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China and the United States and the Balance of Financial Terror

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Brilliant (a word I do NOT use lightly) article, entitled, The $1.4 Trillion Question, by James Fallows over at The Atlantic Magazine Thesis is that China has essentially been subsidizing the United States for a long time and the key questions are whether this will continue, for how long, and what might end it. Conclusion seems to be that it will continue because it is in the best interests of both China and the United States, but some major event might trigger its end.

According to the article, the Chinese government has, for the most part, chosen to save/invest its money to promote growth at the expense of consumer well being. I do not think this assumption can be disputed:

The other major decision is not to use more money to address China’s needs directly—by building schools and agricultural research labs, cleaning up toxic waste, what have you. Both decisions stem from the central government’s vision of what is necessary to keep China on its unprecedented path of growth. The government doesn’t want to let the market set the value of the RMB, because it thinks that would disrupt the constant growth and the course it has carefully and expensively set for the factory-export economy. In the short run, it worries that the RMB’s value against the dollar and the euro would soar, pricing some factories in “expensive” places such as Shanghai out of business. In the long run, it views an unstable currency as a nuisance in itself, since currency fluctuation makes everything about business with the outside world more complicated. Companies have a harder time predicting overseas revenues, negotiating contracts, luring foreign investors, or predicting the costs of fuel, component parts, and other imported goods.

And the government doesn’t want to increase domestic spending dramatically, because it fears that improving average living conditions could paradoxically intensify the rich-poor tensions that are China’s major social problem. The country is already covered with bulldozers, wrecking balls, and construction cranes, all to keep the manufacturing machine steaming ahead. Trying to build anything more at the moment—sewage-treatment plants, for a start, which would mean a better life for its own people, or smokestack scrubbers and related “clean” technology, which would start to address the world pollution for which China is increasingly held responsible—would likely just drive prices up, intensifying inflation and thus reducing the already minimal purchasing power of most workers. Food prices have been rising so fast that they have led to riots. In November, a large Carre­four grocery in Chong­qing offered a limited-time sale of vegetable oil, at 20 percent (11 RMB, or $1.48) off the normal price per bottle. Three people were killed and 31 injured in a stampede toward the shelves.

This is the bargain China has made—rather, the one its leaders have imposed on its people. They’ll keep creating new factory jobs, and thus reduce China’s own social tensions and create opportunities for its rural poor. The Chinese will live better year by year, though not as well as they could. And they’ll be protected from the risk of potentially catastrophic hyperinflation, which might undo what the nation’s decades of growth have built. In exchange, the government will hold much of the nation’s wealth in paper assets in the United States, thereby preventing a run on the dollar, shoring up relations between China and America, and sluicing enough cash back into Americans’ hands to let the spending go on.

A year and a half ago, we said something similar:

More importantly, however, is that both economists ignore the political and social imperative for continued growth in China. I am of the view that the Chinese government wants growth. I am of the view that the Chinese government needs growth. I am of the view that the Chinese government’s comments about wanting to slow down the economy are mainly for foreign consumption.

There were some 87,000 rural protests in 2005 and the best way to reduce that number is jobs. Countless university graduates are without jobs or underemployed. The Chinese government must keep up its growth machine to create jobs for these people.

And is China’s economy really “overheating,” anyway? I have certainly seen a lot of talk about inflation fears, but I have yet to see any numbers indicating much of it already. This Wall Street Journal article says the consumer-price index increased 1.5% in June after rising 1.4% in May. That’s a problem? And will not the huge pool of peasants and university graduates keep wages in check? I ask this not to say inflation in China is impossible, but to ask why should the Chinese government go great guns to slow things down?

