Sunday, January 30, 2011

Guess Hu's Coming To Dinner

The state visit by Chinese President Hu Jintao should be a wake up call to Americans. This is less a friendly visit by a world leader than a triumphant "coming out" party for a President who believes China is now the true world leader. This President believes that China has supplanted the United States as the world superpower and he is here to get his respect.
And get his respect he will. Expect the Obama administration to fawn over Hu Jintao as if he were Elvis come back to life. What choice do they have? As of October 2010, the Chinese held 907 billion dollars in US treasury bonds. These are long term investments and in order to take that risk, the Chinese have to hedge with short term Treasury bills. We need them to buy our Treasury bills or our make believe economy will implode with no way to paper over it or hide it. This is what I like to call the "800 pound Panda" in the room. Sure, we could find other bankers and have. There are sovereign wealth funds and other countries we can go to in an effort to feed our borrowing habit but none have the cash reserves that China has or have shown a willingness to participate in our national Ponzi scheme to the degree that China has. In simple terms, China has become our banker, our enabler and our master.
China is also our manufacturing center. Over the years, U.S. manufacturers have found it cheaper to have goods produced in China than in the States. This phenomenon has been fueled largely by the purposeful devaluation of the Chinese currency, the yuan. Keeping this currency undervalued makes Chinese exports cheaper and has resulted in the decimation of the U.S. manufacturing sector. The fact that China has virtually no environmental protections or regulations also contributes to their competitive advantage. If the value of the yuan remains low, Chinese exports will continue to enjoy a competitive advantage over the few remaining American made goods. This will lead to even more U.S. job losses. If the Chinese decide to properly value the yuan, the Chinese people would, in the blink of an eye, find themselves flush with cash which would fuel massive domestic consumption. If this were to happen, the U.S. would become their secondary market as their priorities would shift and they would market their products mainly to the 1.31 billion people who reside in China. In other words they would be self sustaining and would no longer need us to buy their products.
The proper valuation of the yuan would likely also result in inflation as the price of Chinese goods would soar. The blessing in disguise might be that more American companies would bring their manufacturing operations back home to the States as we got on a more even footing. The fear that the Chinese have is that if they revalue the yuan it would put not only the U.S. on a more level playing field, but also the rest of the world. This would undoubtedly result in some Chinese factories being idled along with civil unrest as their exports fell and workers were laid off. While we speak of "level playing fields" and "even footings" it is important to remember that we are not espousing Marxist philosophy. The value of the yuan has been purposely kept artificially low precisely to give them this unfair competitive advantage as well as to protect the value of the previously mentioned Treasury securities. Allowing the yuan to float on the currency markets could allow for a slower appreciation of the yuan which would soften the blow to the Chinese and also relieve some of the economic pressures here at home as our exports increased and more companies found it feasible to return their manufacturing operations to the U.S. The Obama administration may want to at least broach the subject of Chinese currency valuation with President Hu.
On the military front, the Chinese have made great strides in recent years. Gone are the days when their army drilled with wooden rifles. They are at present building a modern blue water navy to challenge our superiority in the Pacific and around the world. Once completed, they will be able to use their navy to project power throughout the hemisphere and beyond. Also, the Chinese Air Force has unveiled a new stealth fighter dubbed the J-20. While it could be years before the plane is integrated into the Air Force, the unveiling marks a turning point for China as they have made no efforts to hide the plane and actually test flew it during a recent visit by U.S. Defense Secretary Robert Gates. This massive military build-up should be looked at warily as it appears to be a sign that the Chinese have every intention of challenging U.S. superiority and power across the globe.
Increasingly we find ourselves in a position of weakness with regards to the Chinese. On the monetary, manufacturing and military fronts, we face tremendous challenges and there are no simple solutions. The Chinese are overtaking us at almost every turn and we have little leverage to apply. The Obama administration must walk a fine line with the Chinese. They must try to protect American interests and at the same time, while it's painful to say it, show the proper degree of respect and deference to our new master. While this weakened position is, hopefully, a temporary situation that we can overcome, we can no longer afford to ignore the "800 pound Panda" in the room.

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