Over the past half decade, the decline in the dollar’s value against all major foreign currencies and the concurrent rise in oil prices have put the American economy on a precarious footing. Despite the danger, changes in financial and commodity prices have been gradual enough that the economy has had time to adjust, forestalling the kind of swift, deep crisis that keeps the world’s central bankers awake at night.
We might not always be so lucky, however. As the subprime mortgage crisis shows, the global economy is more connected than ever before, and vastly more complex. What began as a slump in one segment of the U.S. housing market has spread rapidly across borders, undermining debt instruments worldwide, staggering massive financial institutions, and thus affecting areas of the global economy not directly connected to the mortgage sector. Future crises could have roots far deeper and effects much wider, thus doing far more damage to the U.S. economy.
Imagine, then, a small group of actors—none friendly to the United States—deliberately triggering an acute economic crisis at a time of their choosing. Such a scenario would constitute a strategic vulnerability of the highest order. Sadly, this scenario is not merely hypothetical.
Countries like Russia and Saudi Arabia have amassed large U.S. dollar reserves from oil exports that are controlled by their governments, not by an anonymous collection of private interests. Beyond their substantial financial and oil resources, these governments can also influence international financial and commodity markets. They cannot, however, command decisive influence over the deep and liquid market for U.S. dollars, for that would require enormous reserves of U.S. Treasury securities that neither Russia nor Saudi Arabia yet possesses. China, on the other hand, holds more of such securities than any country in the world, and while it does not control major oil resources, it has strong ties to countries that do. The possibility that Chinese authorities could choose to undermine the American economy, perhaps in league with oil-rich associates, is impossible to quantify, except to say that it is not zero.
Sources of Vulnerability
China arrived at its powerful position due largely to its economic development choices and how they have interacted with the economic policies of other countries, including those of the United States. During the early 1980s, Chinese leaders began an ambitious effort to transform its socialist economy into a market-based one. Replicating the most successful features of other Asian nations’ strategies, China slowly liberalized economic controls and encouraged the formation of export-oriented industries. It sought a stable economic environment and foreign exchange rate in order to attract long-term foreign investment. Within a decade, China was on its way to becoming the world’s factory floor. Its central bank maintained an exchange rate between the Chinese renminbi and the U.S. dollar that made Chinese exports highly competitive, and as capital flowed into the country, the central bank modulated the circulation of the renminbi to preserve the dollar peg. Combined with excessive domestic bank lending, however, the constant flow of new renminbi stimulated China’s continuing battle with inflation. To dampen inflation and to provide a safe investment for its growing dollar reserves, China purchased ever-larger sums of U.S. government debt in the form of Treasury securities. Along with domestic banking regulations and currency-export controls, this strategy has largely managed to maintain an exchange rate favorable to Chinese exports and keep inflation in check.
The United States, meanwhile, has reaped benefits of its own from a vastly expanded economic engagement with China. In addition to providing U.S. consumers with a steady stream of inexpensive imports, China’s strategy of reinvesting its dollar earnings in Treasury bills allowed the Federal Reserve to set interest rates below levels that would normally have triggered inflation, helping the United States avoid a deeper recession in 2001–02 by encouraging investment, particularly in residential and commercial construction.
The result of China’s strategy and its intersection with U.S. economic policy choices has been a remarkable degree of economic integration between the two countries. In 2007, nearly $387 billion of goods passed between the two countries, about $322 billion of which flowed into the United States, making China our second-largest trading partner, behind only Canada. This difference amounted to more than 34 percent of the total U.S. current account deficit. For China, nearly 20 percent of all its exports in 2007 went to the United States. The economic relationship between the two countries has become so deep that neither country can make major economic decisions without profoundly affecting the other.
Both China and the United States have political and economic incentives to preserve their symbiotic economic relationship. As already mentioned, the United States benefits from high consumption and high employment with low inflation and low interest rates. China benefits from high export demand, industrial development, employment opportunities for rural migrants and accumulating liquid assets. As long as Beijing can keep domestic inflation in check and Washington can do the same for its real asset markets, such as property, all will remain well. But this delicate symbiosis, when combined with several other factors, has made the United States vulnerable to a sudden systemic crisis that could be triggered by financial and commodity market manipulation.
