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
Thursday, July 15, 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 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.”

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.

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.

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.
Copyright © 2010 Yale Center for the Study of Globalization

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