Four years ago, when the foreign-exchange reserves of China totaled about $450 billion and the value of China’s holdings of U.S. securities was about $300 billion, former Treasury Secretary Lawrence Summers warned about the emergence of a global “balance of financial terror.”
Mr. Summers and others worry that U.S. consumption and investment levels are becoming dependent on “the discretionary acts” of other governments. Foreign governments and investors are accumulating huge pools of dollars by virtue of the massive trade deficits the United States has been running. What these governments decide to do with their rapidly growing dollar reserves could have a huge effect on the U.S. economy.
“There is surely something odd about the world’s greatest power being the world’s greatest debtor,” Mr. Summers told the audience gathered at the Peterson Institute for International Economics in Washington.
“It surely cannot be prudent for us as a country to rely on a kind of balance of financial terror” that exists today, he said.
Since Mr. Summers’ March 2004 speech, the United States has racked up an additional $1.2 trillion in budget deficits and about $3 trillion in trade deficits, including more than $900 billion in merchandise trade deficits with China alone.
China’s currency reserves have kept growing since 2004, in tandem with its ever-expanding trade surpluses and foreign direct investment, which has built many of China’s export-generating factories. So-called “hot money” has also been pouring into China seeking to reap the gains from its slowly appreciating currency.
Not surprisingly, China’s foreign-exchange reserves have soared, quadrupling from $450 billion in early 2004 to more than $1.8 trillion today. The International Monetary Fund expects China’s currency reserves will exceed $2.4 trillion by next year.
China’s holdings of U.S. securities have increased from $300 billion in March 2004 to more than $900 billion in June 2007, the latest date for which data are available. Given America’s $250 billion trade deficit with China over the past year and the steady stream of money pouring into the country from abroad, economists believe China probably holds nearly $1.2 trillion in U.S. securities today, mostly Treasuries and corporate bonds.
And that doesn’t include the roughly $140 billion in U.S. securities held by Hong Kong.
China syndrome
China has recycled much of its trade surplus with the United States into U.S. Treasury and corporate debt securities. This policy increases demand for the dollar, raising its value higher than it otherwise would be. The policy also keeps the value of China’s currency, the yuan, lower than it otherwise would be. That makes China’s exports cheaper and more competitive, contributing to rising trade friction with the United States.
The composition of China’s foreign-exchange reserves is a state secret, but most experts believe dollars account for 70 percent to 75 percent of the total.
Clearly, the United States is becoming increasingly reliant upon China to finance its budget deficit, which will likely triple this year, jumping from $162 billion in fiscal 2007 to nearly $500 billion in fiscal 2008.
The Treasury Department doesn’t think that’s a problem.
“We’re part of a global economy in which U.S. investors buy assets abroad and foreign investors buy assets in the United States,” said Robert Saliterman, a Treasury Department spokesman for international affairs.
“A great deal of foreign capital — nearly $2.1 trillion last year — flows into the United States because the U.S. has the largest, most open economy in the world, and our capital markets are the deepest and most liquid,” he explained. “Foreign investment in the United States comes from a diverse group of countries and finds its way into a diverse range of direct investments, securities purchases and bank deposits.”
Meanwhile, China, particularly through its central bank, has become the primary financier of America’s budget deficit by using much of its trade surplus with the United States to purchase Treasury debt. At the end of fiscal 2007, China owned 21 percent of the U.S. publicly held debt that was owned by foreigners, and it was buying more than half of the new debt being issued by the federal government.
The Treasury Department doesn’t think that’s a problem, either.
“The market for U.S. Treasury securities is deep and liquid and continues to be attractive to a broad and diverse pool of investors,” Mr. Saliterman said. “About $5.3 trillion of Treasuries are held in the public markets. We don’t believe that the decisions of any individual buyer of our securities would affect the overall Treasury market given the broad set of investors in the market.”
The ‘nuclear option’
China’s state-run media has begun expanding upon Mr. Summers’ “balance of financial terror” metaphor by occasionally threatening to exercise China’s “nuclear option.” That is the explicit threat to dump massive amounts of dollars on world markets to turn the steady decline of the dollar into a complete rout.
That could force big increases in U.S. interest rates and push the economy into a prolonged recession, analysts say.
“China has accumulated a large sum of U.S. dollars,” He Fan, an official at the Chinese Academy of Social Sciences, wrote last August in an op-ed in the state-controlled China Daily newspaper.
