Why the U.S. Should Learn from China's Foresight

With the waves of destruction brought about by the Global Financial Meltdown there comes a defining moment of obligatory reflection. If such disaster has been visited upon the Globe, what lessons can be learned to dismantle the mechanism that brought it about in the first place? The remedies proposed by Governments the world over are not working, as every real economic indicator confirms. The eternal corrupting influence of Money on Government policies and planning have all but guaranteed that whatever methods are employed to redeem the economy from the whale’s mouth, they will be like drops of rain meeting a river. The one overwhelming factor that does not seem to be factored in to the equation is that to get oneself out of a financial mess one needs financial resources. Not the borrowed kind but the saved kind. This is where China holds an Ace.

The U.S. has a real financial shortfall of $53 Trillion which it can never pay back. The U.K. is on the way to destroying its currency and increase its debt, as is France. China, on the other hand, is in a very unique position in that it has $1.9 Trillion in foreign currency reserves. This puts it in a very unique position with regards to the rest of the world. While the latter was absorbed in consuming everything that China produced, the Chinese were amassing an enormous cushion of real cash that they can now use to divert the focus away from an export driven economy to one that begins to focus on domestic demand. The economic fundamentals for a recovery in China are more evident than in the rest of the world because there has not been the same credit driven overconsumption that was the driving force for GDP in so many other countries. Even on an individual basis “Household savings climbed 382.7 billion Yuan from the previous month (October 2008)."

The Central Economic Work Conference’s $585 Billion stimulus plan addresses several areas that are essential to increasing domestic consumer demand and purchasing power. Housing projects for urban dwelling low-income families, subsidies for low-income rural families, funds for Medical care and education. China is also supporting the Steel, Automotive and telecommunications industries through lowering taxes and encouraging innovation through research and development subsidies. Imports of iron ore are increasing and the steel produced is being stored for future use. The latter point is notable as it presents China with an advantage in manufacturing baseline costs as the fall in shipping and commodity prices has meant that it has built its stockpile at bargain basement prices. The table below shows the investment in the country's fixed assets.

click to enlarge

This is real investment with real available money. China saved up for the rainy day and, now that it has arrived, can put their resources to work for them. It will take time for China to turn around its gigantic economy, but at least they don’t have to worry about paying off an unpayable debt to the rest of the world. While every other country is desperately trying to formulate a rescue plan fueled with an increase in the national debt, China does not have this worry and this will form its primary advantage.

The investment in the population’s purchasing power and employment prospects through improving the country’s infrastructure and providing tax breaks and subsidies will pay off much better than throwing money at financial institutions. The Chinese already knew this and how little use it would be in turning around a bad situation. The world’s Policemen might be Occidental but the world’s teacher, as it has for millennia, still resides in the Orient.

Comments

[bosun.j:]

That being the case I expect the American CIA start something with one of China's strategic partners to force China to waste it's wealth on yet another stupid war.

China should start dumping US Treasuries today so as to destroy the American government before Washington can double down on the harm it's caused the world.

2008 Dec 18 04:05 AM

[Atul Hajela:]

Most of China's foreign reserves are in USD - and USD is going to be worthless soon. So, by logic China's foreign reserves are going to be worthless too!

Any fault in the above logic?

2008 Dec 18 08:14 AM

[tuj:]

The USD does not become worthless unless one of three things happen: a) its perceived that the US will default on its treasury and other debt, b) the Fed actually *prints* new money without selling treasuries, which they have not done thus far, or c) China sells its USD reserves, attacking the dollar.

C) doesn't make a ton of sense unless there is animosity between the two countries since China would ultimately lose value trying to convert such a vast holding to other currencies.

B) doesn't seem to make sense because the Fed is smarter than Zimbabwe.

A) doesn't seem likely yet, as the 3-month treasury is so desired that the yield is zero, suggesting the confidence in US debt is very high. CDO rates for the US market remain around the 4th lowest in the world. So where do you place your debt trust? In the Yuan? Unlikely; its a gov't-controlled peg currency. The Yen? Psh, I can't see that being that great, unless you think it just can't fall any more. The Pound? Well, the UK isn't coupled via currency to the Eurozone, so I think the premium of the pound over the Euro could evaporate.

So that leaves the Euro (unless you want the NZ or Aussie dollars, which aren't bad, but do you really have faith those small countries have a better chance of making good on debt than a big one?). And inside the Eurozone, there's quite a mix of circumstances, including a lot of chaos in Belgium and the Netherlands banking, and potential down-turns coming for Germany's manufacturing industry. Sure, as a whole its diversification can give the Eurozone some benefits, but at the same time, that is exactly what could increase its risk of default. When it comes right down to it, there is a second way to make good on your debt: use force to 'relieve' it. And the USD has probably the most potential force in the world behind it right now.

