China’s “Nuclear Option” is real By Paul Craig Roberts

Dandelion Salad

By Paul Craig Roberts
08/11/07 “ICHTwenty-four hours after I reported China’s announcement that China, not the Federal Reserve, controls US interest rates by its decision to purchase, hold, or dump US Treasury bonds, the news of the announcement appeared in sanitized and unthreatening form in a few US news sources.

The Washington Post found an economics professor at the University of Wisconsin to provide reassurances that it was “not really a credible threat” that China would intervene in currency or bond markets in any way that could hurt the dollar’s value or raise US interest rates, because China would hurt its own pocketbook by such actions.

US Treasury Secretary Henry Paulson, just back from Beijing, where he gave China orders to raise the value of the Chinese yuan “without delay,” dismissed the Chinese announcement as “frankly absurd.”

Both the professor and the Treasury Secretary are greatly mistaken.

First, understand that the announcement was not made by a minister or vice minister of the government. The Chinese government is inclined to have important announcements come from research organizations that work closely with the government. This announcement came from two such organizations. A high official of the Development Research Center, an organization with cabinet rank, let it be known that US financial stability was too dependent on China’s financing of US red ink for the US to be giving China orders. An official at the Chinese Academy of Social Sciences pointed out that the reserve currency status of the US dollar was dependent on China’s good will as America’s lender.

What the two officials said is completely true. It is something that some of us have known for a long time. What is different is that China publicly called attention to Washington’s dependence on China’s good will. By doing so, China signaled that it was not going to be bullied or pushed around.

The Chinese made no threats. To the contrary, one of the officials said, “China doesn’t want any undesirable phenomenon in the global financial order.” The Chinese message is different. The message is that Washington does not have hegemony over Chinese policy, and if matters go from push to shove, Washington can expect financial turmoil.

Paulson can talk tough, but the Treasury has no foreign currencies with which to redeem its debt. The way the Treasury pays off the bonds that come due is by selling new bonds, a hard sell in a falling market deserted by the largest buyer.

Paulson found solace in his observation that the large Chinese holdings of US Treasuries comprise only “one day’s trading volume in Treasuries.” This is a meaningless comparison. If the supply suddenly doubled, does Paulson think the price of Treasuries would not fall and the interest rate not rise? If Paulson believes that US interest rates are independent of China’s purchases and holdings of Treasuries, Bush had better quickly find himself a new Treasury Secretary.

Now let’s examine the University of Wisconsin economist’s opinion that China cannot exercise its power because it would result in losses on its dollar holdings. It is true that if China were to bring any significant percentage of its holdings to market, or even cease to purchase new Treasury issues, the prices of bonds would decline, and China’s remaining holdings would be worth less. The question, however, is whether this is of any consequence to China, and, if it is, whether this cost is greater or lesser than avoiding the cost that Washington is seeking to impose on China.

American economists make a mistake in their reasoning when they assume that China needs large reserves of foreign exchange. China does not need foreign exchange reserves for the usual reasons of supporting its currency’s value and paying its trade bills. China does not allow its currency to be traded in currency markets. Indeed, there is not enough yuan available to trade. Speculators, betting on the eventual rise of the yuan’s value, are trying to capture future gains by trading “virtual yuan.” The other reason is that China does not have foreign trade deficits, and does not need reserves in other currencies with which to pay its bills. Indeed, if China had creditors, the creditors would be pleased to be paid in yuan as the currency is thought to be undervalued.

Despite China’s support of the Treasury bond market, China’s large holdings of dollar-denominated financial instruments have been depreciating for some time as the dollar declines against other traded currencies, because people and central banks in other countries are either reducing their dollar holdings or ceasing to add to them. China’s dollar holdings reflect the creditor status China acquired when US corporations offshored their production to China. Reportedly, 70% of the goods on Wal-Mart’s shelves are made in China. China has gained technology and business knowhow from the US firms that have moved their plants to China. China has large coastal cities, choked with economic activity and traffic, that make America’s large cities look like country towns. China has raised about 300 million of its population into higher living standards, and is now focusing on developing a massive internal market some 4 to 5 times more populous than America’s.

The notion that China cannot exercise its power without losing its US markets is wrong. American consumers are as dependent on imports of manufactured goods from China as they are on imported oil. In addition, the profits of US brand name companies are dependent on the sale to Americans of the products that they make in China. The US cannot, in retaliation, block the import of goods and services from China without delivering a knock-out punch to US companies and US consumers. China has many markets and can afford to lose the US market easier than the US can afford to lose the American brand names on Wal-Mart’s shelves that are made in China. Indeed, the US is even dependent on China for advanced technology products. If truth be known, so much US production has been moved to China that many items on which consumers depend are no longer produced in America.

