Banking on Beijing

http://www.amconmag.com/article/2009/apr/06/00006/

There are two ways to interpret the fact that China is America’s largest creditor at a moment of stupendous American borrowing. The first is as an economist. And we’ll get to that. But the second is as a thriller writer—or paranoid economic and political nationalist—and it is much, much juicier.

The thriller scenario begins in the blood-red corridors of the Zhongnanhai leadership compound in Beijing, next door to the Forbidden City. Here China’s political elite has been plotting their usurpation of American power for decades. Bent over their Lenovo Thinkpads, the brilliant sons of Communism have engineered nothing less than a global revolution.

Dissolute, wasteful, crass America has been rotting, borrowing and spending, licking lead toys and watching “The Girls Next Door.” Meanwhile, diligent, thrifty, clever China has been preparing to take its place, squirreling away money and buying American debt.

Poor America thinks only in four-year election cycles, cackle the Beijing bureaucrats, whereas China thinks in hundred- and thousand-year spans, in vast historical revolutions that must inevitably turn in their favor.

Does any issue sum it up better than patent infringement? “We can’t do business with a country which pirates ‘The Dark Knight’ and Microsoft Office,” screams America. “Fine,” say the Chinese, “But did we ever see a penny from our invention of paper?”



And so, in the spring of 2009, the time came for China to spring its trap.

As with the assassination of Archduke Ferdinand in 1914, no one believed so trivial an incident as the hassling of a U.S. naval ship in the waters of the South China Sea could precipitate the events that followed.

Sunday, March 8, 75 miles south of Hainan Island. The USNS Impeccable was cruising in international waters, dragging behind it a Surveillance Towed Array Sensor System (SURTASS), a listening device used to pick up underwater acoustical data, notably submarine movements.

Suddenly, five Chinese boats appeared and surrounded it, one coming within 25 feet. A Chinese sailor produced a grappling hook and tried to snag the Impeccable’s SURTASS. The Impeccable’s crew sprayed him and his ship with a fire hose. The Chinese sailors undressed down to their underwear and kept coming. One boat tossed wood into the water ahead of the Impeccable, forcing it to stop. Two hours later, Chinese fighter planes flew low over the American ship.

The Impeccable’s captain said Chinese harassment had increased markedly during the previous week, but he had no idea why. The Pentagon maintained that the Chinese have vastly under-reported their military spending and cloaked their intentions for years. Was the truth now starting to emerge? Was China’s pesky aggression a sign of worse to come?

The following Friday, March 13, China’s premier, Wen Jiabao, followed the military attack with an assault on America’s credit-worthiness. “We have lent a huge amount of money to the U.S.,” he said. “Of course we are concerned about the safety of our assets. To be honest, I am definitely a little worried.”

With the U.S. Treasury rolling out ever more plans to borrow and spend, this was no time for one of the biggest acquirers of its debt to be making violent choking sounds.

Or was it the perfect time? With America on its knees, was this not the ideal moment to trigger the shift of power from Washington to Beijing? Would China now dump its U.S. assets, render the dollar worthless, and emerge triumphant from the wreckage of the global economy?

Get me Harrison Ford.

The truth may be more mundane—unless, of course, you are a keen follower of the patterns of global credit, in which case these are riveting times.

China’s massive acquisition of American assets in recent years, from Treasury bills to corporate bonds and equities, seems to have many people spooked. The way they talk about it, you would think some tattooed goon, seconded from a Macao casino, had cornered Lady Liberty and was demanding she pay the vigorish.

China, according to this thinking, is not someone to whom you want to owe money, especially if like America you are already in a deep financial hole and asking to dig further. China’s motives are not aligned with America’s interests. Owe them too much and one day you’ll pay a far heavier price than you imagined.

In fact, Chinese lending and U.S. borrowing have become so fundamental to the success of their respective social and economic models, and the stability of the global economy, that a quick unraveling would be a form of mutually assured destruction. There is no easy way out of the relationship for either country unless they wish to tumble like Holmes and Moriarty into the roaring Reichenbach Falls.