2008 Dec 18 11:44 AM

[OldLimey:]

tuj:

1. If by 'default' you mean refusal to pay - then I agree, US debt should be as good as anybody else's (although a year ago I thought AIG was a solid company, so any assumption these days has to be treated with some degree of circumspection). But the type of 'default' I think a growing number of foreigners are concerned about is the deliberate use of inflation to devalue an unpayable debt.

2. It's true that the large holders of US Treasuries are in a tight spot, not being able to head for the exits in force for fear of provoking a stampede, but I would pose two questions:
i) Even if they don't sell out from their existing holdings, how much longer do you expect surplus nations to carry on shovelling their wealth and their future prosperity into further purchases?
ii) Given that Japan and China in particular (Russia and Korea to a lesser extent) have the fruits of past labours tied up in USD-denominated assets, do you not think it likely they will be quietly diversifying and - should the dollar dam actually burst - they would be prepared to get out quickly? Wouldn't you adopt this approach with your own wealth?

3. Judging by your reference to potential recourse to the use of force to solve what is an economic and financial crisis, I'm presuming you are US-based. If that is the case, you might not be fully aware of (and perhaps do not even care about) the extreme damage being done to America's reputation overseas. Assets whose stewards have a severely damaged reputation - in this case the USD - are inevitably viewed with suspicion by investors who have alternatives. My sense is that the search for alternatives is on. This will probably play out over a span of years, and in the interim it is quite possible that the USD may have more 'time in the sun'; in the long run, however, I think its days as the sole reserve currency are numbered and in this respect we might in future look back at last weekend's Northeast Asian summit as quite significant.

2008 Dec 18 02:30 PM

[Jade Queen:]

Chinese experts shows up at world science meetings and plumb what they can from posters and presentations. This is one way they use foreign currencies. They also send students to MIT and other universities that may have product-spin-off possibilities. I have also heard from diverse sources of their commodities shopping trips. My impression when I was there in 2001, is that they have been successful in encouraging entrepreneurial small ventures in their cities. The merchandising was beautiful, and the shopkeepers hospitable. I am impressed with some of the Chinese company websites I see. I find them to be exceptionally informative and user-friendly. They use wikipedia information, for example, which gives them good translations of stuff they can check from other sources. When China really decides to focus on renewable-energy R&D and production, things are going to change, never mind Obama and change. India could do this too, but Indian government seems closer in its friendliness to corruption to, say, the U.S. I'm not saying China doesn't have corruption, but the ability of China to produce class-mobility is impressive. Its education system tests to see who can best do what work. People wanting to do something other than what they've been tested to do have to teach themselves English or another foreign language and offer to squire around tours. A woman I met in China had worked this angle, and it got her where she wanted to be. Everything about living in China seemed to require brains and hard work both. There are other countries where this is less so.

2008 Dec 18 07:26 PM

[Alexander M...:]

Great article and excellent comments from everyone. I am a European living in the US for the last 11 years...
I came here because this country use to export hope. It used to export jeans, music, cars, movies, Coke, computers. Even if you are a fan of guns & ammo, it used to do that too. We produce less and less by the day. Instead of debating the automobile bailout but approve the banking bailout in a second, maybe we should have let the banks falter and maybe think of how we can save the auto industry (never mind with the fools in place, we cannot even do that) because they actually produce something, albeit broken at the time...

Well, the good old US of A is still the biggest superpower in the world. Both economically and militarily, so for the next 5-10 years, we will just keep seeing erosion of the middle class, greater wealth disparity and decline of our relative standard of living vis-a-vis other countries, primarily Asia. The vehicle for doing this would most likely be the massive, yet gradual, depreciation of the dollar. The fed and the government HAD TO choose between:

A) Depression-era unemployment and credit destruction so large, which in the 30s eventually led to greater problems such as trade barriers, rise of fascism and communism (yes, those forces were strong in the US as well if you look at the history books) and eventually WWII

B) Slow destruction of the dollar, so that the average American does not realize that his purchasing power is declining compared to the rest of the world. In fact, what is happening now if only acceleration of what has been happening in the last 15 years. Just faster continuation of the trend.

So, how can you blame the Govt? If you had to make that choice, I am sure you would choose B as well. Who would want millions of people to suffer. You could have riots, hunger and most importantly a quick change in those who are holding office!!

But the long-term (10-20 years) is a whole different story and it's all in the numbers. Crystal Clear! We are 5% of the world's population consuming 40% of the global resources. I don't need to speak about Asia's population, population growth and what they will need to consume to bring them to parity with our standard of living.

