On foreign reserves: are the Communists about to do us an (accidental) favor?

Communist China recently announced it was creating a new investment firm charged specifically with managing its $1 trillion and change in foreign reserves. The cadres insist the new firm "will not hurt the dollar or the American economy." Of course, the cadres are not sincere about this, but their words may be right despite their actions.

The Communists have spent more than a dozen years building up their foreign reserves with their deliberately depreciated currency. The more obvious result of their predatory economic policies has been a U.S. trade deficit to Communist China of more than $200 billion, the largest bilateral trade imbalance in the history of the world. Now, unlike garden-variety protectionists, I don't consider a trade deficit to be a problem per se. A trade deficit with a geopolitical ally (like the large deficits we had vis a vis Japan in the 1980s) can bring benefits on the world stage that don't show up on the current account balance sheet. More to the point, while every economist agrees about the link between goods trade and capital (investment) trade - i.e., one must counterbalance the other - the issue of causality (which leads to which) makes for heated debate. I tend to believe that America's trade imbalance with the rest of the word is the effect, rather than the cause, of America's appeal as an investment vehicle for foreigners.

In fact, Communist China's depreciation would be impossible without regime's willingness to back it up with massive purchase of American investments (usually U.S. Treasury bonds). Only by swallowing up the bonds (and the dollars in which they are priced) can the Communists hold down the overall dollar supply, and thus make the dollar worth more than it would normally be relative to the Communist currency.

That said, the Communist currency devaluation still has dangers to America. While there has certainly been some damage to American manufacturing, I would submit that the impact on other exporters to the U.S. has been far, far worse. Communist China has now muscled out every other nation except Canada to become the second largest exporter to the United States. Its currency move (begun in 1994) may very well have started the "Asian flu" that hit the economies of Indonesia, South Korea, and to a lesser extent Taiwan. Even Japan's export sector has taken a hit. The damage to so many American allies by Communist China's devaluation makes it had for me to believe this was an accident.

Secondly, the buildup in foreign reserves can create (and in fact, it has created) a mountain of cash that can become a geopolitical slush fund for the Communists. If an American Administration - any American Administration - announced it would take a $1 trillion account and invest it in the stock market, the possibility of "social investments" distorting market decisions would drive most economists to apoplexy. While $1 trillion means a lot less in comparison to the entire globe than it does for Wall Street, the cadres still have a tremendous chance to use their reserves to aid their geopolitical power objectives. At the right time and place, a quick transfusion of funds can help a tyrannical ruler delay hyperinflation (hello, Venezuela), rescue a dictator already neck-deep in it (Zimbabwe, anyone?), or come to the aid of an economically isolated nation (say, the Communist-backed mullahcracy of Iran). The geopolitical gains to the Communists - and damage to the Americans - can be substantial.

Thirdly, there is the effect on the American economy. If Communist China chooses to put its reserves elsewhere around the world, it is no longer swallowing up American bonds (and dollars). The resultant dumping of American currency will send the dollar sinking, and fast. If the Communist play their cards right, they could deal the dollar a body blow from which it could never recover.

Clearly, the move by the Communists to start shifting away from American investments can do tremendous and unspeakable damage to the American economy. So why am I saying the cadres are doing us an "accidental favor"? The answer is simple; the cadres are moving way too soon.

At present (March 2007), Communist China holds just over $350 billion in American debt. Yes, that's quite a lot, but compared to the $8.8 trillion in total American debt, it comes to merely 4%. Even among foreign-owned debt, Communist China's piece is less than one-sixth. This means that Communist China's ability to do long-term damage to the American economy is not particularly high right now. Moreover, the odds of the $350 billion in Treasury bonds finding no takers is practically nil. British investors have been increasing their holdings in U.S. debt at a rate twice as large as the Communists; they would certainly be willing to take a large chunk of what the cadres leave behind.

Moreover, if the Communists decided to scale back on their American investments, their ability to keep their currency devalued against the dollar will vanish. Of course, a drop in the dollar's value is part of the cadres' plan, but it will mean some American manufacturers - and far more exporters among America's allies - will find their products competitive in the American marketplace again.

So, for the Communists to gain geopolitically from dropping the dollar, they would need the knock the dollar so far down it loses its value as the "vehicle" currency in the world economy. If one's intent is to inflict that kind of damage, four percent ownership of total American debt just doesn't cut the mustard.

There will be some short-term damage to America's economy, possibly in inflation and some general capital withdrawal as the dropping currency makes international investors nervous for a time. However, the timing for the Communists couldn't possibly be worse. Communist China is preparing to do visible, painful, and temporary damage to America's economy as it prepares for the Olympic Games and its victim prepares for a presidential election. The political effect in the 2008 race could be a tremendous shot in the arm for anti-Communism. Meanwhile, the Communists' use of their reserves to aid their tyrannical, terrorist-sponsoring allies would bring even more focus to the cadres' nefarious geopolitical plans in the heat of an American election campaign.

Normally, the American political landscape would counteract these problems, what with "engagement" running rampant through the establishments of both parties. However, on the Republican side, anti-Communists of some form are dominating the three main facets of the 21st century campaign - the blogosphere (Duncan Hunter), the polls (Rudy Giuliani), and the current "buzz" (Fred Thompson, best-known for the Thompson-Toricelli Bill, which would have sanctioned Communist China for selling weapons to terrorists - it later showed up as a failed amendment to PNTR). If any of these three were to be the Republican nominee (and my heart is still with Hunter), the events described above could be the added boost they need to win the November election. That would be a political disaster for the Communists.

So why are they doing it? I suspect two possible reasons. First of all, they may not see the political ramifications of their actions. This shouldn't surprise anyone; tyrants have always had serious problems reading democracies. The second reason may be more simple (and is certainly more ominous): the Communists may feel they have no choice but to act now to prepare themselves for the future invasion of Taiwan. I would doubt America would still be feeling the ill effects of the cadres' move by 2012, so this may mean the invasion timetable is being moved up - all the more reason to ensure an anti-Communist is in the White House on January 20, 2009.

Either way, I genuinely believe the Communists are about to make a major geopolitical mistake with their foreign reserves. With a little luck, it will be their last before the Chinese people rise up to take their country back.