The Real Economic Truth About U.S.-China Monetary Ties

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 |  Includes: CHIX
by: Global Intel Hub

This analysis is about debunking the myth that China has some power over the US because of it's large debt holdings. Let's just say this is a myth created by propaganda or lack of understanding. It's nonsense.

Another myth is that China is a currency manipulator. The Yuan is pegged to the US Dollar (although recently it's been allowed to trade in a 'trading band'). Furthermore, if the Yuan would be allowed to freely float against the USD, if it appreciated as many expect it to, the US would see the cost of Chinese goods skyrocket. So what gives?

Origin of relationship

Let's look at how this relationship started. During WWII the Japanese invaded mainland China, and by the US eventually defeating Japan, even if for reasons other than China, the Chinese felt a sense of gratitude. Arguably Nixon opened up China with the beginnings of what eventually became state run capitalism. The US is currently China's 2nd largest trading partner, 2nd only to the EU. For a long time the US was #1. The Chinese Yuan is pegged to the USD, not the Euro. Similar to the situation with the Petro Dollar, China invests much of it's USD profits in what it feels are the safest US investments, treasuries. However China is also a big buyer of US stocks and the recent trend in Chinese business is M&A (used to be trade deals). Covertly and overtly the Chinese are buying US assets as investments. A Chinese investment group recently bought 200 acres of land in Michigan with the intent to build a "China City."

As far as cultural compatibility, the Chinese certainly have Americanized. The Golf industry is booming in China, with over 650 golf courses even though there is an environmental ban on them (yes, contrary to popular belief Golf courses are bad for the environment). By this year, McDonald's plans to have 2,000 restaurants in China. That doesn't seem like much for a big country but consider it took them 19 years to build the first 1,000 and now they want to build another 1,000 in 3 years. The Chinese love American culture. Those who can afford watch NBA basketball through satellite connections. And of course there is a growing obesity epidemic, whereas 30 years ago you'd be hard pressed to find a few slightly overweight people in a crowd. They are also one of the world's biggest polluters, similar to the early 21st century America recently industrialized. They are evolving, enacting regulations, and opening up their capital markets. Yuan trading is exploding, with many swap agreements now in place with major trading partners. Many parts of China look like US suburbs.

The nonsense about treasuries

If China decided in one day to sell all of it's US debt, this would present a few problems. First, because of the size of their holdings, they may not immediately find buyers. This would immediately drive the price down but cause the US to react in a few ways (potentially):

  • Buy all of China's debt back from them and 'monetize it' (The Fed would love this as another opportunity for QE, but in effect what would have changed except ownership?)
  • The US could default on it's obligations (Not the most likely, but anything is possible with Wall St.)
  • The US could ban Chinese imports, thus crushing their domestic economy (If China was serious to dump treasuries this would be likely political blowback)
  • Bomb China (While this may seem extreme, US military intervention is usually started with economic interest such as oil, rubber, bananas, etc. China manufactures large amount of US goods, the US wants to keep those factories open.)

Scenarios that are complete nonsense, that we can assume the US will NOT allow to happen:

  • China's bond selling is allowed to go on without any intervention, collapsing US bond market, dragging down the corporate bond market with it, and thus the stock market, and the US Dollar. The world starts using Yuan in place of USD
  • China negotiates that in lieu of debt obligations they will take California instead - This is no joke there are articles written about how the Chinese are going to use their leverage to seize US properties. See here
  • China abandons using USD completely and ceases trade with US

The Fed creates USD for nothing, sends it to China, who sends manufactured goods to the US. What a great deal, the US is trading worthless paper for products. Some of that money flows back into treasuries at the request of the US. Isn't it in the benefit of the US that some of those USD profits are re-invested in US markets? The alternative would be that China invests in the EU or domestically. China is backing off, while they are not selling US treasuries they are buying less. If China dumped treasuries the US could immediately cut off the supply of USD going to China. Economically speaking they could restructure their economy but this could take decades, as they have used the US model and flow of USD to finance their growth.

Doing business in China

The relationship between the superpowers is mostly economic but fairly complex (maybe intertwined is a better description). It's not only Chinese factories making cheap products for Wal Mart. Now US companies are entering the Chinese market, and establishing themselves. General Motors recently sold more cars in China than it did in the US. Apple manufactures much of its supply line in China, as do many tech firms. A big advantage of off shoring to China is the lack of labor unions and wage floors. So on one hand the US is complaining politically (on the surface) that China is guilty of human rights abuse, while allowing US companies to take advantage of the human rights situation getting cheap labor (see Foxconn Suicides).

