The Sino-American Game of Financial Chicken
Howard M. Wachtel is a professor of economics at American University. His most recent book is Street of Dreams—Boulevard of Broken Hearts: Wall Street’s First Century.
Washington—Go back a little more than three decades when President Richard Nixon had just made his historic trip to China, a country isolated from the world and barely acquainted with the 20th century. Today China is an emerging economic behemoth and entangled with the United States in a financial knot so complex that to untie it invites financial doomsday scenarios.
When the Chinese Communist Party in the 1980s, led by Deng Xiaoping, decided to marry political authoritarianism with managed market economics, US companies aggressively entered the Chinese market with the blessing of US government policy. This coincided with a new global financial deregulation and business practices that celebrated further export platform development of multinational companies. US companies pioneered production outside of the US for re-import back into the US—what the Europeans call "delocalization."
As computer-based technological advances of the 1990s emerged, US companies were far ahead of others in taking advantage of an explosive growth of production in China. They could now manage and monitor production in factories both large and small throughout China from US-based headquarters.
All this was encouraged by China with enterprise zones that granted easy land deals and low taxes—not to mention a guaranteed labor force at wages a tiny fraction of US wages. What made all this possible were technological changes that allowed high-end, low-error-tolerance products, as well as low-end products—computer chips and plastic toys—to be produced with decent quality in low-wage and low-education countries.
The Chinese blend of political authoritarianism and a modern, late-20th-century open-door policy worked, with the unforeseen assist from a technological transformation that no one could have foreseen 30 years ago.
The US trade deficit with China is around $200 billion. Chinese imports are peculiar, however, because virtually all are made by American companies in China, sold in the US and counted as imports just like any others that would be made by foreign companies. To China, these become dollar surpluses. They do not remain idle but are recycled back into the US as purchases of corporate and US Treasury bonds.
So the US public deficit—closing in on $500 billion a year—is underwritten by Chinese surpluses earned from American companies selling production from China in the US In 2004, some $200 billion flowed from China to the US in support of debt, and 2005 is running higher.
This is not costless, because jobs and income are lost in the US through outsourcing production to China. At the same time, consumers benefit from lower-priced products. The substantial Chinese purchase of bonds also keeps interest rates low as they provide a ready supply of funds to purchase bonds. Lower interest rates, of course, enable individuals to incur larger debt for home mortgages, credit cards and home equity loans. It is estimated that median household debt has now reached $100,000, nearly doubling from 1990, and typical household credit card debt exceeds $9,000.
Debt accumulation, driven by low interest rates, has its origins partly in imports from China. There is a mutual addiction: Chinese with their exports to the US and US borrowing from China. But there is a vulnerability to its continuation. US trade imbalances and debt have weakened the dollar, which reduces the value of bonds held by China (because they are worth less when redeemed as dollars) and makes future purchases of US bonds less attractive.
The dizzying pace of this financial revolving door is the essence of globalization’s entanglements. Neither party can extricate itself without consequences. If the US places undue pressure on China or adopts policies to slow down the rate of imports from China, it risks losing the financial foundation on which its debt-ridden economy prospers. If China retaliates by diversifying out of US debt into the stronger euro, it risks a financial fallout in the US that would reverberate back onto its prosperity via reduced imports from China.
Political pressure has increased because of the further expansion of Chinese textile exports, following on the WTO-mandated end in 2005 of the 1974 Multifiber Agreement that had established quotas on textile imports. The Bush administration is pressuring China to revalue the yuan upward from its fixed rate of 8.28 yuan to the dollar. Even if China accedes, anything short of a major revaluation—50 percent or more (and that is not under consideration)—would have very limited impact on the trade imbalance. Economists place too much stock in a textbook incremental response to small price changes that is not borne out by experience.
To create the conditions for a soft landing that untangles this financial knot, there should be a phased-in significant yuan revaluation, enforcement of internationally accepted labor rights and China’s adherence to the commitments it made when it was admitted to the WTO in 2001.
The financial imbalance between China and the US threatens both. Each has a potentially potent bubble: real estate in the US and an unsustainable increase in economic growth in China. The May 2005 Economist Intelligence Unit rates doing business in China moderate to high risk because of an estimated 30 percent of non-performing loans held by Chinese banks. To detach from this financial entanglement will not be easy or painless. This grand game of financial chicken being played out may be more serious than the spread of an avian flu epidemic.