The U.S. Debt Crisis and China's Countermeasures

By BAI MING

ON August 5, 2011, the international credit-rating agency Standard & Poor's (S&P) downgraded its U.S. long-term debt assessment from AAA to AA+ with a negative outlook. For the first time in its history the U.S. lost its prized AAA status, sending shock waves through the global financial markets.

To a large extent, the credit crisis has emerged from the U.S. government's bailout plan three years ago. It remains an open question if the plan will eventually subdue the financial asset bubbles, but it is indisputable that the U.S. government is now confronted with a rising risk of debt default. In fact the volume of U.S. treasury securities issued and those purchased by China has grown strongly in recent years, which would have been a problem even if the government had not raised its debt ceiling three years ago.

The Root of the U.S. Economic Problem

The U.S. is the largest economy in the world, but it has suffered a series of economic problems due to excessive consumption. Under the illusion created by the financial bubble domestic consumers have been spending prodigiously and recklessly, bolstering the American economy for a long time. But in recent years over-reliance on investment banks, hedge funds and financial derivatives has made the country lose direction in financial innovation. The disconnection between the financial industry and the real economy led to the subprime mortgage crash, which developed into the financial meltdown on Wall Street, and eventually a global crisis in 2008.

According to the International Monetary Fund (IMF), the value of worldwide financial assets rivalled global GDP in 1980, grew to more than twice global GDP in 1993, three times in 2003, and four in 2007. On the eve of the 2008 financial crisis, the nominal value of financial derivatives worldwide reached US $6.2 trillion, about ten times that of the real economy.

Unlike three years ago, the world's biggest concern today is debt. As early as November 2009, the Dubai government announced that its state-controlled Dubai World would delay payment of about US $60 billion of debt. The sum is just part of the nation's total liabilities, which some financial agencies put at US $80 billion, but EFG-Hermes, a leading investment bank in Middle East and North Africa, estimated to be around US $170 billion. The Dubai crisis was just a fuse. In 2010, excessive debt broke the backs of a number of European countries – first Greece, and then Spain, Portugal, Italy, Ireland and Iceland, and has now become a full-blown problem. Earlier this year both Moody and the S&P slashed Japan's rating. If the eurozone credit crunch spreads to Britain, France and Germany, a global crisis is around the corner.

Since the global financial crisis broke out, the U.S. government has implemented a series of measures fighting financial bubbles, but its reliance on excessive consumption has remained untouched. Americans are trying to wean themselves off risky financial derivatives, but they are still heavy consumers relying on the perceived strength of the U.S. dollar.

Since President Nixon took the U.S. dollar off Gold Standard in 1971, the currency's strength has largely been tied to the Federal Reserve's control on money supply. Since 2008, the U.S. has loosened its monetary policy to stimulate domestic economy. One method is keeping its interest rate between a meager zero and 0.25 percent to encourage borrowing. To do so, quantitative easing (QE) was put into affect. The first round of QE overdraft the dollar's credibility, but it was a reflexive measure and understandable given the situation.

The Fed carried out a second round of quantitative easing, called QE2, between the end of last year and June 30, 2011, and a third round is becoming increasingly likely. It looks like the U.S. government has become addicted to the policy.

The recent economic recovery is largely attributed to pushing the envelope of the dollar's credibility and the underlying risks cannot be ignored. The unfurling debt crisis shows that the approach is unsustainable, just as one cannot dig into one's credit account indefinitely.

We should note that there is a trade-off between the quantitative easing policy and the anticipated increase in consumption – the national debt. To stimulate the economy the U.S. government has taken on more debt, adding to what has already been a serious problem for a long time. The latest statistics released by the IMF showed that the U.S. national debt accounts for 99 percent of its GDP in 2011, and the ratio will increase to 103 percent next year.

China Should Take Action

The U.S. debt crisis puts a damper on economic growth worldwide, and increases uncertainties in international economic relationships. As the Democrats and Republicans have reached a temporary compromise about the debt ceiling, a default will not happen in the short term. The Fed is able to release liquidity into the market in a timelier manner than during the 2008 crisis. Besides, the G20 and the G7 countries have also come to a tacit agreement about responses to financial risks. The global economy is therefore unlikely to slip into a crisis as severe as the last one.

The U.S. might not see negative growth anytime soon, but stagnation is very probable. As most of the current measures are temporary solutions that don't address the root cause of the problems facing the nation, we will wait a long time to see any improvement in the world economy. After lowering its scores for long-term U.S. government debt, the S &P downgraded the credit ratings of Fannie Mae and Freddie Mac and other agencies linked to long-term U.S. debt. It also cut the ratings for farm lenders, long-term U.S. government-backed debt issued by 32 banks and credit unions and three major clearing houses, which are used to execute trades of stocks, bonds and options. All the downgrades were from the top rating of AAA to AA+. What's more, the S&P also indicated that it will not rule out downgrading the sovereign credit rating of the U.S. again.

The news gave the shudders to many people, including myself. At home the U.S. national debt is mainly held by pension funds and investment banks, while the largest foreign holder is China. So far, the U.S. treasury market is the most important channel for China's massive foreign exchange reserves. As an old Chinese saying goes, "A fire on the city gate brings disaster to the fish in the moat," and China will probably be the biggest fish affected by the U.S. debt crisis. The value of China's holdings in U.S. bonds is in danger of diminishing, even if rating agencies do not lower China's credit scores.

As the largest developing country and trading nation in the world, China will face a more worrying scenario for its exports if the U.S. and European debt crisis grows into another global financial crisis. In fact, Chinese export companies, mainly located in the Yangtze River and Pearl River deltas, were already in plight before the U.S. debt crisis. In recent years they have been struggling to get orders and surviving on meager profits, and some of them closed after seeing no hope of reversing heavy losses. In addition to falling international orders, Chinese manufacturers are also threatened with other problems such as rising raw material prices, dwindling labor supply, higher financing cost and tightened credit.

If the impact of the U.S. debt crisis shows up in the coming months as expected, Chinese exporters will feel more stress than in 2008, when they lost a large number of orders but won them back when the global economy recovered. Losing orders this time could be fatal, as they will flow to Vietnam, India, Indonesia, and other latecomers, and never come back. As the U.S. and Europe debt crisis is already underway, it is no longer the time for pre-emptive measures. Chinese manufacturers have to work out remedies to reduce their potential losses to the minimum.

However, the crisis is an ill wind that blows some good to the Chinese economy, especially regarding inflation. China's Consumer Price Index (CPI) in the first half of 2011 rose 5.4 percent over the corresponding period in 2010 and by 6.5 percent in July.

It appears that the CPI was directly pushed up by soaring pork prices, but imported factors also played a key role. Feed prices, for example, jumped due to rising international commodity prices. The U.S. credit rating downgrade has led to a fall in commodity prices, which lends external force to China's combat with inflation. Because of imported inflation its interest rate policy is ineffective and may even restrain economic growth. China should therefore slow down its deflation policy to avoid the possibility of economic stagnation and the serious consequences we saw in 2008.

A saying goes that if the U.S. sneezes, Europe catches a cold and Japan gets the flu. As China is integrating in the global economy, it should be fully prepared and learn how to adapt. In other words, when sharing the huge dividend of economic globalization, China must also accept the risks it brings with it.

For China, the direct effect of the U.S. debt crisis was short-lived, but the indirect effects are lasting. Through economic restructuring and reduction of reliance on low value-added and low-tech manufacturing and exports, China will be better positioned in international economic markets.

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BAI MING is research fellow and vice director of the International Market Research Division, Chinese Academy of International Trade and Economic Cooperation of the Ministry of Commerce.