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With so much cash at China's disposal and the United States dependent on it, the new U.S. administration in 2009 will find itself powerless to adjust the situation. The trade imbalance, the root cause of this trouble, has for years been neglected. Unless this is addressed, China will always have the upper hand in its dealings with the United States.
China has used its reserves mostly to buy U.S. Treasury Bonds, since they pay good interest. Also the U.S. government is the safest bet for depositing large amounts of cash. Only recently have the Chinese begun considering the purchase of stakes in various stocks, funds and other investment vehicles, allocating US$200 billion for such ventures.
Next on their mind is real estate. With the collapse of the U.S. housing market, commercial real estate has also taken a hit. The Chinese believe the time is right to buy parts of Manhattan or Boston or Chicago.
U.S. Treasury Bonds is just a sophisticated term for government debt. The bonds have been in demand not only by China, but by India, Japan, Taiwan and South Korea, who also have significant cash reserves. Exporting nations tend to keep their cash in this instrument because the U.S. economy is their best option.
U.S. bonds came into existence during World War II, when the government's expenses exceeded its intake. This pattern continued, although the U.S. economy grew by leaps and bounds after the war.
When their petro-dollars arrived in bundles in 1973, U.S. Treasury Bonds were the first instruments the Arabs purchased. Later they diversified into other holdings. All the U.S. military build-up of the last 60 years, as well as the Vietnam War and Gulf Wars I and II, have been financed partly through the sale of these bonds and other debt instruments.
As soon as their exports rose and created the first trade surplus in 1986-87, the Chinese also began purchasing U.S. Treasury Bonds. When Chinese cash holdings grew to a significant amount in 1996, the United States began paying attention to China's cash. Behind the scenes, the United States began to link this money as security for all the foreign direct investment in China. This incoming cheap cash brought about the present era of consumer excesses, sub-prime loans and military build-up.
Today, China owns about US$400 billion in U.S. Treasury Bonds. The remainder of its money is held in other U.S. government long-term securities, investments, gold, etc.
The presence of US$1 trillion of Chinese money has a direct impact on keeping U.S. interest rates down. It has lowered rates by 1.5 percent. In other words, when a consumer walks up to a bank in the United States, part of the lower mortgage rate or line of credit or credit card loan he is offered is financed by Chinese cash.
Under these circumstances, can the United States ever get tough with China on trade or strategic or regional issues?
Imagine a scenario in which China dumps one-third of its U.S. dollar reserves by converting them into euros, or taking them home to bail out its bankrupt banking sector. This would cause a major crash in U.S. financial markets. The value of the dollar would collapse and inflation would be rampant. It would also temporarily drive the stock market up, before it came crashing down. An extended recession would follow.
The United States is not prepared for this unpleasant scenario; hence it will keep extending the welcome mat to incoming Chinese money.
China may suffer a backlash of its own if the dollar collapses. The value of its dollar holdings will contract. Exports will suffer severe consequences of a U.S. recession. Long-range consequences to China would include a dramatic downturn in its economic expansion.
Other nations will suffer as the U.S.-China commercial relationship begins to unravel. With the collapse of the U.S. dollar, Europe will find its business activity diminishing. Arabs will find their cash kitty reduced and their revenues declining as the market for oil disappears.
The rest of Asia apart from China will be severely impacted. India will have nowhere to sell its information technology, business and knowledge process outsourcing services. Cotton textiles in India will suffer the adverse impact of a recession in the West. Africa will be in an unpleasant situation as food and other aid disappears.
In short, the U.S.-China relationship involves so many inter-dependencies that nobody would escape the negative consequences of a split. With all these consequences in mind, neither side will get tough with the other. Today's election-year talk of examining the U.S. trade relationship with China will simply be forgotten.
One cannot help but wonder how the United States got into this mess. The country has been living high on other people's money. This began after World War II, when Japanese export money came in handy. The story was repeated with South Korea and Taiwan 20 years later.
During this period the United States got used to relying on other people's money. When President Ronald Reagan came to power he removed all constraints on using this money. That is how he wished to finance his big military build-up and Star Wars project.
The availability of Chinese money from 1996 onwards created a free-for-all situation. The U.S. housing boom of 2001-07 can be attributed to that. The Iraq War has in part been financed by it. The bulk of consumer credit today has its origin in the free availability of money.
The reverse side of this easy money is the huge U.S. debt it has created. The US$10 trillion debt, which grows every day by $1.5 billion, is already unmanageable. Interest payments alone are $400 billion a year. The $3 trillion annual U.S. budget includes these interest payments.
It is a pity that the United States, the world's most prosperous nation, owes so much to others. There is no quick fix for this; reducing trade imbalances will take a long time to implement.
If the United States is serious about relieving this dreadful debt situation, it has to start working on minimizing trade imbalances. A new inter-currency relationship will have to be worked out. All unfavorable trade treaties will have to be renegotiated.
Last of all, this fanciful notion of democratizing the world will have to be dumped. This will keep the United States out of the world's hot spots.
In summary, the United States should not buy as much as it buys from China today. It should buy only as much as it can sell; in other words, it needs balanced trade. If this happens in the next 10 years, China's huge cash reserves will see a downward trend.
The unavailability of piles of others' cash will prevent crises like the sub-prime housing loans, adventurism in Iraq and overspending on arms. But the reality is that the United States has grown used to using other people's money. It has to kick this habit first and then put its house in order.
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(Hari Sud is a retired vice president of C-I-L Inc., a former investment strategies analyst and international relations manager. A graduate of Punjab University and the University of Missouri, he has lived in Canada for the past 34 years. ©Copyright Hari Sud.)