I am not going to predict whether China will or will not allow the Yuan to appreciate further, but I will say that in analyzing this question, one must do more than just look at the economics; domestic politics must be considered and domestic politics say there will be no appreciation. Indeed, if China does allow the Yuan to rise, I would think it will do so not for economic reasons, but to mollify the United States and the EU

Fallows’ goes on to note how the “Chinese public is beginning to be aware that its government is sitting on a lot of money—money not being spent to help China directly” and “Chinese bloggers and press commentators have begun making a connection between the billions of dollars the country is sending away and the domestic needs the country has not addressed.” Nonetheless, the “balance of financial terror” between China and the United States, likely means little will change until something changes:

Lawrence Summers calls today’s arrangement “the balance of financial terror,” and says that it is flawed in the same way that the “mutually assured destruction” of the Cold War era was. That doctrine held that neither the United States nor the Soviet Union would dare use its nuclear weapons against the other, since it would be destroyed in return. With allowances for hyperbole, something similar applies to the dollar standoff. China can’t afford to stop feeding dollars to Americans, because China’s own dollar holdings would be devastated if it did. As long as that logic holds, the system works. As soon as it doesn’t, we have a big problem.

I agree China has to and will seek to keep growing rapidly — most costs be damned — and that the United States and China have become so economically intertwined neither country should or does want to get off their shared bus. I am just not sure what, if anything, will derail the ride.

What do you think?

11 responses to “China and the United States and the Balance of Financial Terror”

  1. Seems to be a lot of hysteria over this. 1.4 trillion seems like a lot until you realize that US government debt (national + state) is about 14 billion and then the US corporate bond market is about double that about 13 billion which gets you to 27 billion. And then let’s add in the stock or value of the equity markets and real estate markets (regardless of whatever hit they’ve taken) and you have a few multiples of that.
    China’s USD holdings are believed to be a combination of various forms of bond holdings. If seen in the context of debt holdings alone, China’s 1.4 trillion dollars is only maybe 5% of those holdings. So China sells – so what? Further, the idea that if China were to sell, that the rest of the Western central banks would stand idly by and watch the USD sink relative to their currencies seems rather suspect. These things don’t happen in a vacuum after all.
    Further, add in the effect of the equity and real estate markets (not to mention the private equity market). If the USD were to sink rather quickly, based on what amounts to short term trading by one market player that would mean US assets would be undervalued which would attract other players. There is an intrinsic value to the US economy – and just as a stock’s short term value does not necessarily reflect the real worth of an enterprise, the short term fluctuations of the US dollar does not either of the US economy.

  2. So what can the Chinese do? Should they slowly and gradually reduce their USD holdings and shift to something else? Euro? What are the alternatives?
    One thing that I don’t get is Fallows’ assumption that “the government doesn’t want to increase domestic spending dramatically, because it fears that improving average living conditions could paradoxically intensify the rich-poor tensions that are China’s major social problem.” Wouldn’t higher domestic spending and higher standard of living benefit the poor more than the rich?

  3. Cracking article, thank you.
    As I read the article I was asking myself exactly the same question you did at the end. I wonder what the tipping point will be further down the road when Chinese social awareness reaches a critical mass such that it shifts the current M.A.D. situation with regards to the Yuan / USD relationship? That question is way beyond my powers of reasoning. Again thanks for a great article.

  4. Surely, running a large trade surplus with the rest of the world creates domestic inflationary pressures in China, because the PBOC must print RMB to buy the surplus foreign currency (principally US dollars).
    So one could also argue the opposite: that domestic politics – and, above all, the Chinese government’s traditional fear of inflation – may prompt China’s leaders to accelerate the process of RMB revaluation, even at the cost of marginally slower growth.

