The $1.4 Trillion Question

The Chinese are subsidizing the American way of life. Are we playing them for suckers—or are they playing us?
What the Chinese hope will happen

The Chinese public is beginning to be aware that its government is sitting on a lot of money—money not being spent to help China directly, money not doing so well in Blackstone-style foreign investments, money invested in the ever-falling U.S. dollar. Chinese bloggers and press commentators have begun making a connection between the billions of dollars the country is sending away and the domestic needs the country has not addressed. There is more and more pressure to show that the return on foreign investments is worth China’s sacrifice—and more and more potential backlash against bets that don’t pay off. (While the Chinese government need not stand for popular election, it generally tries to reduce sources of popular discontent when it can.) The public is beginning to behave like the demanding client of an investment adviser: it wants better returns, with fewer risks.

This is the challenge facing Lou Jiwei and Gao Xiqing, who will play a larger role in the U.S. economy than Americans are accustomed to from foreigners. Lou, a longtime Communist Party official in his late 50s, is the chairman of the new China Investment Corporation, which is supposed to find creative ways to increase returns on at least $200 billion of China’s foreign assets. He is influential within the party but has little international experience. Thus the financial world’s attention has turned to Gao Xiqing, who is the CIC’s general manager.

Twenty years ago, after graduating from Duke Law School, Gao was the first Chinese citizen to pass the New York State Bar Exam. He returned to China in 1988, after several years as an associate at the New York law firm Mudge, Rose (Richard Nixon’s old firm) to teach securities law and help develop China’s newly established stock markets. By local standards, he is hip. At an economics conference in Beijing in December, other Chinese speakers wore boxy dark suits. Gao, looking fit in his mid-50s, wore a tweed jacket and black turtleneck, an Ironman-style multifunction sports watch on his wrist.

Under Lou and Gao, the CIC started with a bang with Blackstone—the wrong kind of bang. Now, many people suggest, it may be chastened enough to take a more careful approach. Indeed, that was the message it sent late last year, with news that its next round of investments would be in China’s own banks, to shore up some with credit problems. And it looks to be studying aggressive but careful ways to manage huge sums. About the time the CIC was making the Blackstone deal, its leadership and staff undertook a crash course in modern financial markets. They hired the international consulting firm McKinsey to prepare confidential reports about the way they should organize themselves and the investment principles they should apply. They hired Booz Allen Hamilton to prepare similar reports, so they could compare the two. Yet another consulting firm, Towers Perrin, provided advice, especially about staffing and pay. The CIC leaders commissioned studies of other large state-run investment funds—in Norway, Singapore, the Gulf States, Alaska—to see which approaches worked and which didn’t. They were fascinated by the way America’s richest universities managed their endowments, and ordered multiple copies of Pioneering Portfolio Management, by David Swensen, who as Yale’s chief investment officer has guided its endowment to sustained and rapid growth. Last summer, teams from the CIC made long study visits to Yale and Duke universities, among others.

Gao Xiqing and other CIC officials have avoided discussing their plans publicly. “If you tell people ahead of time what you’re going to do—well, you just can’t operate that way in a market system,” he said at his Beijing appearance. “What I can say is, we’ll play by the international rules, and we’ll be responsible investors.” Gao emphasized several times how much the CIC had to learn: “We’re the new kids on the block. Because of media attention, there is huge pressure on us—we’re already under water now.” The words “under water” were in natural-sounding English, and clearly referred to Blackstone.

Others familiar with the CIC say that its officials are coming to appreciate the unusual problems they will face. For instance: any investment group needs to be responsible to outside supervisors, and the trick for the CIC will be to make itself accountable to Communist Party leadership without becoming a mere conduit for favored investment choices by party bosses. How can it attract the best talent? Does it want to staff up quickly, to match its quickly mounting assets, by bidding for financial managers on the world market—where many of the candidates are high-priced, not fluent in Chinese, and reluctant to move to Beijing? Or can it afford to take the time to home-grow its own staff?

While the CIC is figuring out its own future, outsiders are trying to figure out the CIC—and also SAFE, which will continue handling many of China’s assets. As far as anyone can tell, the starting point for both is risk avoidance. No more Blackstones. No more CNOOC-Unocals. (In 2005, the Chinese state oil firm CNOOC attempted to buy U.S.–based Unocal. It withdrew the offer in the face of intense political opposition to the deal in America.) One person involved with the CIC said that its officials had seen recent Lou Dobbs broadcasts criticizing “Communist China” and were “shellshocked” about the political resentment their investments might encounter in the United States. For all these reasons the Chinese leadership, as another person put it, “has a strong preference to follow someone else’s lead, not in an imitative way” but as an unobtrusive minority partner wherever possible. It will follow the lead of others for now, that is, while the CIC takes its first steps as a gigantic international financial investor.

