Foreign Affairs

China’s Empty ‘Nuclear Option’

China is threatening to use a "nuclear option" in an attempt to dissuade the US Congress from starting a protectionist trade war. But there are plenty of reasons for you to discount their threats. And many of those reasons stem from major changes that are now taking place in the global economy, at lightning speed.

So what is China‘s "nuclear option" all about?

There were a lot of news stories about it early last week (before they all got stepped on by the sudden dollar-liquidity crisis). Among the more perceptive pieces was one by Ambrose Evans-Pritchard in the London Daily Telegraph.

China is loudly whispering that they may start selling off some of their holdings of US Treasury debt. They currently have about $1.3 trillion in dollar-denominated instruments, about $400 billion of which is in long-dated debt like notes and bonds. As Evans-Pritchard notes, China wants us to be afraid that, by selling some of this debt, they will cause a collapse in the value of the dollar.

But the Chinese have been saying this for years, most recently in remarks late last year by Wu Xiaoling (the Deputy Governor of China‘s central bank). At that time, you will recall, everyone (wrongly) expected the Federal Reserve to lower short-term interest rates. Pressure was building inside China to find better-yielding investments for their enormous and growing dollar reserves.

But no one in the United States has been expecting lower interest rates lately. (That may have changed in the last three days, of course.) Instead, the Fed has been talking tough on inflation. However, it’s a political season, and Democrats and Republicans alike have been warning of trade war, which deeply frightens the Chinese.

But the "nuclear option" is an empty threat. Forget about the danger to the stability of the US economy. When Wu made her remarks last winter about diversifying out of US Treasuries, Fed Chairman Ben Bernanke went on record saying that he would simply sterilize and/or monetize any large Chinese sales of US debt. Don’t underestimate his willingness to follow through on this, and don’t underrate the Fed’s ability to keep the resulting inflation under control without significantly disrupting the US economy.

But even more to the point is that there just aren’t any asset classes in the world, apart from US Treasuries, that are liquid enough to soak up $400 billion or more should China go shopping for them. Again, the Chinese threat is empty.

The big elephant in China‘s room is inflation, caused by a combination of too many dollars, not enough domestic economy to soak them all up, and the currency quasi-peg that is the cause of the whole political ruckus.

China is caught in a box, and at the worst possible time.

Global markets for nearly every asset class are now in an extremely unsettled state. Investors around the world are raising the prices they expect to receive for taking any kind of risk. This is the very worst time to go to the markets looking for a new home for half a trillion dollars. And the Chinese are very well aware of this.

But by turning the tables and vacuously threatening to wreck our economy, the Chinese are telegraphing severe internal stresses and, possibly, exploitable weaknesses. What can we do to take advantage of them?

Protective tariffs against China are not likely to change our trade imbalance, because we’re no longer a manufacturing economy in the first place. What if China were to revalue renminbi by about 40%, or we were to add a 27.5% tariff to Chinese imports, as provided in legislation by Senators Schumer and Graham?

China would suffer severe internal dislocations, including a destabilizing recession. They would start targeting more of their exports at Europe (against which they already have a trade surplus nearly as large as the one they have with us). And we’d start importing more cheap manufactured goods from places like Indonesia, Taiwan, Korea, Thailand, Vietnam, and the Philippines.

This is why Treasury Secretary Paulson has been trying so hard to engage the Chinese in dialog (which of course hasn’t been working all that well). None of the unilateral options on either side are attractive.

Why does China have so many dollars locked up in unproductive investments, and so much internal inflation? One reason is the requirement that China imposes on its export businesses to convert all of their dollars into yuan.

And China undervalues the yuan by as much as 40%, so when their exporters convert our dollars, they get more yuan from China‘s central bank than they should. This is the engine of growth for China, and (not coincidentally) of legitimacy for the regime. It’s also the engine of inflation, as the surplus yuan find their way into over-investments in manufacturing capacity.

This policy is the instrument by which China‘s regime controls investments by the Chinese people, which is why they will strongly resist changing it. But what would happen if they did? What if it were possible for Chinese export businesses to retain the dollars they earn, and re-invest them directly in the United States? This would be beneficial for everyone from Hank Paulson’s former employer Goldman Sachs, to the People’s Bank of China, to investors here and around the world.

It might also finally strengthen the dollar by improving investment activity within the United States. Today, because of the currency quasi-peg, China and the United States form a single, enormous unified currency zone, that I call the Dollarzone.

You can see it in exchange rates between the euro and the renminbi. They move in lockstep with the euro-dollar rate. I think it’s entirely possible that the dollar is weak not because of conditions created in the US, but rather because a large sector of the Dollarzone economy (namely China) is undervalued and overinflated.

The true challenge for us is to find a way to exploit the weakness in China‘s position. The proper focus for our China foreign policy is to find a way to keep China permanently dependent on us for increases in prosperity, while forcing them to give American investors a considerably larger stake in what is the biggest growth-engine in the world.

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