The United States remains the most powerful economy on earth, with a defense establishment second to none. China stands as the world's second largest economy, measured on the basis of "purchasing power parity."

Yet, America enters what is widely dubbed "the Chinese Century" as the world's largest consumer - and a net debtor. In a time of mounting current account deficits and a rapidly depreciating currency, Washington has ceded unprecedented leverage over the country's future to a government that is a world away, as well as a budding strategic rival.

An emerging power with the long-term potential to eclipse US economic and military superiority, China has a current and future capacity to influence events in the global economy that can scarcely be ignored.

WALKING A TIGHTROPE

From basic economics (Economics 101) "current account:" the balance of payments for a country, reflecting the balance of trade, taking into consideration the net of imports and exports of a specific country.

The US economy's greatest vulnerability to external forces is the burgeoning current account deficit. For the year 2004, the deficit reached yet another record at some $ 617.7 billion, a 24 % increase over the previous year - which was itself a record. The shortfall is forecast to exceed 6.6% of US GDP, the highest percentage of any major industrial country in modern times.

Anxiety over the huge funding needs of the US current account deficit roil financial markets on a daily basis. The US finances the gap through net borrowing and the sale of assets to foreign investors. Despite ballooning deficits, enough buyers have been attracted to US stocks, treasury bills, and real estate to cover the disparity. Nevertheless, US consumption has been growing faster than US income for the past decade. "This force-feeding of American wealth to the rest of the world is now proceeding at the rate of $ 1.8 billion daily," exclaimed Warren Buffet, chairman of Berkshire Hathaway. As a consequence of its chronic indebtedness, foreigners now own about $ 3 trillion of the US economy.

China alone accounts for over one quarter of the 2004 current account deficit. The massive deficit with the communist giant ranks China first among US trading partners when the current account gap is separated by region - ahead of the EU, Japan, and Canada. In the past year (FY- 2004) alone, the US bought $ 162 billion more in goods and services from China than the Chinese bought from the US. And there is little chance of imminent improvement.

Ordinarily, a country running huge deficits in its current account can feel secure that it is, simultaneously, a magnet for foreign capital. What concerns many analysts, however, is how those huge inflows of capital are being used. The past few years have seen a shift away from foreign direct investment (FDI) toward the purchase of hundreds of billions of dollars in US Treasury bonds. Foreign central banks are major buyers of US Treasuries, with the Peoples Bank of China (PBoC) the second largest purchaser after the Bank of Japan.

China's central bank has also led the swelling demand for US mortgage-backed securities. Chinese purchases of Freddie Mac, Fannie Mae, and other pre-packaged debt securities have contributed to bullish momentum in housing prices and helped maintain low mortgage rates. In short, China has played a key role in keeping interest rates low by financing huge US budget deficits, while its participation in the mortgage market has enhanced the pool of capital available for American homebuyers.

Unfortunately, this flow of events could be thrown into reverse by a sudden change in investor sentiment, or a deliberate decision by a foreign government. Continuing erosion in US fundamentals may, sooner or later, trigger an exodus from US stocks and bonds.

Similarly, friction between the US and China - over trade, exchange rate policy, or Taiwan - could encourage the Peoples Bank of China (PBoC) to reduce its asset holdings, or to stop buying US treasuries altogether. Interest rates would escalate as the government struggles to find new sources of finance for its deficits. Americans with adjustable rate mortgages would try to sell homes just when rising rates dampen demand. The rising value of real estate, against which many Americans drew out home equity loans, could tumble with one statement by the Chinese Central Bank.

THE EMBATTLED DOLLAR - AND THE YUAN, ITS UNWELCOME TWIN

Sharing headlines with the US current account deficit is the plight of the US dollar, another major factor in the balance of payments conundrum. In 2004, the dollar fell for the third straight year against the yen and the Euro; the dollar has seen similar losses against the other main currencies. In just two years, the world's reserve currency declined 52% against the Euro, a relative newcomer (as of 1 January 1999). All things being equal, dollar depreciation of this magnitude should have begun to yield benefits for the US in an improved current account.

