from Follow the Money

Banker? Strategic competitor? Both?

February 20, 2005

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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The US borrows about 1/5 of all the money the federal government spends, and most of the borrowed money comes from abroad: foreign purchases of Treasuries in 2004 exceeded the (net) issuance of Treasuries required to finance the deficit. So a decent chunk of the Defense Department’s budget comes not from tax revenues, but rather from a loan from the world’s central banks.

Even if China is not financing the US Treasury directly, it certainly is supporting the US housing market through its purchases of Agency debt and mortgage backed securities. That helps to make W’s policy of guns (defense buildup, war on terrorism), butter (prescription drugs & the pork in the stalled energy bill) and tax cuts consistent with low interest rates and rising housing prices. Take away the "low interest rates and rising housing prices" and there would be a lot more pressure to choose among guns, butter and tax cuts.

That is why the Pentagon’s sense that China is a future strategic competitor, along with the incipient Sino-American rivalry created by China’s growing interest in financing the investment required to meet China’s growing need for natural resources, is so interesting. A sage commentator on this blog noted that Japan can hardly invest its reserves in US corporate debt, since that would finance the US rivals of major Japanese firms. Can the something similar be said of China? Will China want to finance the US government, through the purchases of Treasuries, as US seeks implement a strategy intended to contain China’s regional, if not global, ambitions? Or will it prefer to step up its own direct investment in the production of the world’s oil and other commodities, even if that means investing in places that the US labels pariahs? Will the Pentagon brass start to worry (publicly) about the United States’ financial dependence on China? Worry (publicly) about the large quantities of Treasuries that China could dump on the US market in a crisis?

Make no mistake, China acted as the world’s banker in 2004. Its total reserve accumulation of $200 billion represented about a quarter of the world’s aggregate current account surplus: the People’s Bank of China in effect determined the allocation of a significant fraction of all (net) cross border savings.

Not all of that reserve accumulation was financed by China’s comparatively modest (roughly $50 billion) current account surplus. But that only make China’s government look more like a bank. During 2004, China’s external liabilities rose by roughly $150 billion while the People’s Bank of China’s external assets increased by $200 billion. China’s government effectively uses global demand for Chinese assets to finance its own purchase of asset abroad, and in the process, determines (or perhaps distorts) the allocation of much of the world’s savings.

This is something that I would like to see "strategists" like Tom Barnett take up, but in a slightly more (financially) sophisticated way.

Barnett, author of the Pentagon’s New Map, is a big Sinophile within Pentagon circles, and a major critic of the "China as strategic competitor" thesis. He sees the US and China as natural allies, since both are winners from economic globalization (in Barnett’s terms, they are part of the integrating core). Rather than compete, they should cooperate to bring order and stability to those regions of the world that have yet to benefit from globalization (Barnett’s gap).

Barnett postulates that the US can tap into China’s growth by investing in the production, transport and distribution of the energy China will need to fuel its growth, creating a natural harmony of interest between the US and China (see p. 230 of The Pentagon’s New Map).

Nice theory. Alas, it sort of ignores the fact that the US is a big net borrower on the world stage. The US cannot finance its budget deficit and relatively modest pace of domestic investment out of its own (meager) savings. China, in contrast, invests a ton and saves even more (more than I think it should). It consequently would have a surplus of savings that it could use to finance external investments even if were not attracting large capital inflows from the world.

The US can only invest abroad if foreigners are willing to buy enough US debt to finance both the US current account deficit and its overseas investment. That is what happened in 2004: total sales of US debt abroad of $900 billion exceeded the roughly $660 billion current account deficit, leaving $240 billion to finance investment abroad. However, borrowing abroad at low rates to invest abroad may be a bit too much "exorbitant privilege" -- to borrow a phrase from De Gaulle -- for China’s taste. There is no guarantee that China will prefer to finance Exxon’s investments in expanding the world’s oil production capacity rather than, say, financing similar investments by its own oil companies.

Barnett is aware of these tensions, even if he exaggerates China’s need for financing from Wall Street and understates the United States’ need to tap into Chinese savings to finance its budget deficits. His recent call for a grand bargain between the US and Iran, where the US lets Iran build nukes in return for Iranian recognition of Israel, is premised on the assumption that China and India will invest in Iran’s oil no matter what, and thus efforts to stop Iran’s nuclear program will ultimately fail ...

One small aside: most savings stays at home, so by world’s savings, I am talking about the savings that flows across borders (the global current account surplus). A fair critique would argue that gross flows matter more than net, as the net is often the difference between two much larger sets of gross flows that partially offset. China’s share of the gross flow of savings is clearly much smaller than its share of the world’s net flow of savings. That said, the net flow is not exactly irrelevant either.

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