Tuesday, December 22, 2009

Steven Dunaway: The U.S.-China Economic Relationship: Separating Facts from Myths

I missed this excellent commentary on November 16 when it was published by the Council on Foreign Relations. Essentially, Steven Dunaway argues that the United States has nothing to lose in putting pressure on China. He disputes the four myths that are put forward:
  • Myth No. 1: Washington has limited leverage because China is the main "banker" for the United States.
  • Myth No. 2: The United States is heavily dependent on cheap Chinese goods.
  • Myth No. 3: External pressure on China for policy changes is counterproductive.
  • Myth No. 4: Instability is bad for China
Here's how he addressed the widely-believed first myth:

China holds a large amount of U.S. government securities. Of China's $2.3 trillion in official reserves, it is estimated that 70 percent is held in U.S. dollar assets. China is a big customer for U.S. debt, but it is not America's banker. Nor is the United States dependent on China to finance its budget deficits. If China elects not to buy U.S. Treasuries, there are other willing public and private sector buyers, as indicated by the strong demand for these securities worldwide. Although the U.S. government might have to pay higher interest rates as an incentive to get other investors to buy Treasuries in the event that the Chinese reduce their demand, the increase in interest rates would likely be small.

Major consequences from a decision by China to reduce its purchases of U.S. Treasury securities would depend on the reason behind the decision. It would be in China's best interest (and beneficial for the rest of the world as well) if China reduced its purchases of U.S. Treasuries because it decided to stop heavily managing its exchange rate and allow greater flexibility in the currency's movements. This is an important policy change that is required if China is going to rebalance its economy and be able to sustain rapid growth.

If instead China continues to heavily manage its exchange rate, it will build up large additional amounts of official reserves. If it decides to hold less of these additional reserves in U.S. Treasury securities, then China will increase its purchases of assets denominated in other currencies, with euro-denominated securities being the most likely alternative. In these circumstances, China would continue to intervene in its exchange market, with the central bank buying U.S. dollars for Chinese renminbi and then selling dollars for euro to acquire European assets. The result would be an appreciation of the euro. Consequently, countries in Europe, not the United States, would probably be most affected by China's move because the negative impact of euro appreciation on European economic activity would likely far outweigh the effects on the United States of smaller Chinese purchases of Treasuries.

Alternatively, China could choose to start dumping its stock of U.S. securities. The result would be appreciation of other major currencies (depending on where China would decide to park its reserve assets); upward pressure on U.S. interest rates; and the possibility of financial market disruptions if China dumped its U.S. dollar assets rapidly. However, the U.S. Federal Reserve could limit the rise in U.S. interest rates and would be able to ensure adequate liquidity to prevent market disruptions. But a decision to dump Treasuries would have a large effect on China itself. The country would incur a substantial capital loss on its reserve assets. The Chinese authorities are deeply concerned about such a loss, and are very unlikely to decide to dump U.S. assets. In fact, the discussion initiated by China regarding the need for an alternative official reserve asset is motivated by its concerns about potential losses on its U.S. dollar holdings.

Our leaders really don't have any excuse for not insisting on balanced trade with China.

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