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How Serious Is the Chinese Challenge? Part II

In less than two decades, China will likely be the world’s largest economy, and this YaleGlobal series analyzes China’s growing economic and political influence, particularly its relationship with the US. Some analysts predict conflict, and others expect gradual, peaceful transition. In the second article, Markus Jaeger, a director of Deutsche Bank Research, reviews analysis on China and argues that the interdependence is asymmetric. China’s chief economic leverage is its holdings of US public debt, he notes, and any mass sell-off would hurt China more than it would hurt the US. Trade has increased the cost of any conflict between the two nations. Greater economic power will shift China’s way once it adopts a flexible currency and reduces dependence on US markets relative to US dependence on Chinese markets. Until then, China is more economically dependent on the US, and Jaeger concludes, if conflict emerges, China would pay the higher price. – YaleGlobal

How Serious Is the Chinese Challenge? Part II

Despite its rise, China has lopsided financial interdependence with the US
Markus Jaeger
YaleGlobal, 15 July 2010
King of toys: China's domination of the toy export industry makes it vulnerable too

NEW YORK: The Chinese economy has been growing at 10 percent annually since the beginning of economic reform in the late 1970s. If current trends hold, China will overtake the US in terms of economic size by 2025. In PPP terms, China will be world’s largest economy by 2020.

Economic analysts are divided about China’s road to economic preeminence. Some foresee dangerous speed bumps while others argue that interdependence can only smooth the ride.

Despite China’s dramatic economic rise and increasing financial weight, the Sino-US economic-financial relationship can be best described as one of “asymmetric interdependence” – where Beijing finds itself in a position of “asymmetric vulnerability” – heavily skewed in Washington’s favor.

Several factors and developments could undercut China’s trajectory.

Some analysts anticipate rising competition between China and the US. Others are more optimistic about a peaceful “power shift.”

Some analysts anticipate rising geostrategic competition between China and the US. Historically, rising powers make use of their increasing influence, argues Aaron Friedberg, and increasing dependence on imported commodities could lead China to mitigate supply risks by seeking “regional preponderance,” thus increasing strategic competition between Beijing and Washington. From there, it’s a small step to construct a scenario where geostrategic competition leads to economic conflict weighing on Chinese economic development, as predicted by international relations realists such as John Mearsheimer. Other scholars are more optimistic about the possibility of a peaceful “power shift.” David Shambaugh, Robert Sutter and Bates Gill interpret much of Beijing’s international behavior as evidence that China is becoming a “responsible stakeholder” in an international system that, by and large, offers it benefits through an open trading system.

Some analysts anticipate political instability. The lack of post-Mao charismatic leadership and the declining strength of ideology have weakened the foundations of China’s political system, according to Harvard’s Roderick MacFarquhar. Increasing social activism could undermine Communist Party rule and regime stability. Again, from this analysis, it’s only a small step to come up with a scenario where political volatility and uncertainty weigh on economic growth. Andrew Nathan is more optimistic, arguing that the Chinese government has repeatedly proven its ability to respond to newly-emerging social and economic demands. Localized social unrest does occur, but given the combination of regime responsiveness and political control, he maintains that “a spark isn’t going to start a prairie fire in China.” Demographics ensure that demands for political reform will remain manageable as “the middle class won’t demand democracy when it is afraid of an even more numerous class of peasants and migrant workers, and therefore sees the authoritarian regime as a bastion of order against chaos.”

Other concerns range from environmental sustainability and viability of the current investment-heavy, export-led growth strategy to political event risk.

Lack of further reforms might undercut future growth. Pei Minxin, senior associate at Carnegie Endowment, suggests that partial economic reform has led to the emergence of a “mixed” state-centered system that perpetuates the privileges of the ruling elite. This system allows the elite to “tap efficiency gains from limited reforms to sustain the unreconstructed core of the old command economy – the economic foundation of its political supremacy.” He calls this a “trapped transition,” where the ruling groups have little incentive to pursue further reform. Absent economic reform, however, economic growth is bound to decline. A variation of this argument has been put forward by Woo Wing Thye, professor of economics at UC Davis, who suggests the challenge lies in sustaining economic growth while at the same addressing rising social inequality and accommodating increasing middle-class demands for political reform. Optimists, like Barry Naughton, point out that the government has repeatedly proven its ability to successfully deal with various economic challenges and that growth remains largely driven by large-scale economic and demographic forces that are relatively independent of government policy.

Naturally, other concerns range from environmental sustainability and viability of the current investment-heavy, export-led growth strategy to political event risk. According to the “bears,” all of these might create potentially non-negligible risks capable of undermining, or at least significantly slowing down, China’s rise. Nonetheless, short of a complete – and very unlikely – breakdown, a reasonable downside scenario is likely to mean 5 to 7 percent annual growth, rather than full-blown economic stagnation. China is unlikely to be thrown off-course in the way the Soviet and Japanese economies were. Structurally, China’s medium-term growth potential is, after all, significant. Unlike Japan in the 1980s, China is located far from the technological frontier, and its development model is based on a relatively high degree of economic openness, and unlike the Soviet Union, China is better suited to generate total factor productivity by importing foreign technology. Therefore, China will more likely than not continue to register at least 8 percent annual growth over the next decade.

