Friday, September 12, 2008

China and the U.S.: Playing a Game with No Rules

Longtime correspondent Cheryl A. suggested I tackle the horrendously complex topic of the deeply intertwined financial destinies of China and the U.S. After hours of research and reading over the past week, I am hesitantly ready to give it a shot.

First, you might want to glance at my long 2005 report on China for context: China: An Interim Report and scan the site's archives from 2007 and 2005-2006 for the dozens of entries I've written on China.

Please go to to view the trade deficit charts.

Let's start by stipulating the salient points of the China/U.S. quasi-alliance, quasi-rivalry:
1. There is no precise historical analog to the U.S.-China inter-dependency and what many view as a financially dysfunctional relationship--dysfunctional for both nations.

At no other time has an ascendent Great Power depended so heavily on an Empire for customers and a global financial system which enabled its rapid success, and at no other time has an Empire relied so heavily on an ascendent Great Power to fund its catastrophically imbalanced deficits and debts.

2. The trade between China and the U.S. has been mutually beneficial. Let's remember that trade is voluntary; if one party loses or gets ripped off, they simply stop trading. China benefitted from becoming the manufacturing base of the globe by employing hundreds of millions of former rural peasants, and by amassing garantuan trade surpluses which enabled vast investments in infrastrucure and military improvements.

Recall that the goods are made in China at the behest of U.S. corporations which shifted production to China to vastly increase their own profits. China did not coerce anyone into moving production to China.

The U.S. benefitted by reaping trillions in corporate profits off the new low-cost source of goods, and by "importing deflation," i.e. by importing low-cost goods from China, the cost of living was held down.

Mutually beneficial trade between the West and China stretches back to the Roman Era. The Silk Road merchants braved the harrowing expanses of the Taklamakan Desert thousands of years ago. It's remarkably easy to begrudge the other side of the trade and reckon they're getting the better half of the trade, but the mutuality of trade has to be roughly equal or the traders simply move on to a more profitable trade.

3. These giant surpluses have posed a serious problem for China, which is a convoluted concoction of central-command-economy and free enterprise capitalism. The command economy is controlled by the CCP, (Communist Party) as well as various bureaucratic fiefdoms, some roughly analogous to the FDIC, the Federal Reserve and the U.S. Treasury--agencies which don't always see eye to eye.

The massive influx of billions of dollars in foreign investment and "hot money" seeking the easy gains from the yuan's (RMB) appreciation against the dollar, leveraged loose bank lending and the trade surpluses have fueled a real estate bubble of historic proportions in China, and sparked an unsettlingly high inflationary spiral in food, energy and other real-world costs.

4. The gargantuan trade imbalance the U.S. runs with the world (not just with China) is unsustainable, and the market "cure"--a sharp decline in the dollar's value against other currencies--has been resisted by China and Japan via buying of dollar-based Treasuries, agency debt, etc.

5. Despite years (or in the case of Japan, decades) of talk about "domestic growth," the Asian economies are still heavily dependent on exports for their growth and profits, thus their need to prop up the dollar and sop up any and all U.S. debt (mortgages, Fannie Mae mortgage-backed securities, corporate paper, you name it) to enable the junkie debt-addict U.S. consumer to keep buying their exports.

Though politically they are wary rivals, China has learned from the Japanese just how to manage the U.S. debt junkie--prop up the debtor nation, and it will keep buying trillions in your exports, building your own wealth.

6. Asian cultures have a deep tradition of saving huge portions of their earnings. Thus China and Japan generate stupendous amounts of real capital, that is, savings which are deposited in banks. They can fund their own deficits with domestic savings. The U.S., now a nation of spendthrifts, must rely on foreign capital to fund its staggering $744 Billion trade deficit. (July's deficit: $62 billion. So much for U.S. exports "saving the day.")

7. In Asian cultures, "face" (i.e. prestige and surface appearances) trumps truth and accuracy. Therefore, like it or not, any official accounting must be viewed with great skepticism. Thus in Japan, during the bubble years, Japanese firms bought Old Masters art for astounding sums of money. Later, as they fell victim to losses, the art disappeared from view; years later, it was sold privately in secret sales for big losses. To have the losses made public would have been a loss of face; so while the gains and profits and victories are trumpeted publicly, the losses are hidden or masked.

8. The Chinese have consciously fostered a paranoid "chip on the shoulder" worldview of the Chinese people as victims of Western domination and conspiracies. Thus the Chinese media and blogosphere is abuzz with "conspiracy" theories that the U.S. consciously engineered the entire meltdown of the U.S. financial system just to beggar their Chinese investors.

Forgotten in this scenario, of course, is that the Chinese could have chosen to invest their money elsewhere. They chose the dollar and the U.S. for a specific reason: to prop up the debt-addicted consumers of their manufacturing sector, which kept the social pressure off the Communist Party by employing millions of aspiring peasants.

