Bad debt case

The recent announcement of the US Federal Budget for fiscal year 2011  (see relevant article in USA Today) has spurred quite a lot of reactions. Although President Obama is set to introduce some debt-cutting measures, such as ending the Bush tax cuts for the richest Americans and freezing some domestic spending for three years, those won't be nearly enough to return deficit to normal levels (see another related article in The New York Times).

The deficit will almost reach $1.6 trillion in the current fiscal year, a post-World War II record, and projected deficit for the coming year will nearly be $1.3 trilion, as the country still fights to exit  the recession and create jobs. However, it is obvious that deficits totalling 10 or 11 percent of the country’s entire economic output are not sustainable in the long run (see relevant article in The New York Times), and although Mr Obama has stated that the deficit for fiscal year 2013 will be equal to just over 4 percent of the gross domestic product, the Administration also reckons that, by the end of the decade, annual deficits will begin moving up inexorably, reflecting the fast-rising costs of health and retirement programs for an aging baby-boom population.

US Government debt is still considered one of the safest assets for investors, as their Aaa rating attest. However, Moody's has already warned that this status could be lost due to the rapid worsening of public finances (see releavant article in Bloomberg News). The equation is easy: growing debt, caused by big budget deficits, will erode the confidence of both American and foreign investors with cash reserves to buy US debt. And nowadays, the biggest investor in US Treasury bonds is no other than China.

What if China gets fed up? Much has been said about the economic interdependence and growing importance of the relationship between the United States and China, even to the point of coining a new term –first coined by the British historian Niall Ferguson– Chimerica, to reflect this crucial relationship (see relevant article in Der Spiegel). The reasons that explain this dependency have been widely analized: in short, if the dollar tumbles, China loses part of its $2.3 trillion reserves (about 70 percent of these are in dollar-denominated securities, and a large proportion of these are in US government bonds); if the US economy falters, the still heavily export-oriented Chinese economy will suffer, as 6 percent of China’s entire economic output comes from its exports to the United States. 

In fact, the mutual dependency of the two economies is also shown by one of the current sources of tension between the two powers: the perceived devaluation of the Chinese currency, the yuan, whose exchange rate has been unofficially pegged to the dollar since July 2008. To keep it undervalued, the Chinese government keeps purchasing dollars, pushing demand for the greenback and thus indirectly assuring its strength in the currency markets. American economists say the Chinese government keeps the exchange rate so low for the purpose of artificially increasing the price of American imports and making Chinese exports especially cheap, a blatant manipulation of the market which costs the US a great number of jobs. An unfair accusation, Beijing responds. Many American companies also manufacture their products in China: if prices rose because of a stronger yuan, they would suffer as well.

Based on these facts, it looks quite clear that the economic interdependency of the two powers should last. A full-scale trade war is unlikely, as both governments know the stakes are too high for both economies. However, leading analysts agree that growing tensions in Sino-US relationships could result in a collision. And while it could be argued that China has more to lose from such a standoff in the short term, there are several reasons to support the theory that, in fact, the US would suffer much more than China if the tide changes in the mid term. This is based on three clear tendencies of the Chinese economy:

First, its internal market is growing at a fast rate, thanks to the steady development of an urban middle class, to the progressive increase in wealth in rural Central and Western China and also to Government plans to spur consumption. In fact, several economists already argue that China's growth is mainly due to its internal market rather than to exterior commerce, and this trend should continue and even increase in the future. That all means that the Chinese economy is progressively becoming less export-oriented: when the global downturn started in 2008, many feared that the Chinese economy would be dragged down by a severe drop in consumption in the US. And although it suffered, reduced exports were not enough to offset the enormous growth of the internal market, which, coupled with the 4 trillion yuan stimulus program put in place by the Government in November 2008, prompted a whopping 8.7% GDP rise in 2009. For the first time, economists point to Chinese spending –not the US consumer– as the key to a global recovery. Although it is also true that other experts claim that China is still a long way from developing a strong internal market (for instance, see this article in Project Syndicate), current trends and evidence show otherwise: the stimulus program may have helped boost internal consumption and spending, but its growth had already been steady in the preceding years, as the continuous increase in Chinese imports (leven surpassing the % growth in exports) shows (for instance, see some related fresh news in China Daily).

Secondly, its export markets are diversifying. In other words, although the American, Japanese and European markets –the typical consumers of Chinese products for the last decades– are still key to its economy, but China is fastly developing other markets for its products, creating further interdependency relations with African, Asian and Latin American countries. Despite growing concern and complaints by some East Asian countries (chiefly Indonesia), China is the third largest trading partner of ASEAN since 2006, and ASEAN has become the third largest of China just recently (news published just today, see link in Spanish), right after the full implementation of the China-ASEAN Free Trade Area (CAFTA) on January 1 (see related article in the Asia Times Online), and therefore displacing Japan from the long-standing top three. As for Latin America, Central Asia, the Middle East and Africa, China does not only see them as sources of the raw materials and energy it needs to fuel its industry: under the label of cooperation and investment projects, China is arguably implementing a 21st century  form of economic neocolonialism, helping develop these countries' infrastructures and markets in exchange for access to their raw materials, energy sources and, of course, the markets it helps create. Apart from fostering alternative strategic alliances, this grand strategy will probably help create a budding consumer base in poor and developing countries, from which Chinese manufacturers will hugely profit.

