Calling China’s Bluff

When U.S. President Barack Obama’s choice for Treasury secretary, Tim Geithner, talked tough on China’s exchange rate policy during his confirmation hearing, Wall Street traders got the shivers. Geithner accused the country of currency manipulation, sparking concerns that Chinese authorities might react by scaling back their investments in U.S. Treasurys. The fears, which drove down the price of Treasury debt slightly, are certainly understandable. Last fall, China took over Japan’s position as the largest foreign holder of U.S. government debt. Is the country’s new creditor status transforming China into a major world financial power?

Many assume the answer to be yes. The West — and the United States in particular — is borrowing more than ever, leaning on China more and more to foot the bill. President Obama arrives at the White House pushing an $800 billion-plus stimulus package to pump up a flailing economy. Loans for that stimulus package may well increase the $652.9 billion in U.S. Treasuries already held by China as of October 2008. In December’s Atlantic Monthly, Gao Xiqing, who oversees a portion of that debt for China’s government advised the United States to Be nice to the countries that lend you money. It is no wonder that, when the New York Times reported this month that China was slowing down lending, U.S. analysts took notice.

But China is nervous, too. As a newcomer to the international banking scene, the country is both fiercely independent and alarmingly constrained by its U.S. debtor. For now, dollar-dependence and a preference for conservative reform will keep Beijing strong, but not yet a global financial power.

At first glance, China appears empowered to take center on the world financial stage. The country’s government closely controls its foreign assets — $2 trillion of which are held as official foreign exchange reserves. Beijing also directs China’s fast-growing industry of lending abroad — and not only in the public domain. The government influences Chinese banks directly and indirectly as they are increasingly investing abroad.

Beijing’s monetary muscle-flexing is most visible in the global South. Here, both official and quasi-official lending to governments in Southeast and Central Asia, Africa, Latin America and the Caribbean has grown exponentially over the past five years. While cumulative totals for Chinese official lending are classified secret, massive lending announcements have been part and parcel of the highly publicized tours of southern regions since the late 1990s. Chinese foreign-aid lending to Africa is said to already exceed the World Bank’s $2 billion per year. And this aid makes up only a portion of Chinese lending on that continent.

Loans to Africa, Asia, and the Americas have generated goodwill from recipient governments, as well as concern in Western capitals that face new competition for long-time clients. Washington is at the top of that list. In Angola in 2004 and Chad in 2006, Beijing’s sudden offer to provide large-scale loans of equivalent size to those under negotiation with the IMF and the World Bank led the two borrowers to decline their traditional loaners and ignore their policy recommendations. Unlike with Western lenders, China’s cash came free of stringent preconditions.

But like Japan before it, China’s new-found financial influence is constrained by its major debtor, the United States. Creditor countries such as China do not lend in their own currency. With the loans denominated in dollars, China is exposed to exchange rate risks; the debt is worth more or less with the greenback’s rise and fall. The risk is even higher since China lends in the currency issued by borrower. Japan learned this the hard way when the U.S. dollar depreciated dramatically between 1985 to1987, undermining the value of the country’s foreign assets, most of which were denominated in U.S. dollars rather than yen.

China risks the same fate. Between 70 and 80 percent of its reserves are in dollars. For every 10 percent depreciation of the dollar, China’s reserve holdings lose the equivalent of 3 percent of the country’s GDP. As a creditor state, China has thus acquired strong incentives to defend the U.S. dollar — buying up more Treasury bonds to keep its value strong in a fall.

In addition to its foreign holdings, China relies on a strong dollar to keep its industrial machine turning with exports that are plentiful and cheap. Consumers in the United States, armed with a strong dollar, can buy more of those Chinese products. Such demand has kept the country’s economy growing, as it has at a rate of over 8 percent for the last decade. That is, until the financial crisis revised growth targets downward. That sinking demand will only increase China’s desire to keep the dollar — and its trade surplus — from falling.

Not surprisingly, Beijing is beginning to question the costs of maintaining the dollar-based system. Some Chinese researchers have even suggested that China should consider increasing the role of its own currency, the renminbi, as an international alternative to the U.S. currency.

In fact, it is China’s tight monetary control that keeps this option from enticing international investors. The absence of secure property rights and trustworthy legal infrastructure act as disincentives for foreigners to use the renminbi more widely. Likewise, China’s capital controls and the limitations of its domestic financial markets inhibit the Chinese financial system from challenging the enduring centrality of the dollar and U.S. financial markets — even with their current difficulties. Although China’s potential as an industrial leader is certainly advanced, its capacity to emerge as a global monetary power is still in the offing.

So for now, the uneasy dependence is mutual; the United States needs China, and China needs the United States. China’s new international leverage has stemmed largely so far from its export prowess and resulting creditor position. Since 2003, when China became a net creditor, that position was strong and growing. But the surge of Chinese international lending that the world has witnessed since then will not necessarily continue if the current global financial crisis worsens, if Chinese exports slow down, and if China slips into prolonged recession together with the rest of the world.

Moreover, for China’s financial influence to increase, Chinese policymakers would need to take on the onerous work of constructing new international arrangements that could transform its creditor status into a permanent international fixture. To date, China has seemed reluctant to press for dramatic changes to the global financial architecture. Instead, the Chinese leadership has taken the more cautious tone, supporting proposals for holding the system together.

Such a cautious approach speaks to the gradualism which China’s leaders have cultivated over the past three decades. Both inside China and outside it, this looks likely to be Beijing’s approach to reform.

The tasks for China, then, are great. The country’s leaders will need to maintain stability in China’s domestic financial system amid a worsening global financial situation; carefully pushing ahead with domestic reforms as conditions allow; building up its international financial power slowly; suggesting reforms of the international financial system where necessary to shore up and consolidate the gains made; fostering alternative arrangements gradually and carefully, and in different regions of the world, in order to diversify risk and allow for hedging options; and avoiding sudden ruptures in the international financial system.

It’s a long to-do list. But if Beijing can accomplish all this, and China’s creditor position endures, a more powerful China will certainly result. A great deal of work stands between there and here.