China’s huge dollar reserves are merely a symptom of an economic fix of its own making. Ever since Deng Xiaoping introduced his economic reforms to China 30 years ago, the country’s growth has been driven by exports—mostly to the United States and Europe.

The export focus led to the creation of millions of manufacturing jobs, which in turn served the primary goal of China’s leaders, to ensure social stability through employment and prosperity. China’s factories duly became the last stop on the global assembly line, taking in imports from more advanced Asian economies such as South Korea, Taiwan, and Japan, repackaging them, and sending them off by container ship.

Crucial to this strategy was a weak currency. If the renminbi climbed, as it should have given China’s growing economic power, the value of Chinese exports would rise and their competitiveness fall. So Beijing acted aggressively to keep the renminbi at a consistent level against the dollar. Until 2005, there was a fixed peg. Since then, the renminbi has been allowed to float and has drifted up by around 20 percent, though it still trades well below where most economists believe it should.

How the Chinese achieved this explains much of the present situation. First, the Chinese central bank simply printed renminbi to dilute the existing pool and buy foreign currencies. Then, fearing inflation, they bought back their own currency by issuing bonds and raising capital requirements on Chinese banks, which must now turn over some 20 percent of their cash deposits to the government.

In addition, China lent to its biggest export market by investing in dollar-denominated securities, notably those issued by the United States Treasury and government agencies like Fannie Mae and Freddie Mac. This kept the dollar healthy and Chinese exports relatively cheap.

For years, this policy of keeping the renminbi low against the dollar and using the dollar trade surplus to lend back to the United States to buy more Chinese goods worked. But it was a policy, like a Ponzi scheme, that became all but impossible to reverse and was merely putting off the cost China would one day have to pay for its explosive growth.

As Brad Setser, a global economic analyst at the Council on Foreign Relations, has written, “The benefits—rapid export growth, lots of investment in the export sector—associated with China’s exchange rate policy were front-loaded while the costs—export dependence, losses on China’s reserves—were back-loaded. The bill for subsidizing China’s exports during the boom is just now coming due.”

One consequence of this is that China’s leaders now view America’s economic challenges from two different, often conflicting, perspectives. On the one hand, China is America’s largest foreign creditor. U.S. Treasury and government agency securities are now estimated to comprise $1.25 trillion of China’s American portfolio. Another $250 billion or so is believed to be split between U.S. corporate bonds, money-market funds, and equities. American assets are believed to comprise 70 percent of China’s foreign reserves, with most of the rest held in euros. The numbers are murky as China’s foreign investments are handled by a number of entities, some in Hong Kong, whose holdings are not disclosed.

If America runs up more debt than it can reasonably repay, the value of China’s U.S. holdings will fall. Thinking as a lender, China would rather America tightened its belt, cut its expenses, and focused on paying back its existing debts. It wants America to keep the dollar strong and interest rates low to preserve the value of its bonds.

But if the U.S. economy does not recover quickly, whether through government stimulus or other means, China’s entire growth and export-driven economy risks unwinding. If one accepts that the size of China’s reserves is a sign of its devotion to the goal of social stability, of which the export economy is simply the means, then Beijing must be willing President Obama’s borrowing plans to succeed. Dollar be damned, China needs the American consumer to buy Chinese goods and sustain Chinese jobs.

In this context, Wen Jiabao’s fretting over a fall in the value of China’s foreign reserves, its rainy day fund, is like complaining about a dripping tap when water is pouring in from the ceiling. Even if the value of China’s U.S. portfolio were to fall by 30 percent, it would cost the Chinese around the same as their recent $586 billion stimulus plan. If the whole lot, a sum equivalent to one seventh of America’s GDP, were to go up in smoke, China would remain solvent. Except that would also mean that the United States’ economy had ceased to exist, which would be a considerably larger problem.

From America’s perspective, China’s fussing is a mild concern. If China were to stop lending money to the United States, there are other sources of capital in the world. There are plenty of investors, including American investors, who still see the full faith and credit of the United States government as a decent bet.

