China recently told US Treasury Secretary Henry Paulson to go take a flying f$$k when he tried to jawbone them to revalue their currency higher versus the US dollar. They threatened to dump dollars which would cause the dollar's value to plummet resulting in financial turmoil in the US. China holds some $1.3 trillion in US dollar reserves thus effectively becoming America's banker. Cheap Chinese goods are flooding the US paid for in dollars which have built into a considerable pile in Chinese banks. As the world's largest debtor nation, the US is borrowing something like $2 billion per day to keep itself afloat and fight the Iraq war.
Two Chinese officials at leading Communist Party bodies have given interviews in recent days warning, for the first time, that Beijing may use its $1,330 billion of foreign reserves as a political weapon to counter pressure from the US Congress. Shifts in Chinese policy are often announced through key think tanks and academies.
Described as China's "nuclear option" in the state media, such action could trigger a dollar crash at a time when the US currency is breaking down through historic support levels.It would also cause a spike in US bond yields, hammering the US housing market and perhaps tipping the economy into recession.
It is estimated that China holds more than $900 billion in a mix of US bonds.
Before Ronald Reagan the US was the world's largest creditor nation. Reagan immediately cut taxes and built up a national debt four times the debt accumulated by all the Presidents preceding him. George Bush has followed in Reagan's footsteps, cutting taxes and adding some $4 trillion dollars to the national debt, 45% of which is owed to foreigners. Evidently, Republicans not only believe that government does not work, but they're out to put the US government out of business altogether by driving it into bankruptcy!
The dollar is already losing ground with respect to the Euro and other currencies. It won't be long before countries will not want to hold large amounts of dollars as a reserve if the dollar keeps losing its value which it inevitably will as long as the US continues to spend huge amounts on wars and consumption while sending dollars overseas to its Chinese, Japanese and Saudi Arabian bankers.
Politicians have called the Chinese policy of keeping their yuan pegged artificially low with respect to the dollar "currency manipulation," harsh words indeed, and have introduced legislation calling for tariffs if China doesn't let the yuan float higher with respect to the dollar. The resulting difference in currency values is responsible for the large trade imbalance between the US and China. But the threat of dumping US dollars has left the US stymied as to what to do to prevent the hemorrhaging as it continues to slip further and further into hock to its traditional enemies who are increasingly in a position to call the shots. If the US does nothing, its trade imbalance with China will allow China to accumulate an even larger portfolio of US dollars which means it will be in an even more commanding position. If the US makes good on its threat to impose tariffs, China will dump US dollars wreaking havoc on the US financial system. So the US is in a lose-lose situation primarily caused by the Reagan and Bush tax cuts and its lack of fiscal prudence.
America is addicted to a daily "fix" of Chinese capital that floods in to purchase US government bonds and thereby fund the US budget and trade deficits.
China finances the US deficits as part of a broader mercantilist strategy to keep its currency undervalued. The way it does so is to set a "fixed peg" between the US dollar and the Chinese yuan. To maintain that peg in the face of a record trade imbalance between the US and China, China simply recycles its surplus US dollars back into the US bond market.
Today, as a result of its currency manipulation, China has become the largest monthly net buyer of US securities. More than two-thirds of its massive and highly undiversified $1 trillion in foreign currency reserves are estimated to be invested in US bonds. China will very shortly eclipse Japan as America's largest creditor. And its foreign currency reserves are projected to double within a few short years.
Here's the clear and present danger: What may have started out as a simple mercantilist currency gambit for China to sell its exports cheap and keep imports dear has morphed into a powerful weapon to hold off any effective US response to China's unfair trade practices. And make no mistake: Such practices run the gamut from a complex web of illegal export subsidies and currency manipulation to rampant piracy and woefully lax environmental, health, and safety standards.
In addition China can simply refuse to continue to buy US Treasuries thereby discontinuing funding US deficit spending. So China possesses a dual edge sword: it can dump dollars and it can refuse to buy US Treasuries. Would China make good on its threat to "go nuclear" with respect to the dollar? Probably not, because then it would lose the lucrative US consumer market. No, China would like to continue the present arrangement as long as possible since it is getting richer as the US gets poorer. It would probably prefer to gradually divest itself of dollars thereby gradually beggaring the US without losing its lucrative market. This might be called the "hot frog" strategy. It is well known in scientific circles that, if you drop a frog into boiling water, it will jump right out. On the other hand, if you put a frog into lukewarm water, it will find the water relaxing and stay in. As you gradually raise the temperature of the water, the frog will get more and more relaxed until it's too late to get out, and the frog will eventually get cooked.
