China flexes, and the US catches a chilly reminder

<i>Illustration</i>: Michael Mucci

Illustration: Michael Mucci

In the old days countries threatened each other by sabre-rattling - moving armies, positioning navies, making physical threats. In the past few days we have seen the modern way to intimidate another power.

The Chinese premier, Wen Jiabao, expressed concern about his country's $US1 trillion ($1.5 trillion) holdings of US government bonds.

"We've lent a huge amount of capital to the US, and of course we're concerned about the security of our assets. And to speak truthfully, I am a little bit worried."

That was all it took.

It marked a threshold moment in relations between the current superpower and the potential one - Beijing demonstrated that it is prepared to use its financial power over the US as an instrument of pressure.

US officials, including Barack Obama himself, hastened to reassure the Chinese over the weekend. "Not just the Chinese Government, but every investor can have absolute confidence in the soundness of investments in the US."

Wen's remark was not random. It was made in answer to a pre-approved question at his annual news conference. It came just as his Foreign Minister, Yang Jiechi, was in Washington to negotiate with the US the approach the two countries would take to the Group of 20 summit in London on April 2.

And it emerged a few weeks after Hillary Clinton went to Beijing and explicitly called on the Government to keep buying US bonds - the Obama Treasury is hoping to sell the world another $1.7 trillion in treasuries this year to pay for the US Government's deficit.

In other words, the US, the world's biggest debtor, finds itself unusually vulnerable. And China, the world's biggest creditor, is newly powerful.

It is the culmination of the different ways the US and China have pursued power. In 1992 China formally adopted a new concept of the national interest it called "comprehensive national power."

This is officially defined as "the totality of a country's economic, military and political power". Among these, economic power has held priority as the basis for all other forms of power. And this has been the national strategy ever since.

By contrast, the US, especially under George Bush, put increasing emphasis on its military as its preferred instrument of power. Fiscal prudence was not just overlooked but violated. When Bush's first treasury secretary, Paul O'Neill, warned the vice-president Dick Cheney against tax cuts because of the looming deficit, Cheney said: "Reagan proved deficits don't matter."

O'Neill's resistance cost him his job. Of course, he was right. The deficit has emerged starkly as a vulnerability of the US state. It was in Reagan's term that the US went from being the world's major creditor to becoming its biggest debtor.

Bush, his ideological and political heir, has left the US, at the end of a boom, with a deficit of half a trillion dollars. To fight off recession, Obama is putting the country into much deeper deficit.

One of China's most influential strategic thinkers, Yan Xuetong, observed some years ago that China had put its communist ideologies aside in pursuit of economic growth, while the US increasingly based its economic policies on political ideology: "Which is the ideological country now?" he asked.

The jostling of a US Navy survey vessel by five Chinese ships in the South China Sea last week provided a timely illustration of the weakness of America's narrow concept of power.

The Chinese ships crowded around the US vessel and put wooden barriers in the water; the US ship turned its firehoses on the Chinese sailors.

The US might have decided to press its case. But it would then have to face the reality that its defence budget is crucially supported by the very country it wanted to confront.

China's options for retaliation would include abandoning US government bonds. It could even dump its existing US treasuries, which could seriously damage the country's ability to finance itself on reasonable terms. Obama's recovery plans could be at risk.

But, of course, if Beijing waged fiscal war on Washington, it would rebound. Twenty-one per cent of Chinese exports go to the US. By sabotaging the US recovery, China would be crimping its own.

This is the financial version of the doctrine of "mutually assured destruction" that kept the US and the Soviet Union from launching their nuclear arsenals at each other during the Cold War.

Wen made exactly this point in his news conference: "On the foreign reserves issue, the first consideration is our national interest. But we also have to consider the stability of the overall international financial system, as the two factors are interlinked."

The market reaction to Wen's remarks took this into account. Investors read the comment as a negotiating ploy. Already, Obama has agreed to support China's demand for voting power in the International Monetary Fund, and no doubt other demands are under negotiation in Washington right now.

Still, the world nearly came to an end twice in the Cold War, during the Cuban missile crisis of 1962 and Operation Able Archer in 1983. The deterrent power of mutually assured destruction depends on rationality and sound flows of information, never assured in a real crisis.

As Lawrence Summers, the chairman of Obama's council of economic advisers, said five years ago: "It surely cannot be prudent for us as a country to rely on a kind of balance of financial terror." Yet that is exactly the calculus holding together what is left of the global economy.