The Contest of the Century (36 page)

Except that, eventually, they do. Even for America, there are limits to the sorts of deficits it can run. At some stage, the credibility of the U.S. dollar will be called into question—and with it the underpinnings of America’s global position. To be fair, there have been many dollar scares in the past that proved to be unfounded. When I was studying in Washington in the 1990s, my dissertation supervisor was David Calleo, who was one of the leading voices in the school of thought sometimes called “imperial overstretch.” He wrote persuasively about the ructions caused by Lyndon Johnson’s budget deficits in the 1960s, which were needed to finance the Vietnam War, and the subsequent stresses the dollar came under in the 1970s, when Nixon eventually abandoned the convertibility of the dollar into gold. Yet the dollar’s primacy survived the episode. To Europeans who worried about the risk of inflation, then treasury secretary John Connally retorted: “It is our currency and your problem.”

The same pressures returned during the Reagan years and the arms race with the Soviet Union. The Soviets eventually blinked first, their economy imploding under the burden of heavy defense spending, but America’s finances also came under intense pressure, prompting a new bout of predictions that American dominance and the dollar era that financed it were coming to an end. Paul Kennedy had a massive publishing success at the time with his
Rise and Fall of the Great Powers
, a tome about imperial overstretch over the centuries which captured the prevailing mood. Again, the pessimism proved short-lived. The end of the Cold War and the supreme confidence of the early years of the George W. Bush administration made these sorts of predictions seem alarmist, almost foolish, and in the boom years of the mid-2000s they were brushed aside as a kind of intellectual defeatism. Yet, after a decade of two expensive wars and the biggest financial crisis since the 1930s, which forced the government to run a deficit of $1.1 trillion in 2012, America’s outstanding government debt is now almost as large as the economy itself—something that has not happened since the Second World War. The credibility of the dollar is once again being called into doubt, and the idea of “imperial overstretch” is very much back in vogue. In the financial world, some talk about when rather than if there will be a
dollar crisis. It is precisely at this moment of uncertainty in the fate of the U.S. currency that China has chosen to start claiming a bigger role for the renminbi in the global economy.

THE DOLLAR TRAP

“How do you
deal toughly with your banker?” Hillary Clinton asked, shortly after she became secretary of state. Since the start of the financial crisis, a new phantom has started to loom over U.S.-China relations: the massive amounts of American government debt that are now in China’s hands. China has the largest foreign-exchange reserves in the world, at around $3.3 trillion, and overtook Japan in 2008 to be the largest overseas holder of U.S. debt. Although the exact composition of China’s reserves is a state secret, analysts who have sifted through the available information estimate that around two-thirds of those reserves are in U.S. dollar assets. The likely result is that China owns around $2 trillion of U.S. government debt. “Never
before has the United States relied on a single country’s government for so much financing,” as economist (and later White House official) Brad Setser put it. “Political might is often linked to financial might and a debtor’s capacity to project military power hinges on the support of its creditors.”

The handover of global responsibilities from the U.K. to the U.S. was a long and drawn-out process, but the final blow was delivered because Britain owed too much money to Washington. In 1956, when the U.S. wanted to show its displeasure at the British invasion of the Suez Canal, Eisenhower refused to let the IMF issue an emergency loan which Britain needed to defend its currency. Fearing a complete financial collapse, Britain pulled out its soldiers from the Canal Zone. British influence in the world was never the same again. If China could turn this financial power into real political leverage, it would have dramatic consequences for both America’s economic policy and its ability to exert influence around the world. It would give Beijing the hold over Washington that the U.S. once held over its own great-power predecessor.

