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“A population weakened and exhausted by battling against so many obstacles — whose needs are never satisfied and desires never fulfilled — is vulnerable to manipulation and regimentation. The struggle for survival is, above all, an exercise that is hugely time-consuming, absorbing and debilitating. If you create these anti-conditions, your rule is guaranteed for a hundred years.”
                                          Ryszard Kapuscinski

Commentary & Analysis
Look up dysfunctional in the dictionary and you’ll see a picture of China

One of our many loyal readers sent me a brief comment the other day (his longer comments are usually very entertaining.) He said, regarding Secretary of State Hillary Clinton being over in China to quell their worst fears of a US default:

“Kind of wish I was a fly on the wall for these Hillary meetings in China. From where I sit, we really have no leverage on China other than our growing debt.”

Obviously he has a point – China is stuck in a pretty big investment that’s starting to look a bit inconvenient. David Cohen, a former economist at the Federal Reserve Board of Governors in Washington D.C. is now the Director of Asian Economic Forecasting for Action Economics. Mr. Cohen recently summed up the US position of borrowing from China:

“I owe $1 and I have to worry. I owe $1 trillion and you have to worry.”

Now, it might be a bit different if we were privy to all the political theatre in the undisclosed meetings, discussions and deals between leaders of the two countries, but China did play an active and determined role in devoting so much of its FX reserves accumulation to US dollars.

Why did they continue to make the same decisions to pile so much money into US debt?

Because it made sense for them. [Them being the Chinese political elite who prefer backing Chinese production at all costs in order to prop up headline GDP.]

Why did the US continue to borrow money?

Because it made sense for them. [Them being the US political elite who prefer boosting US consumption at all costs in order to prop up headline GDP.]

So my point is: damn right China has to worry … but let’s not lump all the blame on the US for this little (or not-so-little) debt predicament.

Back to our reader comments … it currently seems (to him and others) the US lacks any real long-term leverage over China. At the very least, the US seems to be squandering what leverage it might still have left, which makes the current proposal aimed at deep spending cuts all the more important in restoring credibility and economic prudence that leaves the US in a position to rebuild its economy and retain its status as a world superpower.

Unfortunately, should a US debt/deficit deal arise in the next week or so, much more restructuring of the US political system will still be necessary. And that’s what should cause China the most worry …

If the US somehow, in some unforeseen way, gets on the fast-track towards limited government and prudent spending, it will likely bring about important changes in the culture of the US economy. These changes (for the sake of this discussion let’s call these changes ‘global rebalancing’ since that’s a somewhat familiar term) would force China to make a consequent transition in its economy.

Andy Xie, now just an “independent economist” according to Reuters, notes that US dollars account for 60% of China’s FX reserves; it is their plan to diversify into other currencies as it brings on new reserves. Naturally. No problems with that.

Xie also comments on why the need for this diversification (which is obvious to everyone at this point but I still want to share his choice word) …

He states the US was once a powerful and efficient system capable of overcoming crisis and financial adversity, but now the US is stuck with a dysfunctional political system.

Dysfunctional? I read that word and I am embarrassed.

Surely the US government is not dysfunctional, right? As much as I think our government is awful and needs a major haircut, that word dysfunctional bothers me. But it is reason for Mr. Xie to suggest that US Treasuries are no longer the safe-haven they once were and that China might instead consider diversifying into US stocks … since corporate balance sheets are strong.

Gee. Talk about a vicious cycle …

China is afraid its massive base of reserves will lose value, rightly so … so they will diversify out of US dollars (Treasuries) which are at risk because the US economy is shaky and overly reliant on debt and deficit spending … they will diversify into US stocks which are supported by global optimism stemming from persistently high Chinese GDP which the latest data shows is decelerating (and to some extent perpetual quantitative easing from the Fed of which there is no guarantee will continue) … and they will feel comfortable with these reserves in US stocks as global deflation looms, the real estate bubble deflates, and private deleveraging seems to be leading to a deeper manufacturing pullback? Hmmm …

The US may be dysfunctional. I’ll argue that China is more dysfunctional. A good way to test that would be to see who can restructure themselves most quickly.

My guess is that China’s potential restructuring would not send shock waves through the US economy. I cannot say the same for a potential US restructuring.

Which is the more dysfunctional system? Which has the most leverage (the good kind)?

Jack just wrote an excellent report for some of our members about how this all might come to pass, specifically how painful an inescapable global rebalancing and economic restructuring will be for China. If you’d like to read the report, you can do so by subscribing to our monthly newsletter – Global Investor – for only $49 per year. Click here to read more about it.

Prepare yourself.