TCS Daily


Peas in a Pacific Pod

By Melana Zyla Vickers - March 23, 2007 12:00 AM

When Treasury Secretary Henry Paulson last Friday visited Shanghai, home of Feb.27's $100 billion market meltdown, he called for more "balanced, harmonious" growth and tried hard not to trash the Chinese for spreading the stomach flu that also hit markets in New York, Europe, and Tokyo.

His mildness was fair enough, because the Shanghai stock market is not yet a serious global player. But regardless whether the correction was one-part Chinese or two, the fact of it, plus Paulson's visit, plus the announcement this week of a giant Chinese investment agency, are reminders of the many ways in which the U.S. and China now share the same economic dinner bowl. The more quickly strategically minded Americans understand the resulting potential harm as well as benefit — the better.

We share markets:

Downside: Shanghai was the world's hottest market, returning 130% in the previous year, when it suffered a 9% drop in that one late-February day. While hardly any foreigners are allowed to trade in the Shanghai market, the drop nonetheless triggered global jitters by affecting nearby Hong Kong and Tokyo, with whom Shanghai shares investors. In future, if the Shanghai market attracts more foreigners yet remains highly speculative, heavily capitalized by government interests, and driven by rumor rather than adequate information on the businesses that list there, its volatility will be more contagious to U.S. markets, not less. In addition, more U.S. investors are sure to chase Chinese returns, with resultant risks.

Upside: The heavy if not always transparent hand of government, heavy government control of information, and corruption in Chinese markets raises the possibility that China's millions of mom-and-pop investors would, in the event of a downturn, take their anger out on the state itself. Bring it on: Anything that's bad for the Chinese Communist party is good in principle.

We share energy:

Downside: Chinese oil demand has doubled in the last half-decade, making the country the world's second largest oil consumer, after the U.S. This growing appetite already helps to drive up global prices. Against a backdrop of dwindling global reserves, China's continued growth may well lead to global geopolitical conflicts over resources. Already, in Africa and Latin America as well as Iran, China has sought to curry favor with oil and gas-rich governments by proposing energy-development partnerships in which China provides funds in exchange for fuel, yet withholds U.S.-style pressure on non-democratic politics. In addition, China's appetite promises also to keep prices high, and high prices line all kinds of Russian, Iranian, and Middle Eastern bad guys' pockets.

Upside: China's energy appetites are an Achilles' heel. For now, the country doesn't control or even largely influence any maritime or overland flows of energy to its factories and home. Meanwhile, for all the United States' Middle Eastern trouble, it does still does control or at least influence those flows, making China ultimately dependent on U.S. good will for continued supply of energy.

We are indebted to each other:

Downside: Thanks to its galloping growth, China has the world's largest stockpile of foreign exchange reserves, $1.3 trillion, almost two-thirds of it invested in U.S. securities such as Treasurys. Indeed, China has in recent years become the second-largest holder of U.S. debt, after Japan. If China should decide to dump U.S. debt, and other foreigners didn't rush in to replace China as buyers, the action could catastrophically drive up U.S. interest rates and the cost of borrowing.

Upside: China owes this giant pool of capital at least partly to U.S. consumers and firms that buy Chinese goods. China invests the fruits of its trade surplus in this country because U.S. investments are high quality — and this is good for both sides. China's action keeps U.S. interest rates down and provides capital to those U.S. companies that seek it. As China now moves some of its forex reserves into a giant government-controlled investment fund, there could be further inflows of capital into U.S. investments, which continue to be attractive to foreigners.

To be sure, the general upward trajectory of the Chinese economy is good for a growing Chinese middle class, which theoretically can become strong enough to assert rights and freedoms, and to oust the ruling one-party regime and replace it with something kinder and gentler. But that's only one possible outcome of China's rise. And in the meantime, the U.S.-China relationship is a close and intense one, fraught with risk.