The latest analyses by Brad Setser suggest that despite all the talk about abandoning the dollar, China is still putting about as large a share of its money into dollars as ever, somewhere between 65 and 70 percent of its foreign earnings. “Politically, the last thing they want is to signal a loss of faith in the dollar,” Andy Rothman, of the financial firm CLSA, told me; that would lead to a surge in the RMB, which would hurt Chinese exporters, not to mention the damage it would cause to China’s vast existing dollar assets.

The problem is that these and other foreign observers must guess at China’s aims, rather than knowing for sure. As Rothman put it, “The opaqueness about intentions and goals is always the issue.” The mini-panics last year took hold precisely because no one could be sure that SAFE was not about to change course.

The uncertainty arises in part from the limited track record of China’s new financial leadership. As one American financier pointed out to me: “The man in charge of the whole thing”—Lou Jiwei—“has never bought a share of stock, never bought a car, never bought a house.” Another foreign financier said, after meeting some CIC staffers, “By Chinese terms, these are very sophisticated people.” But, he went on to say, in a professional sense none of them had lived through the financial crises of the last generation: the U.S. market crash of 1987, the “Asian flu” of the late 1990s, the collapse of the Internet bubble soon afterward. The Chinese economy was affected by all these upheavals, but the likes of Gao Xiqing were not fully exposed to their lessons, sheltered as they were within Chinese institutions.

Foreign observers also suggest that, even after exposure to the Lou Dobbs clips, the Chinese financial leadership may not yet fully grasp how suspicious other countries are likely to be of China’s financial intentions, for reasons both fair and unfair. The unfair reason is all-purpose nervousness about any new rising power. “They need to understand, and they don’t, that everything they do will be seen as political,” a financier with extensive experience in both China and America told me. “Whatever they buy, whatever they say, whatever they do will be seen as China Inc.”

The fair reason for concern is, again, the transparency problem. Twice in the past year, China has in nonfinancial ways demonstrated the ripples that a nontransparent policy creates. Last January, its military intentionally shot down one of its own satellites, filling orbital paths with debris. The exercise greatly alarmed the U.S. military, because of what seemed to be an implied threat to America’s crucial space sensors. For several days, the Chinese government said nothing at all about the test, and nearly a year later, foreign analysts still debate whether it was a deliberate provocation, the result of a misunderstanding, or a freelance effort by the military. In November, China denied a U.S. Navy aircraft carrier, the Kitty Hawk, routine permission to dock in Hong Kong for Thanksgiving, even though many Navy families had gone there for a reunion. In each case, the most ominous aspect is that outsiders could not really be sure what the Chinese leadership had in mind. Were these deliberate taunts or shows of strength? The results of factional feuding within the leadership? Simple miscalculations? In the absence of clear official explanations no one really knew, and many assumed the worst.

So it could be with finance, unless China becomes as transparent as it is rich. Chinese officials say they will move in that direction, but they’re in no hurry. Last fall, Edwin Truman prepared a good-governance scorecard for dozens of “sovereign wealth” funds—government-run investment funds like SAFE and the CIC. He compared funds from Singapore, Korea, Norway, and elsewhere, ranking them on governing structure, openness, and similar qualities. China’s funds ended up in the lower third of his list—better-run than Iran’s, Sudan’s, or Algeria’s, but worse than Mexico’s, Russia’s, or Kuwait’s. China received no points in the “governance” category and half a point out of a possible 12 for “transparency and accountability.”

Foreigners (ordinary Chinese too, for that matter) can’t be sure about the mixture of political and strictly economic motives behind future investment decisions the Chinese might make. When China’s president, Hu Jintao, visited Seattle two years ago, he announced a large purchase of Boeing aircraft. When France’s new president, Nicolas Sarkozy, visited China late last year, Hu announced an even larger purchase of Airbuses. Every Chinese order for an airplane is a political as well as commercial decision. Brad Setser says that the Chinese government probably believed that it would get “credit” for the Blackstone purchase in whatever negotiations came up next with the United States, in the same way it would get credit for choosing Boeing. This is another twist to the Kremlinology of trying to discern China’s investment strategy.

Where the money goes, other kinds of power follow. Just ask Mikhail Gorbachev, as he reflects on the role bankruptcy played in bringing down the Soviet empire. While Japan’s great wealth has not yet made it a major diplomatic actor, and China has so far shied from, rather than seized, opportunities to influence events outside its immediate realm, time and money could change that. China’s military is too weak to challenge the U.S. directly even in the Taiwan Straits, let alone anyplace else. That, too, could change.

