The Dragon and the Green Paper Tiger

The ascent of China on the world stage is being looked up­on with wonder,di­sdain and concern in the United States. If we take gross domestic product (GDP) in purchasing power parity (PPP) terms as the single measure, then China is already a serious candidate for the number one position in the league table. China has four times the population of the United States. If it manages to exceed just a fourth of USA’s per capita GDP, it will soon be the new champion under these rules.

However, it would be childish to crown China as the most powerful economy in the world by this single metric. World dominance is made of sterner stuff. Is China gradually acquiring some of the trappings of a super, economic power? China has huge holdings of US government debts. With such financing, Uncle Sam has been able to keep its interest rates low and stimulate its economy. Ironically, both Ch­ina and the US are apprehensive about the situation.

The US is concerned about China’s role as a creditor nation and America’s increased dependence on foreign debt. Despite its rhetoric of being a strong country with a GDP of $14 trillion, its burgeoning fiscal deficit and the way it is being financed are matters of bipartisan worry. The Democrats want to fix the problem by raising taxes on the super-rich (0.1 per cent of America) and the Republicans hate increases in taxes and want the fiscal deficit reduced by slashing “wasteful” government expenditure.

China is nervous because Uncle Sam has access to the proverbial printing press of the greenback. If it prints its way out of its own misery, then the value of China’s holdings would erode. It will be saddled with losses on its investments. Therefore, almost by stealth, China is acquiring gold, setting up large sovereign funds and diversifying its asset portfolio. It is also keeping up the pressure on Uncle Sam to keep interest rates in line and eschew the temptation of decreasing the value of dollar by pulling the supply lever. The data speaks for itself. China's holdings of US treasuries accounted for 54 per cent of its foreign exchange reserves as of June 30, 2011, according to a US treasury survey released last week. That number is down from 65 per cent in 2010 and a record 74 per cent in 2006.

There are many in the US who honestly believe that China has no alternative investment opportunities so long as the dollar remains the reserve currency of the world. China is riding the proverbial green paper tiger. If it sells its holdings in large chunks, the value of its holdings will come down hurting China.

Way back in 1994, Thomas Friedman narrated a nice story. The plot of that story: Greenbacks constituted the new gold standard. He convincingly wrote, “The United States has an advantage few other countries enjoy: It pr­ints green paper with Ge­orge Wa­shington’s and Ben Fra­nklin’s and Thomas Jefferson’s pictures on it. These pieces of gr­een paper are called ‘dollars’. Americans give this gr­een paper to people around the world, and they give Americans in return automobiles, pasta, stereos, taxi rides, hotel rooms and all sorts of other goods and services. As long as these foreigners can be induced to hold those dollars, either under their mattresses, their banks or in their own circulation, Americans have exchanged green paper for hard goods.”

I have not come across a more persuasive argument outlining the advantages of owning the printing press for the world’s reserve currency. But, is there a scenario in which the little green papers lose their charm? Will there be a twist to the tale? Is the past of the greenback brighter than its future?

I was reading a book by Arvind Subramanian titled Eclipse: Living in the Shadow of China’s Economic Dominance. The book begins by painting a dramatic scenario of the future. It is a cold, blustery morning in February 2021. The place is Washington, DC. A Republican president has just been sworn into office. He is on his way to the office of the Chinese managing director of the International Monetary Fund (IMF) to sign an agreement for an emergency financing of $3 trillion with humiliating conditions that include substantial reduction in military expenditure. Subramanian reminds the reader of a similar incident in 1998 when the IMF’s managing director Michel Camd­essus watched Indonesia’s pr­esident Suharto sign off on an IMF programme diluting the country’s sovereignty and self respect. What a sense of déjà vu!

In reality, the Eclipse scenario may never play out. The US has time on its side to get its house in order. It is still a country that is the hotbed of innovation and entrepreneurship. It attracts talent from all over the world like a magnet. But with its ageing population and connected healthcare ch­allenges, the inequality of we­alth and income, huge fiscal deficits, unemployment and lower manufacturing productivity, the country has a number of issues to fix. China has its own challenges. Its currency is not freely convertible and it has to carry out economic reforms without taking off its political scaffolding.

While the nightmare scenario painted by Subramanian may never come to pass, the dominance of a single currency may be replaced by some other reserve currency like the special drawing rights (SDR) in a new avatar. China will emerge as a dominant power. And while we watch China’s rise, let us not forget that the dark horse — India — will be stomping its hoof to have a rightful place at the head table. More than likely, we will end up in a multi-polar financial world where no single country or currency will dominate. It was the former French president Ge­orges Pompidou, who when asked about the US dollar as the basic monetary yardstick, prophesied, “The rest of the world cannot be expected to regulate its life by a clock which is always slow.” Touché!

(The writer is managing director of Deloitte Consulting, India. These are his personal views)