Rise of China

reviewed by abichara

abichara
01/08/2013

Rise of China 2

Our relationship with China is indeed very significant. Chinese imports are found on nearly every shelf of every store in the US.

As you can imagine, the availability of these inexpensive imported goods from China feeds the insatiable appetite of our consumers. Accordingly, because consumer spending is responsible for about two-thirds of our economy, many tend to believe that this trade relationship is a one-way street with China as the victor. However, China remains much more dependent on the United States than many realize. Ever since entering the World Trade Organization in 2001, China has risen to become the global leader in export trade. But its economic dominance has not been the result of special skills held by Chinese laborers.

The basic history is that trade liberalization and other economic changes initiated during the 1980's enabled China to organize and leverage its labor force. By the 1990's, radical shifts in global trade policy would soon embolden China as a vital member of the global economy. They've risen to power because of numerous government subsidies which have provided domestic firms with significant advantages over their foreign rivals. As well, China has permitted slave labor conditions which have further exploited differences in trade policy with its trading partners.

Our consumerism has fueled the demand required to keep much of the Chinese export engine running. This latter dynamic has also contributed to the loss of millions of American jobs. They call this dynamic "creative destruction" in order to mask its malignant effects on our economy. Irrespective of the collateral damage done to the US economy, the US-China trade relationship has enabled China to amass an enormous current account surplus due to its increasingly large trade surplus. This has generated a large pool of cash, which they use for its sovereign wealth fund that goes towards buying assets and natural resources in other countries. The majority of this surplus however has been put into US Treasury Securities. This financial/geopolitical strategy has several advantages. For instance, since China's trade surplus with the US is already in dollars, by investing in US Treasury securities, China can receive interest payments compliments of Uncle Sam. In this manner, China can avoid the various risks associated with foreign currency transactions.

Consequently, many have likened China's ownership of US Treasuries to America being "owned by China." The argument backing this claim is that because China owns so much US debt, it could dump these Treasury securities at any time, thereby causing interest rates in the US to soar and inflation to skyrocket. In my view, this scenario is unlikely. First, China would have to own a very large percentage of US Treasuries to have that kind of leverage. Next, China would also have to sell these securities over a short time frame, creating an international financial shock that would come back to them. Finally, there would need to be a very low demand for these securities once China dumped them into the bond market. It wouldn't be sensible for them to dump (that is, sell the majority of its position over a short time period) their portion of US Treasury securities.

Plus, they don't own as much US debt as has been let on. Think about it this way: the total outstanding national debt of the US right now stands at about $16.5 trillion. Of this amount, foreign nations own $5.43 trillion, or about one-third of the total. The remaining two-thirds are owned domestically in the form of pension plans, endowments, financial firms, insurance companies and individuals. Out of that $5.43 trillion owned by foreigners, $1.15 trillion or about 20% is held by China. That's certainly a sizable amount of foreign debt. But it only represents about 6% of the total US sovereign debt burden; not exactly a huge amount. In fact, I argue it's not large enough to cause much more than a short-term rise in interest rates if China were to dump its entire holdings. And even if they did, Japan and the UK would likely absorb these securities.

A lot of these ideas about China being the boogieman who holds the cards on the US economy are gross exaggeration. As opposed to selling off their held US debt, they have actually increased their positions by over 60% since the financial crisis of 2008. Why do they hold our Treasuries? Basically it is because China's trade surplus with the US has continued to increase over the past several years. Since the trade surplus is denominated in US dollars, it is much easier for China to keep the funds in dollar-denominated assets rather than to risk losses in the currency exchange market. Furthermore, US Treasury securities remain as the safest investments in the world. So China can easily transform its trade surplus into safe securities that pay interest.

Basically, we have a mutually beneficial relationship with China. By holding and even buying more US Treasuries, China helps keep interest rates low in the US. This in turn keeps the credit flowing to US consumers so they can keep buying Chinese imports. China is also very reliant on Wall Street. Over the past two decades, their fast growth has been fueled by foreign investment, mainly from Wall Street. This relationship was made possible through the gradual privatization of Chinese corporations which began some two decades ago. Privatization of these formerly state-owned firms has enhanced their competitive position around throughout the globe. Once these firms were privatized, they were able to receive foreign investment capital, the majority of which has come from Wall Street in some form or another. Thus, without the continued influx of foreign investment capital, China's economy would come to a halt. In addition, if demand from Chinese imports from the US stopped, China’s economy would crater. From there, Chinese consumers would be required to pick up the slack.

So we do have several advantages over China, but there may come a day when this edge no longer exists. Thus, the US must respond now while it holds a position of dominance.

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By the Numbers