By ANDREW SHENG

 Principles for formulating capital control policies must take local conditions into account.

ON Sept 1, 2011, it would be 13 years to the day when Malaysia first introduced capital controls to stem the effects of the Asian financial crisis on the domestic economy. In 1998, it was heresy to introduce capital controls on capital flows, since it was the International Monetary Fund (IMF) orthodoxy to liberalise the capital account.

From the perspective of history, one tends to forget that in 1945, when the IMF was first established, the consensus opinion among bankers and academics alike was for hot money to be controlled. Indeed, the intellectual father of the IMF, John Maynard Keynes, remarked that “what used to be heresy is now endorsed as orthodoxy.”

In the old days, courtesy to living persons and the statute of limitations would allow history to be written only after 60 years when official archives are opened to the public.

Today, we live in an age of unfettered information, when oral and documented history can be published rapidly, from authorised biographies issued shortly after a leader leaves office to unauthorised leakages from Wikileaks.

The publication of a new book by Datuk Wong Sulong, former group chief editor of The Star, called Notes to the Prime Minister: the Untold Story of How Malaysia Beat the Currency Speculators, only two months after the IMF announced in April 2011 new thinking on capital inflows, is a remarkable achievement.

Sixty-six years after the IMF was formed, capital controls have moved full circle from orthodoxy to heresy and back again to (qualified) orthodoxy.

The book comprises 45 Notes written by Tan Sri Nor Mohamed Yakcop, Minister in the Prime Minister's Department, between Oct 3, 1997 and Aug 21, 1998 to then Prime Minister Tun Dr Mahathir Mohamad.
In short, they were the key briefs that helped Dr Mahathir make up his mind on the key economic policies to help combat the Asian financial crisis.



Book offers deep insights

For both historians and practicing policymakers, this new book offers deep insights into the serendipity and the practice of successful policy decision-making. There is an element of serendipity, because Dr Mahathir recalled that he spotted Nor Mohamed walking down a street in Kuala Lumpur just before he left for Buenos Aires in September 1997 via Hong Kong, where he attended the World Bank Annual Meetings and clashed publicly with George Soros on currency trading.

On Sept 29, 1997, he summoned Nor Mohamed to meet him in Buenos Aires, because he needed someone who understood currency trading. It is a tribute to a politician trained as a doctor that he was willing to spend repeated sessions with an experienced currency trader to understand the intricacies of modern financial markets.

Reading the 45 Notes in historical sequence, one gets a far better appreciation of how the decision to impose capital controls was arrived at. The Notes not only have historical value, but also current-day applicability, as they explain not only offshore currency, the psychology of fear and greed that drive markets, but also market manipulation in thinly traded emerging market currencies.

The major problem of the proponents of the Washington Consensus in 1997 was that most of them were macro-economists who had little understanding or experience of how the markets actually worked. Free markets became a dogma and objective in their own right, rather than the means to an end for better livelihood for all.

The Notes also revealed that in complex decisions under uncertainty, it was vital to understand clearly the key parameters for action. Note 7 clearly pointed out that Malaysia was different from other countries under currency attack because it did not have large short-term external debt. Note 11, dated Oct 21, 1997, spelt out the factors that determined exchange rates, with a particularly illuminating explanation of market manipulation.

Market manipulation was seen as due to concerted effort by hedge funds, using large gearing and available tools and then triggering the element of fear among the long-term investors who have legitimate currency risk.

In other words, if the wolves can trigger the herd to move, then the fundamentals can move. The perception of fear changes the whole game.

Effect of CLOB

Note 39 dated July 9, 1998 is an important study of the effect on Malaysia of the central limit order book (CLOB) for trading of Malaysian shares in Singapore. The Note identified that the CLOB was a convenient way for capital outflows.

Hence, one of the most effective ways for exchange control was to impose the condition that Malaysian shares could only be traded on a Malaysian exchange, which came on Aug 31, 1998, with exchange controls imposed on the following day.

In Dr Mahathir's words, “during the financial crisis, we faced two parallel situations; the ringgit was falling rapidly and Malaysian shares were also falling rapidly. So we had to put an end to both.”
Image via Wikipedi
The IMF has come out with six key principles for formulating capital control policies.

The first is that there is no “one-size-fits-all” policy mix. The second is that capital controls should fit long-term structural reforms. Third, capital controls are only one tool and not a substitute for the right macro policies. Fourth, capital controls can be used on a case-by-case basis, in appropriate circumstances. Fifth, the medicine should treat the ailment, and finally, the policy must consider its effect on other market participants.

It is hard to argue against these common sense “motherhood” principles. The trick in real life policy-making is how to apply them to local conditions.

On of the features of the current Chinese capital controls is that China also has a large amount of Chinese shares listed outside capital controls, such as Chinese shares listed in Hong Kong, Singapore and New York.

