James Fallows on China's $1.58 trillion dollar question

As someone to whom the whole currency issue has always been somewhat obscure, I can't recommend enough James Fallows' latest article in The Atlantic. In his article, Fallows shows that the biggest question in US-China relations is not that of getting China to adjust the value of its currency, but that of China's ever growing dollar reserves (now valued at 1.58 trillion US dollars) and the use to which they are put.

Quite simply, it seems strange in the extreme for a country which has difficulty in feeding and clothing its own people to be investing more than a billion US dollars per day in the United States. The money for these investments is skimmed from the profits made by exporters to the United States and other countries that deal in dollars by forcing the banks in which US dollars are exchanged for RMB to sell the dollars made from such exchanges to the central bank. This money is then invested in various US assets, creating a cycle whereby dollars paid for Chinese imports are shipped back to the US to be invested in American treasury bonds, shares in US companies etc.

Trade deficit wingnuts should take note: far from representing a great transfer of wealth across the Pacific to China which will somehow eventually leave the US bankrupt, trade with China creates a cycle whereby Chinese buy an ever-growing stake in the US economy with the very money that people in the US pay for those cheap Chinese imports. Running a trade deficit with another country cannot result in the country becoming bankrupt as it is impossible for a country to go bankrupt (foreigners require payment for the goods they export to the US, I guess they're funny like that), but it is possible for a large part of that country to become subject to at least a modicum of foreign control.

However, the day is fast approaching when people in China will realise that they are seeing only part of the money made from exports and will demand a greater share, or at least that not so much money is invested in country which the majority of Chinese people view with the darkest suspicion. Of course, there are sound economic reasons for the government to want to keep this money out of the Chinese economy, avoiding run-away inflation perhaps being the most important, but the pressure to diversify away from a weakening dollar may not long be resisted. In fact, as Fallows seems to note, there is a definite danger that both countries may loose out by delaying too long in re-adjusting their relationship: China in that it will become impossible to diversify away from the US without overly harming its investment there, the US in that as this cycle continues an increasing stake in the country's future will pass out of its hands. In fact a growing wariness on the part of the Chinese towards increasing their exposure to the US market is beginning to assert itself, as a recent piece on the Chinapolitics blog shows, money quote:

Well, well, just months after the completion of Citibank's acquisition of Guangdong Development Bank, the table has turned, and Citi is going to the Chinese begging for money. Once again, the State Council squashed the deal, further confirming our suspicion that deals above 1 billion USD (and possibly less) needs State Council approval. Well, are we surprised? No, not really. The reason is many. The most important perhaps is that Wen realized that such an acquisition would expose China too much to the badly damaged US financial sector.