In addition China with its immense reserves soon approaching $2 trillion could go on a buying spree in America buying up US corporations and other real and tangible assets. Other foreigners have bought US assets but this would be different because it would be the Chinese government itself and not individual Chinese who would be doing the purchasing.
"The United States is a power, but it's hardly the only power, and it's certainly not a superpower anymore," said Jim Rogers, who co-founded the Quantum hedge fund with the billionaire investor George Soros in the 1970s. The dollar is perhaps the biggest problem. As a net debtor, the United States must attract some $3 billion every working day to finance a gaping current account deficit that in 2006 amounted to 6.5 percent of gross domestic product. Economic rivals like China and Japan, on the other hand, boast massive surpluses.
Since Americans also spend more than they save, the money to cover the U.S. deficit must come from foreign lenders like central banks. China, which holds more than $1 trillion in foreign currency reserves, is one of the biggest creditors. As the dollar has steadily weakened over the past year, the value of the dollar-denominated assets held by central banks has also declined. The trend may motivate foreigners to start holding more euros instead, exacerbating pressure on the dollar and leading to faster U.S. inflation rates and a declining standard of living. That is increasingly possible because euro-denominated debt today accounts for a bigger share of the international bond market than do dollar-based securities.
That also means that oil exporters could find it easier to start pricing crude in euros, Rogers said, adding to the financial burden on the United States, the world's biggest consumer of oil. While a weaker dollar may bolster U.S. exports and the profits of American companies with overseas operations, weaker foreign demand for U.S. Treasury bonds would push up long-term interest rates, raising mortgage payments for U.S. homeowners and borrowing costs for an indebted government.
Already, there is considerable foreign ownership of US industries. For instance, 97% of the sound recording industry, 63% of book publishers and 64% of the motion picture and video industry are foreign owned. At the same time the US buys 90% of its footwear, 87% of its audio and video gear and 67% of its apparel from foreign companies. So far, foreigners have been willing to let the US run up its credit card, but for how long, for how long?
The Global Imbalances and the US Economy
The US global merchandise trade and current account deficits rose to $857 billion in 2006. This amounted to 6.5 percent of US GDP, twice the previous record of the middle 1980s. The deficits have risen by an annual average of $100 billion over the past four years.
These global imbalances are unsustainable for both international financial and US domestic political reasons. On the international side, the United States must now attract about $8 billion of capital from the rest of the world every working day to finance the US current account deficit and foreign investment outflows. Even a modest reduction of this inflow, let alone its cessation or a sell-off from the $14 trillion of dollar claims on the United States now held around the world, could initiate a precipitous decline in the dollar. Especially under the present circumstances of nearly full employment and full capacity utilization in the United States, this could, in turn, sharply increase US inflation and interest rates, severely affecting the equity and housing markets and potentially triggering a recession. The global imbalances probably represent the single largest current threat to the continued growth and stability of the US and world economies.
So China continues to loan the US money much the same as a credit card company continues to loan its debtors money. Why? Because it makes money on the interest. China not only makes money on the interest, it makes money on the actual products it sells the US although, theoretically, it would make more money if the yuan were revalued with respect to the dollar. That is Chinese products would become more expensive in the American market, but then they would sell less of them. China seems to think that its interests are best served under the current arrangement. Forget revaluing the yuan! As bankers know, the real money is in collecting interest, not selling products, and the Chinese are doing quite well, thank you, buying up US Treasuries and debt instruments which accelerates the accumulation of US dollars and control over the US economy. And by the way, Taiwan is now low hanging fruit which gets lower by the day.
As the dollar depreciates with respect to the euro, it becomes worth less in the rest of the world even as China continues to increase its position as US banker. The US can, therefore, look forward to the loss of the dollar's position as the world's reserve currency and perhaps having to buy oil some day in euros which means it would have to pay a lot more for its oil. Meanwhile, rather than dumping dollars (always a credible threat), China can use them to buy up US assets much as the Saudis, the United Arab Emirates and other oil rich nations have done. After all, as bankers and credit card companies know, you'd much rather have your clients continue to pay you interest than have them go bankrupt and stop paying you at all!
