Washington: A hyper-power and hyperborrower

Philip Segal, Markets and Finance Editor 'Asian Wall Street Journal' Yale Center for the Study of Globalization, New Haven

The United States has emerged as the planet's only superpower and the world's largest debtor nation. Many of the countries that are funding the U.S. debt don't like a lot of what Washington does, but it is unlikely that they would pull the credit rug from under the feet of Uncle Sam. The reason: In an unstable world, they need a strong America -- and its vast market.

With a stock market bubble behind it and a housing bubble that could pop anytime, the last thing the U.S. needs are sharply higher interest rates. That's exactly the punishment China and Japan are in position to administer, if they ever decide to start dumping their vast storehouses of U.S. government debt, which would force the U.S. to raise interest rates.

But chances are that they won't. Japan is a strategic ally and is less of a worry because it has no fundamental strategic differences with the U.S. America also has no reason to fear that to push China on the critical issue of getting North Korea to behave itself would lead Beijing to crash the U.S. government bond market.

According to the International Monetary Fund, China's Gross Domestic Product (GDP) in 2002 was worth US$1.2 trillion, less than 4 percent of the world's total output. Add Japan, and the two were responsible for 16 percent of world GDP. Yet by mid-year this year, China and Japan alone had some $900 billion in foreign exchange reserves, or about a third of the world's total. Much of those reserves were tied up in U.S. government debt, as well as the debt of quasi-government housing financiers Fannie Mae and Freddie Mac. Substantial sales would have thrown U.S. finance into crisis, hence Asia's considerable leverage over America.

Here's how America got itself into this: As the U.S. imports far more in goods and services than it exports, it needs someone to step in a lend it the money to keep spending on imported cars, Italian marble for monster houses, and lots of the stuff you see on the shelves at Sears or Wal-Mart. As it turns out, two of the biggest bankers for the world's uni-polar superpower are a couple of middle military powers, Japan and China. Given their huge trade and payment surpluses with the U.S., their currencies should have risen sharply against the dollar this year.

Instead, Japan's yen has appreciated only slightly, and the Chinese yuan has remained rock steady, given its formal fixing to the dollar. With all the dollars they earn, China and Japan have bought U.S. Treasury debt in huge amounts, becoming bankers to the world's biggest military power. By this summer, holdings by the Federal Reserve of paper on behalf of foreign governments have soared from some $600 billion in July of last year to $750 billion. Asia is mostly responsible for that increase.

Washington would love it if Asian countries let their currencies strengthen against the dollar (by buying fewer Treasury bonds, but not dumping the bonds in one great heap). A weaker dollar would make it easier for the U.S. to export things to Asia, and would also take some of the pressure off the poor euro. With Japan and China refusing to let their currencies rise much against the dollar, anyone who doesn't like the dollar's prospects piles into the euro, which explains that currency's smart rise of late. Too strong a euro would bring on recession in Europe, and nobody really wants that.

There's also a security implication to the China-U.S. financial relationship. Washington's relatively soft approach on North Korea -- a member of the "Axis of Evil"- is often attributed to Pyongyang's nuclear weapons capability. But there's another reason, too. China is the one country that can really hold Kim Jong-il's feet to the fire, but it doesn't always rush to Washington's aid on this score. International Strategy and Investment, a Washington-based newsletter, cast North Korea's role in the Beijing-Washington calculations this way: "The U.S. has leverage because China needs our markets, and China has leverage because the U.S. needs China's dollar support."

That's true, but fortunately for the U.S., China's need is greater. With some of the world's sickest banks and rapidly rising unemployment, the last thing China would want to do is cause a world-wide recession, hitting its main export market especially hard.

Follow the money. China grows only by export-oriented investment. It actually loses money when it lends to the U.S., because U.S. bonds pay lower interest than China receives when it lends on the international bond market. But that's a small price to pay. China's leadership is petrified of a stronger currency and the negative effect that could have on foreign investment, not to mention the social unrest that could follow.

China seems like an economic powerhouse sometimes, but remember: A full 50 percent of China's exports in 2001 came from foreign-invested enterprises, according to the OECD. That's up from a figure of just 17 percent ten years earlier. While foreign-invested companies ran a trade deficit of $18 billion in 1994, that's now turned around to a trade surplus, bringing China a net $7.3 billion surplus in 2001. Take away foreign investment in China, and Beijing has a gigantic problem.

For all the money they bring in, foreign companies employ just 1.5 percent of the total workforce. China's Maoist loss-making state industries still employ 38 percent of volatile urban workers, according to OECD (Organization of Economic Cooperation and Development) figures. Those workers (who are no different from workers elsewhere in that they're prone to unrest when they can't earn money), need more foreign-funded jobs, not fewer.

None of this means the U.S. can go on holding the most financially irresponsible party it's ever put on. In the words of Fred Bergsten, of the Institute for International Economics, "to finance both the current account deficit and our own sizable capital exports, the U.S. must import about $1 trillion of foreign capital every year, or more than $4 billion every working day. The situation is clearly unsustainable."

Still, the leveling off won't happen after a sudden abandonment by Asia of the U.S. capital markets and a plunge in the dollar. China will eventually strengthen its fixed currency from 8.3 to the dollar to somewhere around 6 to the dollar and life will go on. In the meantime, the U.S. can push Beijing as hard as it can to help on North Korea. There will be little real pushing back.