This is a book that is a must read for all emerging market policymakers interested in liberalising their capital accounts and for IMF experts to ponder emerging market experience.

I recommend that this new book be translated into Chinese, so that Chinese policymakers interested in internationalising the renminbi can look at the Malaysian experience.

Tan Sri Andrew Sheng is author of the book, From Asian to Global Financial Crisis.

Related Post:

The untold story of Malaysia foreign exchange controls 

China’s US$3.2 trillion headache

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ENTER THE DRAGON By YAO YANG

WHILE the downgrade of US government debt by Standard & Poor's shocked global financial markets, China has more reason to worry than most: the bulk of its US$3.2 trillion in official foreign reserves more than 60% is denominated in dollars, including US$1.1 trillion in US Treasury bonds.

So long as the US government does not default, whatever losses China may experience from the downgrade will be small. To be sure, the dollar's value will fall, imposing a balance sheet loss on the People's Bank of China (PBC, the central bank). But a falling dollar would make it cheaper for Chinese consumers and companies to buy American goods.

If prices are stable in the United States, as is the case now, the gains from buying American goods should exactly offset the PBC's balance sheet losses.

The downgrade could, moreover, force the US Treasury to raise the interest rate on new bonds, in which case China would stand to gain. But S&P's downgrade was a poor decision, taken at the wrong time. If America's debts had truly become less trustworthy, they would have been even more dubious before the agreement reached on Aug 2 by Congress and President Barack Obama to raise the government's debt ceiling.

That agreement allowed the world to hope that the US economy would embark on a more predictable path to recovery. The downgrade has undermined that hope. Some people even predict a double-dip recession. If that happens, the chance of an actual US default would be much higher than it is today.

Reason to worry: China’s US$3.2 trillion problem will become a 20-trillion-renminbi problem if China cannot reduce its current account surplus and fence off capital inflows. — AP

These new worries are raising alarm bells in China. Diversification away from dollar assets is the advice of the day. But this is no easy task, particularly in the short term. If the PBC started to buy non-dollar assets in large quantities, it would invariably need to convert some current dollar assets into another currency, which would inevitably drive up that currency's value, thus increasing the PBC's costs.

Another idea being discussed in Chinese policy circles is to allow the renminbi to appreciate against the dollar. Much of China's official foreign reserves have accumulated because the PBC seeks to control the renminbi's exchange rate, keeping its upward movement within a reasonable range and at a measured pace.

If it allowed the renminbi to appreciate faster, the PBC would not need to buy large quantities of foreign currencies.



International experience

But whether renminbi appreciation will work depends on reducing China's net capital inflows and current account surplus. International experience suggests that, in the short run, more capital flows into a country when its currency appreciates, and most empirical studies have shown that gradual appreciation has only a limited effect on countries' current account positions.

If appreciation does not reduce the current account surplus and capital inflows, then the renminbi's exchange rate is bound to face further upward pressure. That is why some people are advocating that China undertake a one-shot, big-bang appreciation large enough to defuse expectations of further strengthening and deter inflows of speculative “hot” money. Such a revaluation would also discourage exports and encourage imports, thereby reducing China's chronic trade surplus.

But such a move would be almost suicidal for China's economy. Between 2001 and 2008, export growth accounted for more than 40% of China's overall economic growth. That is, China's annual gross domestic product (GDP) growth rate would drop by four percentage points if its exports did not grow at all. In addition, a study by the China Centre for Economic Research has found that a 20% appreciation against the dollar would entail a 3% drop in employment more than 20 million jobs.

There is no short-term cure for China's US$3.2 trillion problem. The government must rely on longer-term measures to mitigate the problem, including internationalisation of the renminbi. Using the renminbi to settle China's international trade accounts would help China escape America's beggar-thy-neighbour policy of allowing the dollar's value to fall dramatically against trade rivals.

But China's US$3.2 trillion problem will become a 20-trillion-renminbi problem if China cannot reduce its current account surplus and fence off capital inflows. There is no escape from the need for domestic structural adjustment.

To achieve this, China must increase domestic consumption's share of GDP. This has already been written into the government's 12th Five-Year Plan. Unfortunately, given high inflation, structural adjustment has been postponed, with efforts to control credit expansion becoming the government's first priority. This enforced investment slowdown is itself increasing China's net savings, i.e., the current account surplus, while constraining the expansion of domestic consumption.

Real appreciation of the renminbi is inevitable so long as Chinese living standards are catching up with US levels. Indeed, the Chinese government cannot hold down inflation while maintaining a stable value for the renminbi. The PBC should target the renminbi's rate of real appreciation, rather than the inflation rate under a stable renminbi. And then the government needs to focus more attention on structural adjustment the only effective cure for China's US$3.2 trillion headache. - Project Syndicate

● Yao Yang is Director of the China Center for Economic Research at Peking University.