China & US Dollar: Marriage of Economics

Since the time Jim ‘O Neal of Goldman Sachs coined the term BRIC in early 2000, the topic of BRIC nations, especially China, taking over the economic & political leadership of the World away from the United States has always been the hot topic. Add to that the Great Recession of 2007 and you have, media hired top economists, concluding that the sun has already set on the US Empire.

Not so quickly, my friends.

Although my cranium might not have the best of economics brain, but I do know that US hegemony is far away from witnessing any sun set.

Let’s focus on the most highlighted of the US problems, the future of the mighty US Dollar.  America has a deficit of around 10% of GDP and a total debt of around 70% of GDP and that was one of the reasons why Standard & Poor’s issued warning against US debt. But then what happened: the day that S&P raised its now famous warning, the markets decided to lower America's borrowing costs, and the dollar rose against its principal alternative, the Euro. Around the world, people, countries and companies are looking for safe, liquid investments. And the market's judgment is that the safest such investment is the US debt. There is a reason why 60% of the world trade still has US dollar as the medium of exchange, why most of the nations have US dollar as the reserve currency.
             We are all familiar with the $11trillion U.S. debt. It's been discussed all over the media, world over and yet during last three years America's borrowing costs have fallen. Markets are still willing to lend Washington more money at astonishingly low rates. The cost of servicing America's debt today is actually lower than it was in 1998, at the height of the Clinton boom. Of course, markets can change their stance, but for that to happen there has to be a more attractive alternative to U.S. debt.

Since there is a scare in the media over China dumping US dollar, I will take China’s example. As of March China had US$3.1 trillion in reserve and over $2t in US debt. Since last six years its reserves are growing at a rate of around $250-$275 billion a year. They need to invest hundreds of billions of dollars every year in some big, secure and liquid market.

Some popular options:

European Debt: Euro market is almost as large as US debt market but the recent scare of default by PIIGS nations doesn’t help the cause. In fact it’s fair to ask, Will the Euro in its current form will even be around 10 years from now?

Japanese Debt: China could invest in Japan, but it has the worst balance sheet of the major countries with debt at 200% of GDP, slow growth and a rapidly aging population. Also, China still hasn’t forgiven Japan for World War II and is not likely to do anything to shore up the yen as a global currency.

Tangible Assets: China can invest in real assets like mineral mines & oil fields but they are illiquid and even if they bought dozens of them, they would still have tens of billions of dollars left over to put somewhere.

China Debt: They could invest in there own debt but that would drive up the value of Reminbi (Yuan) and make exports more expensive, which would mean fewer jobs at local manufacturing companies.

In short, China is buying US debt not out of any love for America but for good, practical economic reasons.