As America's Banker, China Holds Considerable Sway - But It's a Two-Way Street

As the biggest creditor of a country with a projected 2011 budget deficit of $1.5 trillion, China surely has considerable influence over U.S. monetary and fiscal policy.

Now, China is using that leverage to pressure American policymakers to get their fiscal house in order, prevent the dollar from tumbling, and is even calling on officials to expedite key investments.

Some worry an agitated China could dump its $900 billion holdings of Treasurys or cut back on buying long-term U.S. bonds if it doesn’t get its way, cratering an American economy reliant on using China as its personal banker.

But the world’s two largest economies have a codependent relationship in a global financial system that is still ruled by the greenback, giving America much more leverage on the Asian giant than many realize.

“There’s no doubt China is in a very powerful position. What people miss is this is a two-way street,” said Jim Rickards, senior managing director for market intelligence at Omnis. “If you’re asking whether China can do financial damage to the United States, the answer is yes. But the United States can do just as much, if not more, to China."

China, which last year passed Japan as the world’s second largest economy, has not been shy in exerting its newfound financial weight.

After stocking up on a record $199 billion of foreign exchange reserves in the final quarter of 2010, China owned $2.85 trillion in reserves as of the end of 2010, much of which is denominated in U.S. dollars.

Concerned the Federal Reserve’s $600 billion bond-buying program, dubbed “QE2,” will devalue its dollar holdings, Chinese officials have pressed Fed chief Ben Bernanke to not lower the value of the greenback.

In March 2009, Chinese Premier Wen Jiabao publicly said he was “concerned” about the security of China’s holdings in Treasuries, which as of November stood at $895.6 billion. Treasury Secretary Tim Geithner and other U.S. officials have visited China in an effort to soothe those worries.

In another possible sign of growing Chinese influence, the U.S. gave the green light in 2009 to a $1.2 billion investment in Morgan Stanley (NYSE:MS) by CIC, China’s $200 billion sovereign wealth fund, just a day after the fund’s chairman asked Geithner to expedite the process, Reuters reported, citing WikiLeaks cables.

It’s not clear how Geithner responded to the request, Reuters reported, and experts said it’s unlikely Geithner could have just approved the deal on his own. More likely, he was trying to ease concerns the U.S. isn’t open to investments from China, which has been blocked from key deals for national security reasons in the past. Still, the cables show China isn’t shy about flexing its financial muscles.

“Everyone in the [U.S. government] has their China spidey sense tingling. They are nervous about things,” said Charles Freeman, chair of China studies at the Center for Strategic and International Studies.

There may be a good reason for the jitters. Not only is China sitting on a mountain of cash, its economy continues to accelerate, surging 9.8% last quarter despite serious efforts to cool it. That compares to a Fed-juiced 2.8% rise in gross domestic product in the U.S., which is projected to have a $1.5 trillion deficit in 2011.

“Economically there has been a huge shift in the balance of power from the Western world to Asia,” said Marc Faber, author of the closely-watched Gloom, Boom and Doom report.

Another  key area where China holds leverage over the U.S. and other rivals in is its virtual monopoly of rare earth minerals used in a wide range of sophisticated electronics, from mobile devices to smart bombs.

According to The Wall Street Journal, China, which controls 95% of the world’s current production of rare earth minerals, is building strategic reserves of the resources.

If China cuts off access to these metals “it would be a devastating blow,” said Faber.

Mutually Assured Destruction, on an Economic Scale

However, Faber believes China’s sway over the U.S. has been somewhat overblown, saying “they have influence, but it’s limited.”

The fact the U.S. is on the hook for as much as it is with China isn’t necessarily a positive for the Asian giant.

As Freeman notes, the old axiom still stands: “If I owe you $1, I have a problem, but if I owe you $1 trillion, you have the problem,” said Freeman.

For starters, the Chinese need to make sure the U.S. protects its investment in Treasuries while still maintaining its recovery from the financial crisis that sent Western economies into a tailspin.

“The Chinese are scared to death that Bernanke or others through QE2 are going to destroy the value of their assets, which are mostly denominated in dollars,” said Freeman.

But that argument often looks hypocritical from China, which has prevented its yuan from rising as quickly as currencies in Southeast Asia or Latin American. China’s currency policies have been a huge boon to its economy, making its goods cheaper overseas than those sold by its rivals. U.S. officials and lawmakers have frequently pressed China to allow its currency to freely float.

At the same time, it’s often overlooked how much China still relies on the U.S. to buy its goods. In 2010, America was China’s top export destination, with the U.S. deficit with China reaching $273.1 billion.

The economic relationship between China and the U.S. is often compared with the Cold War theory of Mutually Assured Destruction. Just as the Soviet Union then knew it had the capability to wipe out much of the U.S. in a nuclear attack, it was also assured of the fact the U.S. could do the same.

“Could China threaten to dump its U.S. Treasurys and cause a super spike in interest rates that would sink the U.S. economy?” said Rickards. “Yes, but if they did, they would incur enormous losses in their own position.”

Of course, the U.S. has a number of defense mechanisms that could prevent the situation from ever getting to that point.

Rickards points to the International Emergency Economics Power Act, a little-known law that gives the president the power to seize accounts and freeze assets by executive order (without the consent of Congress) for national security reasons.

If it became known China was dumping U.S. Treasuries, IEEPA, which has been used countless times in the past, could be implemented to freeze the assets and prevent the sales, Rickards said.

Debt Woes Support Calls for Fiscal Reform 

Fears about China displacing the U.S. as the world’s economic superpower are nothing new. After all, there were similar concerns about the strength of Middle Eastern countries during oil crises in the 1970s and some jitters about Japan’s growth during the 1980s.

“Somehow the United States always comes out on top,” said Rickards. “That’s partly because the world is on a dollar system and we control that system… We have ways of stacking the game to make sure we come out the biggest winners.”

Still, the reliance on China as the U.S.’s personal banker stretches to historical levels.

According to Richard Sylla, a financial historian at NYU, “not since the early days of the country” when France helped fund the American Revolution and the Dutch helped finance that debt repayment has one country held such a dominant position over U.S. debt.

The concern in some corners about the leverage China could hold over America only supplements the argument for the U.S. to get its fiscal house in order, a process that recent protests in Wisconsin suggest will be a tall order.

“People may not like dealing with the fact entitlements are out of control, but that’s really what we have to [reform], particularly if we are worried about the Chinese as our bankers,” said Freeman.