Mr. He’s article appeared as members of Congress were demanding that China increase the value of its currency to reduce its trade surplus with the United States. “The Chinese central bank will be forced to sell dollars once the yuan appreciated dramatically, which might lead to a mass depreciation of the dollar,” Mr. He warned.
The dollar has declined about 25 percent since 2002 against a broad index of currencies of America’s trading partners. Many economists, including Federal Reserve Chairman Ben S. Bernanke, believe the dollar’s depreciation has contributed to the soaring price of oil, which is priced in dollars. Thus, among other unpleasant results, the “mass depreciation of the dollar” projected by Mr. He could cause oil prices to skyrocket and give American consumers reason to remember $4 gasoline as “the good old days.”
Meanwhile, Xia Bin, finance chief at China’s Development Research Center, was suggesting that China could use its foreign reserves as “a bargaining chip” to prevent a few “silly senators” from setting U.S.-Chinese economic policy.
A few days later, however, China’s central bank downplayed the threats. The government’s Xinhua News Agency quoted an unnamed central bank official as saying, “China is a responsible investor in international financial markets, and our country’s foreign-exchange reserves are managed with the operational goals of safety, liquidity and profit.” U.S. dollars are “an important part of China’s foreign reserve investments,” the official said.
Li Yang, a former adviser to China’s central bank, indicated in November that China is not likely to divert its existing reserves away from the dollar to other currencies. “If we want to change the currency composition of foreign-exchange reserves, we should use new, incoming reserves,” he told reporters attending a financial forum in Beijing.
Nobody disputes that China’s reserves are growing at a breathtaking pace and that China is rapidly becoming a financial powerhouse.
“In April alone, China’s foreign-exchange reserves increased by $74.5 billion, which, China Daily helpfully reported, was more than $100 million per hour,” said Charles McMillion, president and chief economist of MBG Information Services.
“China’s financial muscle has soared over the past five years,” Mr. McMillion said, citing “the rocketing financial clout of state-owned companies.”
China’s foreign-exchange reserves have increased tenfold since 2000, rising from less than $170 billion to more than $1.8 trillion today. China’s current stash of reserves would be much higher if the country hadn’t spent a big chunk of them in recent years to recapitalize state-owned banks, which were considered to be basket cases earlier this decade.
That is clearly no longer the case, Mr. McMillion said.
Nor does China’s stockpile of foreign-exchange reserves include the $200 billion it spent to fund its sovereign wealth fund, China Investment Corp. (CIC), which began operations in 2007 and spent $3 billion in June 2007 for a 9.4 percent stake in the Blackstone Group, one of America’s largest private-equity firms. In December, CIC put down $5 billion for a 9.9 percent stake in Morgan Stanley, one of Wall Street’s biggest investment banks.
‘Mutually assured destruction’
“There is a balance of financial terror,” Carl Weinberg, a China expert at High Frequency Economics, acknowledged in a recent interview. “But mutually assured destruction guarantees that neither side will pull the trigger. The Chinese have more to lose than we do,” he said, noting that China’s foreign-exchange reserves are half the size of its gross domestic product and account for half of China’s monetary base.
“By buying dollar assets in order to keep its currency artificially low, China has become incredibly dependent on exports to the United States,” said Josh Bivens of the Economic Policy Institute, a Washington-based think tank.
“If China dumps dollar assets on the world market, the reverse will happen: The yuan will appreciate” much more than it has already, “and China’s exports to the United States will decline,” Mr. Bivens said.
“Most of the problems from this massive accumulation of reserves are faced by China,” especially the inflationary pressures that are intensifying there, argued Virendra Singh, senior economist at Moody’s Economy.com. “The inflationary surge in China is less driven by food, energy and other commodities. Rather, it is a monetary phenomenon,” driven by “hot money” flooding into China in search of higher interest rates and gains from the appreciation of China’s currency, Mr. Singh explained.
“If China sells dollar assets,” Mr. Singh asked, “what are they going to buy? There are not enough euro assets. China faces a physical constraint.” For the short and medium term, he said, “the United States and China are joined at the hip. Basically, we are stuck with each other.”