China's currency peg with the US dollar is one factor hampering adjustments in global trade imbalances. Exchange rate adjustments have already occurred among the world's free-floating currencies. But the currency markets cannot correct the undervalued Chinese yuan because Beijing maintains a fixed exchange rate, set firmly to the dollar since 1999. Massive foreign currency reserves allow the People's Bank of China (PBoC) to intervene whenever necessary to prevent appreciation of the Chinese yuan, confining its movement to an extremely narrow band.

Beijing's rigid exchange rate regime has allowed the yuan to follow, in lock step, the dollar's own decline against other currencies. Not only has this hindered the US from narrowing its own trade gap with China. It has also allowed China to maintain the same relative advantage it enjoyed over US goods in global markets before the dollar's steep decline.

Rumors have circulated for months that the Chinese yuan will soon be revalued against the US dollar. But Chinese officials have indicated they will not be rushed into changing its exchange rate, especially if pressured by America. At the close of the National People's Congress on 14 March 2005, China's premier, Wen Jiabao, reaffirmed that China will not revalue its currency if it believes it will impact its immediate goals of rapid growth and further job creation.

China's financial position vis-a-vis the United States gives the communist power advantages it had not known before. If the US were to enact measures to restrict Chinese imports, or pressure Beijing too strongly to appreciate its currency, China possesses the potential to retaliate. Yet the most likely arena for conflict is in the sphere of geopolitics.

SECURITY IN THE PACIFIC

Following two decades of exuberant growth, China is taking strides to make its military power commensurate with its new economic status. China's growing military power is challenging US superiority in the region; this growing military presence of the Chinese has a direct bearing on the security of Taiwan, a focal point of Chinese-American relations since 1949.

Tensions over the Taiwan Strait were inflamed this March 2005 by China's proposal to enact an "anti-secession law," authorizing the use of military force to achieve the island's reunification with the mainland. US officials reacted with surprise. White House and US State Department spokesmen branded the proposal "unhelpful," and underlined US opposition "to any attempts to determine the future of Taiwan by anything other than peaceful means."

Beijing's recent announcement of a 12.6 % increase in military spending marks the 15th year in a row, save one, in which the PRC's defense budget has grown by double digits. New funds have been allocated to naval procurement, battlefield electronics, and the raising of a new paratroop division. According to Francois Godement, Director of the Asian Centre at the French Institute of International Relations, the areas consistently chosen for expansion and modernization "indicate that Taiwan is the target." Indeed, a modernized and strong Chinese Navy could serve to tell all of Asia - "we are here."

Meanwhile, the constellation of island bases that the US won in the wake of Japans defeat in World War II are subject to phantom visits from the Chinese Navy. In November 2004, a Chinese nuclear submarine passed stealthily by Saipan, the homeport of five US supply ships. Such incidents will become commonplace as the US is forced to share the Marianas and the greater western Pacific with the world's fastest growing navy. Hiroshi Nakajima, Executive Director of the Pacific Society, predicts that, given time, "Chinese interests and American interests will clash."

CHINA: GOOD NEWS / BAD NEWS

As China has opened its economy to increased foreign trade and investment, it has learned the value of maintaining good relations with its trading partners. In the process of moving away from central planning, it has developed a practical, and shrewd, understanding of how trade flows and financial markets interact. Knowing its own well-being depends upon the health of its neighbors and the wider global economy, China is less likely to make economic - or military - decisions that are rash or inconsistent with its long-term interests. By the time China achieves superpower status, one hopes that America will have brought its profligate habits to heel.

Businesses looking for export opportunities may be surprised to know that China has become America's 5th largest export market. On a cumulative basis, the US also ranks as China's second-largest foreign investor. Low labor costs and a well-educated work force make China an attractive location for wholly owned enterprises, which manufacture goods for local consumption, as well as for US domestic markets.

Nevertheless, China's business climate remains opaque, arbitrary, and notoriously deficient in the protection of intellectual property rights. Before entering China, prudent managers should seek the assistance of legal experts and consulting firms experienced in vetting potential business partners, preparing contracts, and analyzing political risks.

© Copyright - Smith Brandon International, Inc.

Smith Brandon International, Inc. conducts international investigations and provides actionable business intelligence and risk avoidance counsel to assist companies in their overseas operations. The firm's principals are grounded in investigative, analytical, and intelligence gathering techniques, drawing on decades of experience in the FBI, State Department, intelligence circles and the private sector. For more information, please call 202-887-9363, or visit our website at http://www.smithbrandon.com/.