The Hyper-Power's Hyper-Borrowings

NEW HAVEN: The United States has emerged as the planet's only superpower and the world's largest debtornation. Many of the countries that are funding the US debt don't like a lot of what Washington does, but it isunlikely that they would pull the credit rug from under the feet of Uncle Sam. The reason: in an unstableworld, they need a strong America - and its vast market.

With a stock market bubble behind it and a housing bubble that could pop anytime, the last thing the USneeds are sharply higher interest rates. That's exactly the punishment China and Japan are in position toadminister, if they ever decide to start dumping their vast storehouses of US government debt, which wouldforce the US to raise interest rates.

But chances are that they won't. Japan is a strategic ally and is less of a worry because it has nofundamental strategic differences with the US. America also has no reason to fear that to push China on thecritical issue of getting North Korea to behave itself would lead Beijing to crash the US government bondmarket.

According to the International Monetary Fund, China's Gross Domestic Product (GDP) in 2002 was worth $1.2trillion, less than 4 percent of the world's total output. Add Japan, and the two were responsible for 16percent of world GDP. Yet by mid-year this year, China and Japan alone had some $900 billion in foreignexchange reserves, or about a third of the world's total. Much of those reserves were tied up in US governmentdebt, as well as the debt of quasi-government housing financiers Fannie Mae and Freddie Mac. Substantial saleswould have thrown US finance into crisis, hence Asia's considerable leverage over America.

Here's how America got itself into this: as the US imports far more in goods and services than it exports,it needs someone to step in a lend it the money to keep spending on imported cars, Italian marble for monsterhouses, and lots of the stuff you see on the shelves at SEARS or Wal-Mart. As it turns out, two of the biggestbankers for the world's uni-polar superpower are a couple of middle military powers, Japan and China. Giventheir huge trade and payment surpluses with the US, their currencies should have risen sharply against thedollar this year. Instead, Japan's yen has appreciated only slightly, and the Chinese yuan has remained rocksteady, given its formal fixing to the dollar. With all the dollars they earn, China and Japan have bought USTreasury debt in huge amounts, becoming bankers to the world's biggest military power. By this summer,holdings by the Federal Reserve of paper on behalf of foreign governments have soared from some $600 billionin July of last year to $750 billion. Asia is mostly responsible for that increase.

Washington would love it if Asian countries let their currencies strengthen against the dollar (by buyingfewer Treasury bonds, but not dumping the bonds in one great heap). A weaker dollar would make it easier forthe US to export things to Asia, and would also take some of the pressure off the poor euro. With Japan andChina refusing to let their currencies rise much against the dollar, anyone who doesn't like the dollar'sprospects piles into the euro, which explains that currency's smart rise of late. Too strong a euro wouldbring on recession in Europe, and nobody really wants that.

There's also a security implication to the China-US financial relationship. Washington's relatively softapproach on North Korea - a member of the "Axis of Evil"- is often attributed to Pyongyang's nuclearweapons capability. But there's another reason, too. China is the one country that can really hold Kim JongIl's feet to the fire, but it doesn't always rush to Washington's aid on this score. International Strategyand Investment, a Washington-based newsletter, cast North Korea's role in the Beijing-Washington calculationsthis way: "The US has leverage because China needs our markets, and China has leverage because the USneeds China's dollar support."

That's true, but fortunately for the US, China's need is greater. With some of the world's sickest banksand rapidly rising unemployment, the last thing China would want to do is cause a world-wide recession,hitting its main export market especially hard.

Follow the money. China grows only by export-oriented investment. It actually loses money when it lends tothe US, because US bonds pay lower interest than China receives when it lends on the international bondmarket. But that's a small price to pay. China's leadership is petrified of a stronger currency and thenegative effect that could have on foreign investment, not to mention the social unrest that could follow.

China seems like an economic powerhouse sometimes, but remember: a full 50 percent of China's exports in2001 came from foreign-invested enterprises, according to the OECD. That's up from a figure of just 17 percentten years earlier. While foreign-invested companies ran a trade deficit of $18 billion in 1994, that's nowturned around to a trade surplus, bringing China a net $7.3 billion surplus in 2001. Take away foreigninvestment in China, and Beijing has a gigantic problem. For all the money they bring in, foreign companiesemploy just 1.5 percent of the total workforce. China's Maoist loss-making state industries still employ 38percent of volatile urban workers, according to OECD figures. Those workers (who are no different from workerselsewhere in that they're prone to unrest when they can't earn money), need more foreign-funded jobs, notfewer.

None of this means the US can go on holding the most financially irresponsible party it's ever put on. Inthe words of Fred Bergsten, of the Institute for International Economics, "to finance both the currentaccount deficit and our own sizable capital exports, the United States must import about $1 trillion offoreign capital every year, or more than $4 billion every working day. The situation is clearlyunsustainable."

Still, the leveling off won't happen after a sudden abandonment by Asia of the US capital markets and aplunge in the dollar. China will eventually strengthen its fixed currency from 8.3 to the dollar to somewherearound 6 to the dollar and life will go on. In the meantime, the US can push Beijing as hard as it can to helpon North Korea. There will be little real pushing back.