Research Briefing

Sino-US relations
May 17, 2010 Economic deterrence & asymmetric vulnerability
— China may emerge as the world’s largest economy by 2025 and it may be
Economics & politics

twice the size of the US by 2050. However, China faces various actual
and potential challenges: increasing natural resource dependence and
rising geo-political competition with “status quo” powers, weakening
political legitimacy of current governance structures, environmental
degradation, political and economic limits to the current investment- and
export-oriented growth strategy.
— China’s increasing economic and financial weight, while very
significantly enhancing its role in international affairs, will not translate
into greater leverage vis-à-vis Washington for now.
— The Sino-US economic-financial relationship is best described as one of
“asymmetric interdependence” skewed in Washington’s favour. Both
sides have an interest in avoiding a broader economic conflict. However,
should push ever come to shove, China would incur far greater
economic and financial costs than the US.
— The balance of economic and financial power will only shift once China
reduces its dependence on the US market (or US dependence on the
Chinese market increases).

China vs. US – rising dragon, falling eagle?

According to a recent Pew poll, 41% of people believe that China is the world’s
leading economic power, tied in first place with the United States. More
revealingly, a recent Gallup poll showed that 44% of Americans believe that China
is the world’s greatest economic power (only 27% named the US). The fact that
the US was at the epicentre of the very global crisis that China appears to have
weathered largely unscathed is bound to have contributed to this perception.

Who's the world's leading economic power

% of respondents
Author
60
Markus Jaeger
+1 212 250-6971 48 2008
50
markus.jaeger@db.com 41 41 2009
Editor 40
Maria Laura Lanzeni
30
Technical Assistant 21
Bettina Giesel
20
Deutsche Bank Research 9
Frankfurt am Main 5 10
2 2
Germany
Internet: www.dbresearch.com 0
E-mail: marketing.dbr@db.com USA China Japan EU
Fax: +49 69 910-31877
Managing Director Source: Pew

Thomas Mayer
 Research Briefing

In reality, of course, China’s economy is merely 1/3 the size of the

China rising US economy (measured at market exchange rates), but, admittedly,
GDP, USD bn, PPP
20,000
2/3 measured at PPP exchange rates. While China is set to replace
Japan as the world’s second-largest economy this year, it will not
16,000
overtake the US before 2025. China did, however, replace Germany
12,000
as the world’s largest exporter last year and it is both the largest
8,000 holder of official FX reserves and the second-largest net
4,000 international creditor.
0
China’s economic and financial weight will continue to grow on the
Germany
China

US
Japan

back of continued strong economic growth and (net) foreign asset

accumulation. While enhancing its influence in international
economic affairs (including IFIs), it will not translate into significantly
1990 2000 2010 2015 greater bilateral leverage vis-à-vis Washington. This, despite the fact
that the US will be running ―super-sized‖ fiscal deficits for some time
Source: IMF 1
to come and that China – and primarily the Chinese government – is
the single largest holder of US government debt.
China is world's largest
exporter Remember “Japan as number one”?
USD tr, 2009F
1.6 It is very tempting to regard the global crisis as the event that
1.4
1.2 precipitated the decline of the US and the rise of China. The ―rise
1.0 and decline‖ school has gotten it spectacularly wrong before,
0.8
0.6 however. During the 1970s, especially following the Vietnam War
0.4 and during the economically challenging Carter years, the
0.2
0.0 ―declinists‖ – as incredibly as this may sound today – worried that
US economic stagnation would lose Washington the Cold War
France
China

Germany

Japan
US

against an increasingly assertive Soviet Union. It turned out that it

was the Soviet Union that was experiencing decline, leading to its
eventual economic collapse and political break-up a little more than
Exports Imports
a decade later.
Source: DB Research 2
During the 1980s, when the US was running record-high fiscal and
current account deficits, Japan was going to emerge as ―number
Increasing financial one‖, only to crash financially and burn economically before the
prowess
China, FX reserves, USD bn decade was over. It has experienced economic malaise ever since.
3,000 During the 1990s and early 2000s, the US, supposedly, ―re-
2,500 emerged‖ again as the most powerful economy with no serious
challengers on the horizon, despite attempts to cast a German-led
2,000
Europe and a possibly rebounding Japan as potential challengers.
1,500 Following the 2008 financial crisis, strengthened in their belief by
1,000 apparent US geo-political setbacks in Afghanistan and Iraq, the
500 ―declinists‖ are once more predicting US decline. This time, it is
0 China’s turn to rise and challenge US pre-eminence.
00 02 04 06 08 10 Dragon rising
Sources: IIF, DB Research 3 China does indeed look set to overtake the US in terms of economic
size. Not only has China weathered pretty much unscathed the very
Remember Japan crisis that has pushed the US economy ―off-course‖. But China has
Japan, real GDP growth, % been growing at an average annual rate of nearly 10% since the
8
beginning of economic reforms in the late 1970s. On current trends
6
and at PPP GDP, China will replace the US as the world’s largest
4
economy within the next decade. Chinese GDP measured at market
2 exchange rates should reach US levels by 2025 or so. Some well-
0 respected China analysts, like Bert Keidel, even forecast the
-2 Chinese economy potentially to be twice the size of the US by 2050.
-4
While Chinese growth may slow down from double-digit levels, the
-6
medium-term growth outlook appears solid. A low degree of
1980
1983
1986
1989
1992
1995
1998
2001
2004
2007
2010
2013

urbanization and a low per capita capital stock provide conditions

conducive to continued strong growth. When Japan slipped into
Source: IMF 4 crisis, it had already reached the ―technological frontier‖. The Soviet

