Still Not Time to 'Sell Off' America

The U.S. vice president recently visited Beijing and assured China’s vice president, Xi Jingping, that the U.S. will not default, the national debt is definitely safe and that “no one has ever made money betting against America.”

At the same time, Xi responded that the U.S. economy has tenacity and the ability to repair itself; he believes that the U.S. economy will have better development.

While the U.S. credit rating has just been downgraded and negative economic figures are surfacing one by one, how can Biden be so confident? When the U.S. credit rating got downgraded, China’s state media criticized the U.S. for contracting “debt addiction,” yet why are the top leaders of the country singing the same tune as the U.S.?

Recent European and North American debt issues have caused turmoil in the financial market. The diplomatic language used by Biden and Xi is, to a large extent, meant to encourage market confidence. During the meeting, Xi emphasized that “confidence is more precious than gold.” If Europe and North America are unable to overcome current economic difficulties, Chinese-owned U.S. and European currencies would depreciate and China’s exports would also shrink. European and U.S. economic problems would become China’s problem.

Other than a show of confidence, Biden’s remarks also reflects that post-World War II, the U.S. led the global financial system. Despite repeated setbacks and crises, that leadership is still hard to shake.

Within this U.S. dominated structure, many export-oriented economies, including China, have linked their currencies to the U.S. and use the U.S. dollar as reserve currency. These economies are highly reliant on the U.S. market. To improve export competitiveness, they depreciate their currencies and use foreign currencies gained from trade surpluses and foreign direct investments to purchase U.S. debts or U.S. dollar assets. Foreign currency reserves’ original intention is to deal with trade imbalances or the impact of capital outflows, but the inertia of such foreign exchange hedging and the lack of better choices have caused U.S. dollar reserves in these countries to soar.

The U.S. has invested a large amount of U.S. dollars internationally in order to satisfy international requirements for currency reserves. However this has also caused U.S. over-consumption, leading to both current account deficits (mainly trade deficit) and budget deficits. Large twin deficits require large net capital inflow and issuing bonds is an effective tool for the U.S. to attract capital inflow. At the same time, countries that enjoy trade surpluses are buyers of U.S. bonds. China currently holds $1.16 trillion in U.S. debt.

Another method to resolve the trade deficit is to force countries with trade surpluses to appreciate their currencies, which is to say, allow the depreciation of the U.S. dollar. In September 1985, finance ministers and heads of central banks from the U.S., Japan, the U.K., France, and Germany signed an agreement in New York’s Plaza Hotel to jointly intervene in the foreign exchange market to allow the appreciation of the yen and the mark. The Plaza Agreement led the Japanese economy into the so-called “lost decade.”

Today, the U.S. has shifted its focus towards the RMB. In his visit to China, Biden staged noodle diplomacy: He, along with an entourage of five others, had noodles in a small eatery, spent only 79 RMB and tipped 21 RMB. China’s netizens pointed out that Biden’s action hinted that the RMB should appreciate faster. The U.S. continuously pressures China to allow RMB appreciation but Beijing is worried about the trap of the lost decade. Both parties continue to play this game. However, China is currently facing the issue of inflation and an asset price bubble. Appreciation of the RMB is unavoidable; the question is more about speed and magnitude.

Biden sincerely pledged that the U.S. will not default. This is because countries issuing reserve currencies have the special power to print money. Thus, the problem is not a U.S. default but the purchasing power of the U.S. dollar. China understands the risks to debtors posed by dual U.S. deficits and, following the 2008 financial crisis, has begun to study the issue of diversification of foreign currency reserve and also to look into reserve currencies other than the U.S. dollar.

However, it is a long process to shake off the hegemony of the U.S. dollar. The Euro was once an attractive alternative reserve currency, but the debt problem in the Euro zone is threatening its position. On the other hand, China’s head of central bank, Zhou Xiaochuan, suggested in 2009 that the IMF’s Special Drawing Rights (SDR) establish a super-sovereign reserve currency. But in a later report, the IMF pointed out that the realization of this idea will be a long-term process and includes a large magnitude increase in the allocation of SDRs and the need to overcome the obstacles posed by countries that currently have reserve currency issuing rights.

Zhou’s suggestion seems to have been shelved. China’s current strategy is to internationalize the RMB, to broaden its use, and to gradually develop it into a reserve currency. However, there is a process from the internationalizing of the RMB to the RMB becoming a reserve currency. China’s former head of the central bank, Dai Xianglong, recently estimated that this could require 15 to 20 years.

Despite the weakness of the U.S. economy, the strong growth of the Chinese economy, U.S. GDP is still $14 trillion, more than double of China’s GDP of $6 trillion. There is still a large gap between the two. Also, Bidden stressed, the U.S. has top-notch universities, highly productive labor and highly creative companies and entrepreneurs. This echoes what Xi said about the America’s ability to repair itself.

China’s reform and opening up in the past 30 plus years are export driven. This has led it to enter into an international financial system dominated by the U.S. dollar and it is now required to dance with U.S. monetary policy. To shake off this system would require a huge price and painful adjustments. China is not yet able to do so. In addition, the creativity and business vitality of the U.S. financial sector cannot be ignored.

Right now is not yet the time to sing the tune of selling off the U.S.