Chinese workers are increasingly questioning why their government has pursued a policy that keeps U.S. interest rates low, thereby subsidizing U.S. investment and consumption, while there are so many unmet needs in China. Chinese authorities “must demonstrate that the $1.8 trillion of reserves are a net benefit to China, both in terms of policies that gave rise to these reserves and how they are employed,” said Edwin Truman, a senior fellow at the Peterson Institute.
Moreover, China cannot discreetly unload its dollar assets.
“You can’t sell $500 billion in Treasury securities overnight,” Mr. Truman said. “If you do try to sell the securities rapidly, you will depreciate the value of existing holdings.” That would generate a huge capital loss, calling into question why such a massive stockpile of dollar reserves was accumulated in the first place, Mr. Truman explained.
“The United States is by far the most important market for Chinese exports,” said Alan Tonelson of the U.S. Business and Industry Council, which advocates taking aggressive retaliatory action against China for its unfair trade practices.
“China is desperately trying to keep a lid on unemployment, and job No. 1 for the Chinese leadership is to keep their jobs,” Mr. Tonelson said. “We hold all the cards, despite the huge debt, but we refuse to play them.”
Spreading the wealth
“China’s national wealth is in dollars, for better or worse,” said James Freeman of the Center for Strategic and International Studies. “It keeps them up at night.”
For years, China was content to concentrate its dollar investments in U.S. debt instruments. Only Japan holds more Treasury securities than China, but China is by far the biggest foreign investor in asset-backed securities issued by Fannie Mae and Freddie Mac.
By creating its sovereign wealth fund, CIC, China signaled its intention to diversify some of its reserves from lower-yielding dollar debt securities into higher-yielding equity positions, probably both in dollars and other currencies.
Diversification appears to be China’s long-term strategy.
“The United States welcomes foreign investment, including investment from sovereign wealth funds,” said Mr. Saliterman, the Treasury spokesman.
There may be a fine line between the benefits America derives today from China’s willingness to finance the U.S. budget deficit and the problems that could begin to mount tomorrow as China increasingly diverts its financial resources into America’s strategic economic sectors.
Mr. Summers and others are concerned that America’s rising foreign debt is financing consumption rather than private investment. China is now in a position to use the reserves it has accumulated from its consumption-driven trade surpluses with the United States to embark on a spending spree purchasing U.S. corporate stocks at dollar-depreciated, bargain-basement prices. Suddenly, short-term benefits could evolve into long-term problems.
“So far, China has played a helpful role in the United States” by financing America’s budget deficits at interest rates lower than would otherwise apply, said William Cline, a senior fellow at the Peterson Institute.
“If China diverted Treasuries to stocks, however, a main problem could be a gradual increase in its control of key sectors of the U.S. economy,” Mr. Cline said. If it were inclined to do so, “China could purchase General Motors with its petty cash.”
“At a time when GM, Ford, our airlines and our banks and financial institutions are very highly leveraged and desperate for capital, China is sitting on an incredible stash of cash, and they can do with it as they please,” saidMr. McMillion.
Mr. Cline has recently calculated that the cumulative market capitalization of the world’s 25 largest commercial and investment banks totals $1.1 trillion. Thus, using less than 20 percent of its dollar reserves, China theoretically could purchase 20 percent of the stock in the world’s 25 largest banks.
Even if China’s diversification strategy unfolds gradually over the long term, it could present problems for the United States.
“If China tries to diversify out of dollars, that would increase U.S. interest rates, and asset prices would fall,” said James Dorn, a China expert at the Cato Institute. As a result, it would be more costly to finance both the budget deficit and the trade deficit.
Earlier capital inflows financed investments in railroads, telecommunications and other productivity-enhancing initiatives undertaken by private businesses. Today, Mr. Dorn said, the flood of capital pouring into America has financed public spending and private consumption.
“As long as we live beyond our means, we must borrow. Higher interest rates in the United States could cause a recession or make one deeper than it otherwise would be,” Mr. Dorn said.
Mr. McMillion views China’s diversification efforts warily. Given CIC’s purchases of Blackstone and Morgan Stanley stock, “it’s very clear that [CIC] is buying access - lobbying, basically,” he said. “China wants to get a seat at the table to make sure the most powerful financial and industrial leaders in the world are in its corner.”
China’s reserves and national security
Under China’s diversification strategy, Mr. McMillion expects to see “a vast increase of Chinese participation in key companies in the U.S. and throughout the world to get access and control over patents, talent, natural resources, brands and distribution channels.”