China’s increasing economic size will provide Beijing with growing political, economic and financial influence. While China’s rise has greatly increased its power, this has thus far translated into limited bilateral influence vis-à-vis the US. China’s most important economic-financial lever of influence regarding the US is the threat to sell off its estimated $1.4 trillion in US treasury and agency debt.

China’s most
important lever of influence regarding the US – the threat to sell off its estimated $1.4 trillion in US treasury and agency debt.

Such a move would be costly for Beijing, however, economically and financially, China would shoot itself in the proverbial foot. First, the value of its holdings would decline, and higher US interest rates would weigh on the US growth outlook, hurting Chinese exports. Furthermore, unless it’s willing to accept renminbi apprecation, China would have to find other dollar assets to invest in,as rapid renminbi appreciation is hardly in China’s interest in terms of exports and dollar-denominated US debt holdings. However, if China does re-invest in dollar-denominated assets, this would presumably help ease financing conditions in other segments of the US financial system, potentially offsetting negative effect of higher rates in the treasury market on the economy.

Second, if Beijing were to dump large chunks of US debt, it might disrupt financial markets in the short run. The medium-term impact would likely be manageable, as other official foreign buyers with close security ties to the US, including Japan and Gulf nations, would step in, albeit at higher interest rates.

Last but not least, any politically motivated fire sale of US debt would trigger a severe political backlash – and not just from the US – as well as undermine China’s standing as a reliable financial investor and economic partner.

Beijing would end up paying a higher price than Washington for significantly raising US borrowing costs.

Financially, economically and politically, Beijing would pay a high price for significantly raising US borrowing costs and it would end up paying a higher price than Washington – simply reflecting the fact that China is much more dependent on the US than vice verssa. The US has access to a more diversified investor base, with which it maintains close political relations. The US market is substantially more important to China in terms of both exports and imports than vice versa – and the Chinese export sector is relatively more employment intensive.

China’s holdings of US debt do not lend themselves as a coercive instrument and are perhaps better regarded as a limited deterrent. Rising cross-border asset holdings and trade have increased interdependence, raising the costs of economic conflict for both China and the US. Nonetheless, the potential costs of a conflict due to China’s trade dependence are substantially higher for Beijing than for Washington.

However, if and when China reduces its export dependence on the US market relative to US dependence on the Chinese market, and if and when it adopts a substantially more flexible exchange rate regime, the balance of economic and financial power will shift dramatically in Beijing’s favor. Until then, Beijing has a far greater interest in preventing a wider economic-financial Sino-US conflict than Washington does.

Markus Jaeger is a director at Deutsche Bank Research, New York.
Rights:Copyright © 2010 Yale Center for the Study of Globalization