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11 Comments

fraught with risk?
Isn't it fraught with risk the same as every other human endevour is also so?(perhaps we should include natural phenomena too if you believe the conspiracy theory about Bush having caused the tsunami a few years ago). But in general it's good that red china is getting richer, not only for most of them, but also for westerners. Having china as a serious player means more competition in the world, and that's good. Also politically so, for example when peple see how the chinese operate in places like Africa, people will be able to compare it to the way westerners do, and did as colonists. Then they will see that we were pussycats compared to the way the chinese operate. Also, soon china will not only buy treasury paper etc. but will also be investors in normal companies, and this will make them stakeholders in the success of such instruments. They can see how the government of Singapore invests all over the world, some billions of dollars and gets about 18% return on average. So they figure they can do it too. Disclaimer: I have many investments in red china.

Important piece...
However, Melana seems a bit hawkish. "Anything that's bad for the Chinese Communist party is good in principle."

This is a shallow view. The Chinese government is a single party republic making no pretense of democracy. Whereas the government of the United States is a two party republic with a sham democracy that, to a greater of lesser drgree, distracts our politicians from managing the affairs of the nation.

Any revolutionary disruption to the government of China would immediately damage the world economy in general and the economy of the United States in particular. As the author points out, our businesses are inextricably linked.

"Against a backdrop of dwindling global reserves, China's continued growth may well lead to global geopolitical conflicts over resources."

Total rubbish, Melana. There is no such "dwindling [of] global reserves" at all. Indeed, we continue to discover more proven reserves every year. Don't be silly.

"...may well lead to global...conflicts..." Why would anyone risk any sort of struggle over a commodity that is freely available to anyone with the money? Furthermore, the prices we are paying today are not related to the fundamentals of oil supplies (cost plus) or demand (what the market will bear). Prices are purely a result of commodity trading, investment and speculation.

However, you chose to boldly suggest that some sort of oil shortage will lead to a confrontation between the United States and China. This alarmist rhetoric must be aimed at below medium intelligence voters. You could not possibly be this naive yourself.

"...oust the ruling one-party regime and replace it with something..." What? What would they replace their one-party government with? Do you imagine that there will be some sort of Lech Walesa rising up from among the workers? And that he would last to the weekend? What such revolutionary mechanism do you imagine will be used by the Chinese middle class to oust its one-party government? Some loophole buried in the small print of the Chinese Constitution, perhaps?

Let's get real regarding China. We kid ourselves that they are fundamentally flawed at great risk to our own ability to compete with them. The Chinese are very, very good. Maybe better than we are at creating wealth. And they are growing. The old fashioned way. By converting the most basic (commodity) raw materials into high quality finished goods. And exporting globally to convert their cheap labor into dollars. Perfect.

Raw economic growth is raw financial power if it can be controlled. China is doing this brilliantly.

We are, indeed, two peas in the same pod. The Chinese are learning from us and taking the best of our abilities into their skill set. However, we have much to learn from them just as we had much to learn from the Japanese industrialists 25 years ago. We did not learn enough of it fast enough to stop Japan from taking our automobile industry away from us. Arrogance on our part.

Well. It is happening again. And this time the Chinese (followed by the Indians) are going to take away far more than Detroit.

Enough with the sabre rattling. Let's make money. That is how we won the Cold War. And the game is on.

The US vs China philosophy will only lead to bad policy.
Why is the competition for scarce resources between economic actors in the US and China such a bad thing? The ability of the mind to create and dream is limitless but the resources on this planet are scarce. So it is a good thing to compete with someone for them. Take energy. The citizens of the US and China are bidding up prices for oil and petroleum products. So we can sit there and pay more or get off our butts and invent something different.

So the answer is for the governments of the US and China to stop what ever they do and let entrepeneurs in both the US and China better themeselves and the rest of the world at the same time. I know it won't happen but one can dream.

