Talking Point

The ‘poor’ state of the union

Angry reactions in Beijing to downgrade of its US debt holdings

Spare a dime? China wants the US to get its fiscal house in order so as to protect its bond investments

“Every wrong has its source, and every debt its incurrer” goes the Chinese proverb, a timely view, following Standard & Poor’s downgrade of US Treasury debt this month.

And the Chinese have been very clear after the news: the ‘source’ and the ‘incurrer’ is Uncle Sam.

As noted a month ago (our Talking Point in WiC115), Chinese frustration has been building for months at the deteriorating fiscal circumstances in the US. And while WiC took its two-week summer break, the mood soured spectacularly.

So what happened?

The Chinese view of the deficit negotiations in Washington at the end of July was already a dark one (a “farce” of “immoral” and “irresponsible” proportions was the People’s Daily take).

And there was little sign of improvement when a deal on the debt ceiling was finally announced on Capitol Hill on August 2. Lawmakers had “failed to defuse Washington’s debt bomb”, thought Xinhua, only “delaying an immediate detonation by making the fuse an inch longer”.

In fact, the first explosion was to come just a few days later, as Chinese frustration finally spilled over on news of the downgrade of Treasury debt to an AA- rating.

There was no formal response from the government in Beijing. But local newspapers queued up to put the boot in. State-owned media like Xinhua were again at the forefront, muttering darkly about America’s debt “addiction” and calling time on “the days when the debt-ridden Uncle Sam could leisurely squander unlimited overseas borrowing.”

21CN Business Herald was disgusted too: China was living under a US-inflicted “reign of financial terror”. There had also been plenty of warning that this would happen: Dagong Global (a Chinese rating agency; see WiC87) had announced its own debt downgrade last year but was met “with a sense of arrogance and cynicism from some Western commentators,” Xinhua snorted. Now Dagong could be seen to have been telling “the ugly truth”.

Other newspapers drew deeper political meaning, including the Global Times, which divined a “smashing” of the United States’ reputation.

The problem, the newspaper argued, was that America was still in denial: “It is confronted with new competitions and challenges, but still takes its system for ideal and denigrates all those that disagree. Such arrogant behaviour is at the very core of the US downfall”.

What does China want to see happen next?

Anger seems to have trumped advice. But the main prescription was the obvious one: America had to sort out its “political wrangling” and “live within its means” (cut military and social expenditure first, was one of the more concrete suggestions).

There were also vaguer calls for a system of “international supervision” over the issue of dollars, as well as consideration of a “new, stable and secured global reserve currency” as an option to reduce reliance on the US.

But the message was much clearer on what China wouldn’t be doing – coming to the rescue again.

The Chinese view here is that their $586 billion domestic stimulus in 2009 generated a disproportionate share of global GDP growth following the onset of the global financial crisis. But Beijing would not be pressed into “saving the world” again, said Century Weekly, not least because it lacks “policy space” to launch something similar (domestic inflation hit a three-year high of 6.5% in July).

What impact has the downgrade had?

Officially, China holds a little over $1.1 trillion in US government debt instruments. Adding other purchases through intermediaries in places like the UK and Hong Kong pushes that figure closer to $1.6 trillion. Then include non-governmental securities priced in dollars, and the exposure rises to more than $2 trillion.

That means the downgrade will have triggered a fall in the book value of China’s holdings. But Beijing’s concerns seem more focused on the medium term, as well as the indirect influence of the S&P ruling.

One worry is that a wider loss of business confidence (as indicated by stock market turbulence in recent weeks) will hit economic growth and make a double dip recession a possibility.

The Obama administration could well try to “inflate the burden away”, Yu Yongding, a former member of the monetary policy committee of the Chinese central bank, also warned the Financial Times last week.

Pushing the button on ‘QE3’ would mean more weakening in value of China’s dollar reserves, as well as entice a flush of new money from overseas, pushing up asset prices across the board and further stoking inflationary pressure.

So what are China’s options?

Of course, SAFE (the manager of Beijing’s foreign exchange reserves) can’t just start dumping Treasuries in fury, as global markets would pick up on the move, prompting a wider fire sale. This would drive down the value of China’s remaining reserves, as well as push up American interest rates and hit US growth.

That might then spill over into other areas of the fragile international economy and weaken demand for Chinese exports.

The Chinese have though been making more of an effort to diversify away from Treasuries. In part that has involved more direct investment overseas, including setting up sovereign wealth fund CIC to buy into international assets. Annual overseas investment is up to about $60 billion annually, well ahead of five years ago. But that is still a small fraction of reserve holdings.

China could try to negotiate to convert part of its Treasury holdings into equity stakes in US financial or energy firms, Jing Xuecheng, a former deputy head of research for China’s central bank, suggested to Reuters.

A bold concept, but one that seems rather fanciful. In the longer run, Beijing also expects to see much wider usage of its own currency – the renminbi – in international trade. Yet this shift is also in its early stages and most experts agree that the Chinese currency is some distance from being widely accepted in global markets, especially while Beijing is reluctant to relax capital controls.

It all leads to a situation in which China’s forex managers don’t have many alternatives to the dollar, says Bill Powell, writing for the CNN Money blog last week. How about switching into the second and third largest domestic bond markets after US Treasuries, he asked? That’s Japan and Italy, he chortled. Let’s have a show of hands from the folks at SAFE on who wants to increase their exposure to Japanese and Italian debt right now…

A trap of Chinese making…

Back to the opening proverb: are there any other sources of the “wrong” that China now feels itself to be suffering?

Of course, the argument here is that China’s own development model forces it to buy dollars in order to keep its currency weak in support of exports (there was another $31.5 billion trade surplus in July).

Ergo: it has played its own part in inflating the US credit bubble and must now reap some of the consequences.

In more modern day parlance, sections of the Western media have picked up on the ‘debt-as-drug-addiction’ analogy appearing in some of the Chinese op-ed pieces.

Fair enough, seems to be the general response. Although doesn’t that cast China in the role of drug pusher?

Best whisper that one, given China’s sensitivities (still) about nineteenth century Opium Wars. But Patrick Chovanec, a professor at Tsinghua University in Beijing, agrees that the economic fundamentals do force China into a dependency of its own: the accumulation of dollar reserves. No other currency has the same liquidity, so SAFE has little choice but to hold onto the Treasuries it already owns, and to keep buying more.

WiC has discussed this ‘dollar trap’ before, although Chovanec says that it is not widely understood in China. Still, there are signs that the debate is widening. Yu Yonding, in his FT article, noted greater awareness that huge trade surpluses and accumulating foreign reserves is not in China’s best interests.

“A developing country, with per capita income ranking below 100th in the world, lending to the world’s richest country for decades is not reasonable,” he asserts.

The need for an economic restructuring as a necessary step in escaping the dollar trap – and especially a shift towards a greater reliance on Chinese consumer spending for growth – is also getting more mention in the domestic media, including in some of the coverage of the S&P downgrade.

Perhaps it helps that the Eurozone is also in such a mess. With both US and EU markets looking unreliable, awareness is growing that the country needs to accelerate its shift to an alternate economic paradigm – one that relies less on the West and more on growing demand from itself and ‘the rest’.


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