America and China have a problem. A very big multi-trillion dollar problem that shows no sign of going away whatever the financial crisis throws at it. China's huge holding of US dollars has been built up over years as US consumers snapped up Chinese goods and Beijing built an economic power house off the back of those exports.
This relationship was at the heart of the global growth story in the build up to the 2007 credit crisis and ultimately led to a global imbalance that no one would now deny needs to be, as the economists would put it, rebalanced. But when you owe a country around $2 trillion, actually making this happen is not easy even if the will is on both sides, which it is not.
A New Economic Order
Barack Obama has on numerous occasions since the G20 meeting in London warned that the American people will no longer be the consumer of last resort for the rest of the world. He wants other countries like China, Germany and Japan to pick up the slack that a more frugal America would leave. Faced with the prospect of having to raise trillions of dollars via the bond markets over his first term Obama is looking for an exit strategy from his trade deficit at a time when his budget deficit is set to balloon to historic levels.
The authorities in Beijing view this shift in policy from Washington with trepidation. They say if you owe the bank $100 then it is your problem but if you owe the bank $1 million then it is their problem. When the numbers you are owed are close to $2 trillion then you have an unprecedented problem.
The Chinese economy has weathered the crisis better than any other major economy as the authorities have used their huge cash pile to throw money at infrastructure spending and consumers and businesses via the Chinese banking system. The problem with this policy is that is does not take into account the new reality of the US position. Stephen Roach, the Morgan Stanley economist and one of the world's most famous bears says in his new book, The Next Asia, that this policy shows "worrisome signs that China just doesn't get it, that it is clinging to an antiquated policy and economic growth strategies that presuppose a classic snapback in global demand."
China Does Get It
Roach is correct to criticize China's recent stimulus spending on those grounds, but he may be wrong to say that policy makers in Beijing do not "get it". The Chinese know there is a problem but in the midst of the recent crisis had little option but to throw money at the economy in ways that would shore up demand that had collapsed when the US consumer cut back on spending.
Beijing will at some point have to wean its economy off export-led growth and towards domestic demand. The majority of Chinese people, whilst getting richer, have not been the major winners of the Chinese growth story of the last decade. Wages have been kept low for the majority and the yuan's peg to the dollar has not allowed the rise in people's purchasing power that the last decades of growth should have produced.
Time to Revalue
For this to happen the yuan would have to be allowed to appreciate versus the dollar significantly which is something that, until now, China has rejected on the basis that it would have a negative impact on its export-led economy. Jim Rogers, the Chairman of Rogers Holdings and long-time China watcher told CNBC at the beginning of October that the Chinese will revalue the yuan in either 2010 or 2011.
Such a move would be painful for the exporters and would of course hit the yuan value of its overseas holdings but China knows at some point it is going to have to bite the bullet and get on with the process of facing up to long-term trends. Such a move would also have to pass on higher prices to the rest of the world and as a result push up inflation rates.
Rogers believes US inflation is already far higher than reported. He has been a big critic of Ben Bernanke and Alan Greenspan and believes the huge amount of debt taken on by the US is a currency crisis waiting to happen. "I would expect there to be a currency crisis or a semi-crisis this fall or next year" as a result of the loose monetary policy from the Fed in recent years, he told CNBC. Why the currency crisis? Well, inflation would be bad for the dollar unless the Fed decided to raise rates to curb higher prices. Whilst Bernanke talks of exit strategies from quantitative easing, no one really expects significantly higher rates any time soon. This policy in turn could see investors and governments drop the greenback.
Is a Weak Dollar the Answer?
David Blanchflower, the outspoken former member of the UK's monetary policy committee, believes the UK should target higher inflation in a bid to help its highly indebted consumers pay down the money they owe. In Washington Obama's Treasury Secretary, Tim Geithner will be thinking similar things when he looks at how much money his government owes the rest of the world.
With the US national debt set to hit 85 percent of gross domestic product and the cost of simply paying the interest likely to amount to more than funding the US military in a time of war, it is time for Washington to start thinking the unthinkable. With the ticking time bomb of Medicare set to explode within the decade there is only one viable option on the table for Mr Geithner and that is a weaker dollar. He may talk up a strong dollar but for all intents and purposes this is simply rhetoric. Plain and simple, a weaker dollar and higher inflation are lessons the burden of debt the US owes the rest of the world.
Should the US and China Come to the Table?
Simon Derrick from Bank of New York Mellon believes that Geithner is holding the best hand at the table. Whilst China, the euro zone and others would welcome an agreement similar to the Breton Woods, Derrick believes the US is very happy with the status quo. With the dollar down heavily over the last 8 years already, Derrick points out that those holding US government debt over that period have already lost out.
If we are to see more losses or even a currency crisis as Jim Rogers predicts, then it could well be China that forces the US to the table to discuss how any rebalancing can be achieved without huge losses for China's foreign currency reserves. A weaker dollar would help achieve the rebalancing of the global economy that we hear so much about whilst at the same time helping ease America's debt burden. For the time being the policy will be followed by Washington and there is not much anyone can do about it. The rest of the world looks on at a game that will affect everyone but is being played out by only two players, with one of them holding all the cards.
Sooner or later this will have to be addressed but at the moment no one wants to talk about it.