China vs. the U.S.- Who Will Blink First?

I was flipping through the television late last night and came across a documentary from 2004, called “The Year of the Yao.” It followed Yao Ming during his first year in the NBA, through the eyes of his young American translator. While watching this, it got me thinking about China, and what the future will hold for our two countries.

As Jon Markman, from MSN Money, wonderfully noted in his July 17 piece:

[the U.S. and China are] on an economic path of mutually assured destruction…the world’s largest Ponzi scheme might be coming to an abrupt end.”

The Ponzi scheme he is talking about is not Social Security or Medicare or even Madoff. It is the continual Chinese purchase of U.S. debt over the last decade, which has fueled America’s access to easy credit and theconsumer spending binge. If the Chinese ever decide to stop purchasing our debt, then the whole pyramid scheme will come crashing down. This will make the $64.8 billion Madoff scandal look like chump change.

The Chinese have pegged their currency to the U.S. dollar. If they float their currency, their stock market will plummet, as a fair price is factored in and much of their manufacturing industry vanishes. The government risks a violent overthrow if this happens. Many will ask, "Why don’t the Chinese sell their U.S. debt on the open market?" This is a bad solution, because it will depreciate the value of the dollar. If this happens, any money they get in exchange for their bonds will be worthless. Likewise, if they let the world know that they are dumping U.S. bonds, many will begin shorting the Chinese markets. This domino effect could have a huge impact on the global economy, akin to the 1997 Asian economic crisis.

The U.S. is in an even more precarious position. As of the time of writing this article, we have over $11,675,436,559,627.94 in national debt, with the Chinese holding nearly $800 billion of it. Treasury Secretary Timothy Geithner has asked Congress to raise the debt ceiling, and there is still a strong possibility that the U.S. will enact healthcare legislation and possibly a second stimulus bill that could mean trillions more in debt. If the Chinese don’t buy our debt, who will?

To make up for a shortfall in Treasury sales, the U.S. is left with two options: First, introduce more cash into the money supply, in essence purposefully driving up inflation, or second, do the most dreaded thing in any politician’s vocabulary: raise taxes. Neither of these options is good for the Americans or the Chinese.

The question remains, who will blink first? I have a hunch that it will be the Chinese who play our bluff and start quietly unwinding some of the bonds they hold. For those sophisticated investors looking to play both sides of this faceoff, a very small short position in Chinese A shares, through the Proshares UltraShort FTSE/Xinhua China25 ETF (FXP) might be a good addition to your portfolio (the benchmark Shanghai Composite Index was off over 6.6% last week alone, and a bigger correction might be on the way). A popular recent trade for sophisticated investors betting on a decrease in buyers of U.S. debt has been a shorting of long term U.S. Treasuries, done through a small position in the Proshares UltraShort 20+ Year Treasury ETF (TBT).

Disclosure: No Positions

Comments

[canonicalman:]

Social Security is NOT a Ponzi scheme! The original plan put in place by FDR was a model of brilliant economic policy whereby a fraction current workers production goes to those no longer producing, ie retires. Since then, Alan Greenspan, and his like, have taken it upon himself to kill Social Security, so we can instead invest in that sure fire retirement fund called the stock market. We've seen how 'secure' that investment is. Especially those who invest with Madoff or Stanford. Or those who invest with Goldman Sachs where million dollar bonuses need to be paid before the investor get anything. Social Security is a guaranteed minimal living standard for retired Americans. And succeeds brilliantly at this task.

Aug 17 09:58 AM

[john redmond:]

Brilliant article and yes, SS is a ponzi scheme.

Aug 17 10:19 AM

[Mike Kane:]

Ok, maybe not a Ponzi scheme, let's call it a "pyramid scheme"

Aug 17 10:20 AM

[nefidar:]

SS is a ponzi scheme. Canonicaman probably does not even realize that when SS was created it was OPTIONAL and less than 2% contributions. Like most things government it has been warped into a theft tool against the citizens. One of the only retirement plans i know of that you have no control over your money... you can not will your money to family.. no no... govt steals that! SS = BS

Aug 17 12:37 PM

[patrickX:]

the best management ( and financial) book has been written more than 2.000 years ago by a chinese :' the art of war" ... read it and you will better understand what will happend.

It is not very interesting for them to sale US bond and to get dollars. They are just spending "your debt" buying all they can in the world ( metal, oil, companies ... ) .

Don't forget tat all the numbers published by China are from chinese and checked by chinese .. you don't know what happens really . You will understand , soon !!

Aug 18 06:15 AM

[sheeple123jump:]

.... getting back to the subject,a good question,which you just started to address, really,....who will blink first.
buying or not buying us bonds to save our empire's ass is just the tip of the issue.
I think the bigger picture is about the rise of the next emerging Empire versus the fall of the current Dying empire. The dying empire is desperate not to die,and might have played it's cards right to ... let's call it... bring the rest of the economic world down with it, to level the playing field at least, or delay the inevitable rise of the new empire.... and the next issues,which could become even more desperate ,might involve the question of how fast and how well can the emerging empires recover and can they do it without being tied to the usa? and more questions emerge in this vein, like will the usa 'allow' any nations to actually 'decouple' as they might want to do? and what will/can the usa do to stop it from happening? you ask the question "who will blink first?" but tell me ,as they stand there facing each other.... what weapons do they hold in their hand?

more questions to ponder... is it a marriage of two arch enemies,or a marriage of two friends who have no real choice but to help each other survive. ? I hope it's the latter, because the world wont be left standing if these two heavyweights decide they cant find a way to live together and the old dying empire cant manage to let the new emerging empire assume the new mantle .
200 years ago, the last great empire ,Britain, new that someday the USA would emerge as the heir to the global throne.
Britain fought the usa, every step of the way with economic warfare, through the civil war, achieving great victory in 1913 with the establishment of the Fed, and have crippled the US empire as a result with such control... such that the US Empire has never been able to shine and live up to the founding father's visions.

Now, here comes China...and the question the world is waiting to see answered is... how will the USA deal with China...how will China deal with the USA. ..... fighting with industrial sabotage,bio-terror ,weapons of mass destruction,collapsing each othr's economy,intensifying desperation to the brink of armagheddon? or will they find a way to coexist and establish a smooth,survivable transition of 'empire status' for the 21 st century ?
It seems that there really is no choice. They Must find a way to cooperate. The usa has to be noble enough to allow the chinese empire to emerge.and the chinese empire has to be benevolent enough to bring the usa along in recovery ,and inclue the rest of the developing world as well.

Aug 22 08:18 PM