They have a bit of a history doing this..
In the period up to the financial crisis, the rapid growing Chinese economy provided an impulse to the world economy. The entry of China, India and the former Soviet Union into the world economy roughly doubled the global labor force. This held down inflation, disciplined labor elsewhere and increased the world's growth potential.
Profits in the rich world rose as a result as capital became scarcer, labor (especially cheap labor) more abundant so its relative return changed in favor of the former. The Economist even quipped that American capitalists had to thank Chinese communists at the time.
China, by investing its trade surpluses into U.S. Treasuries, also kept the cost of capital down in the U.S. and the flow of cheap manufactured imports from China kept a lid on inflation, enabling the Fed to maintain lower interest rates than would otherwise have been possible.
No doubt the latter contributed to the financial crisis, but when that broke out, the massive Chinese stimulus program of 2008-9 (five times the relative size of the U.S. stimulus) provided a much needed boost to the world economy when much of the rich world was in a deep funk.
Drag on the world economy?
So on the whole, up to now the rise of China has been beneficial. But since 2005 especially, China began to run large trade surpluses, resulting in an accumulation of more than $3 trillion in foreign currency reserves and with each month's trade surplus, this is growing.
Basic economics shows that a country which runs a persistent trade surplus and is accumulating foreign exchange reserves is a net saver. It produces more than it consumes, and exports the rest to other countries.
In an era in which much of the developed world experiences a large output gap, hence too much savings and too little spending, this is the last thing the world economy needs. With American households repairing their damaged balance sheets from overleveraging the U.S. domestic market is less of the export market of last resort than before.
It would be very beneficial for the world economy and China alike if China was to rebalance its growth model from excessive reliance on exports and investment, towards a model that involves more domestic consumption. This, in fact, is a particular aim of the Chinese economic policy, and in a way, this is already happening.
The Chinese currency is creeping up against the dollar and, most importantly, prices and especially wages are rising at a fast rate. This causes the real exchange rate to increase much faster than the nominal rate, eating into China's competitiveness. It's therefore not surprising that trade surpluses have begun to narrow.
This is all good. For the world economy, and for China itself. Its growth is still relying way too much on investment, running the danger of creating huge overcapacities in many industries for the output of which there are no final consumers, something which could unleash fire sales and deflationary forces in the world economy.
Any shift away from this investment and export driven model should be welcomed. China could, as many argue, accelerate this process by appreciating its currency faster (which would have the added benefit of reducing inflation in China), and building a social safety net, and better public education and healthcare which would reduce the very large savings rate of households.
China's $3 Trillion Kitty
But there is something else the Chinese could do, they could be more creative with its foreign currency reserves it has accumulated with its investment and export driven economic model.
As The Economist pointed out, China has a bit of a problem with its gargantuan seized foreign currency reserves. Why is this a problem? Well, the amounts are so big that moving it around or generating a return on it becomes a bit of a headache. It needs big, liquid markets, which is why most of it is in U.S. Treasuries.
However, with the super accommodating monetary policies of the Fed, they are afraid that too many dollars will depreciate its value, saddling China with big losses. Should that happen, liquidating will only exacerbate the problem.
Selling U.S. Treasuries will reduce the value of their remaining holdings, and selling the received dollars will devalue these further. What's more, the fall in the dollar will make Chinese exports less competitive, and with much of the export industry on wafer thin margins and social stability depending on growing jobs and prosperity, this is something the authorities want to avoid at all cost.
Therefore, it really isn't the case that China holds the U.S. hostage with a threat of liquidating U.S. assets. China itself will suffer much more from doing that. It will shoot itself in the foot so it can only shift minor amounts at any given time. What else can they do?
The Economist mentioned a few half serious options:
China could gobble up Apple (AAPL), Microsoft (MSFT), IBM and Google (GOOG) for less than $1 trillion. It could also follow the lead of those sheikhs and oligarchs who like to buy English football clubs. According to Forbes magazine, the 50 most valuable sports franchises around the world were worth only $50.4 billion last year, less than 2% of China’s reserves. Another favoured sink for the world’s riches is property. Perhaps China should buy some exclusive Manhattan addresses. Hell, why not buy all of Manhattan? The island’s taxable real estate is worth only $287 billion, according to the New York City government. The properties of Washington, DC, are valued at a piffling $232 billion. China is accustomed to being Washington’s banker. Why not become its landlord instead? [The Economist]
This is all funny stuff which serves to underline the problem.
Lender of the Last Resort?
A more serious option is the following:
China could buy all of the outstanding sovereign debt of Spain, Ireland, Portugal and Greece, solving the euro area’s debt crisis in a trice. And it would still have almost half of its reserves left over. [The Economist]
This was written in April, just before Italy became the eye of the storm of the European sovereign debt crisis, but The Economist was kind enough to note that half of its reserves would still be left over after buying all of Spain's, Greece's, Portuguese, and Irish debt.
However, several very useful objectives can be achieved should China start buying European debt in serious amounts. Italy has become the latest victim of the European sovereign debt crisis, but its public finances are by no means on an unsustainable path. With a relatively modest public deficit (3.8% of GDP) but a huge debt (120% of GDP), the sustainability depends crucially on interest rates.
This reality hasn't escaped the European Central Bank (ECB), intervention is supposed to serve the dual aim of keeping interest rates at levels where financing cost don't spiral out of control and applying enough pressure on the Italian government as to solve the underlying deficit problem.
China could really help here if it were to join the ECB. If successful, and joint ECB and Chinese purchases will make that much more likely, it even stands to gain substantially on its Italian bond holdings, as they're likely to appreciate in value.
The Chinese might very well be reluctant because they can't force the Italians (or other European countries with public finance problems) into taking the necessary measures, so they do risk throwing good money after bad. But the ECB is already doing this for them, so they don't have to apply pressure. Needless to say that the Italians are the first to have an interest in keeping their public finances on a sustainable path. We think it's only in situations where such a path is really unlikely to be attained (like Greece) where incentives of creditor and debtor might diverge.
It also goes without saying that with its open, export driven economy, China stands to loose enormously, should the European sovereign debt crisis spiral out of control. If that would happen, the world would likely experience a steep recession with dire consequences for the Chinese economy and possibly the legitimacy of its authorities.
Another more tacit advantage of such Chinese intervention would be a gain of influence. European authorities would be that much more reluctant to criticize the Chinese if they've just been saved by them.
China is already embarking on buying European debt of countries in distress. It recently pledged to buy Hungarian debt, for instance. Moves like this come with increased Chinese presence and influence:
China would also provide a special loan of one billion euros (1.4 billion U.S. dollars) to support joint projects between enterprises from the two countries. The Chinese government would support companies to participate in the construction of Hungary's infrastructure, industrial parks and logistics centers, and to import Hungary's competitive products [xinhuanet]
It has done something similar with Spain. By changing it's export and investment led economic model, and investing some of its massive foreign currency reserves in distressed European debt, the Chinese authorities are again in a position to help save the world economy. The amounts might not be large, but together with the ECB which is also acting as the much needed area's disciplinarian of budgetary policies, it can potentially make a crucial difference.
It's good for the world economy and it's good for China. It's win-win.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.