China

Although China and the United States don’t always agree on everything, their recent dealings have suggested that they were meant to be together. After spending so many years courting China, trying to get the timid nation to open its doors to global trade and business, China eventually came around and the two nations have been riding a honeymoon high ever since.

But things have been a bit rocky recently. They are staring right into each other’s eyes, faces void of expression, suppressing contempt for all the annoying things the other one does, realizing that they don’t have very much in common, and trying to search through the haystack for reasons to stay together.

In January of this year, I posted a piece discussing how we are witnessing the decline of the US dollar as it slowly loses status as the world’s reserve currency.

The price of gold, which was the world’s original reserve currency for centuries, continues to rise, as Investors try to find a safe place to park their money. Greece is being bailed out as it would otherwise have defaulted on its sovereign debt. In the past, this would have been a time where investors blindly purchase the Treasury notes of the greatest nation on earth.

But institutional investors are hesitating as America’s balance sheet continues to accelerate towards insolvency. There is no plan in place to reverse this. Let’s not even bring up the fact that they will have to incur more debt to finance further stimulus in an attempt to end the recession (or what they like to call “jobless recovery”).

Until now, America’s saving grace has been its relationship with China. China is the largest lender to the US, and the main reason is trade. China’s explosive growth for the last two decades is completely attributable to their ability to export manufactured goods, and America is their largest consumer. However, the natural balance of trades when one nation (US) continues to import from another (China) is that China’s currency will rise in value versus the American Dollar. As this happens, it becomes more expensive for Americans to purchase the same goods. That isn’t good for production (China), or consumption (US).

To offset this natural movement in the foreign exchange rate, China lends money to the US by purchasing American Treasury bills. Because these amounts are so large, it pushes the value of the American dollar back up relative to the Yuan. America takes the money it receives from the proceeds of these T-bills, and subsequently lends it out to banks. Banks lend it out to the rest of the economy, and they continue to purchase goods from China. This relationship is what allowed China to experience an industrial revolution for the very first time.

I encountered these facts in one of my most recent readings, The Ascent of Money by Niall Ferguson. He continues by saying, “…the importance of net exports to Chinese growth has declined considerably in recent years.” This implies that making goods affordable for Americans is becoming less important to the Chinese economy.

That statement explains a recent move in the markets by the Chinese government. In this article, the Associated Press mentions how a $5.8 Billion sale of US T-bills by China can potentially raise the cost of borrowing for the US in the future.

The value of bonds is inversely related to interest rates, so such a market move would raise interest rates in the US economy. However, rising interest rates will have detrimental consequences for an economy mired in a recession, as it would contract the money supply and stifle growth.

To top it off, China is trying to have its cake and eat it too. It is in the unique position of centrally controlling its foreign exchange rate, which means as it slowly tip-toes away from being America’s biggest lender, it can simultaneously offset the natural rise of its own by setting its currency exchange rate too low in order to retain its export advantage. The Americans find this practice unfair, as a low Chinese currency means they are able to retain an export advantage over the US and other nations. Because the US is trying to spark production in its own economy, things are heating up.

So now it becomes a political exercise for America to have other countries continue to purchase their bonds and hold the value of the US dollar up. We used to call America the most powerful nation in the world, but that’s no longer true. Power comes from position – you can only have power if others are dependent on you.

I mention Ferguson’s book as he spends a chapter discussing what he calls the symbiotic relationship between the two nations. He makes a bold prediction that we should expect to see tensions between the two nations as China becomes less dependent on the US. He even goes as far as saying we shouldn’t be surprised if it comes to war. In this Newsweek piece, he elaborates on some of the ideas he introduced in the book.

As alarming as that sounds, it’s not an unreasonable conclusion given that every single war mankind has fought could easily be expressed as a battle for economic resources and prosperity. Sure, there are other reasons too. China’s policy on human rights, the questionable credibility of its economic data, currency manipulation…the list goes on. America happily swept most of this under the rug while times were good.

But I understand what America is going through. It hurts to think about China going off on her own, making new trade relationships. At G20 meetings, every nation is hovering around her, laughing at all her jokes even though she’s not that funny. It’s almost as if she used America’s ability to consume goods in order to develop her own manufacturing infrastructure. And now she thinks she’s all that? Does she honestly think she can do better? The natural economic response to a situation like this is that America has to get a much hotter trophy girlfriend instead of whining and complaining about how annoying China is.