He has little confidence in the Committee on Foreign Investment in the United States (CFIUS), an interagency committee that scrutinizes the potential national-security implications of foreign investment in the United States.
CFIUS is a very political process that is very conflicted, Mr. McMillion said, “particularly with the key role of the Treasury Department, which doesn’t want to disrupt the financial markets.”
Mr. Tonelson, of the U.S. Business and Industry Council, called the CFIUS process “woefully inadequate.”
The Treasury Department disagrees.
“If genuine national-security concerns arise, CFIUS provides robust reviews of transactions and heightened scrutiny of foreign government-controlled investments,” said Mr. Saliterman, the Treasury spokesman.
Larry Wortzel, the current chairman of the congressionally mandated U.S.-China Economic and Security Review Commission, said he was less concerned with China pulling out of Treasury securities and “more concerned about the national security implications of equity investments in U.S. companies and technologies, which could lead to them acquiring assets or information that otherwise would not be released to China.”
China’s enormous foreign-exchange reserves provide the Chinese government with “an immense amount of resources to build up the Chinese military,” Mr. Tonelson said. This explosive growth of China’s wealth means that its communist government will be less constrained by the guns vs. butter trade-offs that all governments face, he explained.
Brad Setser, a fellow at the Council on Foreign Relations who has written extensively on America’s growing dependence on foreign capital, especially from China and other nondemocratic regimes, explained how this trend can evolve over the long run to America’s detriment.
China and America clearly have a symbiotic relationship. China heavily relies on Americans to purchase its exports, and America heavily relies upon China to finance U.S. deficits at low cost.
“It gives rise to the possibility that this level of interdependence may create leverage for one of the two parties in the relationship, and that includes the possibility that China can be the one with the leverage,” said Brad Setser, a fellow in geoeconomics at the Council on Foreign Relations. “The national security implications, not just the economic implications, of America’s heavy reliance on nondemocratic governments to finance its trade and budget deficits deserve more attention.”
Mr. Tonelson was more blunt. While he believes America has the advantage today in the U.S.-Chinese relationship, he worries that the long-term trend is moving in the other direction.
“What’s most disturbing about the U.S. situation is that as America’s debts rise higher and higher, the less influence the American government will have over the critical decisions” that will need to be made to address these imbalances,” Mr. Tonelson said. “Those critical decisions will be made in Beijing, not in Washington, and they will be made to promote Chinese economic and national-security interests.”
Mr. Dorn, of the Cato Institute, has a different perspective on the threat to national security.
“The greater national security threat would come from U.S. protectionism, which would embolden Chinese hard-liners, who would argue that the United States is trying to thwart China’s development,” he said.
Inevitably, American and Chinese negotiators will square off over geopolitical issues in the future. Presumptive Democratic presidential nominee Sen. Barack Obama acknowledged the potential American disadvantages when he observed earlier this year, “It’s pretty hard to have a tough negotiation when the Chinese are our bankers.”
Noting America’s “unprecedented level of foreign borrowing,” Pete Peterson, the former commerce secretary who founded the Peterson Institute and co-founded Blackstone, recently told reporters at a Christian Science Monitor breakfast, “I assure you it won’t be too long before we start looking like a developing country.”
Mr. Peterson is worried that Congress and the White House won’t do anything about America’s long-term fiscal problems until a crisis erupts.
“The most likely crisis will come from the foreign capital markets, when they lose confidence and stop funding our deficits,” he said. “The dollar would fall steeply and suddenly, and interest rates would rise dramatically.”
Told that numerous economists downplayed the likelihood that China would execute the “nuclear option” and dump Treasury securities, Mr. Peterson recalled the 1956 Suez crisis. In order to force Britain to end its military occupation of the Suez Canal, which Britain, France and Israel had seized after Egypt nationalized it, President Eisenhower threatened to dump U.S. reserves of the British pound on the world market - a move intended to trigger a collapse of the British currency. With the pound under pressure, the British government was forced to resign and withdraw.
Confident that he had made his point on the pivotal role currency reserves can play in a geopolitical crisis, Mr. Peterson saw no need to draw an analogy between the Suez spat involving America and Britain and a potential crisis pitting America against China in the Taiwan Strait.
At that point, Mr. Summers’ “balance of financial terror” could be joined by a balance of military terror.