  5. I’m no economist, so I can’t offer a very precise critique, but recent developments seem to conflict with the argument that China just wants growth and has no interest in slowing its economy.
    I won’t argue with the first assertion, that in the short term China doesn’t want the yuan to appreciate too quickly because that would harm manufacturers. However, in the long term, a floating yuan makes more sense. Most importantly, it will allow China to implement a more effective monetary policy, which recently has been a major concern as China tries to find an effective way to deal with inflation. It will ease inflation by giving Chinese consumers more buying power compared to the rest of the world. It may even help China maintain growth, as the rising cost of oil and other commodities will probably become a drag on the Chinese economy.
    Movement towards a freer currency less dependent on US spending seems to be playing out now, slowly and not as some crisis. As inflation becomes an issue the RMB is rising faster. Meanwhile, manufacturing subsidies are being dropped, which should lower upward pressure on the yuan, but hurt growth. Clearly growth is not as high a priority as it once was, which makes sense if inflation is erasing the benefits of higher wages for Chinese consumers. Also, if China does develop a bubble that eventually pops, the shock would probably cause far more unrest than slowing growth from 11% a year to 8% or 9%. The threat of a recession causing mass layoffs does not seem to justify a bubbles-be-damned, pure high growth policy.
    Finally, even if building infrastructure like sewage treatment plants and schools would spur inflation, it could also raise growth (a healthier and better-educated workforce would be more productive) and lower costs (people’s medical bills would go down). This seems especially so after the “Green GDP” fiasco, when it was shown that taking environmental damage into account erased a large portion of China’s growth.

  6. Heh. oops. Substitute those figures of billions for trillions in my last comment. Also I’d add comment that this pretty much means the US is in total control. If China were to sell at firesale prices, they would only hurt themselves (selling their assets at a discount) with very little effect on the US in the mid to long run.

  7. One of the above comments reminded me- a Chinese official (I think it was Wu Xiaoling, Vice Gov. of the PBOC) recently said China should diversify its holdings and buy more euros. I don’t know if the proportion of euros to dollars has actually increased yet, but it is more evidence that China is moving away from buying dollars to boost growth.

  8. Growth Matters, I’d have to disagree with you that the U.S. is in total control. What China does matters a lot… in fact, China is one of the two buyers of last resort of the USD (along with Japan). Despite the massive buying by these two countries, the USD has been headed sharply down in the past 6 years against every major currency, except the Yen and the Yuan. Forget about the panic that would ensue if China were to sell. If China were even to stop buying, the USD would plummet dramatically. The fact is, the intrinsic value of the USD is much lower than it is now because the market doesn’t appreciate countries with massive deficits, uncontrolled binge spending habits, weakened military, and not a care in the world about how many dollars it creates to dilute its holders and a weakened military to boot.
    I think that some of the assumptions that you’ve made are incorrect. Firstly, western banks have been watching the USD slide against their currencies for the aforementioned 6 years. It used to be that it took 88 cents to buy one Euro. I don’t think a 50% slide qualifies as a short term fluctuation. To Euro holders, the U.S. economy has been contracting this entire time. If a European invested in the U.S. stock market, despite the Dow reaching all time highs, he would have lost quite a bit of value.
    China is a willing player in this game only because the insane American consumer spends everything he has. This growth is critical for China because it needs to create jobs for the immense number of people who are entering the work force, or else risk riots. Believe it or not, despite the boom, fresh graduates have a tough time finding work! Now that the U.S. consumer is nearly broke, this bargain of necessity has nearly run its course. The end game is upon us and it will not be pretty.

  9. How exactly can China spend its foreign reserve to build schools or agricultural labs? That will need RMBs and it translates to fiscal deficits. Not impressed by Fallows’ writings at all! If you are interested in macro subjects related to China, check out Brad Setser, Jon Anderson and Andy Xie.
    @Fiscal Discipline, don’t forget the Gulf states. These central banks are the last bag holders of USD. When they start dumping, look out!

  10. I agree with your basic points here, and that seemingly, there is very little that can “derail the ride”. Surely, there will be some pressure within China to begin using these reserves in more openly socially responsible ways, too. However, one additional point from the article that I think should be drawn out is how dramatically Chinese policy is forcing the country to live below its means, and on the other side, how much the US has become hooked on living beyond its means. From a strategic point of view, the Chinese state suggests a fall-back position of self-reliance, whereas the US suggests a fall-back position of outwardly directed dependence. It’s hard to see how anything besides US aggression could “derail the ride,” unless one understands the Chinese position as a form of passive aggression.

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