Late in 2006, Treasury Secretary Henry Paulson led a large American delegation on a widely-publicized and closely watched mission to Beijing. It had to be a serious trip, for was not Paulson bringing along with him Ben Bernanke, the Chairman of the Federal Reserve Board? Yes, Paulson, Bernanke — and what seemed like the larger part of the Bush Administration — would be participating in what is known, formally, as the United States-China Strategic Economic Dialogue, an innocuous-sounding venue. But what did it mean, really?
We have learned that such meetings, combining substance and ceremony, help inform the world’s expectations for how larger relationships will develop. They also tell us something about the “high politics” of the moment. Years ago, American statesmen had to prove their mettle at Middle East diplomacy and then perhaps pass the test of a Soviet-American summit conference. Now the relationship among the Great Powers — at least between the Superpower and the Rising Power — is more about money than missiles.
This is an improvement. During the Cold War we worried about the Soviet military buildup, especially of long-range missiles with hydrogen warheads. The Soviets had a dangerously large hoard of those — but very little money. Hence, the long-running diplomatic drama that was the Strategic Arms Limitation Talks (SALT.) China today has only a modest supply of long-range missiles with hydrogen warheads, but a very large amount of money — and getting bigger by the day. Today, it is the Chinese financial buildup which concentrates our mind. Just as strategists once speculated about what the Soviets might do with all those missiles, today they think about what the Chinese might do with all that money.
The best-known weapon in China’s financial arsenal is the more than one trillion dollars of foreign exchange held by China’s central government. These reserves are the money China has earned in foreign trade. Of the trillion it has banked, it has invested about $400 billion in US treasury notes and bonds — another way of saying that it has lent $400 billion dollars to the US government. Suppose China unloaded the US government securities it now owns, and also decided not to buy any more, that is, not lend us any more money. What would happen then? Students of international finance tell us that our interest rates would soar and the value of our dollar would plummet. Moreover, as a Chinese general might observe with satisfaction, Chinese money would no longer be financing a part of the American military buildup. He might also wryly note that the US trade deficit with China, also financed by Chinese lending, is about $200 billion per year, the equivalent of one year of the Iraq war and its related costs.
Thus, it would appear, China has the capacity to initiate a financial first strike of no small consequence. But it hasn’t yet, and appears unlikely to; to borrow a word from Cold War days, it is deterred. Indeed, so far as this aspect of US-China relations is concerned, there exists what former Treasury Secretary Lawrence Summers has brilliantly termed “a balance of financial terror.” Like the “mutual assured destruction” of nuclear deterrence which it resembles conceptually, “the balance of financial terror” is mathematically elegant and, from one perspective, perfectly reasonable. But, like its Cold War ancestor, its breakdown would be catastrophic. Though no one quite planned it this way, a financial doomsday machine now exists and it would not only automatically inflict horrible retaliation on the Chinese economy — putting at risk the forty percent of China’s GDP which now derives from its international connections — but a big chunk of the world economy would be taken down with it.
The polite term for this is “mutual interdependence,” — the interconnected flow of commerce and finance, and the intricate public and private infrastructure that maintains it — and we are learning to live with it. Our political system has sometimes shown itself agreeable to military re-armament when needed, but as Secretary Summers has also noted, it has always been far less amenable to financial re-armament — that is, major shifts in our patterns of saving, spending, and taxing.
Outside China’s government, China’s companies and private citizens are also accumulating substantial sums of their own. The Chinese are great savers, to the point that they’re often criticized for saving too much. But the abrupt political and social changes of the past have made them cautious investors in the present-day Chinese system; after all, it has been in place for only thirty years. The government, however, is eroding their reticence by allowing the socialist social safety net to unravel. It is relentlessly transferring the costs of housing, education, medical care, and retirement to individuals, thereby compelling Chinese citizens to invest as First World citizens routinely do.
Accordingly, China now also has stock exchanges and pension funds. The total market capitalization of all companies whose shares are traded on China’s stock exchanges is below a trillion dollars, not a trivial sum, but far from the comparable number for all of Japan — about seven trillion — or for the New York Stock Exchange alone — about thirteen trillion. Over the longer term, however, what will become important to us outside China is that Beijing now allows Chinese to invest a growing portion of their money in foreign markets. Before long, many tens of billions of dollars will be deployed around the world; hundreds of billions, perhaps even trillions, will follow.
Are we prepared for a time when a fund which has pooled the retirement savings of the municipal employees of Shanghai — dare we call it SHANGPERS? — will demand its rights as a shareholder in our blue chip companies? In the arena of mergers, acquisitions, leveraged buyouts, and private equity acquisitions of publicly-traded companies, we in the US may not be especially vulnerable to still-small players like China. But suppose the Chinese become strategic investors elsewhere. For less than fifty billion dollars, they could buy all the publicly-traded shares in New Zealand; for another fifty billion, they could buy all the publicly-traded shares in Argentina. Intriguing calculations all, and they will now challenge investors and geo-strategists alike.