from Follow the Money

Can the Pentagon balance Chinese power …

November 17, 2005

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with money the Treasury borrows from China? 

Ok, China, Russia and Saudi Arabia ...

The answer so far has been yes.   The Pentagon - or at least influential voices in the Pentagon - want to discourage a Chinese military buildup with a strong American presence in Asia.  As the Wall Street Journal reports, back in their days as civilians, Abram Shulsky and Zalmay Khalizad urged the US "to develop a network of military partners in Asia' in order to "emphasize to China the cost of, and thereby deter, any Chinese attempts at seeking regional hegemony."   As a result of the war on terrorism, the US now has bases all around China - something China no doubt has noticed.

And with China set to add between $250 and $300 b to its reserves this year - and probably an equal amount next year - a large share of the Defense Department's budget comes from money borrowed in some sense from China.  

Not that you would know just by looking at the TIC data. According to the TIC data, China has bought about $70 billion of US debt (and $28.5 billion of Treasuries) in the first three quarters of 2005.  in September, China bought 4.2 billion of treasuries, and $8 b of us debt.  But, to be honest, those numbers seem a bit low.  If adjustments are made for valuation losses, China's reserves increased by close to $200 billion in the first three quarters (without adjustments, but including reserves transferred to a state bank, China's reserves increased by $174b).  So the $70 billion in inflows in the US data accounts for only roughly 35% of the total increase in China's reserves.

If, as i suspect is likely, something like 70% of Chinese reserves are going into dollar assets, China is providing the US with something like $175-$200 b in financing this year -- though it is not necessarily providing the US Treasury with that much financing directly.  Here is another way of looking at it: China's reserve growth in FY 2005 was large enough that it could have bought all of the Treasury's net issuance in FY 2005.  China didn't do that.  But it could have.

It is pretty clear that occasional saber rattling from the Defense Department has not prompted China to stop funding the US - no doubt in part because China cannot stop funding the US without hurting its economic interests. Still it is hard to rely on such an imbalanced economic relationship to create the countervailing interest against a Defense Department driven China policy.  There certain sectors of the US economy that don't think the current China trade is in their economic interest.  The Economist (emphasis added):

In America, China looms enormous in the public's fear of globalisation. According to a recent Harris Poll, four in ten Americans believe that China will be stronger than America within a decade, and most reckon the Asian giant will have a negative effect on the future of America's economy.

Michael Phillips reports in the Wall Street Journal (p. A4 of the print edition) that the Treasury is not going to name China as a currency manipulator in its foreign exchange report ("other people familiar with it [the draft report] ... said the current version doesn't list China as a currency manipulator;" Phillips is a long-time Treasury beat reporter, he should know), and that the vote on Schumer-Graham (the bill imposing tariffs) has been put off until March.   This makes political sense.   2006 is an election year.   So it makes more political sense to vote for Schumer-Graham then than it does now.   And assuming that China does not move more, I suspect that the Bush Administration will end up doing two things in 2006: they will veto Schumer-Graham, and they will declare China to be manipulating its currency.  That declaration does not immediately lead to the imposition of tariffs; rather, it gives time for negotiation, but with a big threat of eventual action if nothing changes.   Without more movement from China though, I doubt the Bush Administration will be willing to continue to give China a pass in the foreign exchange report.

The IMF might be able to head off this bilateral confrontation if it took a more active role.  The US Treasury certainly wants the IMF to play a bigger role.  But there is no sign that the IMF is willing to do so. 

I do give the Treasury credit for encouraging the IMF to take the lead here.   China's exchange rate regime is not just a problem for certain sectors of the US economy.  It is an impediment to effective global adjustment.   And the global financial and monetary architecture set up after World War 2 clearly give the IMF the lead in helping to resolve disputes over exchange rates.

I have focused here on the politics of US/ China trade - but in this case, I do think the political pressure is a reflection of a real economic problemIn 2006, the monthly bilateral deficit with China will likely top the United States monthly petroleum import bill.  And that bilateral deficit is part of an even bigger global deficit in the US, and a global surplus for China.    If US imports from China rise by 20% in 2006-- a significant slowdown from current growth rates - total US imports from China will reach $300b.   And if imports from China continue to grow rapidly even if the US economy slows, the current concerns of US workers will only increase.

For all the talk in China about reorienting the economy away from investment and exports (and similar talk about stimulating growth in the interior provinces), China's growth in 2005 has been driven by, guess what, investment and exports.  That through the end of September shows that exports are up about 30% y/y.  And through the first three quarters, national fixed asset investment (not urban fixed asset investment) is up 26% y/y.   That number needs to be adjusted down for the national income accounts, but there is little doubt that investment and exports continue to rise as a share of China's GDP.

Here is one way of highlighting the difference between the US and Chinese economies -

  • In 2006, China will export about as many goods as the US.   That is one measure of economic size. 
  • Conversely, the US will import well over two times as many goods as China. That is another measure of economic size.
  • In terms of GDP, China's economy is about 1/6th the size of the US economy ($12 trillion v. $2 trillion). 
  • With private consumption something like 70% of US GDP and something like 40% of Chinese GDP, the US consumer market tops in at something like $8.5 trillion while the Chinese consumer market is more like $800 billion.  These are all very ballpark numbers.

So the key ratios are exports one to one, GDP (at market rates) six to one, and consumption, over ten to one.   And it would not totally surprise me if -in dollar terms - net investment in China was close to net investment in the US, despite the difference in the size of the two economies.

Back to politics.  The security hawks on China (the US Navy and Air Force, some civilians in the Rumsfeld Defense Department) generally are found in a different political party than the economic hawks on China (generally Democrats with labor ties), so policy generally has been driven by the center.  But there are no guarantees that this will last - particularly if neither China nor the US are willing to take real steps to reduce the underlying imbalances in their economic relationship.   But maybe I worry too much.

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