So, here are my thoughts:

1. In the best case scenario, our standard of living will decline and theirs will go up. That will happen slowly and the rebalancing will take place via dollar depreciation. No major run on the currency. They will keep investing in Treasuries but also start investing in their own economies. If we are lucky, once we get out of the recession, our government will be smart and politically skillful enough to raise rates ala Paul Volcker in the 80s to reign in the money supply. At the same time, we will be smart enough as Americans to start living within our means, start producing more and consuming less. Eventually, China WILL become the world's largest economic power. That is inevitable (barring scenario #2). We will probably still live a little better than them but the disparity will not be as large as it is now. We will have to adjust our lifestyles to live within our means, and some industries will return to the US.

2. In the worst case scenario, the US govt will implement a policy of segniorage to purposely devalue the dollar and therefore its debts to foreigners. China will keep investing in infrastructure and its people. By pure numbers, it will be come the largest economic power. At some point, the foreigners will demand higher rates from the US for its Treasuries because they will have the better options of investing in their own economies. There will be rivalry and we will feel as if we are being dethroned as the de-facto superpower. In reality, the US will still be the most powerful military power the world has ever seen BUT it will not be the most power economically. Sounds familiar? If one reads any history, one would know what this is the most likely scenario for a great power to start a war: to restore its economic power by brute force.

At this point, moneywise, we are relative losers either way but I am just praying for the best case scenario... And if we have to make a small sacrifice for other people in the world live better than they used to, so be it. I'll just settle with one instead of 2 cars in my driveway knowing that the great American Dream became International. And when I see Jefferson, Hamilton & Franklin in the other world, I'll tell them they were the winners!

2008 Dec 18 11:54 PM

[tuj:]

OldLimey said: "ii) Given that Japan and China in particular (Russia and Korea to a lesser extent) have the fruits of past labours tied up in USD-denominated assets, do you not think it likely they will be quietly diversifying and - should the dollar dam actually burst - they would be prepared to get out quickly? Wouldn't you adopt this approach with your own wealth?"

Ok, so I hadn't looked at the data in a while, so I went ahead and did a little checking (www.treas.gov/tic/mfh....). China has actually increased their holdings of US debt steadily since March 08, both as a percentage of total outstanding US debt, and in absolute terms. Conversely, Japan has done the opposite since Oct 07, although their absolute levels have only consistently declined since June 08. China holds 21.5%, Japan; 19.2%.

Russia is #8 in holdings (2.7% of total), and their holdings of US debt have virtually doubled since Oct 07. Korea isn't much of a player at #17, holding 1.1% of the overall debt.

The next big debt holders are the UK at 11.8%, and as a historical ally, they don't have strong reasons to mount an attack on the dollar; it would be very bad politically. I'll also note that the UK as a percentage has doubled in holdings since Oct 07, and even more than that in absolute terms.

Following the UK are the Caribbean banking countries, and the oil exporters. Both of these groups have very strong reasons to support the dollar, as the Caribbean countries generally all have local currencies with 1:1 USD pegs and rely on the US for banking activity, while the oil exporters want some reserves in dollars since their product is priced in USD. Overall, they hold 7.2% and 6.2% respectively. The Caribbeans have increased their share, while the oil exporters have stayed basically flat. In absolute terms, both have increased their holdings.

Now yes, there was a lot of talk about the Chinese diversifying their reserves into more currencies, and possibly taking the Yuan to a peg against a basket rather than the dollar. But we must take into account the Chinese economy's dynamics first: last I checked the trade balance was something like 20:1 to the US, and the US remains the biggest market for the Chinese, even if growth is much more rapid in other areas.

So they are trying to diversify to those areas, and recall they raise the Yuan peg against a falling dollar earlier this year, but suddenly they are doing the reverse. What I'm trying to say is that the Chinese want to diversity their export markets to more than just the US. However, that takes time, and in the meantime they need to support their economy in numerous way, one of which being keeping exports up to the US by devaluing the Yuan.

China needs strong trade balances with these markets before it can begin to even think about diversifying its reserves at this point in time. So for a successful attack on the dollar, I'd think you'd need strong selling without any defensive actions. Given that China, Japan, and the UK together hold 52.5% of the debt, and the next biggest single nation debt-holder is Brazil at 4.4%, this seems difficult to me, **at least in the short term.**

The US does have a real problem in that is has so much outstanding debt. BUT, the fact that so many countries are willing to purchase and hold this debt, particularly even now, at unprecedented risk, and with very low yields, it suggests that confidence in the US as a leading-economy remains strong. The idea that the US financial sector is dead isn't correct; we managed to get many of our banks smoothly merged. A perfect example is JPM-Wamu. Their transition has been flawless to average customers, as it should be under FDIC guidance.

For contrast, check out what is going on with PM Leterme in Belgium, and the attempt to save Fortis Bank first through nationalization, then through a brokered transaction to BNP Paribas. Its a complete disaster, and that type of nationalism and difficulties is a major barrier to European banking surpassing US financial services in the long run. At that's least my thoughts....

2008 Dec 19 10:28 AM