Chinese problems

To make this nonsense even more fantastic, China is in no position to stand up to the US even if it wanted to (and it doesn't want to, it would lose it's most valuable partner). China has massive internal problems. The internet is giving rise to a growing educated population (even with the Great Firewall of China). Pollution such as the Asian Brown Cloud, dust storms, desertification, water shortages, smog in cities, and a host of other environmental problems are threatening the health of the domestic population as well as the economy. In order to reform environmental policies sufficient to start solving these problems, it would require political change and an increase in cheap goods to justify the financing of it.

US partner

China relies on the US for much more than money and the US consumer. The US gives credibility to China on the world stage, arguably, if the US pulled out of China the EU would be pressured to back off. China can't exist in an Asian bubble with India and Russia at least for the next 50 years until their economies develop. Also the Chinese rely on US technology, for whatever reason they are not innovative by themselves. Many of the trade deals with US companies include clauses that Chinese companies are granted access to patents and other technological know how. They are very industrious and shrewd but have never proven to be big innovators (unlike their Japanese cousins and many other Asian nations). Losing the US as a partner would be a devastating blow for China.

China partner

While the US has the upper hand, the US would suffer greatly if China was no longer a partner. The US has dismantled it's manufacturing base, and it would take decades to rebuild it, but it would be questionable how that could be economically feasible considering US standards. Many US companies such as Apple rely on cheap Chinese manufacturing. Also the US exports 122 Billion worth of goods and services to China, which is the 3rd largest export partner. Politically, many in the US (especially neocons) see Asia and especially central Asia key regions to control. While China has reluctance to bow to US whims, such as with Tibet and other disputed territories, China is the elephant in the room. It borders India, Pakistan, Afghanistan, Tajikistan, Kyrgyzstan, Kazakhstan, Mongolia, Russia, North Korea, Vietnam, Laos, Myanmar, Bhutan, Nepal, and Hong Kong. It's in the US interest to share close political ties with China for this reason, and also not to completely lose them to Russia. Russia and China have a close political and military relationship which if taken to deeper levels, especially including other regional nations, could pose a regional threat to US interests. Not to mention demographic changes make China one of the fastest growing consumer markets to which the US could market its goods. Finally, there aren't too many countries in the world the size of China, so the US has no reason NOT to foster close relations. China is now growing but in 20 or 40 years what will China look like on the world stage?

Conclusion

China does not plan to destabilize the US economy by selling treasuries, but even if they wanted to it's not possible. China does not want to replace the United States. It's focus, at least for the time being, is domestic growth and systemic evolution. In many ways China is behind the times, although they are changing rapidly. They do not have resources for foreign entanglements whether they be economic, political, or military. This may not be the case in 50 years but much can happen before then. For the time being, we can sleep soundly knowing the US and China have ties that bind, which if unwoven, would be catastrophic for both countries.

How to trade this

If you wanted to bet that US China relations were going to be stable, one way to invest in this would be to buy China ETFs available on US exchanges. This article is not about a specific China ETF but by having stable relations with the US it would indicate that in the long run, China ETFs should do well. Some analysts on Seeking Alpha have done Chinese ETF specific research, here, here, and here. If we had to pick one, it would be (NYSEARCA:CHIX) - Global X China Financial ETF. The reason is that as the Chinese economy grows, companies will need ever increasing financial services. It could be argued that while the Chinese economy has been growing steadily, the financial services sector has not grown enough to facilitate needs of new businesses. With the above mentioned plans of China to make the Yuan a freely convertible currency, China's financial sector will have to grow not only in size, but in the complexity of its offering. The sector will need to at least have the similar minimum services offered by Western financial sectors including complex financial products, derivatives, active foreign exchange management, international payment systems, and possibly a growing investment product line. Some of these items already are being used by Chinese banks but they are limited to large companies and only being offered by a few companies. Most investors don't know, the 2 largest banks in the world are actually Chinese banks, followed by HSBC and Wells Fargo. But their focus until now has been basic banking services, with a domestic focus. So the best way to capture US China relations may be .

Research about China data

List_of_the_largest_trading_partners_of_China

China - Wikipedia, the free encyclopedia

The World Factbook - China

Golf in China

China Economy :: The Market Oracle

For more articles like this and more research see Global Intel Hub.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.