China is well aware of the potential significance. Every now and then, there have been comments from low-level Chinese officials raising the potential threat. In 2007, Xia Bin, who was then a leading economist
at a government think tank called the Development Research Center, caused an international fuss when he suggested that China’s dollar holdings should be used
as a “bargaining chip.” When the U.S. announced it would sell more arms to Taiwan in 2010, three senior PLA officers—Major General Zhu Chenghu, Major General Luo Yan, and Senior Colonel Ke Chunqiao—told the Xinhua News Agency that China should retaliate by selling U.S. government debt, which could lead to a sharp rise in U.S. interest rates. According to American diplomats, the threat to sell dollar assets has also occasionally hung over conversations about the Dalai Lama. The more nationalistic sections of the Chinese press call it “the nuclear option”—threatening to dump dollar bonds in order to change American policy. Or, as Gao Xiqing, the head of China’s sovereign-wealth fund, told the American journalist James Fallows:
“I won’t say
kowtow
, but at least be nice to those countries that lend you money.”

In the U.S., this potential threat from China has now been a feature in two presidential elections. When he was running for the 2008 presidential nomination, then senator Joe Biden warned, in a Democratic debate, about the risks of having China finance U.S. debt. We need to “make sure that they no longer own the mortgage on our home.” Hillary Clinton, also then a senator and a presidential candidate, piped in: “I want to say ‘Amen!’ to Joe Biden, because he’s 100 percent right.” In 2012, the theme returned with a vengeance. In May, there was a standoff in Beijing over the blind activist Chen Guangcheng, who, having escaped house arrest and taken refuge in the U.S. Embassy in Beijing, announced that he wanted to leave China for the U.S. Paul Ryan was asked if the U.S. still had any influence over China in such a dispute. The Republican vice-presidential nominee answered: “When you depend on another country like China for the cash flow in your country and for your debt, there is not a lot you can do when you are asked to stand up to them on a principled matter such as this.” Ryan somewhat misread the situation: the next day Chen was given permission to move to New York.

——

Paul Ryan was wrong for a reason. The supposed leverage that China derives from its dollar holdings is something of a myth—and China
knows it. The curious thing about this discussion is that, although some Americans complain that the debt gives China excessive influence, China is increasingly angry at how little sway it has. In the years since the financial crisis, there has been a growing frustration in China that its U.S. bond holdings give it almost no leverage whatsoever. When the crisis broke, Beijing started to issue a series of warnings about American economic policy and its obligations to do right by China. “I request the U.S. to maintain its good credit, to honor its promises and to guarantee the safety of China’s assets,” Premier Wen Jiabao told a 2009 press conference. Beijing worried very loudly about the inflationary risks of the monetary expansion the U.S. Federal Reserve launched in response to the crisis. Chinese officials started to push for guarantees about repayment on their U.S. debt, especially in the troubled mortgage agencies Fannie Mae and Freddie Mac. It is possible that Chinese pressure had something to do with the timing of when the two mortgage agencies were brought under government control. But, by and large, China’s attempt to strong-arm the U.S. did not work. Beijing did not receive any formal guarantees, and it exerted no influence over American monetary or fiscal policy. The Fed has continued to do as it wishes. The Tea Party has more influence over the Fed than does the Chinese Communist Party.

Larry Summers, the former U.S. Treasury secretary, once described the situation between the two countries as “mutually assured economic destruction.” Beijing has come to realize that it is trapped—trapped by the size of its exposure to the U.S., trapped by the reality of financial markets, and trapped by the logic of its own policies. In any month when China exports more than it imports, this leads to an inflow of foreign currency into the country. In order to prevent the value of the renminbi from rising, which would hurt its exports, the Chinese central bank buys up the dollar excess. China’s foreign-currency reserves are the direct product of this policy of keeping its currency artificially cheap, in order to boost exports. This was a choice made by China, not by anyone else. Indeed, large parts of the world have called on China to change its approach and to allow its currency to become more expensive. Having built up such a stockpile, China’s official money managers are then faced with limited options. The U.S. Treasury market is by far the largest and most liquid in the world. It is also the only one with the
size to absorb the sort of volumes of reserves that China has been accumulating. China therefore has little choice but to recycle a large portion of its surpluses into U.S. government bonds.

