There is a widespread belief (apparently shared by President Obama) that because of growing Chinese economic and financial power, and particularly its large holdings of US securities, China can now dictate terms to the US, particularly on financial matters. Even the assumption that this is the case by policymakers can lead to restricted policy decisions and choices.
In December 2008 an advisor to the US Director of National Intelligence observed that China possessed “de facto veto power over certain US interest rate and exchange rate decisions.” The head of the China Investment Corporation ,Gao Xiqing, seemed to agree with this assessment “[The US economy is] built on the support, the gratuitous support, of a lot of countries. So why don’t you come over and… I won’t say kowtow, but at least, be nice to the countries that lend you money.” (Be Nice to the Countries That Lend You Money, James Fallows, Atlantic, December 2008.)
A detailed research paper (Bad Debts, Assessing China’s Financial Influence in Great Power Politics, by Daniel W. Dreszner, International Security, Fall 2009) suggests that both the assumption and the belief that China has this power to dictate US financial choices are fundamentally incorrect.
The ballooning budget and until recently persistent trade deficits in the US have required corresponding inflows of foreign capital to finance them. Much of this foreign capital has come from the central banks of other countries, sovereign wealth funds and other state run investment vehicles. China has recently dominated the provision of such finance to the US.
Officially, China stated it held US $1.95 trillion in hard currency reserves at the end of 2008. However this amount includes holdings of the People’s Bank of China only. When other Chinese holdings are taken into account, Chinese state investors were estimated to possess US $2.3 trillion in US assets at the end of 2008. This represents roughly 30% of global currency reserves, and is now more than twice the reserve level of Japan, and four times the holdings of Russia or Saudi Arabia. As two analysts, Setser and Pandey, concluded: “Never before has the US relied on a single country’s government for so much financing”.
For this reason most observers conclude, apparently relatively reasonably, that China can dictate terms to the US. However in doing so they forget both the lessons of history and here in Ireland (and worldwide) our very recent experience with bankers and developers. As Drezner graphically puts it “To paraphrase John Maynard Keynes, when the US owes China tens of billions, that is America’s problem When it owes trillions, that is China’s problem”.
To try to understand how this power equation is likely to work out, Drezner reviewed the history of financial pressure in international politics and then researched in detail two recent situations where non-US entities clearly had significant financial muscle and the US reaction to it.
The first was the controversy over regulating sovereign wealth funds between 2007 and 2009. The trillions of US dollars these investment funds from mainly authoritarian states in the developing world (particularly the Middle East, the Pacific Rim, and China and Russia) wished to invest in the US created significant concerns about their potential impact on and control of US companies and policy decisions. The second situation was an evaluation of China’s trade leverage over US financial policies in 2008 and 2009 during the acute phase of the credit crunch. Both provide excellent real information to determine how usable financial power really is.
As background to his research, Drezner considered the possibility of the US dollar being replaced as the main international reserve currency in the short to medium term. He saw this as highly unlikely, quoting Luo Ping, a director-general of China’s Banking Regulatory Commission, who said in a speech in New York:
“Except for US Treasuries, what can you hold? Gold? You don’t hold Japanese government bonds or UK bonds. US Treasuries are the safe haven. For everyone, including China, it is the only option.
“ We hate you guys. Once you start issuing $1 trillion-$2 trillion… we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.” (Financial Times, February 11, 2009.)
Dependence on foreign creditors alters the power equation through two different pathways: deterrence (to deter or prevent a country from taking a particular action) and compellance (to force or compel a country to take a particular action). In a deterrence scenario lenders use their financial holdings and power to ward off pressure from debtor countries. In a compellance scenario (the much more powerful one, if available) lenders threaten to use financial statecraft to extract concessions from debtor states.
The conclusion from Drezner’s research was clear, and not unexpected in the first area. China’s reserves clearly endow it with greater policy autonomy, giving it the ability to deter US financial pressure on its domestic financial and economic policies. Developments since the publication of this research have confirmed this conclusion.
However in looking at China’s compellance ability against the US, the conclusion was also surprisingly clear: “the utility of financial statecraft is more circumscribed than current theories suggest.” In simple terms China could not compel the US to do China’s bidding despite its massive reserve holdings of US Treasuries. Particularly looking at 2008 and 2009 when the US was particularly weak and exposed in the financial and economic area the conclusion was stark. China’s efforts of financial statecraft did not appreciably affect US foreign and economic policies. The Chinese themselves acknowledged this: “The US is making policy decisions purely according to domestic considerations and is giving little thought to the outside world.” (Zhang Ming, economist at the Chinese Academy of Social Sciences, Reuters, May 19, 2009.) Subsequent events have not significantly changed this conclusion.
This broad area was touched on briefly at the Global Strategic Review of the International Institute for Strategic Studies in Geneva in early September 2010. Noting that at some stage China’s GDP could be greater than that of the US, the question arises- so what? Can GDP be actually used for power compellance purposes? The answer appears not, but most people do not stop and think beyond the obvious slogan.
The other frequently ignored side of the equation is the strength and depth of current Chinese economic and financial developments. A recent review essay [The Party: Impenetrable, All Powerful, by Ian Johnson, The New York Review of Books, September 30, 2010] details the continuing significant role of the Chinese Communist Party (with a membership of 78 million) and the “leading small groups”, which together control most facets of business, economic and financial life in China today. The resultant increase in state control of almost all activities is slowly squeezing out some foreign-owned businesses, and increasing the already high level of “crony state capitalism”, local protectionism and corruption. The future impact of this, already evident in many areas as set out in this review essay will be severe. In addition as the next stage of economic development requires a more open economic and social system (to foster innovation and creativity) China is beginning to hit a significant Catch-22. Either the communist party lets its control erode or its economic and financial performance will inevitably be degraded. Johnson concludes: ” None of that threatens the party in the near term, but this means it also lacks the impetus to reform. With China on top of the world, the party’s perch atop the country seems impregnable and yet more vulnerable than ever.”
Overall, for us the good news is that in the medium term it is likely that between China and the US, the incentive structures in global finance will closely resemble the logic of nuclear deterrence. A “balance of financial terror” (a.k.a. mutual dependence) clearly applies as Drezner puts it. This hopefully should lead to relatively peaceful coexistence between China and the US, albeit a relatively nervous one. That is certainly good news for the rest of the world.