China and the US deficit

Any reference to the exploding US fiscal deficit is almost certain to include a mention of China in the very next sentence.

It goes something like this: the US budget deficit is projected to hit a record $1.6 trillion this year and something close to that in 2010. What happens if China is unwilling to finance that deficit?

China, of course, is the largest foreign holder of US Treasuries, with $776.4bn as of June. That represents a 41 percent increase from June 2008.

These statistics don’t tell the whole story. The two countries actually have a symbiotic relationship, even though it’s portrayed more often than not as parasitic, with the US dependent on China to buy its bonds.

Because the US government spends more than it collects in taxes, it has to borrow — from you and me, from domestic money managers, from foreign central banks — to make up the difference.

The idea that China may decide not to finance our deficit makes no sense.

“It’s the equivalent of believing the sun travels around the earth,” says Jim Glassman, senior US economist at JPMorgan Chase & Co.

China is a developing nation that manages its currency, the yuan, to maintain its comparative advantage in producing cheap goods for export. China’s exports to the US rose to a record $337bn in 2008.

For about three years, from mid-2005 to mid-2008, China let the yuan appreciate from 8.2 yuan per dollar to about 6.82. It’s probably no coincidence that China froze the yuan at 6.83 a year ago as the world economy, and global trade, went into freefall, Glassman says.

“They’re definitely attuned to the danger of getting less competitive,” he says.

US consumers are happy to buy cheap Chinese goods, paying for them in dollars. China’s exporters turn the dollars they don’t want or need over to the People’s Bank of China, the country’s central bank, in exchange for yuan.

The PBOC, which had dollar reserves of $2.1 trillion at the end of the second quarter, can invest in safe, dollar- denominated instruments, such as US Treasury securities. Or it can sell the dollars in exchange for euros, let’s say, which would depress the value of the dollar.

So unless China wants those factories to stop humming, the PBOC will invest those dollars in the US, recent protestations by policy makers notwithstanding.

There are some 500,000 to 600,000 jobs in the US that are reliant on a product or service they sell in China, according to Jim Bianco, president of Bianco Research in Chicago. In China, the number of jobs dependent on a product or service sold to the US is 50 million to 60 million.

These numbers, which come from China Online, a Chicago think tank, go to the heart of the matter: if the Chinese don’t want to buy US Treasuries or other dollar-denominated assets, they have to stop selling us stuff.

“China needs those jobs,” Bianco asserts. “It keeps people too busy to organise revolution.”

Historian Niall Ferguson calls the partnership between big saver and big spender “Chimerica”. He fears the two interconnected economies are headed for divorce as US consumers rebuild their savings and China strives to become less export-dependent.

Chinese leaders have been voicing concerns publicly about soaring US spending, huge budget deficits and the potential for higher inflation down the road. They have talked about moving away from an export-dependent economy to one that relies more on domestic demand.

That’s what developing nations typically do when they emerge. It goes hand in hand with an appreciating currency.

As long as China keeps a tight rein on its currency — selling yuan and buying dollars to keep it from strengthening — the decision to finance the US budget deficit is secondary.

In buying US Treasury securities, China isn’t being altruistic. It’s acting in its self-interest.

China sells the US goods; China gets US dollars in return. China invests the dollars in the US.

Why this is made out to be anything more than a mechanical transaction is a mystery. (Go back 20 years, substitute Japan for China, and the storyline is the same.)

Even the discussion about moving away from the dollar as the world’s reserve currency leaves me scratching my head. Reserve currencies aren’t selected by a poll of countries or anointed by a committee of experts at the International Monetary Fund. The dollar is the world’s reserve currency because other countries are willing to hold it in order to trade with or invest in the US.

This isn’t to say deficits don’t matter or the US can be cavalier about funding them. Private investors may see no value in a 10-year Treasury yielding 3.4 percent if they anticipate higher inflation.

China’s central bank does not have the same investment parameters. Nurturing growth is a higher priority than enhancing returns.

Caroline Baum is a Bloomberg News columnist. The opinions expressed are her own.

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