What are these factors, and how might they combine to pose a potential threat? The first and oldest factor traces its origin to the advent of the modern central bank. An aggregation of macroeconomic and monetary power, a central bank is charged with managing the stability of a country’s currency and monetary supply. In a financial crisis, it provides liquidity to its country’s banking sector. Yet the rise of its importance to maintaining economic growth sometimes overshadows the fact that, in nearly all countries, the central bank remains an arm of the state. Only a handful of central banks are genuinely independent, and political rather than financial interests are the principal motivators for most of the world’s central banks.
A second factor is the proliferation of electronic funds transfers since the 1970s, which has steadily improved the ease and speed of financial transactions. That has increased not only the absolute number of transactions, but also the impact those transactions can have on markets, as Black Monday (October 19, 1987) demonstrated. The sheer scale of trading today has become ever more difficult to monitor, making the concealment of trading strategies involving large sums easier to execute.
Ease of concealment is compounded by a third factor: the higher amount of leverage—borrowings that are reinvested to earn a higher rate of return than the cost of interest. Leveraged trading in international financial and commodity markets has soared since the 1990s and has accelerated further since the early 2000s. Of course, speculators have always used leverage to magnify their trading strategies. But as private equity and sovereign wealth funds have amassed ever larger sums of capital, the leverage they can command has grown larger still.1 The huge amount of capital leveraged by international financier George Soros to induce the collapse of the European Exchange Rate Mechanism in 1992 had become a common sum by the end of that decade. Today, most traders use leverage daily, and in so doing provide global markets with the liquidity they need to operate. But in a crisis, these traders, with their market-moving access to capital, could just as easily contribute to paralysis simply by rushing to exit their positions in unison.
There is a fourth and final factor: Washington’s willingness to continually run large Federal budget deficits. These deficits require the U.S. Treasury to issue substantial quantities of securities to finance them. Since anyone can trade these securities, friend and foe alike can accumulate them. Yet prior to World War II, the foreign interests holding U.S. Treasury securities were mainly institutions and investors, not central banks. Throughout the Cold War, the Soviet Union and its allies never held large sums of U.S. government debt because Moscow feared dependency on the West and restricted financial ties to it. Only since the 1990s has international finance become truly global. Only in the past few years have certain central banks, including China’s, amassed enough U.S. dollar reserves to have a substantial and immediate impact on international financial markets. This is a new phenomenon.
The Will, and the Way
Most economists believe that the mutual benefits of the economic relationship between China and the United States, however awkward, will deter either side from undertaking belligerent action. Yet in August 2007, two members of influential Chinese government research institutes publicly commented that Beijing has the power to set off a dollar collapse if it chooses to do so. Xia Bin, the director of the Research Institute of Finance at the Development Research Center of the State Council, suggested that such power should be used as a bargaining chip to counter American pressure in trade talks. Washington immediately denounced these comments and China’s central bank eventually issued a soothing statement reaffirming its role as “a responsible investor in the international capital markets.” Reassurances notwithstanding, it is clear that the idea of such an action has surfaced among at least some senior Chinese leaders.
The Chinese central bank’s massive dollar reserves—largely held in the form of U.S. Treasury securities—put Beijing in a strong position to capitalize on any weakness in the dollar. Were it to sell even a small fraction of its holdings, the value of the dollar would plummet. Normally a safe haven in times in high global uncertainty, the dollar would be at the center of the storm. U.S. short-term interest rates would surge and American corporate and financial institutions would suddenly find their assets devalued and access to capital restricted.2
China might also elect to use its strong ties with oil-rich countries—Iran and Venezuela come to mind—to influence international commodity markets. Given the world’s limited spare oil production capacity, any supply disruption in international markets would cause prices to surge and economies to stumble. Meanwhile, other oil-exporting countries, such as Russia, could see China’s action as an opportunity to make their own strategic gains on America and manipulate the flow of their oil exports.
