Paper Tiger: China's No Threat to the U.S.

The mythical story of Damocles, a naive courtier to the tyrant Dionysius the Elder of ancient Sicily, has been making the rounds in Washington circles lately. According to the ancient Greek legend, Damocles was forced by his king to sit at a banquet table under a sword suspended by a single hair to demonstrate the precariousness of the sovereign's fortune. Consider the much-hyped weapons of mass economic destruction, the holding of U.S. bonds, China has at its disposal against America and it is easy to see why the conventional wisdom is that a Damoclean sword hangs over a humbled superpower. However, on closer inspection, the Chinese sword is much less formidable—and the hair by which it hangs is in fact a sturdy and well-fastened rope.

To be sure, Beijing views economic warfare as a legitimate tactic against a strategic competitor. The threat of financial retaliation has been repeatedly raised by influential strategists within the People's Liberation Army. For example, China's official news agency Xinhua reported Major Generals Zhu Chenghu and Luo Yuan and Senior Colonel Ke Chunqiao calling for broad retaliation against recent U.S. transgressions such as its arms sales to Taiwan and President Barack Obama meeting the Dalai Lama. Urging a "strategic package of counterpunches covering politics, military affairs, diplomacy, and economics" and an "attack by oblique means and stealthy feints," these strategists have recommended the dumping of U.S. bonds as one way to demonstrate China's rising national strength.

They don't acknowledge, though, that China stands to suffer from any such demonstration of its alleged strength. The country holds $700 billion to $800 billion worth of U.S. T-bills and around $1.4 trillion in American dollar assets overall. The dumping of T-bills would lead to a fall in the value of the greenback and significantly devalue Beijing's international assets.

But it is not just the case that the U.S. and China are locked in an inextricable economic embrace along the edge of a "Damoclean precipice"—another fashionable phrase within the Treasury. China is actually much more vulnerable than America, and has fewer economic options compared with the U.S. than is commonly assumed. China sold an estimated $34 billion in T-bills in December. Some people see this as evidence of Beijing's economic leverage. Unfortunately for their argument, though, the sell-off barely created a ripple. This is because Beijing's capacity to wreak havoc on the American dollar is overstated.

China's Debt Holdings

A little-known fact is that the proportion of U.S. government debt financed by Chinese foreign exchange reserves has been falling significantly since 2008. For example, China purchased around $100 billion worth of T-bills in 2009. That's a lot of IOUs, but with the U.S. federal government running a deficit of $1.4 trillion, China is bankrolling only around 7% of the red ink. In fact, following the December sale, Japan has overtaken China as the largest foreign holder of American T-bills.

Bear in mind that there is a further reason China cannot use its alleged economic WMD: It has no choice but to continue buying low-yielding U.S. bonds. Indeed, the willingness of China to purchase U.S. bonds at weekly auction markets shows no correlation with peaks and troughs in the Sino-American relationship.

There are two related reasons for this. China's foreign exchange reserves—well over $2 trillion—are the direct result of its trade surpluses, especially with the U.S. However, China is the only major economy that pegs its currency to a dollar-dominated "basket of currencies." To maintain this peg—and effectively artificially suppress the value of the yuan vis-à-vis the greenback—the Chinese central bank is forced to keep buying dollar assets.

China experimented with allowing its currency to rise 21% against the dollar beginning in 2005. By 2008, Communist Party officials and Chinese exporters insisted on putting an abrupt halt to the appreciation. Experts estimate that the yuan is still 25%-50% undervalued vis-à-vis the dollar. The deliberate suppression of the value of the yuan is designed to help protect its export sector, which generates well-paid jobs for hundreds of millions of Chinese, picking up the slack created by the coddled 120,000 state-owned enterprises. Compared with the private sector in China, these SOEs are two to three times less efficient at generating employment. Allowing the free conversion of dollars into yuan would cause a rise in the value of the Chinese currency and a significant decrease in the price competitiveness of Chinese exports.

Currency Restrictions

Furthermore, there is a related reason Beijing chooses to buy T-bills with its spare foreign currency. Restrictions on converting foreign currency (mainly dollars and euros) back into the yuan means that Beijing is left with a huge pile of foreign currency that it needs to park somewhere outside China. The American economy is the only place big and secure enough to absorb the enormous surpluses that China is generating. There are only so many mining companies and other businesses around the world that China will be permitted to buy.

The upshot of all of this is that Beijing's economic choices are limited, and its leverage over the U.S. is far weaker than is commonly made out. Even if Beijing correctly worries about the size of the American deficit, it can do little else but continue to buy dollar assets. Meanwhile, Washington should not underestimate its own leverage. The Chinese sword hangs by a well-secured rope rather than by a single hair, and the weapon is blunt and smaller than the sword of Damocles in legend might have been. Giving the U.S. a bloody nose is hardly worth breaking one's hand in doing so.

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