4.2 The Undercurrent in the SCS Conflict
1 March 2017
The Turning Point
The Global Financial Crisis in 2008-2009 is the turning point for both the US and China.
For decades since its embrace of capitalism and globalization in the late 1970s, China has been a subservient rule-taker that accepts the status quo of the current US-centric international monetary order. The Global Financial Crisis triggered by the collapse of the US subprime derivatives market, however, changed all that. Amid the progressive delegitimation of the US-led international monetary system in the aftermath of the crisis, China’s moves began to exhibit behaviours as both a rule-maker, promoting global reforms, and a rule-breaker, creating its own arrangements.
The Chinese were appalled by how regulators in the US allowed financial institutions to blatantly and systematically defraud investors, putting the entire global financial system at risk in the process. Anyone in China at that time watching how its government scurried to contain the damages of the shocks as the crisis evolved in the US would not have missed the resolve of the Chinese that something ought to be done about how the US is abusing the ‘exorbitant privilege’ it enjoys from the US-led international monetary system and the dollar hegemony.
Hence, in the aftermath of the Global Financial Crisis, Chinese officials began talks about a new international financial order not dependent on the US dollar as the world’s reserve currency. In early 2009, the governor of the Chinese central bank the People’s Bank of China, Zhou Xiochuan, called for the de-dollarization of the international monetary system by gradually moving toward a “super-sovereign” reserves currency to minimize the risks associated with using a national currency as international money. This could be achieved, for example, by establishing Special Drawing Right (SDR) as a supranational currency, which was valued based on a basket of four major currencies. Because the value of the SDR is independent of the macroeconomic policies of one country, it is less volatile than the US dollar currently is. Its stability therefore makes it a better store of value for countries that wish to park a proportion of their savings in foreign assets. For a start, the SDR could be used to denominate all IMF transactions as well as those between central banks. International financial institutions can also issue more debts denominated in SDR. In time, the stability of the SDR may encourage its adoption by also the private sector to denominate and invoice all international transactions.
To prepare RMB for inclusion as one of SDR’s basket of currencies, China also embarked on its quest to internationalize RMB based on a plan to promote it first as a transactional currency for conduct of international trades and an investment currency for cross-border investments, then progressively as a reserves currency for central banks and safe assets investors. To reduce its dependency on the US dollar, China also announced in June 2010 that it would release the RMB from its dollar peg and allow the currency to float against a basket of currencies instead.
Clearly, China sees the internationalization of the renminbi as an important step in reining in America’s abuse of the dollar’s role as the global reserve currency. It dawned on the US political elites that China now has not only the intention but also the capability and an action plan to strike directly at the root of American’s geopolitical power – the US-led international monetary system and the dollar hegemony – and a decisive preventive response is overdue. An inevitable showdown that both sides had all along known would come was imminent.
In short, the SCS conflict to the Americans is more than just China’s conflicting territorial claim with its neighbours. Rather it is driven more by the undercurrent of China’s challenge to the dollar hegemony which in turn threatens US’ geopolitical hegemony.
It is not that the Chinese leaders had thrown to the wind Deng’s exhortation of lying low to build strength (韬光养晦). In 2010, a book entitled China Dream published by a hawkish Chinese colonel of the National Defence University outlines the vision of a world where a rejuvenated China rises to replace the declining US as the leader by 2050. The book was soon withdrawn from circulation to avoid alarming China's neighbours and the US.
Not long after Xi assumed the top post in 2012, however, it was put back on the shelves of state-run bookstores as a recommended read. Xi’s implicit endorsement of Colonel Liu’s book appears to be in line with the triumphalist view of a group of Chinese elites that with the US greatly weakened by the financial crisis and their military misadventures, the time has come for China to catch up with the US. However, since that triumphalist thinking runs smack into US’ belief of its supremacy, the Chinese elites envisaged that a zero-sum conflict between the two powers would be inevitable. Moreover, Obama’s “Pivot to Asia” also made it clear to the Chinese that even if they had wanted to focus on economic developments, their hand would still be forced in the end by entrapments by the US and its allies.