Comments on this Article

26 July 2010
You make the proposition that American geostrategic imperatives can impede China's economic interests in its economic development because America holds the upper hand in the relationship between the two nations. Let me say that this is a very naive theory. First, if America acted to impede China's economic development, the whole world will be in the great depression rather than the current great recession. And just like America suffered the great infamy when the wholly world knew instantly that the invasion of Iraq was based on a lie, so too will America suffer from world public opinion as a result of the worldwide great depression resulting from American containment of China. I remember that right after the financial crisis of 2008, many western economic experts made the case that as result of the crisis, many African and South American countries will suffer the most economically. However, no body predicted that due to China's economic might, Africa and South America' GDP will grow at an annual rate of 5 to 6% per year while western economies were either rotting from within or in decline or both.
-shui yao , Usa
26 July 2010
The writer of this article is clearly not familiar of how the world has changed or the lightening speed in which information travels around the world today. America is infamous around the world for invading Iraq, but not so much because of the invasion in it self. But because the whole world new instantly that the invasion was based on a lie. Today, China has already overtaken America as Brazil's largest trading partner. Therefore, should America invade Brazil in order to contain China economically, and at the expence of Brazil's economic interests?. In such a scheme, Brazilians will fight back, therefore leading to a much faster pace of American decline and demise. Remember this, the Russians have enough weapons to destroy the world many times over. However, many countries look down on Russia because Russia it so weak economically and not beneficial to any one of them. America is actually coping the Russian way to demise. China is quickly becoming the largest trading partner to all of East Asia and South Asia. These are the same countries the USA has asked to join in containing China. But how long before they decide that its not in their economic interest to to be a pawn of US hegemony against China, since their economies can make more money trading with China than with the USA.
-hughes feinstein , USA
24 July 2010
Captainjohann, China cannot have a military drill with South Korea. The United States acted patiently and intelligently with Japan, which was therefore saved from making a blunder of drifting toward Beijing. I feel the wind is blowing in a different way.
-Yoshimichi Moriyama , Unnan City, Japan
23 July 2010
The Chinese leadership is clever and silent.It mostly listens unlike the western leaders which tends to give imagined supreiority.The very fact US has to conduct a military drill with South Korea, has to browbeat Japanese for continued Okinawa lease, shows which way the wind is blowing in Asia.Ofcourse US cannot even call Pakistan is the home for Alquaeda while blaming Afghanistan for all its troubles inspitre of times square and forthood is watched by the world with interest.
-captainjohann , Bangalore,India
21 July 2010
Islam is a violent political movement and not a religion in the sense of the word RELIGION.To a reasoned debate Islam responds with suicide bombers.BE WARNED.
-John Timbaktu , Paris France
19 July 2010
Dear Mr. AAprime , San Diego, CA
Thanks for your very valuable comment on my post.
It is somewhat sad to see in your informed worlds the understanding that the human race, even on its highest expression of scientific and social advancement, has been unable to use intellect to overcome and bring under control our ancestral instinct of exploitation and domination over the competition, often using military means with its undesirable consequences.
Your concern about nations been left behind is real and a result of the current model that demand everyone (from individual to national level) to fiercely and blindly compete to avoid been outcompeted.
It is a wonder that 21st century men still thinks in clans (nations) instead of human race. While we carry this medieval notion and armed as we are arming today, discussions about sustainability, global warming, biodiversity, etc will be condemned to be politician’s photo opportunities and scientists conferences talk.
It always feel like a waste of time to be pointing out what looks to be wrong and the alternatives to make it better, soon we realize that nothing is going to change and that, against all odds, we should keep watching CNN for news on the decapitation strike on the Iranian leadership carried out by the United States of America or its overseas state of Israel.
Keep well.
-Paulo Borges , Brasil
19 July 2010
Manipulating the financial markets for 35 years since Bretton Woods has come home to roost.Imperial America thought it could fiddle the world financial system as pax america and make the world works for them for cheap and for good.Little did the US foresee with all their futorologist and sooth sayers that China economics would work.U cant fool the world all the time with financial guru's and five star rating by financial agencies.Now the time for reckoning has come and U.S. is scuttling for shelter but unfortunately????Very soon the Chinese will have a 25 hour time system because work is leisure for them.No more free scentist to built pax america on the cheap in the first instance who are all going home to their respective countries.Let's hope your alleged soft power still works?
-Henry , Singapore
19 July 2010
It is difficult to predict the future but, according to this article will not be good. This requires a deep analysis and plan how to resist the growing influence of China on the U.S. economy and its weakening. The solution surely exists only to take the action.
-John Wiliams , California
18 July 2010
Greetings Mr. Borges,
I completely agree that a multipolar world is the ideal international system with all stakeholders accepting leadership roles and responsibilities. The point of my argument is that world has entered a new era, one in which the survival of the human species is at stake. This being the most important issue that needs to be considered in a global system. For that reason alone, a multipolar global system is the optimal outcome.
Most US citizens are only dimly beginning to realize that American ideals of democracy and capitalism are being viewed globally as somewhat passe while China demonstrates that top-down socialism driven by a market economy can unleash dynamic economic growth. Indeed, there is little academic research in the United States on the topic within the field of international economics or in the institutions of higher learning that highlight international relations.
The real dilemma BRIC nations face is what happens to the other nations that are left behind because they are unable to compete in a market-driven global economy irregardless of their political system? How do these nations participate in the global economy without losing their national identity and culture? Will they be able to accept their lesser international roles with dignity and grace? These issues become very thorny when that nation is a nuclear power or possess a radical political fringe element within their population. The security issue then becomes the paramount factor to political stability and economic growth.
Unfortunately, coercion by force of arms has always been the historical answer to maintaining security. This idea has come into vogue among certain circles of Americans. I wholeheartedly agree that diplomacy makes more sense, yet warfare by other means is still coercion and has the potential to violate American principles of freedom and liberty.
I have no answers to these challenges, yet I am certain of this one great truth. The privileged elite are usually the last to understand when a quantum shift has happened and typically the first to deny it as well. This may be what causes the demise of great civilizations and empires: The inability to recognize change and respond to it with timely action. I have no empirical proof to support my argument, yet it seems quite intuitive to my mind.
-AAprime , San Diego, CA
17 July 2010
Dear Mr. AAprime , San Diego, CA
It is not a question of what is the best empire. I am convinced that ANY sole superpower will eventually fall and, as it descends, it will resort to its military superiority to keep afloat (just as you mention and we see everyday on TV). As it digests its certain demise, respect for somebody else’s property and life becomes tenuous (as we also see everyday in Iraq and Afghanistan and expect to see in Iran)
I am convinced the reason to celebrate is not on the ascension of China as the new super power but the multi polarity the raise of the BRIC nations along a declining and no longer sole (and above international law) world superpower.
America will have to learn to remove the always present (and top on the list) military option from the table and learn to use diplomacy to achieve its international objectives and SHARE common interests with nations that will not be as ready as today to tolerate crimes against humanity under cover of spreading of democracy and wars on terror.
-Paulo Borges , Brasil