Attached at the Wallet: The Delicate Financial Relationship between the U.S. and ChinaPublished: April 29, 2009 in Knowledge@Wharton
For nearly two decades, the United States and China have held each other in an awkward but mutually beneficial economic embrace. Despite the countries' political differences, American consumers gobbled up Chinese-made goods, while China piled up billions of dollars from U.S. trade.
The arrangement worked for years. But recently, under mounting pressures from the global economic crisis, the financial relationship between China and the U.S. is beginning to look like an unhealthy co-dependency. China holds so much of its foreign reserves in dollar-based assets that it is now vulnerable to shifts in the U.S. economy. And the U.S. has allowed China to purchase so much of its debt that it is now beholden to Chinese interests.
"China's investments in the U.S. are so large that we are mutually dependent," says Wharton finance professor Richard J. Herring. "They would suffer serious financial loss if they did anything to cause the dollar to depreciate. Indeed, at this point they seem to be alarmed that both our monetary and fiscal policy are out of control and may cause" that to happen.
China's foreign exchange reserves have increased sharply over the past decade, from $216 billion in 2001 to $1.52 trillion in 2007, then $1.95 trillion in 2008, according to a Congressional Research Service (CRS) report published in March. Some estimates put the current figure as high as $2.3 trillion. As a percent of GDP, China's foreign exchange reserves grew from 15.3% in 2001 to 45% in 2008. Economists estimate that about 70% of those reserves are held in dollar-backed assets. China now holds as much as $1.36 trillion in U.S. securities and government debt.
Some in the U.S. worry that China's massive dollar holdings could spell trouble for the U.S. economy if China ever decided to divest. "It's a weakness from the U.S. point of view," says Wharton finance professor Franklin Allen. "We are the vulnerable ones, because if [China] pulled out, there could be a run on the dollar, which would be very bad for the U.S."
Mutually Assured Distress
Such economic calamity is precisely the reason why China won't sell off its U.S. debt, others argue. China is dependent on the U.S. to buy its goods, and has no interest in seeing the American economy or the dollar collapse. Besides, if China sells off a chunk of its U.S. Treasury bonds, the value of the rest of its dollar-backed holdings would also fall. "If they begin to unload their holdings of U.S. Treasuries or even slow down the purchase [of them], it's going to have a huge impact on the dollar, and that's going to have a huge impact on the U.S., and they don't want to do that," says Todd Lee, greater China chief economist at research firm IHS Global Insight. "The U.S. is, after all, the most important export market for them."
So far, the U.S. has been happy to sell Treasury bonds to the Chinese because it helps finance America's $11 trillion national debt. China's strong appetite for U.S. Treasuries has kept bond prices high and interest rates low. Experts disagree, however, about why China has chosen to hold so much in U.S. securities, and they also disagree about how likely it is that China would ever sell them off.
China holds the bulk of its U.S. securities in long-term Treasury bonds and government agency debt, such as securities from Fannie Mae and Freddie Mac. The country pulled ahead of Japan in September to become the largest foreign holder of U.S. Treasuries. By the end of February, according to U.S. figures, China held approximately $744 billion in U.S. Treasury notes -- about a quarter of all foreign holdings. It is also by far the largest foreign holder of U.S. agency debt, with nearly 36% of all foreign holdings as of the end of June 2008.
Some say China has purposefully hoarded dollar-backed assets to manipulate the value of its own currency, the yuan (or renminbi). Buying dollars keeps the value of the yuan down, the argument goes, thus making Chinese exports cheap. Others say that China has simply needed a safe place to put its dollars, and has invested them in U.S. Treasuries because they are considered the safest possible investment. "For a long time, there has been no safer investment in the world than Treasury bonds," says Wharton professor of legal studies and business ethics Philip M. Nichols. "It's not just a good place, it's a comfortable place."
