US - China Financial Entanglements

01 June 2005

(Published under the title "The Sino-American game of financial chicken")

Go back a little more than three decades and President Richard Nixon had just made his historic trip to China, a country isolated from the world and barely acquainted with the twentieth century. Today China is an emerging economic behemoth and entangled with the United States in a financial knot so complex that to untie it invites financial doomsday scenarios.

When the Chinese Communist Party in the 1980s, led by Deng Xiaoping, decided to marry political authoritarianism with managed market economics, U.S. companies aggressively entered the Chinese market with the blessing of U.S. government policy. This coincided with a new global financial deregulation and business practices that celebrated further export platform development of multinational companies. U.S. companies pioneered production outside of the United States for re-import back into the United States, what the Europeans call "delocalization."

As computer-based technological advances of the 1990s emerged, U.S. companies were far ahead of others in taking advantage of an explosive growth of production in China. They could now manage and monitor production in factories both large and small throughout China from U.S.-based headquarters. All this was encouraged by China with enterprise zones that granted easy land deals and low taxes - not to mention a guaranteed labor force at wages a tiny fraction of U.S. wages. What made all this possible were technological changes that allowed high end, low-error-tolerance products, as well as low end products - computer chips and plastic toys - to be produced with decent quality in low wage and low education countries.

The Chinese blend of political authoritarianism and a modern late 20th century open door policy worked, with the unforseen assist from a technological transformation that no one could have foreseen 30 years ago.

The U.S. trade deficit with China is around $200 billion. Chinese imports are peculiar, however, because virtually all are made by American companies in China, sold in the U.S., and counted as imports just like any others that would be made by foreign companies. To China these become dollar surpluses. They do not remain idle but are re-cycled back into the U.S. as purchases of corporate and U.S. Treasury bonds. So the U.S. public deficit - closing in on $500 billion a year - is underwritten by Chinese surpluses earned from American companies selling production from China in the U.S.. In 2004 some $200 billion has flowed from China to the U.S. in support of debt and 2005 is running higher.

This is not costless, because jobs and income are lost in the U.S. through out-sourcing production to China. At the same time, consumers benefit from lower-priced products. The substantial Chinese purchase of bonds also keeps interest rates low as they provide a ready supply of funds to purchase bonds. Lower interest rates, of course, enable individuals to incur larger debt for home mortgages, credit cards, and home equity loans. It is estimated that median household debt has now reached $100,000, nearly doubling from 1990, and typical household credit card debt exceeds $9,000.

Debt accumulation, driven by low interest rates, has its origins partly in imports from China. There is a mutual addiction: Chinese with their exports to the U.S. and U.S. borrowing from China. But there is a vulnerability to its continuation. U.S. trade imbalances and debt have weakened the dollar which reduces the value of bonds held by China (because they are worth less when redeemed as dollars) and makes future purchases of U.S. bonds less attractive.

The dizzying pace of this financial revolving door is the essence of globalization's entanglements. Neither party can extricate itself without consequences. If the U.S. places undue pressure on China or adopts policies to slow down the rate of imports from China, it risks losing the financial foundation on which its debt-ridden economy prospers. If China retaliates by diversifying out of U.S. debt into the stronger EURO, it risks a financial fallout in the U.S. that reverberates back onto its prosperity via reduced imports from China.

Political pressure has increased because of the further expansion of Chinese textile exports, following on the WTO-mandated end in 2005 of the 1974 Multifiber Agreement that had established quotas on textile imports. The Bush administration is pressuring China to revalue the yuan upward from its fixed rate of 8.28 yuan to the dollar. Even if China would accede, anything short of a major revaluation (50% or more and that is not under consideration) would have very limited impact on the trade imbalance. Economists place too much stock in a textbook incremental response to small price changes that is not borne out by experience.

To create the conditions for a soft landing that untangles this financial knot there should be a phased-in significant yuan revaluation, enforcement of internationally-accepted labor rights, and China's adherence to the commitments it made when it was admitted to the WTO in 2001.

The financial imbalance between China and the U.S. threatens both. Each has a potentially potent bubble: real estate in the U.S. and an unsustainable increase in economic growth in China. The May 2005 Economist Intelligence Unit rates doing business in China moderate to high risk because of an estimated 30% of non-performing loans held by Chinese banks. To detach from this financial entanglement will not be easy or painless. This grand game of financial chicken being played out may be more serious than the spread of an avian flu epidemic.

Copyright 2005 New Perspectives Quarterly