The combination of a major devaluation of the dollar and a sharp increase in oil prices would immediately send U.S. equity and bond markets into turmoil, while fears of higher inflation and interest rates would drive investors away. Liquidity would disappear. One IMF working paper has calculated that should the U.S. dollar, U.S. equity markets and U.S. bond markets unexpectedly fall 10 percent, domestic wealth would be reduced by $1.3 trillion—almost 11 percent of GDP—under the prevailing economic conditions.3
Beyond the immediate tumble in the markets, the U.S. economy would slow as firms, particularly those that rely on imported goods, saw their supply chains disrupted and costs climb. In the long run, the upheaval could alter the global perception of the U.S. Treasury note as a risk-free asset. Adding such a risk premium to U.S. Treasury securities would have an enduring effect on U.S. interest rates.
Of course, China would not escape serious consequences from such a gambit. Its actions would sharply reduce the value of its own dollar holdings, making it poorer by as much as 4.5 percent of GDP. Assuming trade was not suspended altogether, China’s exports to the United States would fall as they became more expensive to American importers. Moreover, the ensuing recession in the United States would further dampen demand for Chinese goods, leading to double trouble for Chinese exporters. Many would cut staff or shutter altogether, spurring higher unemployment in China’s coastal cities. Nonetheless, given the Chinese leadership’s principal motivations, even significant economic pain may be acceptable to achieve its political ends. It would not be the first time national leaders heard the siren of politics over the whine of economic plaints.
These costs raise the obvious question of why China would ever resort to such a measure in the first place. Indeed, many of those who downplay the threat of China’s vast dollar holdings suggest that the costs of aggressive behavior are self-deterring. But China is many years away from military parity with the United States. While it will no doubt close the gap over time, it will still have strategic use for asymmetrical capabilities for many years to come. In the event of a war with America, instigating serious economic instability would be an effective complement to a defensive military strategy, and it could also serve as non-nuclear defense of last resort.
Sino-American relations might seem reasonably stable now, but there are real opportunities for conflict. The most obvious is Taiwan. China regards Taiwan as sovereign territory, and the failure of the Chinese government to at least maintain its claim over Taiwan would seriously dent its legitimacy to govern by antagonizing an increasingly nationalistic populace and empowering hardliners within the Communist Party. Given its formidable internal security forces and still-massive foreign exchange reserves, the regime might feel that it could better withstand the fallout from a significant economic disruption than face the consequences of having its legitimacy to govern cast into doubt. Whether this assessment would be valid in any particular case is not the point; it need only be valid in one case. What matters, therefore, is that the U.S. government be prepared for an aggressive Chinese economic action in case one is launched.
So how should we prepare? Unfortunately, there are few policy tools currently at our disposal. As things stand now, the United States would have but three levers to pull to contain the damage caused by such an event.
First, the Federal Reserve could rapidly raise short-term interest rates to entice institutions and investors to soak up the flood of dollars pouring onto international financial markets. Whether that would stabilize the U.S. dollar or merely moderate its decline is impossible to know in the abstract. But not doing so would surely threaten the dollar’s credibility as the world’s premier reserve currency.
Second, the U.S. government could ask its major allies, whose long-term economic interests coincide with those of the United States, to start buying dollars. While they would likely agree, they would also likely seek assurances from Washington that it had plans to halt the dollar’s decline beyond the immediate need for damage control.
Finally, the U.S. government could attempt to relieve the upward pressure on oil prices that a supply disruption would cause. Unfortunately, it could not accomplish this quickly. The only option would be to release oil from the U.S. Strategic Petroleum Reserve’s sixty-day supply onto the international market, but even that would require time.4 While a release under such conditions would certainly be warranted, its influence on prices is hard to predict. It may offer hope to some, but may also be seen as a signal of grimmer things to come by others.
The limits of conventional damage control have been amply demonstrated during financial crises in Mexico, Thailand, South Korea and a host of other places in recent years. These experiences suggest that Washington must move immediately to defeat the manipulator. Doing so will require a dual approach to raise the level of economic damage to China beyond what it expects, and alter to the extent possible the assumptions on which the strategy is based.
Despite its newfound economic clout, China’s developing financial institutions and markets limit its economic resilience. Though currently benefiting from a speculative boom, China’s equity markets remain hamstrung by controls over listings for private companies. Only in 2005 did Chinese regulators begin to phase out a two-tiered share system whereby controlling-interest shares, typically held by the government, could not be traded, creating uncertainty for investors. Similarly, China’s debt market lacked any solid foundation until August 2007, when regulators permitted corporate debt listings on a trial basis, replacing a rigid quota system and lengthy government approval processes that inhibited issuances in the past.
