US - China: Approaching Economic Divorce?

Brian Durrant - Mon 14 Apr, 2008

Has the trade imbalance reached its limit as China stops buying US treasuries?

One of the features of our style at the Fleet Street Letter is the top-down approach to factors that influence our prosperity. The enduring theme at the moment is the fall-out from reckless lending to Americans with poor credit histories. These toxic loans were repackaged with good quality instruments and sold on throughout the world. Like some financial virus it has brought some credit markets to a halt. The different reactions of policy makers around the world had got me thinking. Why is it that the Federal Reserve and the White House are prepared to slash interest rates aggressively, flood the markets with the liquidity and engage in tax cuts, while the Bank of England and European Central Bank are much more wary of loosening monetary policy because of worries about inflation and concerns about moral hazard? Are the European authorities being too complacent? Or does the US have an insight into the specific dangers it faces?

I was intrigued by observations made by Dr Pippa Malmgren to UK investment professionals earlier this year. She was the former Special Assistant for Economic Policy to President George W Bush and now is only one of a handful of independent analysts invited to attend the Fed's Annual Economic Symposium. The media may present the current situation as a sub-prime mortgage crisis. But there is more to this problem than meets the eye. The Fed acknowledges that as the banks cut credit lines, it will impinge on the ability of businesses to expand their operations and create new jobs. Moreover there is also a question mark about the willingness of foreigners to lend to the US to fund a way of life in which Americans spend more than they earn. Did the United States meet that limit last summer? The relationship between the US and China is key to answering this question.

A few years ago I highlighted the marriage of convenience that exists between the US and China. Part of China's emergence as an economic power was founded on a manufacturing export boom. America was a huge and willing customer. Americans spent their cash on Chinese goods at Wal-Mart. This resulted in a huge trade imbalance between the US and China. A free market response would be for the Chinese currency to rise, in turn making Chinese goods less competitive in the US, thereby choking off the export boom. What actually happened was the Chinese authorities recycled its surplus by investing in US Treasury bonds. On the one hand this kept the renminbi artificially competitive against the dollar and so sustained the Chinese export boom. On the other hand, massive foreign purchases of US public debt kept US interest rates low and so fuelled not only the American consumer binge on Chinese goods, but also the US house price boom. Both parties were happy with this arrangement.

The boom in manufacturing exports in China is essential for accommodating the masses emigrating from the rural hinterland to the manufacturing bases on the coast. At the same time inexpensive Chinese goods kept the lid on inflationary pressures in the US. However, not everyone is happy. Manufacturing jobs in the US are being lost to cut-price competitors across the Pacific. To the extent that the renminbi was prevented from rising, this was seen as unfair competition. Accordingly, some sections of the US did not view China as an economic partner, but as a threat.

Political relations between the US and China started to deteriorate in the summer of 2006. While Americans were celebrating Independence Day on 4 July, the North Koreans decided to fire seven missiles, one of which was an inter-continental ballistic missile. The long range Taepodong 2 missile failed after 40 seconds and landed in the sea 200 miles from Japan. The test may have been an operational failure, but it raised security concerns in the region. The Americans feel that China is responsible for containing North Korea, a regime which China supports because it doesn't want a united, democratic Korea on its border. Then in October, North Korea detonated a nuclear device underground. The US felt it needed to respond. A nuclear powered aircraft carrier, the Kitty Hawk, was moved from Hawaii to Okinawa and also spy satellites were sent over North Korea. The Chinese were very unhappy about these manoeuvres happening on its doorstep. In response, the Chinese began to use ground based laser systems to 'blind' the US satellites.

China is very conscious that the shipping lanes, rather than railroads, are its economic lifeblood. Raw materials are shipped in: iron ore from Australia, oil from the Middle East and Africa. Exports are shipped out across the Pacific and the Indian Ocean. In fact, one can name only two countries along those critical shipping lanes that are not completely aligned to the US. One is Burma and the other is North Korea, not exactly lynchpins of the world economy.

China is extremely uncomfortable with this situation and has given the Americans cause to ponder in three starkly different ways. Indeed, a minority of commentators link the unhinging of the financial system not to the emergence of delinquent sub-prime loans, but to a US Treasury auction last May. The US Treasury held a typical, regular scheduled auction of its debt and the Chinese did not show up. China had been signalling for some time about its desire to diversify out of dollar-denominated assets. But no one expected them to be totally absent. Predictably, US interest rates firmed up, but more importantly, the mood in the market changed. The marriage of convenience was now in doubt.

Six months on, the Chinese reacted to the increased American naval presence in China's backyard. The Kitty Hawk, fully laden with 4,500 US naval personnel, was refused permission to dock in Hong Kong for Thanksgiving.

Then in January the Chinese put further strains on the relationship when it destroyed a defunct six foot-long weather satellite using a solid-fuel missile tipped with what they call a 'kinetic kill device'. This represented more than a demonstration that China had joined an elite club of nations (the US and Russia) that can aim at a target in space and actually hit it. This was an aggressive and calculated move. Moreover, it is unclear whether the People's Liberation Army had been given the explicit go-ahead by Beijing. The US aircraft carrier that had been on manoeuvres off the coast of Japan does not rely on a compass but 'Sat Nav'. If you can take out satellites in space, you can disable the US naval presence in the China seas.

China and Russia are experimenting with different brands of authoritarian state capitalism. Both nations have become more confident in their dealings with the US, whose own economic model is under strain. Indeed, China and Russia are working together to create the Shanghai Co-operation Organisation, which seeks to reduce US influence in Asia over time.

In return, the US has expressed its misgivings about the motivations of Chinese and Russian sovereign wealth funds and also signed a nuclear deal with India last year. At the same time the US maintains its ban on exporting high technology to China, and so the Chinese have resorted to hacking into the Pentagon's computers. Not the behaviour of two partners in matrimony! Don't get me wrong; both Washington and Beijing have a lot to lose from a marital break-up. But there are elements in the Pentagon and People's Liberation Army that see the relationship differently. This escalating military rivalry threatens to unravel the web of mutual interests.

America's commitment to free markets is its strength, but it sits uneasily with US politicians concerned about national security. What if China uses Sovereign Wealth Funds (SWFs) as a Trojan horse to obtain access to the latest cutting edge US technology? When China began making its investments in Blackstone, one of America's foremost private equity firms, a congressman wanted to launch an investigation into whether this sort of investment should be allowed. From a national security standpoint, what better way for China to circumvent the high-tech ban than to get Blackstone to call all their top high-tech companies and organise an appointment.

There are similar concerns with distressed US financial institutions. Ten years ago Citicorp merged with Travelers Group to create a behemoth, Citigroup, which would 'redefine world finance'. Look at it now. The credit market now believes that the unthinkable, a Citigroup default, is thinkable. Now Sovereign Wealth Funds could conceivably come to the rescue. The US authorities do not seem to have a problem with the Abu Dhabi Investment Authority, presumably because they believe their investments are motivated by profit. But Chinese SWFs are a different kettle of fish. The US authorities are watchful of the Chinese Investment Authorities $5bn stake in Morgan Stanley. If the US authorities want to block Chinese intervention on strategic grounds, the best thing to do is make sure major US financial institutions do not fail in the first place.

Following the 9/11 attacks, it was the number one priority for the US authorities that such an atrocity would not bring the US economy to its knees. The Federal Reserve responded to this challenge by keeping the economy going on a tide of cheap finance. The challenge to American prestige is much greater now, and that's one reason why the Fed is so much more committed to countering deflationary forces than either the European Central Bank or the Bank of England.

Regards,

Brian Durrant
for The Daily Reckoning