Almost two decades since the Cold War got relegated to history, the spectre of a sharp rift between the two largest world powers is reviving notions of a split world afresh. The heightened exchange of rhetoric between Barack Obama and the Chinese leadership in the last few weeks over Taiwan, Tibet and trade is a sharp change from Obama?s rather cordial visit to China last year. To what extent does economics explain this change in mood?
At a fundamental level, the financial crisis has exposed the stark imbalance in the portfolios of long-term income-generating assets between the US and China. At the end of November 2009, China held $789.6 billion of US Treasury Securities. This amounted to 22% of the aggregate outstanding securities worth $3.6 trillion. China has the largest claim on American treasury bonds followed by Japan, which holds an almost equivalent amount of $757.3 billion. While Japan, as of now, is not a source of worry for the US, China is.
And that is not only on account of the significant Chinese command over US commercial paper. It is also on account of the huge trade imbalance that US has built up with China. China?s trade surplus with the US was $208.7 billion at the end of November 2009. Though this was lower than the $268 billion at the end of November 2008, the difference was not on account of any structural shifts in the pattern of trade. It was merely a reflection of the contraction in trade precipitated by the financial crisis. In contrast, the US trade deficit with Japan at the end of November 2009 was $40.1 billion, just about a fifth of its trade deficit with China.
China?s large holdings of US securities and a substantial trade surplus puts it in a commanding position as far as influencing the future prospects of the US economy is concerned. The US economy appears to be turning a corner with the fourth quarter estimates for growth in real GDP in 2009 showing a reasonably robust 5.7% compared to a much lower 2.2% in the third quarter. It is important for the US to maintain and consolidate this growth momentum in the coming quarters. This is where, however, its economic equation with China assumes critical importance.
The emphasis on job creation, higher income generation and the consequent revival of demand has forced the US to take a close look at its domestic economy. US manufacturing requires deeper and wider space to expand. The expansion can set off a virtuous process of increase in capacity, rise in investment, increase in demand and an overall increase in GDP growth. However, dominance of Chinese products in the US market is unlikely to allow domestic manufacturers much room for growth. Indeed, Chinese products heavily out-compete their US counterparts in most categories.
There are several reasons behind the Chinese products being as competitive as they are. Their extensive penetration is a phenomenon that is not limited to the US market alone. Among other factors, the Chinese policy of pegging its currency to the US dollar for obtaining a price advantage is a critical issue. President Obama?s administration has been trying to force China to revise its exchange rate policy without any success. Matters have now reached a stage where China?s refusal to revalue its currency has acquired the proportions of a diplomatic spat. President Obama has been forced to adopt a tough posture in order to assuage US manufacturers about his administration?s determination to take up the issue squarely with China. This comes on the back of a series of anti-dumping measures taken by the US on Chinese products that have provoked retaliations from China as well.
China?s refusal to revalue its currency and a continuing appetite for acquiring overseas investment assets also indicate that China will probably continue to pick up more US securities. Its purchase of such securities has increased from $713 billion in November 2008 to $789.6 billion in November 2009. The increase occurred despite prevalence of recessionary conditions in the global financial markets. Thus Chinese control over US debt is unlikely to reduce in future.
The US-China spat can take an ugly turn if the US President finally decides to label China a ?currency manipulator.? Given China?s refusal to bend backwards despite persistent pressures, and the US determination to force it into submission, economic bickering does have the possibility of blowing up into a dispute of bigger proportions.
The author is a visiting research fellow at the Institute of South Asian Studies in the National University of Singapore. These are his personal views
