How will the Rising U.S. Deficit Impact China?

The U.S. government’s 2010 deficit will reach as high as $1.56 trillion, following on the heels of last year’s $1.42 trillion deficit and once again marking a record high since the start of the war.

By September 2009, 61.65 percent of the world’s foreign reserves were held in U.S. dollars. The unique international position of the U.S. dollar means that the high American deficit will have an effect on the interests of nearly every nation in the world. At present, Obama has decided he must gamble with the economy in order to handle the massive expenditures required for America’s overseas military bases, other military expenses, health care reform and double-digit unemployment. Increasing the budget deficit in situations like this is a technique that has been used by all previous U.S. administrations and Obama is no exception. But when they use a high budget deficit to develop their own country, resolve their own domestic problems and support their own soaring military expenditures, they are actually using the wealth of the world’s other nations to line America’s pockets and to increase America’s fortune. In essence, this is a way of plundering other nations.

Why is the U.S. reluctant to raise interest rates? It is because it is not to America’s advantage to raise interest rates right now. In the wake of the financial crisis, Obama has used the stabilization of the international economy as a reason to require other countries to consume more, invest more and export less to America, while America will increase its exports, using exports as an engine to drive the economy. At the same time, the U.S. trade deficit is huge, and overseas holders of American assets are numerous. Regardless of whether you look at it from the perspective of national economic development or overseas debt, whether you take a long-term or short-term view, the devaluation of the dollar aligns with America’s interests. So why would America be in any hurry to raise interest rates? The U.S. can rest easy knowing that their outrageously high deficit will solve their national problems.

The impact of America’s high deficit is greatest on China. There are three principal aspects to this: First, a high deficit will bring about the devaluation of the dollar, which will inevitably harm China the most since China is the largest holder of American foreign exchange reserves. The most recent data shows that at the end of 2009 the China’s foreign reserves balance reached $2.3992 trillion, the majority of which consisted of U.S. assets, these [foreign reserves] no doubt being most likely to suffer as a consequence of the devaluation of the dollar, triggered by America’s sky-high deficit.

Second, as the deficit drives the value of the dollar down, the declining dollar will inevitably cause the value of the large quantity of U.S. debt held by China to shrink. At of the end of November 2009, China held a total of $789.6 billion of America’s national debt, making it still the largest overseas holder of U.S. national debt. In addition, China buys other American stocks and bonds in great quantities.

Lastly, as the deficit drives the value of the dollar down, the devalued dollar will raise the relative value of the RMB, which will have a significant impact on Chinese exports, worsening the downturn already experienced by China as a result of the financial crisis. This in turn will impact China’s economic growth.

The persistent devaluation and turmoil of American currency has already challenged its international position so that the share of global reserve currency held in U.S. dollars has been in decline. China should follow this trend. The recovery of the American economy will be a comparatively long process; the American deficit and the devaluation of the dollar will continue. For this reason, China should progressively reduce and withdraw from holding American national debt and other assets. The risk that the RMB will appreciate as the dollar drops in value will require China to preserve the stability of the exchange rate, adopting a cautious strategy towards raising interest rates, such that interest rates will only be raised as a last resort.