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Are China's huge foreign exchange reserves, most of it in dollars, an advantage against the US? Two experts, a foreigner and a Chinese, present their views.
Joseph S. Nye, Jr.
This round, too, goes to the US
For several years, American officials have pressed China to revalue its currency. They complain that the undervalued yuan represents unfair competition, destroying American jobs, and contributing to America's trade deficit. How, then, should US officials respond?
Just before the recent G20 meeting in Toronto, China announced a formula that would allow modest revaluation of the yuan, but some American Congressmen remain unconvinced, and threaten to increase tariffs on Chinese goods.
America absorbs Chinese imports, pays China in dollars, and China holds dollars. It has $2.4 trillion in foreign exchange reserves, much of it in US Treasury securities. To some observers, this represents a fundamental shift in the global balance of power, because China could bring the US to its knees by threatening to sell its dollars.
But, if China were to bring the US to it knees, it might bring itself to its ankles in the process. China would not only reduce the value of its reserves as the dollar's value falls, but also jeopardize America's continued willingness to import cheap Chinese goods, which would mean job losses and instability in China.
Judging whether economic interdependence produces power requires looking at the balance of asymmetries, not just at one side of the equation. In this case, interdependence has created a "balance of financial terror" analogous to the Cold War, when the US and the erstwhile Soviet Union never used their potential to destroy each other in a nuclear exchange.
In February 2010, angered over American arms sales to Taiwan, a group of senior military officers on the Chinese mainland urged their government to sell off US Treasuries in retaliation. Their proposal went unheeded. Instead, Yi Gang, director of the State Administration of Foreign Exchange, explained that "Chinese investments in US Treasuries are market investment behavior, and we don't wish to politicize them." Otherwise, the pain would be mutual.
Nevertheless, this balance does not guarantee stability. There is always the danger of actions with unintended consequences, especially as both countries can be expected to maneuver to change the framework and reduce their vulnerabilities. For example, after the global financial crisis, while the US pressed China to let its currency rise, People's Bank of China officials began arguing that America needed to increase its savings, reduce its deficits and move toward supplementing the dollar's role as a reserve currency with special drawing rights issued by the International Monetary Fund (IMF).
But China's bark was louder than its bite. China's increased financial power may have increased its ability to resist American entreaties, but despite dire predictions, its creditor role has not been sufficient to compel the US to change its policies.
While China has taken minor measures to slow the increase in its dollar-denominated holdings, it has been unwilling to risk a fully convertible currency for domestic political reasons. Thus, the yuan is unlikely to challenge the dollar's role as the largest component of world reserves (more than 60 percent) in the next decade.
Yet, as China gradually increases domestic consumption instead of relying on exports as its engine of economic growth, its leaders may begin to feel less dependent than they now are on access to the US market as a source of job creation, which is crucial for internal political stability. In that case, maintaining a weak yuan would protect the trade balance from a flood of imports.
Asymmetries in currency markets are a particularly important aspect of economic power, since they underlie global trade and financial markets. By limiting the convertibility of its currency, China is avoiding the currency markets' ability to discipline domestic economic decisions.
Compare, for example, the discipline that international banks and the IMF were able to impose on Indonesia and South Korea in 1998, with the relative freedom of the US - bestowed by denomination of American debt in dollars - to increase government spending in response to the 2008 financial crisis. Indeed, rather than weakening, the value of the dollar has risen as investors regard the underlying strength of the US as a safe haven.
Obviously, a country whose currency represents a significant proportion of world reserves can gain international power from that position, thanks to easier terms for economic adjustment and the ability to influence other countries. As former French president Charles de Gaulle once complained: "Since the dollar is the reference currency everywhere, it can cause others to suffer the effects of its poor management. This is not acceptable. This cannot last."
But it did. America's military and economic strength reinforces confidence in the dollar as a haven. And as a Canadian analyst put it: "The combined effect of an advanced capital market and a strong military machine to defend that market, and other safety measures, such as a strong tradition of property rights protection and a reputation for honoring dues, has made it possible to attract capital with great ease."
The G20 is focusing on the need to "re-balance" financial flows, altering the old pattern of US deficits matching Chinese surpluses. This would require politically difficult shifts in consumption and investment, with America increasing its savings and China increasing domestic consumption.
