US and China — Two Peas in a Pod

(Source:imovermyhead)

From all appearances, the United States and China have an adversarial relationship. Economically speaking, the former nation has always been a bastion of capitalism while the latter has introduced sweeping market reforms into what was a communist system.

Leaders from both sides regularly rattle their sabers over political issues and express concerns what the other is doing within its sphere of influence. But appearances, even those maintained over decades can be deceiving. Dig deeper and you will find two nations who have grown so close in the past decade that their economic futures are now to a large extent co-dependent.

Many people in the US are uncomfortable with the fact that China today wields tremendous power, thanks to its more than one trillion dollars invested in US government debt. On the flipside, the health of the US economy is crucial to the success of China’s economic growth, given the demand for cheap goods from American consumers. For more than a decade, both countries have benefited from this arrangement, but now in the midst of the global financial crisis, leaders are raising questions about its long-term viability. Does it make economic sense?

You aren’t the only one worried about your portfolio. In recent weeks, China’s leaders have publicly fretted over the health of their portfolio and their dependency on the US economy. “We have lent a huge amount of money to the U.S. Of course we are concerned about the safety of our assets. To be honest, I am definitely a little worried,” Chinese Premier Wen Jiabao said, according to comments reported by the New York Times in March.

A Communist leader worried about his investment in the US Economy? What is this world coming to? China’s leaders are freaking out because they fear they have over-invested in the US. And with inflation expected to rise as the result of printing more money to pay for the stimulus plan, China is fearful that its investments portfolio will lose significant value. There are other cries in China to reduce its dependency on the US and to diversify, raising the nightmare scenario of a significant divestment in US assets. While the move may seen logical, it’s unlikely that China will do anything drastic, given the sheer size of its investment in the US and the global consequences that a divestment would cause.

“From an economic aspect, it would be suicidal for them to sell their US assets, which would diminish the value of their portfolio,” said Kathryn Dominguez, professor of economics and public policy at the University of Michigan. “They are in a way stuck because were they to do this it would harm them at least as much as it would the US”. Such is the reality of a globalized economy. Systems are interconnected to the point that drastic moves by one country will have drastic effects on many other countries. Pulling out hundreds of billions of dollars in US Treasury bills would make a serious impact the value of other countries’ holdings.

So far, there are no signs of China pulling out its money en masse, but there is no doubt an easing of China’s appetite for US holdings. The US Treasury released figures showing China increased its Treasury holdings by a mere $4.6 billion between January and February 2009, maintaining a slowdown in China’s appetite for U.S. government securities since the financial crisis hit. Earlier this month, China’s central bank released figures for the first quarter this year showing its foreign holdings increased by $7.7 billion, considerably less than the $153.9 billion surge during the same quarter last year, according to the New York Times.

Dominguez added that China’s investment philosophy prevents it from rocking the boat because the government is more worried about the issues that could arise twenty years from now. Despite its pace of growth, China continues to face many domestic challenges, such as the growing disparity in wealth, a growing population of senior citizens, and potential social upheaval from greater masses of unemployed workers affected by the downturn.

Besides, where else will China put its money? The US Treasury remains a safe haven during these challenging times.

For now, both countries face an urgent need to bolster their economies, and both have launched massive stimulus packages. It remains to be seen whether this cycle of cheap imports and cheap credit needs to change. What’s certain is that the US and China remain reluctant dance partners who can’t find a suitable replacement among the crowd.