Meanwhile, China has maintained strict controls on international capital flows, which are intended to ensure that domestic savings stay in the country. That has helped stabilize its foreign exchange rates and sustain a high level of bank liquidity. Yet China has been unable to keep its banking sector healthy. Even after disposing of its banks’ non-performing loans through asset-management companies in the 1990s, and disbursing vast sums of foreign currency reserves to support those banks during the clean up, Beijing continues to accept its banking sector’s poor lending practices. Though the upgraded loan-classification system now reveals problematic loans more quickly and consistently, poorly managed state-owned enterprises still receive low-interest loans, encouraging excess capacity and unsound investments.
The Chinese economy’s dependence on its frail banking sector makes it the ideal target for an effective U.S. defense against manipulations. Essentially, the policy goal would be to drain liquidity from China’s banking sector faster than Beijing can prop it up. Some obvious ways to do this include freezing Chinese bank assets in the United States; pressuring offshore banking centers to freeze Chinese bank accounts, particularly those of its central bank; preventing all Chinese corporate, financial or government entities from participating in clearinghouse operations managed in the United States; instructing American companies to remit all outstanding debts to Chinese entities into a special fund controlled by the U.S. government that would be invested in U.S. Treasury securities; and delisting Chinese companies on U.S. equity markets to drain the liquidity they could access from their stocks.
Such actions hardly exhaust U.S. options. Given the trillions of daily transactions in markets around the world, it is easy to forget that all exchanges and over-the-counter markets depend on assumptions in the form of rules that underlie how they operate. China’s manipulations would have to take place in those exchanges and over-the-counter markets. Should their rules change, Beijing’s market manipulation strategy could be deflected or made untenable.5
Indeed, temporarily altering the rules of how major exchanges and over-the-counter markets operate may be the most effective way to unravel a market manipulation attempt, and the global trend toward exchange consolidation makes this approach more practical than ever. To be effective, however, Washington would have to act on a global scale to ensure that not only trading venues in New York and Chicago accede, but also those of London, Tokyo and wherever else major trading in currencies and commodities occur—in effect cornering the market on trading. One effective rule change would be to require traders to cover all short positions (bets that the price will fall) in U.S. Treasury securities at the end of each trading day.6 Regulators could also require financial institutions to post a bond to buy or sell U.S. Treasury securities and limit the flow of electronic transfer of funds out of the United States.
Of course, China could anticipate some sort of rule changes beforehand and have countermeasures ready. And it would still have access to Hong Kong, the one major financial center firmly under Chinese control. Thus, it is important for the U.S. government to develop the widest possible range of options to thwart whatever strategy Beijing might choose. No doubt changing the rules would risk tarnishing America’s reputation for having the freest and most open markets in the world. But during an international financial and commodity crisis, when the stability of the dollar—and far more than that—rests in the balance, rule changes would likely be greeted with acclaim rather than scorn, as long as they are only temporary.
These vulnerabilities have drawn the attention of American politicians. Senator Hillary Clinton once even suggested that the United States set “a benchmark for foreign-held U.S. debt that would trigger some sort of White House action.”7 Precisely what the benchmark or action would look like she does not say, but either step would be unwise. The imposition of an artificial inefficiency into the U.S. Treasury market without the justification of an impending crisis would undermine confidence in the openness of U.S. capital markets and raise the U.S. cost of borrowing. Moreover, it would further exacerbate foreign anxiety over the reliability of the dollar as the world’s reserve currency and hasten its abandonment. Any benchmark would also create a tempting target for market manipulators of all stripes, much as a currency peg can act as a speculative magnet.
Nonetheless, the benchmark idea does highlight the difficulty in tracking the registry and ownership of U.S. Treasury securities. Third-party custodians can often obscure the real debt holders from view. Clarifying the registry of U.S. Treasury securities would therefore be extremely useful. It would provide the practical information necessary for not only other policy actions related to countering market manipulation, but also those related to combating terrorism and other forms of global crime, as well.