Does this mean they'll buy our mortgages?
"Also, soon china will not only buy treasury paper etc. but will also be investors in normal companies, and this will make them stakeholders in the success of such instruments."

Yeah, about that: When I first heard the announcement of them setting up this 'agency', my immediate reaction was "so they can buy our bundled debt instruments like mortgages and credit card debt". Central banks frown on investing in non-government issued debts, so they would be inclined to set up another agency to do that. China would thus get the triple benefits of:

the continued ability to 'wash out' all those dollars from their economy (to keep the yuan artificially low), something their central bank has been doing by buying US treasuries like a crack addict - but losing value in the process. higher returns for that money that private investments can only return, thus ameliorating a lot of currency risk in the US dollar becoming cheaper (which is will continue to do no matter what) if they do concentrate in investing in bundled debt instruments, then their favorite sugar-daddy -- the US of A Consumer with a capital 'C' -- will be able to continue that much longer to finance his/her/their Wal-Mart purchases with home equity based debt.
Or, they can invest in companies, as everyone on this thread talks about. My guess is -- because of the above reasons (temptations) -- they will eventually invest directly as possible into the 'mortgage biz' with this fund as well, if not predominantly so.But then gain, I'm not an international finance expert.

No oil shortage, but serious distribution challenges
"However, you chose to boldly suggest that some sort of oil shortage will lead to a confrontation between the United States and China. This alarmist rhetoric must be aimed at below medium intelligence voters. You could not possibly be this naive yourself."

I believe the author was describing a conflict caused by the fact that China has far less control over the distribution channels of its oil supplies than we do, not over supply shortage of oil per se (which will affect them via higher world oil prices no matter what).

The US Navy has long ago accomplished what its British counterpart only was able to claim to do: dominate the world's seas. That is despite the fact that said navy went from having 500+ ships in the 1980s to just something over 200 today. At this point in time, all the other world's navies combined can't beat the US' in terms of both technology and raw ship numbers.
The US thus has full de-facto control over the Strait of Malacca, could block shipping from the Strait of Hormuz or shipments from Africa and easily disrupt traffic in parts between those straits(Indian & Pacific Oceans) and China proper -- something the Chinese are very sensitive about and will only become more so. For similar reasons, they are also nervous about India's growing navy and expanding deep water operational abilities. Most of their oil from the Middle East and the raw materials increasingly used in Chinese factories being mined and shipped from Africa have to go that route. I believe that one of the real reasons why cooler heads in Beijing have prevailed on forcing the Taiwan issue so far have to do with the fact that the PRA navy can't even pretend to claim that they can protect the aforementioned supply routes from US disruption.


That is why China has been establishing at great expense deep navy capabilities along that route. I believe they have established multiple naval bases. A large one is/will be in Burma, for example. And, they will continue to aggressively do so.

Some sobering info on the fragility of the Strait of Malacca:

"If the strait were closed, nearly half of the world's fleet would be required to sail further, generating a substantial increase in the requirement for vessel capacity. All excess capacity of the world fleet might be absorbed, with the effect strongest for crude oil shipments and dry bulk such as coal. Closure of the Strait of Malacca would immediately raise freight rates worldwide. More than 50,000 vessels per year transit the Strait of Malacca. With Chinese oil imports from the Middle East increasing steadily, the Strait of Malacca is likely to grow in strategic importance in coming years."Source: http://www.eia.doe.gov/emeu/cabs/World_Oil_Transit_Chokepoints/Malacca.html

Logistics...
It is in no one's self interest to compromise shipping through the Straights of Malacca. Why would we do that? To start a problem with China? To push up oil prices worldwide? Lots more than oil goes that way.

Oil prices are not related to the fundamentals of taking it out of the ground or transporting it to market. Oil prices are purely driven by the commodities market. Consumers are pretty much price insensitive. Consumers will adjust to very high prices. So why hasn't the price of crude gone past $80 and on up to $100?