The Chinese government "is inherently cautious, given that they were born of a time that can only be described as vicious and savage," Nichols notes, alluding to the civil wars and foreign occupation that led up to the communist takeover in 1949. "So their thinking is often more towards the cautious than the risk-taking. In my mind, that's a much more likely reason to invest in Treasuries than holding down the renminbi."
Although China has previously dipped its toe into riskier investments, it turned back to U.S. Treasuries after suffering considerable losses in 2008. Its sovereign wealth fund, China Investment Corp. -- created in 2007 with a mission to better manage the country's foreign exchange reserves -- invested in Blackstone, a private equity group, and Morgan Stanley, an investment bank, right before the U.S. market tumbled. In June 2007, the fund had bought $3 billion worth of shares from Blackstone LP at $31 each. The value of those shares fell to below $8 by October 2008.
China subsequently purchased $44.5 billion and $65.9 billion of U.S. Treasury securities in September and October of 2008, according to the CRS report. "This may in part reflect a movement by China and other foreign investors away from purchases of U.S. agency asset-based securities, such as those issued by Fannie Mae and Freddie Mac, to more 'safe' U.S. Treasury securities," wrote the report's author, Wayne M. Morrison, a CRS specialist in Asian trade and finance.
China may also be accumulating massive amounts of foreign reserves as a result of the Asian Economic Crisis in 1997, when it watched the IMF impose strict conditions on bailout recipients. "In my view, that's a major contributor" to China's ballooning reserve of foreign exchange, says Allen. "I think most Asian countries looked at what happened and decided that they hadn't been treated fairly. So that's why they have been accumulating trillions of dollars in reserves."
China's trade surplus could swell to $325 billion this year, an ING Group economist told Bloomberg on April 23. According to Bloomberg, China's currency reserves fell $32.6 billion in January, $1.4 billion in February, then went up $41.7 billion in March.
A Strategy of Manipulation?
But a lot of China-watchers assert that China purchases U.S. Treasuries as a way of manipulating its currency. "The way the Chinese manage the value of the yuan is through buying and selling dollars," says Wharton professor of business and public policy Howard Pack. "They have been intentionally incurring these export surpluses, so they have too much foreign currency. When they buy U.S. Treasuries, it keeps the value of the yuan low relative to the dollar. That enables Chinese exporters to sell at relatively low prices to the U.S."
China needs to keep its currency low to support its export-driven economy, says Wharton professor of management Marshall Meyer. "China is unusually dependent on ... exports," he says, and it is purposefully controlling the value of its currency by hoarding dollars. "The deliberate strategy of growth through low-cost manufacturing [means that China] wants to maintain a modest, reasonable -- some would say 'artificially low' -- valuation of the renminbi to be competitive in the global market."
China's net exports (exports minus imports) contributed to one-third of its GDP growth in 2007, according to another Congressional report. The foreign trade sector employs more than 80 million people.
According to Meyer, China's foreign exchange reserves have increased, not only because of trade, but also due to "hot money" -- cash coming into China from currency speculators who are betting on the value of the yuan to rise -- and direct investment by foreign corporations, including many U.S. firms. Since the economic crisis hit, "hot money" is now flowing out of China. Meyer notes that China can't reinvest its dollar wealth in China because "then they would have to convert it to RMB (renminbi), which means it would drive the RMB up. So that's one of the paradoxes. They've got all this money, but they can't invest it domestically."
Allegations of currency manipulation have led the U.S. Congress to threaten trade sanctions against China, but despite the bluster, no laws have been passed. The China Currency Manipulation Act of 2008 died in Congress last year.
For the entire period from 1994 to July 2005, China pegged its currency to the U.S. dollar at 8.28 yuan. On July 21, 2005, the Chinese government said the yuan would become "adjustable, based on market supply and demand with reference to exchange rate movements of currencies in a basket." The yuan has strengthened more than 20% against the dollar since 2005, but many say the yuan is still undervalued.
