Washington’s Downgraded Debt And Beijing’s Tied Hands

If past is prologue, then the criticism heaped on Washington by China’s state media earlier this week for its handling of its debt-ceiling debacle was mere throat clearing for the lambasting of America’s “addiction to debt” that followed credit rating agency Standard & Poor’s controversial downgrading of the U.S.’s credit rating to AA+ from AAA. From Xinhua:

The days when the debt-ridden Uncle Sam could leisurely squander unlimited overseas borrowing appeared to be numbered as its triple A-credit rating was slashed by Standard & Poor’s (S&P) for the first time on Friday…

Dagong Global, a fledgling Chinese rating agency, degraded the U.S. treasury bonds late last year, yet its move was met then with a sense of arrogance and cynicism from some Western commentators. Now S&P has proved what its Chinese counterpart has done is nothing but telling the global investors the ugly truth.

China, the largest creditor of the world’s sole superpower, has every right now to demand the United States to address its structural debt problems and ensure the safety of China’s dollar assets…

The U.S. government has to come to terms with the painful fact that the good old days when it could just borrow its way out of messes of its own making are finally gone.

It should also stop its old practice of letting its domestic electoral politics take the global economy hostage and rely on the deep pockets of major surplus countries to make up for its perennial deficits.

However, Beijing, for all it’s righteous indignation, faces what economists call the bank-loan problem. If you owe the bank $100 that you can’t repay, then you have a problem. But if it is $1 million that you owe, then it is the bank that has the problem.

Beijing is Washington’s banker right now, holding some $2 trillion of dollar-denominated assets. No one in Beijing thinks Washington will walk away from its debt. Nor can they want to. The collapse of the global financial system in that event would be beyond the repair of any amount of administrative guidance and Party discipline.

But China does need to do what it can to preserve the value of it’s dollar-denominated assets. Dumping them in a fire sale would only leave scorched earth. Diversifying into other currencies has been happening but it is only feasible to do at a measured pace and the alternatives to the dollar are in practice not particularly more attractive. The euro has a sovereign-debt crisis of its own and there are precious few, if any, other fully convertible currencies whose nations could absorb the volumes of capital flows and potential macroeconomic instability that would be involved. Beijing has little alternative at this point to sitting and fulminating.

One day, it’s own currency might be a reserve currency, but there is an awful lot of financial reform to be undertaken in China before that day comes to pass (and we are not sure it will come soon). In the meantime, Beijing has been promoting the greater use of the IMF’s Special Drawing Rights (SDRs) as a surrogate international reserve currency that could challenge the dollar’s primacy in that role. Hence, slipped in to Xinhua’s commentary:

International supervision over the issue of U.S. dollars should be introduced and a new, stable and secured global reserve currency may also be an option to avert a catastrophe caused by any single country.

There is no way, even in these deficit-reducing times, that Washington would accept anyone’s but it own control over its printing presses. And turning the SDR in to something that could even share the role of the world’s reserve currency is a long, long way off. Disheartening as it may seem, Beijing’s best hope is that Washington gets its fiscal house in order, and, longer term, that it progresses with it’s own structural reform to make its economy more dependent on domestic demand and so reduce the global macroeconomic imbalances that are underpinning the U.S.’s deficits.

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