A Balance of Terror

Let’s take these fears about a rich, strong China to their logical extreme. The U.S. and Chinese governments are always disagreeing—about trade, foreign policy, the environment. Someday the disagreement could be severe. Taiwan, Tibet, North Korea, Iran—the possibilities are many, though Taiwan always heads the list. Perhaps a crackdown within China. Perhaps another accident, like the U.S. bombing of China’s embassy in Belgrade nine years ago, which everyone in China still believes was intentional and which no prudent American ever mentions here.

Whatever the provocation, China would consider its levers and weapons and find one stronger than all the rest—one no other country in the world can wield. Without China’s billion dollars a day, the United States could not keep its economy stable or spare the dollar from collapse.

Would the Chinese use that weapon? The reasonable answer is no, because they would wound themselves grievously, too. Their years of national savings are held in the same dollars that would be ruined; in a panic, they’d get only a small share out before the value fell. Besides, their factories depend on customers with dollars to spend.

But that “reassuring” answer is actually frightening. Lawrence Summers calls today’s arrangement “the balance of financial terror,” and says that it is flawed in the same way that the “mutually assured destruction” of the Cold War era was. That doctrine held that neither the United States nor the Soviet Union would dare use its nuclear weapons against the other, since it would be destroyed in return. With allowances for hyperbole, something similar applies to the dollar standoff. China can’t afford to stop feeding dollars to Americans, because China’s own dollar holdings would be devastated if it did. As long as that logic holds, the system works. As soon as it doesn’t, we have a big problem.

What might poke a giant hole in that logic? Not necessarily a titanic struggle over the future of Taiwan. A simple mistake, for one thing. Another speech by Cheng Siwei—perhaps in response to a provocation by Lou Dobbs. A rumor that the oil economies are moving out of dollars for good, setting their prices in euros. Leaked suggestions that the Chinese government is hoping to buy Intel, leading to angry denunciations on the Capitol floor, leading to news that the Chinese will sit out the next Treasury auction. As many world tragedies have been caused by miscalculation as by malice.

Or pent-up political tensions, on all sides. China’s lopsided growth—ahead in exports, behind in schooling, the environment, and everything else—makes the country socially less stable as it grows richer. Meanwhile, its expansion disrupts industries and provokes tensions in the rest of the world. The billions of dollars China pumps into the United States each week strangely seem to make it harder rather than easier for Americans to face their own structural problems. One day, something snaps. Suppose the CIC makes another bad bet—not another Blackstone but another WorldCom, with billions of dollars of Chinese people’s assets irretrievably wiped out. They will need someone to blame, and Americans, for their part, are already primed to blame China back.

So, the shock comes. Does it inevitably cause a cataclysm? No one can know until it’s too late. The important question to ask about the U.S.–China relationship, the economist Eswar Prasad, of Cornell, recently wrote in a paper about financial imbalances, is whether it has “enough flexibility to withstand and recover from large shocks, either internal or external.” He suggested that the contained tensions were so great that the answer could be no.

Today’s American system values upheaval; it’s been a while since we’ve seen too much of it. But Americans who lived through the Depression knew the pain real disruption can bring. Today’s Chinese, looking back on their country’s last century, know, too. With a lack of tragic imagination, Americans have drifted into an arrangement that is comfortable while it lasts, and could last for a while more. But not much longer.

Years ago, the Chinese might have averted today’s pressures by choosing a slower and more balanced approach to growth. If they had it to do over again, I suspect they would in fact choose just the same path—they have gained so much, including the assets they can use to do what they have left undone, whenever the government chooses to spend them. The same is not true, I suspect, for the United States, which might have chosen a very different path: less reliance on China’s subsidies, more reliance on paying as we go. But it’s a little late for those thoughts now. What’s left is to prepare for what we find at the end of the path we have taken.

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James Fallows is an Atlantic national correspondent; his blog is at More

James Fallows is based in Washington as a national correspondent for The Atlantic. He has worked for the magazine for nearly 30 years and in that time has also lived in Seattle, Berkeley, Austin, Tokyo, Kuala Lumpur, Shanghai, and Beijing. He was raised in Redlands, California, received his undergraduate degree in American history and literature from Harvard, and received a graduate degree in economics from Oxford as a Rhodes scholar. In addition to working for The Atlantic, he has spent two years as chief White House speechwriter for Jimmy Carter, two years as the editor of US News & World Report, and six months as a program designer at Microsoft. He is an instrument-rated private pilot. He is also now the chair in U.S. media at the U.S. Studies Centre at the University of Sydney, in Australia.

Fallows has been a finalist for the National Magazine Award five times and has won once; he has also won the American Book Award for nonfiction and a N.Y. Emmy award for the documentary series Doing Business in China. He was the founding chairman of the New America Foundation. His recent books Blind Into Baghdad (2006) and Postcards From Tomorrow Square (2009) are based on his writings for The Atlantic. His latest book is China Airborne. He is married to Deborah Fallows, author of the recent book Dreaming in Chinese. They have two married sons.

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