2 May 17, 2010

Sino-US relations

economic model, based on ―extensive‖ rather than ―intensive‖

Impressive performance growth, was not sustainable, especially in the context of strong geo-
China, real GDP growth, %
16 political competition that forced Moscow to keep defence
14 expenditure at ultimately ruinous levels. By contrast, China is
12 generating both intensive and extensive growth. So if China
10 manages to avoid geo-political competition by way of a ―peaceful
8 rise‖, it is likely to enjoy continued solid growth for the foreseeable
6 future. This is the ―consensus China story‖ as seen through the eyes
4 of the ―extrapolators―.
2
0 Cautionary voices of the bears
1986
1980
1983

1989
1992
1995
1998
2001
2004
2007
2010
2013

The China bears, on the other hand, not only expect Chinese growth
rates to decline substantially. But they also see other, potentially
Source: IMF 5 dangerous speed bumps on China’s road to economic pre-
eminence. To stick with this metaphor, a speed bump can slow one
down; but if one hits it at top speed, it may throw one off-course, and
More urbanisation-driven may even land one in the ditch. These ―bumps‖ include, among
growth in the pipeline others, the following: increasing natural resource dependence and
Rural population, % of total
100 rising geo-political competition with ―status quo‖ powers (Friedberg),
80 a ―trapped (economic) transition‖ (Pei), a crisis of political legitimacy
60 potentially coinciding with political instability (MacFarquhar), political
40 and economic limits to investment-heavy and (supposedly) export-
20 oriented growth (Goldstein/Lardy).
0 One does not have to be a China bear to believe that the risks are
biased to the down- rather than the upside. But it is equally
2000
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995

2005
2010

important to recognise that a reasonable ―downside‖ scenario is

China Japan
This may be a little too
bullish
GDP, 2005 USD terms, tr
2005 2020 2040 2060 2080 2100
US
Source: Bert Keidel
Very dependent on
commodity imports
Net exports, % of GDP, 2008
BR CN IN RU DE JP US EU
Agro Fuels & mining
Manufactures Services
US
likely to mean 5-7% annual growth rather than economic stagnation.
China is unlikely to be thrown off-course in the way the Soviet and
Source: UN 6
Japanese economies were. Structurally speaking, China’s medium-
term growth potential is very significant. China is located far from the
technological frontier (unlike Japan in the 1980s). China’s
development model is also based on a relatively high degree of
500 economic openness and is hence much better suited to generate
400 total factor productivity growth than the economically closed Soviet
Union, which lacked access to advanced Western/global technology.
300
The Soviet and Japanese examples, nonetheless, suggest the need
200
to critically re-examine the economic and political sustainability of
100 China’s growth strategy given China’s rapid progression from low- to
0 middle-income economy. In Rumsfeldian parlance, China faces
quite a few ―known unknowns‖ and, one must assume, a non-
negligible number of ―unknown unknowns‖, though this can, of
China
course, not be known. History, in any event, would seem to counsel
7 some caution when it comes to simply extrapolating current trends a
decade or more out into the future.
China’s financial prowess & Sino-US relations
China’s increasing economic size will provide Beijing with greater
25
20 political, economic and financial influence. China is in a radically
15 different position from where it was a decade ago. Political,
10
5 economic and financial influence comes in many guises. But over
0 the medium-term, it requires a strong economy and a solid financial
-5
-10 position. On both scores, China compares favourably to the US.
-15 While China is the world’s second-largest net creditor (after Japan),
-20
-25 the US is the world’s largest debtor. While the US is running the
largest current account deficit, China is running the largest surplus.
Arguably this has thus far provided Beijing with little in terms of
bilateral influence. It may have made Washington more reluctant to
pursue a confrontational policy towards Beijing, but it does not
Source: IMF 8

