Stumbling around the blogosphere I came across Angry Bear's post on China's new weapon (via Brad Setser's anaylsis of global reserves accumulation). Kash fantasises about a China holding the US foreign policy hostage to China's massive holdings of US securities. The same lead me to Kash's original post on China's real weapon. In it he speculates what would happen if China decided to dump, say, $100 bn of US government bonds on the market all at once? In fact, what would happen if China simply threatened to do so?...Is China’s influence over the US bond market similarly irrelevant, or is it actually a useful weapon? After weighing the pros and cons, the conclusion is this would impose enormous costs on the US, while imposing moderate costs on China. Read the comments for an even more amusing ride to the corner of Paranoia St and Stupidity Lane.

Kash outlines the likely effects on both countries and puts paid to the scenario even if he doesn't realise it. To summarise in the US:

1. Immediate rapid rise in interest rates and large falls in stocks.
2. Higher mortgage and consumer interest rates, bursting the real estate bubble.
3. Curtailed spending from households.
4. Cuts in business investment.
5. In sum, an immediate halt to US economic growth.

Funnily enough all those effects would also have the up-side of correcting many of the imbalances in the US economy. It would lead to a rapid change in the US trade balance, reducing the need for foreign purchases of US dollars and securities. It would obviously involve economic pain, but it is pain that is due to occur in the US sooner or later regardless, unless Alan Greenspan is able to defeat the laws of economics. The effects on China:

1. Massive capital losses on China's official reserves.
2. Need to buy back yuan sterilisation bonds i.e. a need to inject money into China's already inflation prone economy.
3. China's interest rates would rise with the US, although because credit is often allocated based on other reasons than price it may not be as big a factor. That, however, is rapidly changing as China's banks clear up balance sheets, crack down on corruption and move to a proper price/credit risk model. Mr Bear doesn't mention it but the devaluation of the dollar would automatically mean a depreciating yuan, at a time when many want it revalued.
4. The slowing of the US economy would hit China's exports and slow its economy.

The sum of all this: China would be hurting itself, but hurting the US more, so it would likely use this "weapon". The analysis ignores second order effects (global recession, potential help for the US from others, the higher proportion of China's GDP devoted to trading, knock-on effects on both China and US trading partners to name a few), plus the rapid end to China's massive foreign direct investment inflows that have been responsible for much of its current boom. It also ignores other countries that also hold large reserves such as India (Kashmir), Russia (Central Asia, Putin's moves away from democracy) and Taiwan to name a few. What the post demonstrates is an increasingly common but worrying trend in America - paranoia about China. Many Americans cannot understand China so they are choosing to react in the easiest way: by fearing it.

This is effectively the economic equivalent of nuclear war. It is, especially in the case of the USA and China, a case of mutually assured destruction. What Kash and others seem to miss is how crucial the current system is to China's well-being. China still has 800 million peasants who have barely felt the economic growth that has so benefitted the city dwellers. China's per capita GDP is 1/30th of the United States. Additionally none of the potential issues on the table between US and China are insolvable or even worthy of this nuclear option. That includes Taiwan. And China's leadership are particularly keen to make sure their legacy is a more prosperous China, not the starters of the world's second Great Depression with disppoportionate effects on its population. Finally the analysis assumes China wouldn't mind taking a massive hit on their portfolio and the destablisation of their financial system because of the geopolitical benefits of getting their own way. The Chinese are many things, but they aren't stupid.

This isn't to say the underlying economic problems don't exist. Quite to the contrary. My issue is the focus on China. Japan is an even larger holder of US dollar reserves. As pointed out above several other nations with geopolitical points of difference with the US are also large reserve holders. The sustainability (or lack thereof) of the world's current economic system is for another time. But this scenario, singling out China as the bogey-bear, is far-fetched. It reminds me of the kind of Japan-bashing that was so popular in the 80s, where Japan was destined to rule the world economically. It assumes China weighs the costs and benefits and decides it comes out slightly ahead, so it would go ahead. But the costs to China are far more long term and long range than this analysis gives credit.

China (and others) are lenders to an America that is spending more than it earns. China holds a reasonably large percentage of American debts. But would Japan, Russia and others stand idly by while China decimated their holdings of American debt to further its geopolitical aims?

One of the commenters at Angry Bear said it best:

I don't think China has any great animus towards the US. There is no reason to believe that they do. No great admiration, either. Rather, they are completely indifferent towards the US. They don't care if the US rises or falls. So they have no "long range plans" wrt. the US. They'll play it as it develops. If they have a plan it is concerned chiefly their own long range goals. But they really don't care, one way or the other.

This indifference is very hard for many US citizens to get. The US Is NUMBER # 1...so when someone else merely looks at the US as a fixture of the landscape--something to mate with, run away from, or eat--they just don't understand. "They" must hate us, or love us, and act accordingly.

Well, the Chinese (and the Russians, and the Europeans, and so on) don't.