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Published: July 22, 2010
The United States and China have been
locked in a dysfunctional relationship for far too long. We here
in the states have been consuming Chinese imports at an
ever-rising rate. And China has helped fuel our addiction by
keeping its goods very cheap. It's managed this by pouring much
of its export profits into U.S. Treasury bills and bonds,
keeping its
currency,
the yuan, artificially low.
Now, the two countries are locked in an uncomfortable scrum.
China is legitimately concerned that the United States will be
unable to pay back the hundreds of billions of dollars it owes.
And the United States desperately wants the yuan to strengthen.
There's a straightforward solution, and policy makers in both
countries would like to see it happen: A rising middle class. In
China, that boosts domestic consumption. And that would help to
reverse persistent large trade deficits. It's starting to
happen, but perhaps not fast enough to avert a crisis.
The Worst Case Scenario
In a doomsday scenario, China starts to panic about potential
U.S. government
bond defaults and decides to sell a large amount out of its
U.S. bond portfolio. That would cause a quick run on the dollar,
and lead to an alarming spike in interest rates. As we're
running large budget deficits right now and will need to keep
issuing hundreds of billions of dollars worth of bonds, our debt
service costs would skyrocket. That's why it's imperative that
the United States balances its budget before any China problems
spiral out of control.
Of course, China has ample reason not to panic. After all, the
United States represents its largest export market, and a
weakened American economy would stumble as a trade partner. Any
major shift in bond ownership that weakens the U.S. dollar would
reduce the value of China's foreign bond portfolio by a
commensurate amount.
The Middle Path
Rather than make an abrupt shift in its bond portfolio, China
can gradually reduce its exposure to the United States. And it's
doing just that. China trimmed its exposure to U.S. bonds by $33
billion to $867 billion in April, according to data released
last week. This is not the start of a fast drawdown of U.S. bond
holdings, as China will proceed slowly. But it's a sure sign
that the United States shouldn't count on China to help support
its addiction to debt.
In an ideal world, Chinese domestic consumption would start to
rise, and China's trade balance would swing from surplus to
deficit, which would have myriad benefits for both sides.
For the United States it would mean higher exports. And
increased foreign earnings would to help mitigate any potential
inflationary fall in the dollar. For China, rising domestic
consumption would help create jobs at a time when
export-oriented factories are starting to see a slowdown.
Yet as noted earlier, that is likely to happen far too slowly to
be of real help. That's why U.S. policy makers are practically
begging China to let its currency rise. China has reasons to
move very slowly on the currency front. For starters, it would
see a drop in the value of its foreign bond holdings. More
important, its exports would become less competitive compared
with other exporters such as Vietnam, Malaysia and the
Philippines. Policy planners dread any potential civil unrest
that would come from a swelling tide of laid-off factory
workers. Trouble is, an artificially weak yuan is unsustainable,
and the longer China drags its feet, the higher the risks of a
global economic crisis.
How This Plays Out
Despite all of the potential pitfalls, investors need not panic.
The United States has been running large trade deficits for a
very long time, and fears of its deleterious effects have been
evoked ever since. Yet remarkably, the dollar remains strong,
thanks to the very long and successful track record of the U.S.
economy, and the perceived "safe haven" that the dollar offers.
But investors might need to brace for a long period of subpar
U.S. economic growth, unless its exports can rise sharply. Just
a few years ago, investors were cheering the fact that the
dollar was moving into a long-term weakening phase, which would
ultimately enable the country to export its way out of its
problems. Trouble is, the global crisis of 2008 and 2009 turned
the euro into the lagging currency. President Obama has
expressed hopes for an export boom. But with a strong dollar, a
weak euro and an even weaker yuan, it's not clear how that can
happen.
So what can we expect during the next few years? Well, economics
is known as the "Dismal Science" for a reason, and many
forecasts miss the mark. But economists generally agree that
China will only slowly reduce its exposure to U.S. bonds. Which
means that the United States hopes that other buyers will emerge
for its new debt. (Budget deficits are expected to remain high
for at least the next three to five years). More than likely,
Uncle Sam will have to pay higher and higher interest rates to
attract buyers for its bonds. And higher interest rates can
stifle economic activity.
To be sure, the economy can handle interest rates that are
higher than current levels. For example, inter-bank lending
rates (set by the Federal Reserve) might move up to 3% rather
than the current near-zero levels. That might actually be a
positive for the stock market, as it would reduce fears of an
inflationary bubble, which would justify higher
price-to-earnings ratios as risk is reduced. Yet as we recall
from the 1970s, if interest rates must rise closer to 7% or 8%,
then it's, "Katy, bar the door." Stocks went nowhere in the
1970s as most investors were content to simply clip
high-yielding bond coupons.
-- David Sterman
Staff Writer
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