OPEC would love it. The oil companies would love it. All the governments you can name would love it. Because none of these players can keep it high and no one can keep it low. The commodity players trade oil without the fundamentals of supply and demand engaged at all.

The economists entertain the media with explanations but they have nothing when it comes to predictions.

China has not annexed Taiwan because we would immediately go to war. I think we have sufficiently demonstrated our willingness to fight. If we would not protect Taiwan then we would not protect Korea, Japan or the Philippines. Japan would immediately go nuclear (six months) and the world order would change forever.

We will not try to squeeze China by turning back supertankers in the ocean off Malaysia if they attack Taiwan. They know that much for certain.

Zyndryl..
Dollars entering the Chinese economy when US companies buy components and products over there are converted into yuan inside the banks and those dollars cease to exist.

The Chinese government enjoys rapidly growing tax revenues. Surplus funds must be invested in interest bearing bonds. US Treasury debt instruments are the best. The Chinese FOREX account is substantial. More than they need to dominate trade in yuan versus dollars. They buy dollars at their own official rate but they also do just fine shorting dollars against other currencies. People seem to think that the Chinese keep the yuan pegged to the dollar by throwing their dollars at the yuan. Wrong. The Chinese actually buy dollars to accomplish that.

The dollar is not weakening. We know this is true because our domestic inflation is so low. The dollar is flat.

The other major currencies are strengthening because their economies are finally healthy and growing. Especially in Europe and Japan.

If China wanted to become the new Fannie Mae then our real estate market would do precisely what it is doing anyway. Do you really think that Fannie Mae caused the problem with sub-prime mortgages? Fannie Mae is going to take something of a beating this year. China is certainly not lining up to take on that stupidity.

You see China making bad loans to Wal-Mart shoppers so they will continue buying cheap imported consumer goods? Really?

Uh...sorry, bud
"Dollars entering the Chinese economy when US companies buy components and products over there are converted into yuan inside the banks and those dollars cease to exist."

Uh...no, dollars don't 'cease' to exist. Unless the Chinese are burning them.
The Chinese currency has a fixed rate to the dollar but is nonconvertible on capital account. Over the past year, there has been a $25 billion trade surplus, a $45 billion net inflow of foreign direct investment—which also puts upward market pressures on the exchange rate—and over $50 billion of central bank purchases of foreign exchange. In this case, the central bank purchases offset almost three-quarters of market-generated upward pressure on the yuan from the trade surplus and the FDI inflow combined. China does not have 'normal' foreign exchange procedures.
"Do you really think that Fannie Mae caused the problem with sub-prime mortgages?"
No, I never mentioned Fannie Mae. And Sub-primes are just under 25% of all securitized loan bundles, last time I checked. I don't expect the Chinese to purchase securitized loan bundles in the future with bad sub-primes in them anymore than I expect anyone else will (hence why Congress is mulling a bailout via the FHA).
"You see China making bad loans to Wal-Mart shoppers so they will continue buying cheap imported consumer goods? Really?"

Uh...yeah! Because THEY ALREADY HAVE BEEN DOING JUST THAT, indirectly via their massive Treasury purchases. They might as make real profits in it.
"The dollar is not weakening."
The dollar has become weaker against most major currencies in both a market and trad-weighted exchange basis over the past five or so years now.

Forest...
"Why would we do that? To start a problem with China?"
Did I say we would start it? No. I inferred that the chinese would over Taiwan (although in their view if we interfered we would be 'starting it', I suppose).
Either way, the Straits of Malacca would be open game. The Japanese took our most of our Pacific Fleet at Pearl Harbor to keep us from doing a similar thing to them while they went for the rubber plantations and oil of southeast asia (because we cut off all exports of our oil to them).
"Oil prices are not related to the fundamentals of taking it out of the ground or transporting it to market."
Oh boy...did you READ anything I wrote? I never said anything that disputes what you just said, so why are you assuming I did? I was referring to political/military interference of the otherwise normal transport of oil, which really doesn't have anything to do with taking it out of the ground or putting it on a tanker, does it? So what's with the unnecessary lecture?
"China has not annexed Taiwan because we would immediately go to war."
Not exactly. China has not forcibly pacified Taiwan ('annex' refers to taking foreign territory and absorbing it within your nation's own. since Taiwan is considered by the PRC to already be part of China, 'annex' is not the correct term to use) not because they fear war with us, but because they don't want to fight a war with us they cannot win.And as long as they keep thinking that way, that status-quo will continue for a while longer than it otherwise would.

