China is Sick of US Hollow Promises and Reckless Government: Stephen S. Roach

August 3, 2011Marketsby Stephen S. Roach

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China is Sick of US Hollow Promises and Reckless Government: Stephen S. Roach

4 August 2011.

The Chinese admire America’s economic dynamism, but they have lost confidence in the US government and its dysfunctional economic stewardship. The debate over the debt ceiling and the budget deficit is the last straw, and China's own shift away from export-led growth implies an end to its limitless demand for US government securities.

NEW HAVEN – The Chinese have long admired America’s economic dynamism. But they have lost confidence in America’s government and its dysfunctional economic stewardship. That message came through loud and clear in my recent travels to Beijing, Shanghai, Chongqing, and Hong Kong.

Coming so shortly on the heels of the subprime crisis, the debate over the debt ceiling and the budget deficit is the last straw. Senior Chinese officials are appalled at how the United States allows politics to trump financial stability. One high-ranking policymaker noted in mid-July, “This is truly shocking… We understand politics, but your government’s continued recklessness is astonishing.”

Related: Infographic: The US Debt Ceiling Crisis - Local Politics, Global Implications

Related: Economic Policy Institute: US Debt Deal Will Cost 1.8 Million Jobs

China is no innocent bystander in America’s race to the abyss. In the aftermath of the Asian financial crisis of the late 1990’s, China amassed some $3.2 trillion in foreign-exchange reserves in order to insulate its system from external shocks. Fully two-thirds of that total – around $2 trillion – is invested in dollar-based assets, largely US Treasuries and agency securities (i.e., Fannie Mae and Freddie Mac). As a result, China surpassed Japan in late 2008 as the largest foreign holder of US financial assets.

Not only did China feel secure in placing such a large bet on the once relatively riskless components of the world’s reserve currency, but its exchange-rate policy left it little choice. In order to maintain a tight relationship between the renminbi and the dollar, China had to recycle a disproportionate share of its foreign-exchange reserves into dollar-based assets.

Those days are over. China recognizes that it no longer makes sense to stay with its current growth strategy – one that relies heavily on a combination of exports and a massive buffer of dollar-denominated foreign-exchange reserves. Three key developments led the Chinese leadership to this conclusion:

First, the crisis and Great Recession of 2008-2009 were a wake-up call. While Chinese export industries remain highly competitive, there are understandable doubts about the post-crisis state of foreign demand for Chinese products. From the US to Europe to Japan – crisis-battered developed economies that collectively account for more than 40% of Chinese exports – end-market demand is likely to grow at a slower pace in the years ahead than it did during China’s export boom of the past 30 years. Long the most powerful driver of Chinese growth, there is now considerable downside to an export-led impetus.

Second, the costs of the insurance premium – the outsize, largely dollar-denominated reservoir of China’s foreign-exchange reserves – have been magnified by political risk. With US government debt repayment now in play, the very concept of dollar-based riskless assets is in doubt.

In recent years, Chinese Premier Wen Jiabao and President Hu Jintao have repeatedly expressed concerns about US fiscal policy and the safe-haven status of Treasuries. Like most Americans, China’s leaders believe that the US will ultimately dodge the bullet of an outright default. But that’s not the point. There is now great skepticism as to the substance of any “fix” – especially one that relies on smoke and mirrors to postpone meaningful fiscal adjustment.

All of this spells lasting damage to the credibility of Washington’s commitment to the “full faith and credit” of the US government. And that raises serious questions about the wisdom of China’s massive investments in dollar-denominated assets.

Finally, China’s leadership is mindful of the risks implied by its own macroeconomic imbalances – and of the role that its export-led growth and dollar-based foreign-exchange accumulation plays in perpetuating those imbalances. Moreover, the Chinese understand the political pressure that a growth-starved developed world is putting on its tight management of the renminbi’s exchange rate relative to the dollar – pressure that is strikingly reminiscent of a similar campaign directed at Japan in the mid-1980’s.

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