In the broader context of economic policy, the United States will find it extremely difficult to escape its economic vulnerabilities and the cycle of debt and current account deficits that gave rise to them. Each of the cycle’s actors, whether the United States or its trading partners, have short-term political and economic incentives to preserve it, and it is difficult to find any painless way to escape it. As one recent study noted, only a major devaluation of the dollar—perhaps by as much as 25 percent—might revive and sustain “aggregate growth in the United States . . . so long as domestic demand was curtailed by restrictive fiscal measures while overseas demand was increased by an accompanying fiscal expansion.”8 That would mean the Federal budget would have to shrink while foreign citizens and governments expand their consumption. Even if the former were somehow to become politically palatable within the United States, such actions would be nearly impossible to coordinate on a global scale.
When considering the possibility of manipulation in the oil market, Washington also faces a serious challenge. Potentially hostile countries have great influence over that market, and friendly ones no longer have the excess production capacity to offset a manipulative action, as Saudi Arabia did in earlier times. While increasing domestic production may lower prices under normal circumstances, the United States would still be left vulnerable to manipulated price spikes on oil trading floors around the world. Since petroleum is principally used in the United States as transportation and industrial fuels, policies that promote substitutes to it—be it ethanol or, much better, non-petroleum-generated electricity—constitute the best long-term remedy.
American macroeconomic and monetary policies helped produce the preconditions for the threat of foreign financial and commodity market manipulation to the U.S. economy. But it is the interplay between politics (domestic and international) and economics that makes the threat possible. And any country with control over sufficient financial and commodity assets, not just China, can in time develop a similar potential. Russia is particularly dangerous in this regard, given the substantial U.S. dollar reserves it has accumulated, the energy resources required to add dramatically to its holdings in future, and its resurgent global ambitions.
The best way for the United States to minimize the likelihood that China or some other country might seek to harm the United States through market manipulation is to ready a credible defense against it. Unfortunately, we do not currently have such plans. U.S. government responses to market distortions have all been ad hoc, such as the U.S. Treasury Department’s rescue plan during the Mexican financial crisis of 1994–95, its intervention in the Long Term Capital Management debacle in 1998, and its actions to remedy the credit crisis that began in mid-2007. All three could have benefited from having had plans in place detailing the full range of options available to the U.S. government and weighing their repercussions. Given that market manipulation could be employed as part of a larger confrontation against the United States, these plans should also be coordinated within the U.S. national security policy apparatus. As long as the Treasury Secretary remains outside the NSC system, that will require a special effort.
All this may sound like preparation for an event unlikely to ever occur. That may be so, but the consequences for the United States would be so dire were a financial manipulation to occur that a failure to prepare for it would be folly. Strategic planning means being ready for what could happen, not just for what will happen. The key is finding the balance between the likelihood of an event, its consequences, and the cost of preventing it. While the United States must not overreact, it must still prepare deliberately and quietly, especially if beneficial preparation is relatively cheap—which it is. As Oliver Wendell Holmes put it: “Prophesy as much as you like, but always hedge.”
While the Federal Reserve limits broker loans to stock market investors to 50 percent of the total investment, no such regulation exists for other sorts of trading.
See Francis E. Warnock and Veronica C. Warnock, “International Capital Flows and U.S. Interest Rates”, International Finance Discussion Paper No. 840 (Board of Governors of the Federal Reserve System, 2005).
This calculation also excludes any currency hedges (or financial positions) held to minimize the exposure to foreign exchange-rate movements.
While the decision to release oil from the Strategic Petroleum Reserve may immediately influence the price of oil, it would take 13 days for the oil to reach the market from the time its released is authorized.
Recall that rules changes brought down the Hunt brothers’ scheme to corner the silver market in the late 1970s.
Since the U.S. Treasury market has more defined trading hours and regulators fine cheaters, such a requirement could act as a break on a manipulated decline in the U.S. dollar. A seller would have to sell his U.S. Treasury securities for dollars by the end of each trading day before he could sell the dollars themselves.
Deborah Solomon and John Harwood, “Clinton Brings Debt Worries to the Fore”, Wall Street Journal, March 5, 2007.
Wynne Godley, Dimitri P. Papadimitriou, Claudio H. Dos Santos and Gennaro Zezza, “The United States and Her Creditors: Can the Symbiosis Last?” Levy Economics Institute Strategic Analysis (September 2005).