"The Chinese vehemently deny currency manipulation, and the U.S. Treasury's official position is that China does not manipulate the exchange rate -- despite [U.S. Treasury Secretary Timothy Geithner's] confirmation testimony in which he said they did," says Wharton professor of insurance and risk management Kent Smetters. "China's official stated reason [for buying U.S. Treasuries] is that they want a safe security, and they recognize that our economies are intertwined: We buy their cheap products while they buy our ... debt. In practice, the Chinese have tried to keep the RMB cheap in order to promote their exports. But they probably also do value the appearance of a safer investment. So both are likely at work."
University of Pennsylvania political science professor Avery Goldstein says there have actually been conspiracy theories floated in both the U.S. and China, blaming the other for current economic woes. Goldstein doesn't buy those theories. "I think [the current situation] developed over time because it made economic sense for both countries. We appreciated the fact that the Chinese were purchasing U.S. Treasury securities and the Chinese liked that there was a safe place to invest."
The financial tangle binds both countries in uncomfortable political straightjackets. "In the context of the current crisis, I think it's made both sides much more sensitive to the effect of how much their fates are tied," says Goldstein. "The two are connected in ways that can't be easily separated."
U.S.-China negotiations on such sticky issues as North Korea, global warming, human rights, terrorism and arms sales to Taiwan could be increasingly tinged by economic concerns such as trade imbalances and currency manipulation, Goldstein says, especially since the Obama administration has decided to combine political and economic dialogues into one. "It creates opportunities for either explicit or implicit linkages between political and economic issues, where you want to keep them separate. The relationship is one where neither side can really rock the boat too much because we really need each other."
A Political Tool
Nichols says "it strains credulity" to think that China hasn't used its holdings as a political tool to some extent. Lee, at Global Insight, predicts that China will use its holdings as a chance to put political pressure on the U.S., but in the end, "they may say one thing, but they're not going to go through with their threats. It's a gamesmanship-type of thing."
The "threat" would be for China to significantly reduce its purchases of U.S. debt holdings, or, in a more extreme scenario, to stop investing in them altogether. Either scenario would force the U.S. to offer higher interest rates on its bonds, making continued deficit financing difficult or impossible. Experts say it is unlikely China will sell off its holdings all at once because nobody would buy them and it could lead to financial losses for the Chinese government. Also, any shocks to the U.S. economy could ultimately hurt China's export-based economy.
Still, the Chinese have expressed unusually forthright concern about the health of the U.S. economy recently. "We have made a huge amount of loans to the United States," Premier Wen Jiabao said at a news conference following the closing of China's annual legislative session in March. "Of course, we are concerned about the safety of our assets. To be honest, I'm a little bit worried. I would like to call on the United States to honor its words, stay a credible nation and ensure the safety of Chinese assets."
What really worries the Chinese, says Allen, is that "we're going to borrow so much that we're going to have really high inflation. I don't think they're worried that we'll actually default." But if the U.S. borrows so much that the value of the dollar begins to fall, then it will be as if China "gave us $2 trillion and we give them back, effectively, $1 trillion."
Pack agrees. "The Chinese for the first time are getting worried. They're worried that the U.S. deficit will lead to inflation in the U.S., and that means the value of the bonds they hold will go down. So they're diversifying a bit into other currencies. It's small so far." The question, Pack says, is what China will do in the years to come.
Going forward, experts say one of the underlying questions is how the U.S. will curb its voracious appetite for debt. "For the long term, the U.S. will want this growth pattern to be a little more balanced," says Lee. "You can't have consumers continue to run up consumer debt and have the lowest savings rate indefinitely."
If China is able to shift its economy to a more domestic-driven economy, it would have less to lose in disrupting the U.S. economy by selling off its debt. "If budget deficits continue, we don't reduce our entitlement problems and the BRIC countries [Brazil, Russia, India and China] continue to develop and rely less on U.S. consumers, we will need the Chinese more than they will need us within 15 years or so," says Smetters. "Of course, that's somewhat loose language. But, the point is that lousy U.S. fiscal policy and continued economic growth in the BRIC countries will render the U.S. as good as Rome."