Now let’s consider the cost to China of dumping dollars or Treasuries compared to the cost that the US is trying to impose on China. If the latter is higher than the former, it pays China to exercise the “nuclear option” and dump the dollar.

The US wants China to revalue the yuan, that is, to make the dollar value of the yuan higher. Instead of a dollar being worth 8 yuan, for example, Washington wants the dollar to be worth only 5.5 yuan. Washington thinks that this would cause US exports to China to increase, as they would be cheaper for the Chinese, and for Chinese exports to the US to decline, as they would be more expensive. This would end, Washington thinks, the large trade deficit that the US has with China.

This way of thinking dates from pre-offshoring days. In former times, domestic and foreign-owned companies would compete for one another’s markets, and a country with a lower valued currency might gain an advantage. Today, however, about half of the so-called US imports from China are the offshored production of US companies for their American markets. The US companies produce in China, not because of the exchange rate, but because labor, regulatory, and harassment costs are so much lower in China. Moreover, many US firms have simply moved to China, and the cost of abandoning their new Chinese facilities and moving production back to the US would be very high.

When all these costs are considered, it is unclear how much China would have to revalue its currency in order to cancel its cost advantages and cause US firms to move enough of their production back to America to close the trade gap.

To understand the shortcomings of the statements by the Wisconsin professor and Treasury Secretary Paulson, consider that if China were to increase the value of the yuan by 30 percent, the value of China’s dollar holdings would decline by 30 percent. It would have the same effect on China’s pocketbook as dumping dollars and Treasuries in the markets.

Consider also, that as revaluation causes the yuan to move up in relation to the dollar (the reserve currency), it also causes the yuan to move up against every other traded currency. Thus, the Chinese cannot revalue as Paulson has ordered without making Chinese goods more expensive not merely to Americans but everywhere.

Compare this result with China dumping dollars. With the yuan pegged to the dollar, China can dump dollars without altering the exchange rate between the yuan and the dollar. As the dollar falls, the yuan falls with it. Goods and services produced in China do not become more expensive to Americans, and they become cheaper elsewhere. By dumping dollars, China expands its entry into other markets and accumulates more foreign currencies from trade surpluses.

Now consider the non-financial costs to China’s self-image and rising prestige of permitting the US government to set the value of its currency. America’s problems are of its own making, not China’s. A rising power such as China is likely to prove a reluctant scapegoat for America’s decades of abuse of its reserve currency status.

Economists and government officials believe that a rise in consumer prices by 30 percent is good if it results from yuan revaluation, but that it would be terrible, even beyond the pale, if the same 30 percent rise in consumer prices resulted from a tariff put on goods made in China. The hard pressed American consumer would be hit equally hard either way. It is paradoxical that Washington is putting pressure on China to raise US consumer prices, while blaming China for harming Americans. As is usually the case, the harm we suffer is inflicted by Washington.

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4 thoughts on “China’s “Nuclear Option” is real By Paul Craig Roberts

  1. Not only is the Treasury Secretary clearly delusional, he doesn’t seem to be much of an economist either. The argument that a rise in the Yuan will make all America’s trade-imbalance problems go away is plain ridiculous. American trade imbalance is primarily a cause of low savings rate and high fiscal profligacy. US-European trade provides a precedent: although the Euro has appreciated nearly 40% against the dollar since its introduction, the American trade deficit with the Euro-zone has nearly doubled, from US$64bn in 2001 to US$120bn in 2006. And there are good arguments to be made that even if China was to float its currency, it may not even rise that much.
    Apart from buffing dollar and Treasury bond values, the large scale buy-up of American treasury bonds also keeps the US interest rates lower – to the tune of 1%. At a time when everyone is frantically running in circles about what to do with the shaky US housing market, attacking a financial maneuver that results in such a reduction in interest rates seems, how shall I say….suicidal? Unmentioned is also the fact that there isn’t even much overlap between American and Chinese manufacturing sectors – meaning that American goods would not be able to replace Chinese goods and it would instead have to import from other, more expensive sources, which would undermine the already low American savings rate even further. The low Yuan is all in all therefore more a subsidy to American consumers as it is to the Chinese exporting sector.

