G-2

The China and U.S. agreement at the conclusion of the 5th Strategic Economic Dialogue talks in Beijing earlier this month to give traders of both countries $20 billion in trade financing credit to boost bilateral commerce is the first right step in the direction of upgrading the SED to a G-2 biannual summit between the two countries. The export-import banks of America and China will offer $12 billion and $8 billion respectively to credit worthy importers in developing countries.
The U.S. also said it would support China joining the Financial Stability Forum, a club of central banks and finance ministries from the world’s richest nations.

After president-elect Obama’s election victory, the Chinese congratulatory message emphasized that China is ready to strengthen its relationship with the U.S. and further promote friendly and constructive cooperation. Obama agreed with China’s president Hu that the development of Sino-U.S. relations is not only in the interest of countries, but the interests of the world. Let’s hope he sticks to that agreement and brings about the necessary “change” in U.S.-China relations and doesn’t get his mind changed by Congress. Any treaty with China requires a two-thirds vote by the Senate, a potential hurdle with Democrats retaining their overwhelming majority.

Why not elevate the biannual SED meetings to the presidential level and make them G-2 meetings? Why not make them even stronger? America and China must step up their dialogue and cooperation in areas of trade, energy, environmental protection, food safety and military cooperation and sign a mutually beneficial bilateral treaty governing their relationship in these areas.

The China challenge is first and foremost, really about money and military might. Energy and the other geopolitical issues are secondary. The other side benefits of a bilateral treaty are that it would allow U.S. firms to invest in China’s industrial sector and allow U.S. firms in China to settle disputes by international arbitration rather than subject them to the arbitrary rule of law that currently exists in domestic Chinese courts. In turn, China would have an incentive to improve its legal system and to better protect private property rights and intellectual property.

With a U.S. federal budget deficit that could reach $1 trillion in Obama’s first year in office, a national debt of more than $10 trillion that requires more than $2 billion a day just to stay afloat, with China owning over half-a-trillion dollars in U.S. government bonds ─ more than any other country and Washington’s continued need for China to buy more ─ how many other options does America have to finance its national debt and the $700 billion financial industry bailout? America can’t just “spend” its way out of the financial crisis alone. It desperately needs a long term partner that can help it.

Giving China greater recognition would also send a strong signal that the U.S. is not opposed to China’s peaceful rise, prosperity and ability to invest in or buy U.S. companies the way it attempted to do in 2005, when China National Offshore Oil Corp tried to acquire Unocal, a U.S. oil and gas company for $18 billion, much more than it was eventually sold to Chevron for. America would also affirm its confidence in a policy of engagement and its distrust for protectionism. That would be good for America, China and the world.

Necessary Dialogue

The fifth U.S. China high level get-together on December 4 and 5, 2008, under their Strategic Economic Dialogue Agreement of 2006, in Beijing was the main event to watch as America changed White House Administrations and its congressional makeup.

The dialogue was conceived as a civilized mellow way of dealing with prickly and sensitive issues without any one at any time ending the process acrimoniously. The dialogue held twice a year in China and the U.S. in turn, have so far achieved 150 agreements ranging from the macro economy to environment protection.

With all the noise and media coverage of the need for China to revalue the yuan, the fact that the yuan has appreciated about 20 percent in the less than three years since it was de-pegged from the dollar has been conveniently overlooked. Granted, but not surprising, the yuan recorded its highest one-day fall against the dollar during the high level meeting. Just a reminder of who controls currency fluctuations. Many economic and political experts speculate that China let its currency weaken to help its exporters during the crisis. The yuan will continue to appreciate with time.

Another significant fact that is overlooked is that for every gain the yuan makes against the dollar, the lesser the value of China’s holdings in dollars become. Being the largest holder of America’s debt, that can be a significant financial hit. Why should China follow in America’s footsteps? Just because America says so? America was again reminded that its un-ceasing pressure to revalue the yuan is tantamount to interference in China’s economic affairs.

