The Chinese American Melodrama

So, what is all the fuss about China and US? Well, one is the worlds largest economy and the other after having grown at 8-9% for nearly three decades now has become the worlds second largest economy. People say it is just a matter of time before China eventually replaces US as the Worlds largest economy. Some Economists like those from Goldman Sachs have quoted 2027 to be the penultimate year in this regard, while other Researchers from OECD have painted an even brighter picture saying that year would be 2016. Others claim that projecting economic future of any country beyond a 5 year timeline will not be a viable proposition to count upon. Real GDP growth of nations in the past have not necessarily shown adherence with numerical calculation of growth figures over any said timeframe. Even during the 80s, many feared the US was not capable of holding on to No1 position economically. In those days the envy and fear was from Japan. But many of the projections of that time have not yielded desirable results. But beyond all this Objectivity and Subjectivity, there are a certain mechanics that are engineered to run the global economy. In this article we will try and explore those mechanics behind two of largest economies of our days China and USA. In my previous article the theme was the Coming Currency Collapse. The premise of same was the potential for the crash of major international currencies resulting from monetary easing measures of various central banks. Now, how can a currency crash happen, especially in case of USD as long as the demand for the same as a forex reserve does not subside? Irrespective of how much ever dollar gets printed; a single currency that dominates the international currency market, accounting for nearly 60% of reserves globally is unlikely to loose sheen due to money printing. But still, is everything so full proof? Or is there some possibility of things going weird? Let us try and understand how this reserve currency status shields or may wield cracks to global currency system in times to come. Let us explore this further with the case of US and China. Within currency system, there is fixed and floating rate system. The USD is a free float currency where its value is purely determined by its demand and supply in the international market. So what is the case with Chinese Yuan?

Its a pegged Currency. The value of one Yuan vis--vis USD is fixed by PBOC and the monetary policy of the Chinese central bank is altered accordingly so as to ensure this pegged exchange rate. So what is the advantage for China as a result? The Chinese produce gain immense competitive edge in global trade as their goods cost far less than most of their trading peers. The US is the worlds largest consumer and imports heavily from across the world. And China, with its competitive advantage exports a lot to these markets. So in transactional terms, the US gets a lot of goods and debt. The Debt In this case is a byproduct of the trade deficit which is financed through borrowing. China in this case is the creditor for US. So what are the statistics here? How much debt do US owe to China? As of March 2013, the Chinese ownership of US treasuries stood at a whopping $1.22 trillion. Of the $16 trillion US Debt the vast majority is held by Bulge bracket banks at home, namely Goldman Sachs, JP Morgan, Citibank, Bank of America etc. China still holds a meager 7.5% of this debt. China is an export oriented economy and vast majority of its economic activity is dependent on foreign trade unlike other economies like India whose economy is driven by domestic consumption. China exports $2.021 trillion of its production, making it the world's second largest exporter. The EU is the world's largest, exporting $2.17 trillion, while the U.S. is third, exporting $1.612 trillion. China ships 17% of its exports to the U.S. which created a $315 billion trade deficit for US in 2012. There has been accusation from US against china claiming that its involved in unfair trade practice. US foreign policy experts even claim that the Chinese ownership of US treasury is potentially one biggest risk that US faces. In a way china could use this as a tool of coercion. Often when there have been demands from US to devalue Yuan, the Chinese have responded with threats of dumping the US Treasuries. And clearly if something on these lines were to ever happen in future, it would open a Pandoras Box in the financial world. Any such move by china would just be the tip of the ice berg. Other nations could follow the suit which would flood the international currency market with USD. Then simple economics would come to play.

When there is a sudden increase in the supply of USD in international market (considering more than a trillion dollar holding by china), the value of USD would plummet. The reason that any adverse Chinese move would just be the tipping point is that other countries may follow suit as china with $1.22 trillion in treasury reserve may be able to significantly impact currency value in international market.

As an investor, the ultimate aim would be return on investment. A rapidly falling dollar may jeopardize that for many central banks forcing them to rethink their investments in Treasuries. But again, how realistic is such a scenario if it ever were to happen? If not very realistic, the past and present saga of the US Debt ceiling does paint a grim future.

So far, on two major instances, the US has romanced with the Debt ceiling. The first major instance was in August 2011 where after some intense debate the US House of Representatives approved legislation to raise the U.S. debt limit by at least $2.1 trillion and cut federal spending by $2.4 trillion.

During the course of the senate debate doomsday predictions were making news. There was talk of life post a potential Debt default which though was and still is a remote possibility could have wrecked a financial tsunami that would have made the Lehman crisis look like a movie trailer. But this initial saga did leave a trail of destruction. The S&P lowered the United States long-term rating to 'AA+' due to what it claimed were inherent political risks and rising debt burden. This was the first time in nearly 70 years of history that the US AAA rating was downgraded. The markets however did not react sharply to this event. The second saga came to haunt the Senate in December 2013. November was the election season in US and no major move could be made to diffuse this drama until the end of December. The US had even technically defaulted on its debt as it reached the statutory debt limit on Dec. 31 giving Congress about two months before the payments to creditors would kick in. The US House later on January 24, passed a resolution by 285-144, to lift the governments $16.4 trillion borrowing limit until May 19.

So what major threat could come forth? The warning bells this time has come from Fitch which has reiterated that another so-called debt ceiling crisis would probably lead to a reduction in the U.S. credit rating.

A downgrade automatically makes the US bonds riskier and thus increases their yield and lowers their price which in effect hurts the investors. This could well be the tipping point by other central banks to start dumping treasuries. On the other hand any debt default would take these yields to the stratosphere wreaking havoc of unimaginable magnitude. There are investors like Jim rogers, Marc Faber, Peter Schiff who claim that the current AA+ rating also do not reflect the reality. Jim Rogers for instance has quoted saying that he even doubts a rating of C. Though most of the names quoted a big bears, the underlying is that the fundamentals emanating from the US debt saga still has the potential to yield results which may not

necessarily be warranted by the global economy. In the worst case scenario, the entire world order of present could be put into question.
And China with its huge Treasury holdings may play the key. In fact china started diversifying its stock of $3.2 trillion in foreign reserves in July 2011. Chinas holdings of US Treasuries fell to $1.15 trillion at the end 2011 from $1.16 trillion at the end of 2010 after having reached a high of $1.31 trillion in July 2011.

Even these data do not conclusively suggest any formidable move by China. However, the threat remains. Neither can China afford to dump the Treasuries as its economy is dependent on exports nor can US afford to challenge china on its pegged rate system as any adverse Chinese move in this regard would wreak havoc for US. Thus the vicious cycle of Chinese American Melodrama continues..