我们是第一 (We’re number one)

Remember “mutual assured destruction?”  MAD was the dominant principle of the Cold War:  The Soviet Union would not attack us as long as we retained the ability to retaliate.  They might surprise us and obliterate New York, Chicago, Los Angeles, and Washington, but our nuclear subs and hardened silo-based missiles would respond in kind, turning Moscow, Leningrad, Kiev and Vladivostok into historical footnotes (if mankind survived to write any more history).

A kind of financial “MAD” became our consolation in the 1990s as China continued to accumulate foreign exchange, the vast majority of which was in dollars (or financial assets like bonds that were priced in dollars).  At present, China’s holdings of dollar assets top $1.5 trillion, says the Peterson Institute for International Economics.

“What if the Chinese stop buying our debt?” we asked. “And what if they sell what they already hold?” World markets would be flooded with dollars and the value of the dollar would fall.  Then others who are holding dollars as reserves would sell, OPEC would probably stop pricing oil in dollars, and the dollar would begin a steep dive. Interest rates would soar as the Treasury would be forced to offer higher rates to entice folks to buy U.S. debt. The shock to our economy would be dramatic and long-lasting.

“Why, the Chinese won’t unload dollars because to do so would hurt them as much as it would us!” was the answer. According to this argument, Chinese & American economies are in a symbiotic relationship.  We depend on them to make stuff and they depend on us to buy it. The Chinese buy our debt to keep the game going—because they can’t afford not to.

The so-called “Great Recession” has tested the notion that the Asian economies, particularly China, have “de-coupled” from the U.S. economy. As it happens, the emerging Asian economies did fairly well in the recent recession. China’s real gross domestic product (GDP) grew nearly 8% in the second quarter when compared to 2008 Q2. When compared to the first quarter of 2009, China’s economy actually grew an amazing 15%. By way of comparison, real GDP in the U.S. had fallen almost 4% from 2008Q2 to 2009Q2. And the U.S. economy was still shrinking from the first to second quarters.

Emerging Asia’s dependence on the U.S. has been steadily falling over the decade. The Economist reports that the region’s rising trade surplus with the U.S. accounted for only 6% of GDP growth from 2001 to 2006. Not only have internal markets expanded dramatically within and among these nations (led by China), but they have expanded their range of trading partners. China’s trade with (and influence in) Africa and South America has been growing exponentially.

Much of the recent dynamism in the Chinese economy has come from government spending, to be sure. China’s response to the global financial crisis was larger and swifter than anywhere else on the planet. Moreover, they have plenty of productive places to spend their “Stimulus Yuan.” Public investment spending in China increased by nearly half in real terms from May 2008 to May 2009, exceeding total public investment by the U.S. for the first time. Relative to GDP, the Chinese invest much more than we do in public infrastructure.  Estimates for total public investment in 2008 put it at 44% of GDP, well over twice the 18% of GDP spent in our country. Where did it go? The World Bank estimates that spending on railways more than doubled this year. Roads, power generation and other infrastructure projects also got a big boost from the government. Given the breakneck pace of growth in China and the size of the country, these investments will pay off in years to come as Chinese producers can move their production facilities into the interior and sell their products more cheaply to distant Chinese consumers.

So, have we reached financial Armageddon? Will the Chinese sell their dollars?  They certainly have been talking a good bit about reducing the world’s dependence on the U.S. dollar. In March their central bank chief urged a new monetary regime that would be unconnected to any specific nation (wink, wink) and suggested that the International Monetary Fund’s Special Drawing Rights (SDR) was a good candidate. The value of the SDR is based on a basket of major currencies. A few days ago the Chinese took further steps to dethrone the dollar, announcing that they would be purchasing $50 billion in SDR-denominated bonds from the IMF. Not long ago, this purchase would have been of bonds denominated in dollars. In effect, the divestment of dollar assets has begun.

I don’t think we need fear that China will be selling all of its dollar-denominated assets tomorrow, however. As long as they expect that the dollar is a more stable currency than the others on offer (including the basket of currencies making up the SDR), they will continue to hold and buy dollars.  This is one of the reasons we need to take steps to avoid fiscal policies that will spur future inflation, of course. Nonetheless, the dependence of China on the U.S. is much less than it was and it is lessening every day.

I wonder if I’m too old to take up Mandarin?

Kent Gardner, Ph.D. President & Chief Economist
Published in the Rochester (NY) Business Journal September 11, 2009