Asia's Burden

Eve

n by the buttoned-up standards of central bankers, Alan Greenspan is not an effusive man. But one economic phenomenon has driven the U.S. Federal Reserve Board Chairman to reach for the superlatives: in March, he marveled at the "extraordinary" efforts of China and Japan to prop up the dollar by pumping money into U.S. bonds. Japan's accumulation of U.S. securities, he declared, was "awesome." Indeed, in the first three months of this year, China and Hong Kong bought $167 billion of American securities (primarily U.S. treasuries and corporate bonds), while Japan bought $336 billion worth, according to the Asian Development Bank. Greenspan isn't the only one doing a double take. Last week Bill Gross, America's most influential bond investor, warned that the dollar could plunge by 20% if China and Japan stop supporting it by buying U.S. bonds. "Japan and China will change their stance," Gross told the Financial Times. "We don't know when, but we know they will." By investing in American assets on such a massive scale, Japan and China have undertaken one of the biggest financial experiments in history. Why on earth are they doing it, and how worried should we be?

The central banks of Japan and China aren't buying American bonds out of charity. They're doing it to shore up the dollar and prevent their own currencies from appreciating; this is making their exports cheaper and more appealing to American consumers. One result is that Japan and China have been running enormous trade surpluses with America. They have then reinvested a chunk of that surplus in U.S. bonds. Trans-Pacific trade is thus starting to look like that theoretical impossibility, a perpetual-motion machine: America pays for Asian goods with borrowed money, then Asia uses the profits from these sales to lend more money to its favorite customer. It's a deal that has been beneficial for both sides. A boom in exports to America has fueled economic growth in Japan and China. Asia's eagerness to buy bonds, in turn, has helped America avoid the full consequences of its reckless spending. The U.S. current account deficit touched $542 billion last year and the fiscal deficit, which has burgeoned because of tax cuts and the war in Iraq, is projected to hit $521 billion this year. Huge deficits usually make investors nervous and drive up interest rates, but Asia's bond purchases have allowed Greenspan to keep interest rates low, making life easier for millions of U.S. home buyers and credit-card owners—not to mention President Bush, as he scrambles for money to rebuild Iraq.

But for Asia, this goods-for-bonds system is beginning to outlive its usefulness. For a start, if U.S. interest rates rise, as Greenspan has hinted they soon will, bond prices will fall—and the value of the assets held by Japan and China will be slashed. Another concern is that buying dollar assets to keep its exports cheap might have worked a bit too well for China, with strong exports contributing to the over-heating of the mainland economy. The biggest failing of the goods-for-bonds deal, however, is that it has hooked American consumers onto cheap imports and caused a huge deterioration in the U.S. current-account deficit. If U.S. interest rates surge, the ripple effect will be felt throughout the world in the form of higher mortgage payments, credit-card repayments, and lower corporate investment.

Already, Asia's willingness to bankroll America's debts may be starting to wane. David Wyss, chief economist at ratings agency Standard & Poor's, says anecdotal evidence from bond traders suggests that China's purchases of American securities are slowing. Japan's appetite for U.S. bonds might also begin to ease, if its own economy continues to recover, making domestic investments more attractive than buying American debt. If China and Japan lose their hunger for American assets, the dollar will slide. The question is: how far and how fast? A gradual drop would boost U.S. exports, cut its trade deficit, and help silence protectionist American politicians who demand that trade barriers be raised against Asian countries. But a free fall in the dollar would trigger panic throughout the world's financial system—and remind America's protectionists of the startling new truth of international economics: that the billions of dollars that Asian bankers have parked on Wall Street are now as crucial to America's financial security as America's military power may be to Asia's political security.