This is part 4 of a continuing series on the strategic and financial relationship between China and the United States: how it came to be, how it works, and where it’s going. You can read part 1 here and part 2 here, and part 3 here.
In the previous installment of my series on the role of big American capital in the development of China, we left off in the 1990s, when big American corporations were finally starting to reap profits from doing business in China by integrating Chinese labor into their supply chains, or by supplying goods and services to China’s growing economy. At that time, China’s economy was growing fast and there was a lot of money to be made if you could get at it, but it was still a poor country with a relatively small economy. In 1997, the year that JP Morgan Chase first underwrote a Chinese government debt issuance, GDP was still under $1 trillion. That meant that GDP per capita amounted to a paltry $774, or about $2 per day.
Even though China was growing at an astonishing rate of over 10% per year, American’s didn’t yet feel that China could become a strategic rival. After all, how could a country so poor that most people lived on $2 per day be a threat? That began to change in the 2000s. After just a few more years of that record-breaking economic growth, important, smart people like Professors John Mearshimer and Ken Waltz started to say China was a threat. They said stuff like “The rise of China will not be peaceful at all” and talked about China’s eventual replacement of the United States as the leading power on the planet. The idea of China as a rival to the United States, set to overthrow global American hegemony any day now, has become something of a meme. Based Donald talks about it all the time. In the 2012 remake of Red Dawn, China even replaced the Soviet Union for the role of bad guys invading America, until pressure from the Chinese government forced MGM to change the script and make North Korea the villains. If the ability to muscle Hollywood isn’t proof that China is out to get us and has too much power, what is?
But, dear reader, remember that earlier in this series we learned that the industrial and financial elite of America were a big part of China’s development. Even before the Second World War, they had hoped and worked for a more prosperous China. They advocated for it behind the scenes during the Cold War and they even paid for a big chunk of it after Deng Xiaopeng’s opening in the 1980s. Do you really think that they would do all that, just to watch China replace them as rulers of the world? Of course not.
What most people don’t realize is that America and China are not rivals, but partners. In fact, China and the United States have been partners in a big financial scheme for about 15 years. If they didn’t work together this scheme couldn’t exist. It’s an immensely profitable arrangement for both countries. They have to get along. If you don’t understand this scheme, you don’t really understand how the global economy works. I’ll explain it.
Loaning to Your Best Customer
The scheme started with the Rockefeller-led surge of American foreign direct investment in China during the 1980s and 1990s, chronicled in Part 3. As barriers to trade between China and the US came down, international capital investment increased China’s manufacturing capacity. The goods that China manufactured were exported, mainly to the United States. Thus, beginning in about 1985, China began to run a trade surplus with the United States, meaning China sold more to the United States than it bought from the United States. As more and more American corporations (and corporations from other countries too) began manufacturing in China to take advantage of the low labor costs and the lack of pesky regulations there, the amount of goods that China exported to the United States and the rest of the world grew and grew.
The Chinese exporters were paid in dollars, but you can’t use dollars in China, so the People’s Bank of China, China’s central bank, took these dollars and exchanged them for yuan. Because China was selling so much more than it was buying, the PBOC quickly built up a stack of billions of dollars that it didn’t know what to do with. That sounds pretty good to me, but it’s actually a problem: if you’re sitting on a bunch of liquid cash, you don’t want to just let it sit there. Inflation and exchange rate fluctuations will eat away at its value, and you’re sacrificing the returns you could be getting if you invested it. You gotta put that cash to work. So the Chinese government decided to buy a safe, conservative asset with a guaranteed return: US Treasury bonds, the gold standard of debt.
Beginning in the early 1990s, the PBOC began regular purchases of billions of dollars of US Treasury bonds. Today the total Chinese holdings of US Treasury securities stands at $1.2 trillion. This is why people say that “China owns America’s debt”. Actually, China owned about 8-10% of the total outstanding debt of the US government, at max, back in 2013. Regardless, it’s no secret that China is one of the major creditors of the United States government.
Now, here’s the key part–the part that makes it a such a brilliant scheme. If the US government borrows all that money from China, it must spend it on something. Mostly, it finds its way back into the American economy, and ends up in the pockets and bank accounts of American workers and firms. Those workers and firms then turn around and spend the money they earned from the government on all sorts of things–including goods from China. So it goes like this: Americans purchase Chinese goods–Chinese get American dollars–Chinese loan dollars to the United States–Americans use those dollars to purchase Chinese goods. Isn’t that nifty? When we look at the US trade deficit and Chinese debt holdings as one single balance sheet, everything makes sense.
For years, this arrangement worked to the advantage of both parties. The Chinese got to develop their industrial base, become a world leader in manufacturing, and stockpile trillions of dollars in low-risk securities. The United States got to buy tons of consumer goods at low prices, and the government got access to a new line of credit which kept borrowing costs down, even as it racked up bigger yearly budget deficits than ever before.
The big Trans-Pacific balance sheet grew and grew throughout the 1990s and 2000s. China grew its production, and America grew its consumption. Together, the United States and China formed a piston powering the engine of global economic growth. During the years when the big balance sheet effect was in its prime from 2000-2010, the entire global economy grew from about $33 trillion to about $52 trillion, according to the World Bank. The US and China’s combined domestic growth accounted for about $6 trillion of that alone. Global knock-on effects of their growth accounted for another large chunk of the total global growth during that decade (for example, remember all the commodity-driven emerging markets that saw explosive growth during the 2000s as they fed China’s hunger for raw materials?).
All Good Things Come to an End
This system worked fine for many years. But beginning around 2007, some problems started to appear. You might remember that in 2007 all those subprime home loans started to go bad in the United States, and by 2008 one of the world’s largest banks had imploded into a million pieces. We were on the verge of going full Mad Max. With the American economy in a shambles, it could no longer be counted on to reliably consume ever larger amounts of cheap plastic crap from China. Even worse–the Federal Reserve started helicopter-dumping gajillions of dollars into every major financial institution by purchasing any kind of securities the banks owned with printed cash, to save the banks from their own bad investments.
This drove down the value of the dollar and pushed down the interest rate China could earn on new purchases of US government debt. Why pay a higher rate to Chinese creditors, when the Treasury Department could just get loans from the Fed at almost 0% interest, guaranteed? Suddenly, it no longer made sense for China to reinvest its trade surplus back into American government debt. And another, bigger problem now presented itself: if America wasn’t going to buy ever-larger amounts of cheap manufactured products anymore, how could China keep growing its economy?
The Chinese government decided that the answer to that question lay with a policy of encouraging domestic investment in real-estate and infrastructure projects. They went all out. In 2008, the Communist Party announced a $586 billion package of investments in infrastructure and housing, to make up for the shortfall in growth caused by the collapse in exports. In the conclusion of our saga, Part V, we’ll finish this story with a look at the present state of China’s economy and find out if the infrastructure and real estate plan worked out for them (SPOILER ALERT: It didn’t. Now they’ve got even bigger problems). With the crisis of 2008 and the beginning of quantitative easing, the Trans-Pacific balance sheet, that once great piston of the global economy, started to slowly die. Today, the piston effect has ended and both the United States and China are struggling to make their economies work in its absence, lurching from one wild and crazy macroeconomic policy to another. In Part V, we’ll see just how much trouble they’ve gotten themselves into.