    But while I agree that the notion that the US can tell China what to do with its currency has no leg to stand on, the threat that China will start dumping dollars was also a hollow one and China is not stupid enough the make good on it. It knows full well that for all the above mentioned reasons a dollar-dump would have a high chance of resulting in a US recession. And a US recession doesn’t stay a US recession for long – it’s got a tendency to go global. With Wall Street and the London and Tokyo stock markets taking a nose dive, and everyone immediately placing the blame squarely on China’s shoulders for having triggered it, I wonder where China would continue to get the FDI it needs to keep its overheated economy racing. So China will not dump dollars. In fact, the Chinese financial authorities have already rejected this policy shortly after it was voiced. There is a different and bigger threat though: Sovereign Wealth Funds.

    This article:

    provides a very good assessment of what we really should start worrying about – and it’s not overvalued currencies.

  2. Namiste,

    David is right pretty much.. Yes they have all ready started a Co that they have reverse engineered Boeings super air buses and are already started building them to compete with Boeing for the share of selling Air planes. Large parts of the Boeing’s air craft had already been being built there except for a lot of the electronics. Now they have the capabilities to make and run a large air ship like Boeing’s largest air bus… He is right the cities and the pollution and the vast differences in the social economical way that the Chinese people are living and the Amount of pollution. I have been there 4 times myself and the last time was for 3 months earlier this year!!!

    Namiste and peace,


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  3. Your article makes it sound like China is benefitting from the status quo. Perhaps it was beneficial for China to get its manufactering started by selling to the US. But now they have all of the US technology (except maybe building air planes?) of what value is continuing to amass dollars that can never be redeemed?

    You mention that “China has raised about 300 million of its population into higher living standards”. Have you visited the cities that these 300 million live in? Many of their cities are so polluted that there is simply no blue sky anymore – in Beijing they have resorted to building apartments with blue tinted windows. Instead of houses with land the residents own apartments. Instead of suburbs with parks and libraries the population is crammed into concrete jungles so large the horizon is endless buildings.

    Plus the other over 700 million in China are not somehow converging towards American lifestyles. They live lives of such poverty that its as if the 20th century never happened at all. The Chinese manufacturing is based on their poverty instead of real productivity and so an internal market will be difficult to develop. Meanwhile China is so short of water that it plans to drain Tibet in order to continue –

    But the water is a digression this isn’t about China not having enough water (sand storms are common in Beijing) its about China not having enough oil – Currently the US uses 1 in 4 barrels of world oil production. There’s simply not enough oil supply for Chinese demand to continue to grow at its current rate of 7.5% and so the status quo, in fact, cannot continue anyway.

  4. Namiste,

    I think that your totally correct, but I also disagree that I believe that unless these traitorous companies that left Americas heart land and went to over seas to mass produce there wares for penny’s on the dollar screwing over the Us workers and their communities then I say let them get a knock out punch. I say let America once again start standing strong and put an end to NAFTA that never helped out the American worker their families or the communities that the companies used to reside in with huge tax incentives to getting them there in the first place. Once the tax incentive was gone they always move on else where or over seas or down to Mexico. I think that we should take it on the Chin if need be and start a new. The products that we as Americans are buying are just going to have to start saying made in the USA at least 50% or more should say that at lest. A three Trillion Dollar trade deficit that I had known about way back in early April from CCTV channel 9 when I was in China said that is what the trade deficit is with the American dollar they make no hiding of it. In fact they figure that the longer that they keep the yuan at 7.6 as it is now I believe that the more that their country is still making.

    I even seen multi billionaire computer manufacturer Bill gates was over there setting up a company to be making his chips there cheaper, which by the way is also giving the Chinese government a easy ride into all of our technologies if any body ever took a minute to think about it. Also Boeing who has been having parts of its air busses made in China now the Chinese are going to be building their own air busses to be competing with Boeing for the market share of building and selling and maintaining huge air planes from the air plane industry. This is also how they gain a lot of their key knowledge is through our companies giving them the technology and then they are beaten out by a population of people working for less and able to produce more with out the benefits that Americans should be getting.

    Don’t be surprised if your able to buy the newest and better computers from China in the future as the newest innovations in the software and the chip industry is going to be right there as Mr. gates has put a lot of money investing there. They will be able to copy and duplicate it with in weeks I am sure and have a different name brand in it in days for ½ the price I am sure…

    With out the Americans having the good paying jobs who do the big companies expect is going to be able to afford and to buy their goods wither it is a computer shoes t-shirt or what ever? Americans need the good high paying jobs too and they shouldn’t be being outsourced to over seas or Mexico…

    Namiste and peace,

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