And realistically, where else is China going to go? It has already tried to use its economic muscle to patch together a network of oil suppliers around the world to immunize itself from price movements and supply disruptions by cutting deals with Iran, Sudan, and Angola. But it still depends on global supply for 95 percent of its energy needs. This policy of going where squeamish rivals fear to tread has also led it to become the largest trading partner of Iran, North Korea, and Sudan and the second largest of Burma and Zimbabwe. You scarcely need to be the UN High Commissioner of Human Rights to understand this is not the Peoria Chamber of Commerce.

The China Investment Corporation, a sovereign wealth fund, and the State Administration of Foreign Exchange (SAFE), a shadowy body with responsibility for managing China’s foreign reserves, have made a number of investments in Western financial firms in recent years. Two years ago, the Chinese paid $3 billion for a stake in the Blackstone Private Equity Group. The value of that has fallen by around 75 percent. In December 2007, the CIC paid $5 billion for a 10 percent stake in Morgan Stanley. That has since fallen by more than half.

The Chinese were reportedly stunned by their losses in Lehman Brothers and by the lack of support they received from the U.S. government. When Fannie Mae and Freddie Mac were close to collapse, only intervention by the Bush administration saved the Chinese from dramatic losses on hundreds of billions of dollars in mortgage-backed securities. Since then, the Chinese have sold their government agency securities and bought short-term Treasury bills, which carry less risk.

In fact, when you decompose the risks and returns on China’s portfolio, U.S. Treasuries may well be its soundest investment. Singapore’s vaunted Temasek sovereign wealth fund, for example, lost 31 percent of its value last year. Had China followed Temasek’s investment strategy, or indeed Blackstone’s, instead of buying boring old Treasuries, Wen Jiabao would have thrown himself into the Yangtze.

Over the next few months, the extent of China’s buying of U.S. assets will be closely watched. The World Bank forecasts that China ran up a $425 billion current account surplus in 2008. It has to put the money somewhere, and there is already a surfeit of domestic credit. That cash, perhaps the last of the great savings glut piled up in emerging markets over the past decade, has to go overseas.

The appetite of foreign central banks for U.S. Treasury securities is already falling as the global economy contracts. But for the next few months at least, long enough for President Obama to get his stimulus funding in place, the money, with China’s help, should be there.

And then what? Then the really hard work begins for China. Wen Jiabao has conceded that the government target of 8 percent growth this year, necessary to contain unemployment, is unrealistic. He has called on China’s businesses to “focus on adjusting product structure, improving quality and upgrading technologies in the face of economic woes.” It is high time, he was saying, for China to move up the economic value chain, to go from sweatshop to design shop, to develop its domestic markets and create investment opportunities for its own citizens.

The reason the Chinese save so much is not because they are better than us or because they all read Suze Orman. They save because they have nothing to buy or to invest in and because they are terrified that when they get sick or grow old or have to educate their children, the state will not help them.

China’s priorities are territorial integrity and economic growth, not bankrupting the United States. Growth can only continue with greater economic liberalization and a move away from the government’s mercantilist policies, notably its insistence on using an artificially low currency as its main competitive weapon. For all of its success, China’s GDP per capita still ranks only 100th in the world. It is a woefully inefficient consumer of energy, a rank polluter, and a poor provider of educational and health services to its people. If you think the United States has problems, try living in Guangzhou Province, the heart of China’s manufacturing industry, where millions of migrant workers are struggling to find work.

The stark facts of China’s relative position to the United States are these: China has four times the people and one quarter the GDP.

Wen Jiabao is within his rights to express concern about his investment in the United States. But he must also acknowledge that China’s ability to convert its surplus into loans to Americans has been crucial to China’s economic growth.

Had China pursued a different strategy over the years, letting its currency float, liberalizing its markets, and stimulating domestic consumption, its progress may have been more uneven and less predictable. It would have had a different set of problems to face today—problems that might have looked more like America’s.
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Philip Delves Broughton is the author of Ahead of the Curve: Two Years at Harvard Business School and a former New York and Paris correspondent for The Daily Telegraph.


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