   

The third reason is that China is also steadily diversifying its economy and industry. China  is undeniably the world’s manufacturing workshop, specially for cheap, low value-added products, but also increasingly a worthy competitor in most industries and, increasingly, a major source of research and development. Apart from the big "national champions", huge state-owned enterprises (SOEs) in strategic sectors, business in the coastal areas, mostly led by an elite of foreign-trained Chinese enterpreneurs, are increasingly focusing on delivering quality products, with superb design and cutting-edge technology. Moreover, to further bolster this trend, the Chinese government has set higher education as one of its top priorities. As a recent article in China Economic Review attests, some Chinese MBA programs are becoming global competitors. Meanwhile, according to several sources, the Chinese government now spends billions of yuan –at least 1.5% of its gross domestic product– on higher education, with the aim of propelling its best institutions. According to Professor Richard Levin, he president of Yale University, China's top universities could soon rival Oxford, Cambridge and the Ivy League (see relevant article in The Guardian). And, if that's not enough, the data and forecasts offered by a recent article by Robert Fogel in Foreign Policy clearly show the aim of the country leaders: more educated workers are much more productive workers, while better educated managers are more innovative and successful.

The combination of these three key economic factors with a growing sense of self-confidence among Chinese intellectuals, businessmen and policymakers could foster a more belligerant attitude towards other countries, chiefly the United States. And while Western powers at both sides of the Atlantic are increasingly worried about China's recent threats and menacing words (see relevant article in The Washington Post), there's still a long way to go for China to even consider a cut a big chunk of its economic ties with the US.

However, if current trends continue, it is not impossible to envision an scenario in which China progressively disrupts its economic ties with the US. It could first come in the form of explicit or implicit restrictions for foreigners that want to invest in China, although they already exist anyway and also despite that the prospects for foreigners to undertake profitable, undisrupted business activities in China are becoming darker by the day (for instance, see this interesting article in Seeking Alpha and this one in The New York Times). 

Although not all experts agree (see this article from a Brookings Institution expert), one of the immediate threats for the US would be that China stops buying its debt or even starts selling the large pile it possesses (about 10% of the total US Treasury debt owned by the public). Emerging stronger from the global crisis, China can afford it more than ever, and its relative strength position will only keep growing. The sense that it would be better to dissolve the forced  Sino-American union sooner rather than later is growing within China's Communist Party. According to Der Spiegel, Financial managers within the party are already exchanging long-term US Treasury securities for more short-term securities. While it  is undeniable that a generalisation and radicalisation of such measures can notably hurt Chinese economy, but we must bear in mind that it would flat out destroy the value of the dollar in international markets and, not least important, make America default on its debt.

In any case, this would be a surprisingly dramatic move for all parts involved, and obvioulsy one that should be avoided at all costs. How can these risks mitigated? Two measures are key to secure global financial stability and reining in China's pereceived danger:

The first would be taking serious steps towards reducing US fiscal deficit and public debt levels, even if that means raising taxes. Sadly enough, no politician seems ready to admit it, neither in America nor in other Western democracies, as it would cause dissatisfaction among voters and doom reelection prospects. However, it seems many are still keen on proposing further tax cuts, a populist and self-destructive measure that is indeed still popular among many voters (related to that view, here's a very interesting and critical article that appeared in Slate). Be as it may, current budget deficits are too large to be sustainable, and they can only be controlled via a tax raise or by slashing spending in a country where 46 million people don't yet enjoy full medical coverage and where 40 million –or 13% of the total population– live below the poverty line (source: US Census Bureau) and where improving aging infrastructures and energy efficiency are also to be considered short-term priorities.

The second way to appease China would be a deep reform of the international monetary system, so that the dollar is no longer the only reference currency. Instead, a basket of reference currencies, including the euro and the yuan, should be created. When Zhou Xiaochuan, head of the People's Bank of China, called for the dollar to be replaced in the long term as the world's reserve currency, he was also sending a clear signal: Beijing politicians want to have a stronger voice in bodies such as the International Monetary Fund. They don't want to leave it completely in the hands of their rival on the other side of the Pacific. Above all, what China wants for now is to prevent the US from printing too much money to stimulate its economy, as high inflation would cause the dollars China has invested in the US to quicly lose value, while also force it to buy even more dollars to keep the yuan undervalued. Anyhow, such a reform would not only make the Chinese happy, but also give extra stability to the battered global financial markets, as Dominique Strauss-Kahn, the managing director of the International Monetary Fund, has already acknowledged (see relevant article in El Economista). Even better, it would force China to adopt a fairer exchange rate policy, which would clearly be good news also for the US.

Even though it can be argued that adopting such measures would also mean a big change of the current status quo –i.e. the US borrowing billions to finance its growing public debt and China accumulating dollar-denominated securities while keeping its currency undervalued–, it would surely make for a much less dramatic change than any radical breakup of the current system due to growing tensions. In fact, it is still possible to revert some dangerous tendencies. Instead of imposing trade sanctions and protectionist measures, Western countries should rather look for consensuate solutions to bolster stability. If the right steps are taken, currently growing tensions between China and the West could abate, paving the way for a safer and fairer global economic market on the basis of free trade. Yet some analysts are already wondering what will happen to Chimerica, claiming that, sooner or later, this forced economic marriage will come to a painful end (see this relevant article in Newsweek). And, if it happens, the partner who will suffer the most will surely be the debt-laden US economy.