Sunday, April 4, 2010

Why China Needs the United States

One of the most common misconceptions that I find in conversations is the view that the United States need tiptoe around Sino-American relations for fear that the Chinese won't fund their burgeoning deficit. This is a timely topic given Geithner's choice to delay his decision on whether to label China a "currency manipulator" (see US delays decision on China currency manipulation in today's FT). More accurately, both countries need each other, and are engaged in a delicate dance of imbalances. This, in a sense, is what "fragile equilibria" are about.

Over the past 30 years, China has risen to power largely through its export-led growth policies (although in recent years, their economy has been gradually moving to being more self-sustaining). Through this period, they have fixed their currency, the Renmimbi, to the US Dollar, as the United States had a more stable economy. Similar growth strategies were pursued by Japan and Germany in the 1960s and 1970s. I would highly recommend Niall Ferguson's piece The End of Chimerica which details these histories.

Under circumstances where a currency is allowed to "free float", market imbalances are assumed to correct over time. For example, when we buy clothing that is imported from China, that merchant would sell the money that he receives from you (US dollars) and buy a currency more useful to him (Chinese renmimbi). Normally, this would cause the renmimbi to increase in value relative to the dollar (because somebody is "buying" renmimbi with dollars). A higher renmimbi would make it more expensive to for our corporations to hire Chinese workers. Most of us are more familiar with this concept via travels to Europe. When the dollar is weak our trips to Europe are more expensive. This is the same phenomenon that corporations deal with.

Now just as our purchase of clothing from China causes the renmimbi to go up (and makes Chinese labor less competitive), China can purchase things from the United States to make the renmimbi go back down (and make Chinese labor more competitive once again). Just such purchases are required in order to maintain their currency peg.

What exactly have they purchased from us? Our debt: Treasuries and mortgage debts. Chinese involvement is one of the primary reasons that interest rates remained as low as they did for as long as they did (the "conundrum" that Greenspan spoke of). These low interest rates permitted (but did not force!) Americans to borrow more money and buy more things (often from China).

A picture is worth a thousand words, and this case is no exception. China's accumulation of foreign reserves (comprised largely of American debt) have increased by 1100%.

Shockingly, at $2.4 trillion, China's foreign reserves are now 50% of its gross domestic product (annual economic output). If the roles were reversed, this would be the equivalent of the US owning $7 trillion of Chinese debt. More remarkable perhaps is the speed at which the chart increases: it shows the ever-growing effort required to keep its labor artificially cheap, and that of the United States artificially expensive.

The problem that China has with boycotting the US Treasury market is that they own so much of it. For every 1% that their foreign reserves go down in price (assume this is an average across the basket of debt they own), their "portfolio" declines in value by $24 billion USD. Although running a profitable Treasury portfolio has never been their intention nor their goal, they have equally backed themselves into a corner.


  1. Good analysis. To me, I think it wise for the US and China to make a joint compact to back down from their current borrower-debtor relationship. I fully support the US Dollar as the default world reserve currency but it is time for China to spend some it's enormous savings as the US reduces its debt. This seems like a mutually beneficial reduction in the mutual dependency between the two countries. We buy their stuff while they buy our debt. They get rich while we grow indebted. But, if we go down, we're taking them with us. Seems like trouble to me. Our democratic system doesn't seem particularly well built to address these challenges.

  2. Very well put. I largely agree, but with a few limitations. First, although China can start spending into its trade surplus, spending beyond that becomes difficult. They own such a staggering amount of Treasuries that once they begin divesting of them (or even slow their purchases!) it has the possibility to push interest rates higher. With the housing market still in a state of fragility, this could cause further downturn and wealth destruction.

    Secondly, one of the greatest exports for the United States is intellectual goods: software, media, and education. Given the lack of rigid international copyright laws, it is more difficult for us to monetize our competitive advantages. As China's needs can be classified as more goods-oriented than service-oriented, this becomes difficult for the US to competitively export.