Such changes do not occur quickly. Neither side is in a hurry to break the symmetry of interdependent vulnerability, but both continue to jockey to shape the structure and institutional framework of their market relationship. For the sake of the global economy, let us hope that neither side miscalculates.
The author, a former US assistant secretary of defense, is a professor at Harvard University and author of a forthcoming book, Power In The 21st Century.
Project Syndicate.
Yao Yang
'Smart power' is what China needs
Professor Joseph Nye's article contains factual statements that we Chinese have to swallow and respect despite feeling hurt by his arrogance when he talks about US military and economic strength. We live in an interdependent world, in which we will probably harm ourselves if we take unilateral action aimed at harming another side.
Of course, the US would be hurt if China were to "sell" the $900 billion worth of US Treasuries it holds. But then the "sale" would hurt China, too, because it would wash away the value of its $2.4-trillion foreign reserves, most of which is believed to be in dollar-denominated assets.
China is caught in a dollar trap. A major part of China's $1.4 trillion exports is conducted in dollars. The greenback is the favored medium of currency even in Sino-Japanese trade, accounting for up to 60 percent of the transactions. So, for now, maintaining a "balance of financial terror" with the US seems to be the only option open to China.
China has accumulated huge foreign reserves because of its high domestic savings rate. In recent years, national savings, that is, the sum of savings coming from households, enterprises and the government have accounted for half of the country's GDP. About 80 percent of those savings is absorbed by domestic investment, leaving the rest 20 percent, or 10 percent of the national GDP, as China's net savings, most of which is held in the form of official foreign reserves.
So, why does China save so much? Chinese households save a lot, 37 percent of their disposable income, to be exact. But the government saves as much as the households. In the last decade, the central and local governments have spent 30 to 50 percent of their revenues on roads, buildings, public utilities and equipment. Chinese enterprises are even more thrifty, pumping virtually all their retained profits back into the economy.
This "savings glut" is a combined result of China's large reserves of labor and its integration into the world economy. Currently, China occupies the highest point of demographic dividends, that is, the benefit of large amounts of labor supply. Today, one working person in China needs to take care of only 0.4 non-working person, the lowest ratio in the world. The abundant labor supply - China has to create 24 million jobs to absorb new workers each year - means more savings.
But demographic dividends are not likely to last long in China. Most predictions show China will lose its demographic advantage by 2025. That may sound far off, but it's not that far if we consider the issues confronting the US today. The US government's debts have grown to more than $10 trillion, and there is no sign of the growth slowing down, at least not in the coming decade.
Ironically, China's savings are helping finance those US debts. For this, if not for anything else, Nye and other Americans should feel grateful to the Chinese people. Even without this courtesy, Nye should have questioned the sustainability of the American model of extravagant consumption built on debts. A debt is a debt, that is, the debtor is obliged to pay back someday.
Today, China holds its savings in US Treasuries; but there will soon come a day when China's savings decline and the Chinese people begin to consume more. What will the US government do then?
For Nye, the answer must be "continue", because "America's military and economic strength reinforces confidence in the dollar as a haven". If China stops recycling the dollar, other emerging countries or oil rich countries will. This is one kind of power the US enjoys, but not the kind Nye usually promotes.
What I am more worried about, however, is how China will find room for improvement amid this seeming inevitability. Nye incidentally reveals a secret held by some American elites: an undervalued yuan is good for the US because it provides Americans cheap goods and cheap finance to buy those cheap goods.
One of the immediate actions China can take to deal Nye and his likes a blow is to allow the yuan to rise against the dollar. My colleagues at Peking University, Xu Dianqing and Li Xin, working in collaboration with some American experts on an international project, have found that a moderate revaluation of the yuan against the dollar, say by 10 percent, will have only a minor effect on China's exports and GDP.
China could expedite the process of internationalizing the yuan to escape the dollar trap, too. One way of doing this is to issue yuan-denominated debts to countries in which the yuan is already strong and, at the same time, issue yuan-denominated bonds in Hong Kong to create an offshore yuan bond market. With $2.4 trillion in reserves, it is not difficult to build confidence in the market. This is what US Secretary of State Hillary Clinton calls "smart power".
The author is professor and director of Peking University's China Center for Economic Research.