"We will not try to squeeze China by turning back supertankers in the ocean off Malaysia if they attack Taiwan. They know that much for certain."

No. Apparently YOU are certain of that. But don't talk for the rest of us. :)
"It is in no one's self interest to compromise shipping through the Straights of Malacca. Why would we do that? "
Naval blockades during times of war are SOP. And we could easily make it selective. Not ALL shipping would be stopped, just that delivering raw materials to China. The oil tankers bound for Korea and Japan would be free to pass. We can track them all by satelite. If a shipping firm is so stupid to diss the US Navy, we can stop ALL their ships in just about ANY sea in the world if we want to. Or, just simply ban them from doing any commerce in US ports. Trust me, we have plenty of mojo available to force them to sing the Yankee Sea Tune in this matter if we had the will.
There will be blockade runners, sure. But giant supertankers won't be part of those rinky-dink operations. China will be screwed. Beijing knows this and that is one of the big reasons they fear getting into a war with us they can't win (see above).
"To push up oil prices worldwide?...OPEC would love it. The oil companies would love it."
Oh, no doubt. But if war were to break out with the US and China, world oil prices (and probably some other commodities besides gold) would spike ANYWAY. Why, because the markets will be anticipating the possibility of what we've been chatting about here. In point of fact, oil prices have risen recently simply because the Iranians snagged over a dozen of their service folks and started a nasty international incident over it. Imaging what would happen to ALL the markets worldwide if the US and China went to war?
Which nation was the number one foreign trading partner of the US of A when the US entered on the side of the allies in WWI? Answer: The Empire of Germany. When wars break out -- particularly major wars -- it really does hit the fan despite what conventional logic would seem to intuitively dictate.

OK...Zyndryl...
Lots of nations do not allow their currencies to be freely converted during their transition from a soft currency. This typically means that the currency does not trade on FOREX. In the case of the yuan China purchases dollars at a fixed rate of exchange through their FOREX account in order to eliminate the same sort of dangerous volatility that caused the (Japanese) yen to strengthen into deflation following the Plaza Accord (1985).

For many years the Korean Central Bank severely restricted the amount of foreign currency their own private parties could hold. Good for Korea and this did not hurt the United States at all. (Of course, we like the Koreans.)

"Sub-primes are just under 25% of all securitized loan bundles..." Are you out of your mind? If 25% of the mortgage paper out there was sub-prime and thereby exposed...How can you write something like that and not see how incredibly impossible that must be?

When a Central Bank (in China or anywhere else) purchases interest bearing Treasury debt instruments as a store of wealth that money is not used by the government of the United States to underwrite credit card debt to consumers. I am not sure how you think this might work...

If the dollar was weak then we would have inflation. We don't. It isn't. However, your entire position regarding the Chinese refusal to allow the yuan to strengthen against the dollar flies in the face of your concern that the dollar would be weakened if they did.

Which would you like Zyndryl?...Because you can't have it both ways. And then I am certain that the Chinese will do just what you want.


Mutual Assured Destruction...
Zyndryl,

Clearly, you are young.

We cannot go to war with China or Russia and neither of them can go to war with us or with each other. We all have the bomb (actualy, lots and lots of them) and sufficient delivery systems to kill most of mankind and put the rest of us back into the Stone Ages. No such wars...Not ever.

You don't already understand how this works? Right.

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