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Op-Ed: Is China Your Daddy?


Or is the idea just another dollar-bear fantasy?

Editor's Note: As an emerging-markets banking analyst, James Kostohryz has firsthand experience of banking collapses and their subsequent resolutions in Mexico, Argentina and Southeast Asia. Since leaving his position as Head of International Investments at Brazil's Banco Pactual in 2000, James has worked as an independent trader and investor.

There's been a great deal of hand-wringing the past few weeks by US dollar bears and other assorted alarmists regarding the "leverage" that China presumably has on the US government. The tenor of this chatter is that we "need to be nice" to the Chinese, or else they'll stop buying our bonds and force us into sovereign default.

These pundits have variously pointed to Secretary Clinton's "kowtowing" trip to China, comments emanating from Chinese officials expressing "concerns" about their US investments, and various statistics showing Chinese holdings of US Treasury debt. The latest fodder for these pundits has been China's suggestion that the world move away from the US dollar as the global reserve currency - and Tim Geithner's supposedly contradictory responses to same.

The issues surrounding the soundness of the US dollar as a currency are complex (take a look at UUP, UDN, FXY and FXE). But I'd like to suggest that the alarmist notion -- that the Chinese have the US by the throat -- has little merit, and that the real situation is, if anything, quite the opposite.

The Fantasy of China as Daddy

The chattering punditry loves to pose the question: What happens if the Chinese stop buying our bonds?

The pundits that rhetorically pose this question seem to automatically assume this would be a catastrophe for the US, as the US would have nobody to sell their Treasury bonds to. The pundits also seem to think that China (FXI) would come out of such a situation just fine. After all, they could just purchase euro- or yen-denominated bonds, right? Or perhaps they could just monetize their export earnings forcing exporters to repatriate their dollars and buy Yuan?

Such fantasies betray a profound level of misunderstanding about the nature of the China US economic relationship.

What If?

Let us ask a different question: What would happen if, for whatever reason, the US stopped buying Chinese goods to the point where the trade deficit disappeared?

This might happen for one of many reasons, and you can take your pick:

1. Severe US economic contraction. Due to the high marginal propensity to import, the volume of Chinese imports declines disproportionately to the contraction in aggregate demand in the US.

2. Trade protectionism. Trade is balanced through policy measures specifically designed to "manage" the trade balance.

3. Yuan appreciation/US dollar depreciation. This could occur either because the US forces China to end its "currency manipulation" or because market forces force the issue.

Note that in effect, the fantasy about the Chinese refusing to buy US Treasuries would force a severe economic contraction in scenario number 1, either by way of contracting US government spending or rising interest rates. It would also likely involve scenario number 3 and perhaps generate a backlash resulting in scenario number 2.

Thus, asking the question, "what happens if the US stopped buying Chinese goods," is for all intents and purposes identical with the question, "what happens if the Chinese stopped buying US bonds."
No positions in stocks mentioned.

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