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February 25, 2010

Sino-American Economic Power: A Mexican Standoff
Posted by Jacob Stokes

2003-9-27-china_money1Former IMF chief economist Simon Johnson over at Baseline Scenario has an important post that squashes the notion, which has become conventional wisdom, that China’s reserves of US debt take away American leverage in US-China relations.

“There is a perception that China’s large dollar holdings confer upon that country some economic or political power vis-à-vis the United States and, in particular, that Chinese reserves prevent us from putting pressure on that country’s authorities to revalue (i.e., appreciate) the renminbi. This view is incorrect and completely misunderstands the situation.”

Johnson goes on to explain how the US-China debt relationship—much pointed at as an example of waning US poweris a two-way street. In other words, while America needs anxious buyers like China to purchase its debt in order to do things like fund the war in Afghanistan, China needs debt to buy. That’s because China must stock up on assets in foreign currencies to keep its currency value low so that its export-driven economy can thrive. This purposeful manipulation is of course bad for the American economy, particularly the ailing US manufacturing sector.

But what options or leverage do we have? America needs to the money. 

Well yes, but China also has an export-driven economy that requires a cheap currency to thrive. In other words, in order to maintain its low currency value China needs us to issue debt as much as we need them to buy it. Even if China decides to change its mind and invest somewhere else, any option other than buying US debt, from purchasing US stock to buying foreign currencies, would help stimulate the US economy in other ways. Which would be a good thing. (Johnson explains this in more detail.) 

And if China decides to start plowing money into its domestic economy, it will force China to push up the value of its currency or have its economy overheat. This will make American exports relatively cheaper and more competitive. Johnson says in fact that this is the policy we should be aiming for.

The bottom line on this rather wonky subject is that the Sino-American relationship is not one where China is holding a debt gun to America’s head, forcing an emasculated America to do China’s bidding. It’s more like a Mexican standoff: only by slowing lowering our gunsor, in this case, rebalancing our trade and monetary postures—can we both resolve the situation in a way that benefits both parties.

In order to do this, America should do all it can to put pressure on China to slowly but steadily let its currency appreciate so that American exports can be more competitive. It should also reduce it foreign currency reserves and push its citizens to consume more. The renewed vigor in the US economy created by this rebalancing would help erase the need to sell our debt in the first placemaking a measured, incremental rebalancing good for everyone.

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