Bottom line: both China and the U.S. have acted entirely out of self-interest; everyone acts on their own behalf, and the consequences flow not from not scullduggery but from the unsustainability of massive imbalances in trade and currency valuations.

9. Since nobody has ever played this complex a game before, nobody knows what to do; both the Chinese and U.S. authorities are making this up as they go along.

It would be foolish to assume the Chinese know any better than we do how to manage the unwinding of such weighty imbalances.

The Chinese did what they had to do to prop up the dollar and a key market for their export machine; now they are hemmed in because supporting the dollar isn't going to produce any results: the U.S. consumer is dead regardless of the dollar rising or falling, and so they might as well let the dollar fall.

10. China's property real estate bubble is enormous and the popping will have consequences. Our Chinese friends' friends have all owned 2-4 housing units each for investment purposes since back in 2004. Multiply that by millions and it doesn't add up--millions of units seem to align with the needs to house a huge under-housed population, but the hundreds of millions of low-wage former peasants cannot afford to rent fancy condos. As the global economy falls, China will lose jobs income, too.

There is one key difference between the Chinese working class/factory worker and its white-collar middle-class: the peasants can and are simply going back to their villages when the jobs vanish. There they can live frugally on very little.

But the middle-class doesn't have a village to go back to; they are stuck, especially if they can't get renters for their numerous investment properties. The glut of unoccupied formerly white-hot dwellings turns into huge losses.

The bursting of the real etsate bubble in China has yet to play out, and the consequences will be as dire as the bubble bursting in the U.S.

11. China--meaning the CCP and its authorities--heavily stage its economy, choroegraphing the private/capitalist markets for political and economic gain. The key issue to the Beijing leaders: How best to create and support more jobs?

12. There are two basic theories about China's manipulation of the dollar and U.S. debt: China's gambit to prop up the dollar was a bargain, as they gained trillions in value via jobs and capital inflows--or, they squandered money that could have been invested domestically. Recall that high school is not free in China; the social net is full of holes.

13. There is little allowance for market forces to impose discipline or change in either the U.S. or China, where the command economy attempts to game/control open market forces for its own purposes. Thus many apparently "private" companies are actually controlled by the CCP or the PLA (People's Liberation Army). A remarkably small percentage of the Chinese economy is actually totally privately owned.

14. The main goal of both the U.S. and Chinese leadership is to prevent rapid change, and to manage whatever "adjustments" have to be made slowly.

15. If the dollar is strengthening for fundamental reasons--and many believe the euro and pound were overvalued, so the dollar's rise is simply a reflection of other currency's weakness--then perhaps the Chinese would be wise to sell into this strength and exit their dollar positions, since they now no longer need to invest their surpluses to prop up the dollar.

16. Many argue that the "reserve currency" status of the dollar gives U.S. hegemony over global finance--that enables us to borrow freely at low rates at the expense of the rest of the world. It's been a nice scam while it lasts. Nonetheless it is unsustainable, and the British Empire's once-dominant pound is the historic analog which proves this.

17. I have highlighted again and again the importanace of expectations and the psychology of disappointment which will hit China like a tsunami once job losses creep up from textile factory floors to the nascent middle class.

Cultures which allow little dissent are like pressure cookers; when the populace finally rebels, it is explosive. Compare Britain's slow transition from monarchy to France's explosive revolution and wild swings from monarchy to republic to dictatorship.

I would guess that the Chinese will endure a lot, but at some point their extreme disappointment to the end of the "China economic miracle" will surprise those with little understanding of that nation's culture and history.

18. The more the central governments of both nations try to control and game the markets, the bigger the failure will be. The more the Fed and Treasury try to game the system back into "working," i.e. enabling relentless expansion of credit and the destruction of savings incentives, the bigger the blowback will be when their gaming finally blows up.

Here is an event which may well foretell the future of China during the global recession, courtesy of correspondent C.V.: Large Protests in China’s Hunan Province Protesters allege to be victims of illegal fund raising.

C.V. commented:

See how Chinese investors handle their versions of financial scams from their government! What would be their response to a Fannie or Freddie? It'll be interesting to see if the Communist regime can handle the unrest as more and more of the Goldman Sachs and AIG influence becomes apparent to the Chinese people.

Here are two compelling articles on central bank gaming, courtesy of frequent contributor by U. Doran: Paulson to China: "We need to do this..."

Is there an exit strategy? The idea that the world's largest economies are merely facing a short-term panic looks increasingly strained

And here are three articles from Cheryl A. which sparked this entry:
Main Bank of China Is in Need of Capital
Council on Foreign Relations--Brad Setser

Thank you, Richard K. ($10), for your generous contributions (intellectual and financial) to this site. I am greatly honored by your support and readership.

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