The harsh reality for China is that it has too much at stake to turn its back completely on U.S. bond markets. Economic interdependence makes it hard for China to rock the boat. At best, China can gradually scale back the rate at which it buys new American debt. But if China were to try and sell a substantial chunk of its U.S. bond holdings, it would send the market into a tailspin, and bond prices—including China’s own investments—would plummet. Such action would also force down the value of the U.S. dollar, making China’s exports less competitive and threatening hundreds of thousands of factory jobs. It would be a huge self-inflicted wound. This formula does not make sense for a regime whose legitimacy is tightly wound up in delivering economic results. China’s holdings give it theoretical leverage over the U.S., but it is leverage that it is technically difficult and politically suicidal to exploit. Beijing knows as much. “We hate you guys …” Luo Ping, a senior Chinese banking official, admitted in 2009. “US Treasuries are the safe haven. For everyone, including China, it is the only option.” He continued: “Once you start issuing $1 trillion–$2 trillion… we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.”

——

Luo Ping was only half joking. His mock anger was politically important because that sentiment became one of the starting points for the campaign to take the Chinese currency global. Frustrated at its inability to influence American economic policy, Beijing has started to think much more seriously about finding ways to rein in the influence of the dollar and Washington’s ability to run endless deficits. Resentment at the “dollar trap” helped launch a much broader Chinese critique about the place of the U.S. dollar in the international economy. If China could not influence the way the U.S. managed its economy, it would try and reshape the international financial system instead, and make the dollar less indispensable. Hu Jintao called in 2008 for a “new international financial order that is fair, just, inclusive and orderly.”

The first sign that something was brewing in Beijing came from
the governor of the Chinese central bank, Zhou Xiaochuan. Zhou is a chemical engineer by training but is considered one of the Communist Party’s intellectual heavyweights in the field of international economics. With his donnish air, he likes to tease journalists with the sort of delphic pronouncements that once made Alan Greenspan a cult figure—before the financial crisis, that is. In March 2009, six months after Lehman Brothers collapsed, the central bank started to put up on its Web site a series of long and detailed speeches and essays by Zhou that called for substantial reforms of the international financial system. Zhou had himself some fun at the expense of the Western investment banks, which had almost felled the global economy. He criticized the “herding phenomenon” among investors and the “inertia and sloppiness” that stopped executives from “asking tough questions.” But his broader message was aimed at the role of the U.S. currency. The international financial system, he said, needs a reserve currency “that
is disconnected to individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies.” In between the technical language of international financial policy, the message was clear: the world needs to become less reliant on the dollar.

Zhou’s speech was the starting gun for China’s campaign to develop a more international currency. Since then, China has unveiled a steady series of reforms aimed at forging a bigger role for the renminbi. Using Hong Kong as a trial ground, the government in 2009 started to allow the use of the renminbi to settle international trade—the first stage in a plan to turn it into the main currency for trade in Asia and between developing countries. In 2011, it allowed renminbi bonds to be sold in Hong Kong, letting foreign investors buy assets denominated in the Chinese currency. Since then, Beijing has announced a slew of reform measures that will gradually make it easier to trade and invest in the Chinese currency. By the end of 2012, around 15 percent of China’s trade was being conducted in renminbi. The final stage would be to turn the renminbi into the sort of international safe haven that attracts the world’s central banks to park a substantial share of their reserves in the currency. That would be the real stamp of approval. In what was largely a symbolic gesture, Malaysia has already taken the first step, acquiring some renminbi bonds.

Chinese policy makers usually couch the project in technical terms, pointing out that it will reduce the costs of doing business for Chinese companies and expand the opportunities for Chinese banks. But they also do little to hide their broader political objective of forging a new international system that is not dominated by the U.S. dollar. Li Ruogu, head of the China Export-Import Bank, argues that “the financial crisis
 … let us clearly see how unreasonable the current international monetary system is.” Another official told me: “We have the second-biggest economy in the world, so we should have a currency that enjoys many of the privileges that the U.S. also gains.” According to Zha Xiaogang, a researcher at the Shanghai Institutes for International Studies:
“The shortcomings of the current international monetary system pose a big threat to China’s economy. With more alternatives, the margin for the U.S. would be greatly narrowed, which will certainly weaken the power basis of the U.S.” One Chinese academic even goes so far as to say that ending the dominance of the dollar is as important for Beijing’s ability to project power as was
“China becoming a nuclear power.”