It should therefore come as no surprise that Chinese officials urged the U.S. to stabilize its economy and protect China’s U.S. dollar based investments as the two sides opened their first cabinet-level economic talks in Beijing since the global financial meltdown.

China pointed out that it had made important contributions to the global economy by keeping its economic growth steady, adopting pro-active fiscal and monetary policies and raising domestic demand. China also assured America that it would sustain its growth and financial stability. Excessive consumption in the U.S. and over-reliance on debt are the key reasons behind the global financial crisis, said China Central Bank Governor Zhou Xiao-chuan, as he lectured America about its economic frailties.

China expressed its concern over the constantly shifting U.S. regulatory environment which made it difficult for China to invest in U.S. companies. U.S. Treasury Secretary Henry Paulsen, the architect of SED, took most of the criticism on the chin like honest bankers do.

China’s GDP growth dropped to 9 percent in the third quarter of 2008, the lowest in five years. The forecast for 2009 doesn’t look any brighter according to the World Bank. It has slashed it to 7.5 percent, the lowest in almost two decades. Although China also faces a rapidly slowing economy and rising unemployment, the tone of the critical comments reflected the shift in power. China made it clear that it is more productive for China to put its foreign reserves to work in China rather than continue underwriting America’s debt.

The U.S. has no basis to lecture China, or any other country really, about prudent financial policies. It really should devote most of its time to get its financial house in order. Why does China’s agreement to open its markets to foreign banks come across like such a big diplomatic coup? China has seen how incompetent they are and now that it knows it is welcoming them to its financial poker table as it rethinks its view of the U.S. banking system. The U.S. system, once the epitome of modern economic thinking and an example to emulate, suddenly imploded.

The Main Event

he G-20 meeting in Washington, on the cold Atlantic seaboard, was a warm up to the Asia-Pacific Economic Cooperation forum that took place in Lima Peru last week. The APEC meeting of leaders from 21 Pacific Rim countries that account for half the world’s economy endorsed the Washington Declaration of the G-20 and pledged not to implement protectionist measures for 12 months ─ no matter how punishing the global downturn gets.

APEC 2008 was President Bush’s global summit swan song before he hands over the Washington reins to his successor on January 20, 2009. President elect Obama will preside over the April 2009 G-20 meeting and take on the global financial crisis head on. That is the main event that can bring about financial discipline and order to the global financial markets. Obama will personally grapple the global financial issues with his new economic team, in contrast to what he did at the 2008 G-20 meeting in Washington, when he sent a bi-partisan team of two out of respect to Bush and his presidency. Thankfully, he actually understands what is being discussed and if he doesn’t, makes sure he does. The same cannot be said about his predecessor, which can be a problem when confronted with today’s unprecedented global financial meltdown.

Capitalistic America that believes in free enterprise, individualism, none-or-minimal government interference ─ and God forbid intervention ─ allows the government to bailout and become a shareholder in America’s financial pillars of capitalism ─ AIG, Bear Stearns, City Bank, Fannie, Freddie, Wachovia and Washington Mutual. And guess who is picking up the tab? American taxpayers, as their homes are foreclosed, their gas and food prices rise and the standard of their children and grandchildren’s education plummets.

The lesson is that, when government pollutes capital markets by implicitly guaranteeing debt, market participants recognize that they will be protected if the enterprise runs into difficulty. There are exceptions. Lehman Brothers over-played its hand. That is why foreign investors, including the People’s Bank of China, hold more than $1.3 trillion in just Fannie and Freddie bonds.

The subprime crisis that started the financial tsunami, is at its base, a crisis of markets tainted by government intervention, along with the failure of the Federal Reserve to tighten monetary policy. It is also a failure of regulation to effectively monitor lending practices in the subprime market. Hopefully, Obama and his economic team at the main event in April will start to rebuild the necessary new global financial architecture to ensure it doesn’t happen again.