The Entangling Relationship With China

Posted: Aug 25, 2007 12:01 AM
The Entangling Relationship With China

While trade sanctions against China are being discussed on Capital Hill, the Chinese government has begun a concerted campaign of economic threats against the United States in a game called “Who will blink first?”

Several leading Chinese Communist officials have warned that Beijing may use its $1.33 trillion foreign reserves as a political weapon to counter Congressional plans for trade sanctions. Some have called this China’s “nuclear option” since dumping U.S. bonds could trigger a dollar crash at a moment when the currency is already breaking down through historic support levels.

Such a move could cause a spike in U.S. bond yields, hammer the already vulnerable housing market and perhaps tip the economy into recession. Therefore these threats cannot be taken lightly.

It is estimated that China holds over $900 billion in a mix of U.S. bonds, clearly the bulk of its foreign reserves. Xia Bin, chief at the Development Research Center, indicated that Beijing’s foreign reserves should be used to influence U.S. trade policy in what is an unambiguous threat. “Of course,” he added “China doesn’t want any undesirable phenomenon in the global financial order.”

He Fan, an official at the Chinese Academy of Social Science, said China has the power to set off a “dollar collapse if it chooses to do so.” He noted, “China has accumulated a large sum of U.S. dollars. Such a big sum, of which a considerable portion… contributes… to maintaining the position of the dollar as a reserve currency.”

Clearly China is unlikely to follow this scenario as long as the yuan’s exchange rate is stable against the dollar. Moreover, the U.S. has some leverage in this arrangement since a recession would diminish U.S. buying and importing power thereby adversely affecting Chinese markets.

But there is little doubt the Chinese intend to play the blackmail card and contend the U.S. is hostage to economic decisions made in Beijing. Having control of over 44 percent of the U.S. national debt undoubtedly leaves America acutely vulnerable.

The timing of these threats is particularly troubling. They come at a time when credit markets are already fearful of contagion from subprime mortgage troubles. That may explain why Secretary of Treasury Henry Paulson said any trade sanctions would undermine America’s authority to promote free trade and open markets.

While some compromise with China is likely to be worked out, as it has been in the recent past, the backdrop for decision making is colored by the large sum of U.S. dollars sitting in Chinese hands. The Chinese government has allowed the yuan to appreciate 9 percent against the dollar over the last two years under a crawling peg, but it has not diminished the current account imbalance and the growing Chinese trade surplus.

From a strategic perspective the Chinese have a nuclear arsenal to thwart American interests in Asia and now have a financial nuclear option to influence U.S. political judgments as well.

Where this will lead is hard to say. But on the central issue no guess is needed: American options are circumscribed by the real threats China may impose.

China is not an enemy of the U.S., but neither is it a friend. Recognizing the potential collision of interests in the Taiwan Straits and elsewhere, it is best to keep in mind the dangers that could result from an entangling relationship. Unfortunately this has already occurred and it is not possible to see how the U.S. easily extricates itself from the entanglement.