The danger of default

China’s trade surplus is now so big that one must begin to ask: Can the global system stand it for long?

Of course, the issue is not just China’s surplus but the combined surpluses of East Asian economies plus the major oil exporters. Add all those together and you have a total of around US$750 billion annually in wealth transfer. Because of the way the system operates, this is in effect a transfer from the major developed economies, principally the US but with secondary roles for the Euro-area and minor ones for Britain, an official reserve currency country, and Australia, an unofficial one.

All US dollars are at the end of the day claims on the US even if dollars accumulated by China’s sovereign wealth fund are used to buy African mining companies.

In theory at least, it would be far better if deficit nations were able to borrow in their own currencies. This would reduce their exchange risk and enable surplus countries to acquire a broader range of debt, for example of Turkish or Indian government debt issued in lira and rupees rather than dollars and euros.

But that is not how it works. China, like the others, has few choices in investing its surpluses. Basically it is either dollars or euros. This inflexibility brings the whole process into question, particularly given the large surpluses that continue to be generated in East Asia despite the rise in the price of oil, which all of them must import.

Export oriented

China faces a particular challenge because its exports have been growing faster than any other major country – successive years of over 20%. This rate may well slow down as imports pick up due to rising domestic demand, higher commodity prices and currency appreciation.

But at the same time, China is climbing the product value chain and moving away from assembly operations that lend themselves to exports with very high import content. This trend seems unlikely to stop in the near future if only because of strong foreign and local investment as well as more sophisticated manufacturing.

There is clearly a dilemma for China. It is possible to use some of the current account surplus to buy oil deposits and other natural resource producing assets (see PetroChina, Sinopec and others) or even foreign manufacturing expertise or networks and global brand names (such as Lenovo’s purchase of the IBM PC division).

But much will still have to be invested in the debt of developed country governments and financial institutions – not least because of the political sensitivity a foreign state enterprise buying assets on a huge scale. The bigger these debts become, the more likely it is that they will at some point to be written down in value. This could come about via currency devaluation, financial institution write-offs, the bankruptcy of household borrowers or, ultimately, whole or partial default.

Suspect borrowers

No matter how good a country’s credit may appear, times and circumstances do change. Who would have forecast a year ago that major Western financial institutions – including Citigroup, Merrill Lynch, UBS and Bear Stearns – would hand out equity to the Gulf states, China and Singapore in exchange for US$50 billion to replace what was lost in a credit crisis for which these firms were directly to blame.

Although global financial systems keep evolving, the underlying principle is the same: Before you lend money you investigate credit worthiness, i.e. ability to repay.

Can the major Western debtors – US, UK, Australia and much of the euro zone except Germany, repay the US$2.5 trillion they collectively owe to East Asia and the oil exporters? And if they did happen to so tighten their belts that they could start making repayments, what would this do to Asian exports?

There are no easy answers for Beijing or anyone else. However, we are now at a point of near crisis in the international system. The legitimacy of China’s trade situation is not in doubt. Nor is its ability to withstand a US recession with the improved domestic value-added element enough to offset perhaps a reduction in export growth from 20% to a still very healthy 10%.

But the bigger questions remain: How much longer can the global system continue to live with such a large trade imbalance? And is China taking note of the fast deteriorating credit conditions of the creditor nations?