May 17, 2010 3

 Research Briefing

provide Beijing with a lever of direct influence vis-a-vis Washington,

Who depends on whom? mainly because of the US’s reserve-currency country status and
Holdings of US government debt,
% of total debt outstanding* China’s dependence on the US as an export market.
18 China’s most direct lever of influence vis-a-vis the US is the threat to
16
14 sell off its estimated USD 880 bn worth of US treasury securities (as
12 of February) – and another USD 450 bn worth of agency debt (as of
10
8 June 2009). Such a move would be quite costly for Beijing, however.
6 First, economically and financially, China would shoot itself in the
4
2 proverbial foot. The value of its holdings would decline and higher
0 US interest rates would weigh on the US growth outlook, hurting
2000 2002 2004 2006 2008 Chinese exports. Furthermore, China would have to find other dollar
Japan China
assets to invest in, unless it is willing to accept RMB appreciation –
and too rapid a RMB appreciation is hardly in China’s interest in
*2009 data based on new benchmark survey.
terms of exports and dollar-denominated US debt holdings. If it does
Source: Treasury 9
re-invest in dollar-denominated assets, this would presumably help
ease financing conditions in other parts of the US economy,
Who depends on whom potentially offsetting the negative effect of higher rates in the
(cont'd)? treasury market. But these assets would be less liquid and carry
Chinese holdings of US l/t debt,
% of l/t securities outstanding higher credit risk. A Chinese threat to divest US debt may therefore
18 not be considered very credible by Washington.
15
12 Secondly, even if Beijing were to sell large holdings of US debt, it is
9 unclear how sizeable an impact this would have on US yields. In the
6
3 very short run, it might disrupt financial markets, but the medium-
0 term impact would likely be manageable, as other foreign (official)
2005 2006 2007 2008 2009 buyers would step in, albeit at higher interest rates (e.g. Japan, Gulf
Treasury countries). Last but not least, any politically motivated fire sale of US
Agency debt would trigger a very severe political backlash – and not just
Corporate & other debt from the US. A fire sale (as opposed to a gradual unwinding of
*Excludes short-term.
Source: TIC 10 holdings) would also undermine China’s standing as a reliable
financial investor and economic partner in the eyes of many other
Vastly different positions countries.
Current account, USD bn
1,000 Deterrence & asymmetric interdependence
800
600
Financially, economically and politically, Beijing would pay a high
400 price for pushing up US borrowing costs and, in all likelihood, a
200 much higher price than Washington would end up paying. First, the
0
-200 US has access to a more diversified investor base (with parts of
-400 which it maintains close political relations) than Beijing has markets
-600
-800 to invest in – at least as long as Beijing seeks to maintain a stable
-1,000 USD-RMB exchange rate. Second, in the short run, the US market
00 03 06 09 12 15 is also substantially more important to China in terms of both
exports and imports than vice versa (chart 12) – and the Chinese
China US
export sector is relatively more employment intensive! Last but not
Source: IMF 11 least, Beijing’s concern about maintaining near-double-digit growth
rates would diminish the credibility of any action that risks triggering
China is much more an outright economic conflict with the US, or a severe US economic
vulnerable slowdown on the back of financial instability.
Bilateral trade, % of GDP
7 In short, China’s holdings of US debt do not lend themselves as a
6 coercive instrument. They may act as a sort of limited deterrent.
5 Naturally, rising cross-border asset holdings and trade have
4 increased interdependence, raising the costs of economic conflict
3 for both sides – but the potential costs of a conflict due to China’s
2 trade dependence are substantially higher for Beijing than for
1 Washington. The Sino-US economic-financial relationship is
0 therefore best described as one of ―asymmetric interdependence‖
US China (or ―asymmetric vulnerability‖), skewed in Washington’s favour for
Exports Imports now.
Source: IMF 12

4 May 17, 2010

Sino-US relations

Only trailing Japan Washington continues to hold a stronger hand – for

Net IIP, USD tr, 2008; data label in now
% of GDP
None of this means that China’s financial and economic power is not
50.6 4 a force to be reckoned with. China’s growing international financial
35.1
25.3 2 resources, rising outward investment, increasing prominence as a
15.2
trade partner and importance as a location for global FDI have
0
-1.2 -3.2 -17.7 materially increased its influence (and interests). Nonetheless, as
-2 regards Sino-US relations, China will – for the foreseeable future –
-4 derive only limited bilateral influence from its meteoric economic and
-24.0
financial rise.
-6
By the same token, Beijing will have a greater incentive to avoid a
China

India
Germany
Japan

Russia

UK

US
Brazil

broader bilateral economic confrontation than Washington given the

substantially greater economic and financial costs China would incur
in the event of such a conflict. None of this is meant to suggest that
Source: IMF 13 a Sino-US economic conflict will never occur. Domestic political
considerations do sometimes result in ―miscalculated― government
policies. However, if raison d’état and pragmatism prevail in both
Becoming a player Beijing and Washington, inevitably recurring economic tensions will
Chinese outward FDI flows, USD bn
remain manageable.
60
Last but not least, if and when China reduces its export dependence
50
on the US market relative to US dependence on the Chinese
40
market, the balance of economic and financial power will change
30 dramatically in Beijing’s favour. Until then, Beijing will have a far
20 greater interest in preventing a wider economic-financial conflict
10 than Washington.
0
2005

2006

2007

2008

2009
1990-2000*

*Annual average
Sources: UNCTAD, DB Research 14

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