Dollar Hegemony: Blessing or Curse?
China’s desire for change is understandable. The US creates dollars out of thin air while China painstakingly builds its reserves of every US dollar at the expense of its workers’ welfare and the environmental degradation. In the end, the value of their dollar reserves is still constantly diluted by the US printing ever more dollars and raising more debts.
To be fair, the American-led international monetary system and the dollar hegemony have facilitated the rapid expansion of global trade over the past decades. But it has also conferred on the US the ‘exorbitant privilege’ of being able to raise any amount of debts at low costs. That privilege is a double-edged sword. It is a huge blessing for not only the Americans but also the world if used responsibly and measuredly but a damning curse when abused.
And curse it has been for the US as the ease of raising debts encourages profligacy and allows American politicians on both sides of the political divide to kick the can down the road rather than confronting tough domestic socio-economic issues head-on. For example, instead of resolutely tackling income and wealth inequalities caused by deindustrialization and financialization of the American economy, the government chose to increase welfare-related spending as wage growth languishes. Between 1962 and 2016, health and human services spending rose from 3% of the federal budget to 28% while social security outlays also increased from 14% to 23% during the same period. In other words, non-productive welfare-related expenditure today constitutes more than half of the US federal budget.
More pertinently, for the rest of the world, the ease of raising debts helped to finance American’s military adventurism to project its hegemonic geopolitical power overseas. Over the past decades, the US had consistently outpaced all other nations in military expenditures. Its spending of $592 billion in 2015, for example, was roughly the total size of the next seven largest military budgets around the world or 37% of the $1.6 trillion total world defence spending. In contrast, military spending of the Chinese and Russian amounts to only about 25% and 10% respectively of US’ military budgets.
America’s excessive military spending is possible because the world clamours for US dollars and debts as safe assets. To counter the US’ geopolitical hegemony, therefore, China knows that it has to neutralize the dollar hegemony lest it suffers the fate of the Soviet Union bankrupted by its arms race with the US. In other words, because the dollar hegemony is the root of US’ geopolitical hegemony, it is also its Achilles’ heel. Internationalizing RMB is thus both a defensive move, to protect its currency, and an offensive move, to erode the dominance of the US dollar as a global currency.
The Impending US Debt Crisis
To be sure, RMB is unlikely to replace dollar any time soon, given the dollar’s unique long-standing status as a safe asset as well as the unparalleled liquidity afforded by US’ extraordinarily efficient and deep capital markets. Today, RMB accounts for only 1.86% of payment volume and 1% of the total global reserves compared to the US dollar’s 42.5% and 64% respectively. China’s strategy is thus to position RMB as an alternative currency side by side with the US dollar at this stage to encourage its use in the coming years while working to put in place the international infrastructure needed to make it a global currency.
The unlikelihood of the RMB to replace the dollar, however, belies the fact that there is really no such need to in order to hurt the US. All it takes is for interest rates to creep up. The pain of financing the federal debts coupled with increasing difficulty to raise new debts may set off chain reactions that not only inflict great pains on the American people, millions of whom are already struggling to service their debts, but also make it harder for the US government to finance existing debts and future deficits.
The Americans’ lack of financial reticence has increased the likelihood of an impending financial calamity. In the last eight years, for example, the federal government added $9 trillion to the public debt. Today, the US government gross debts stand at US$19.8 trillion or 105% of GDP. Over the next decade, based on planned spending alone, national debts are projected to increase by a further $8.6 trillion before even factoring in Trump's $1 trillion projected infrastructure spending as well as tax cuts which policy experts say would add $10 trillion to the national debt in the coming decade. Estimates by Committee for a Responsible Federal Budget show that, under Trump’s spending plan, gross debt would rise to $39.5 trillion, or 143% as a share of GDP, by 2026.
Furthermore, Trump’s fiscal spending is likely to also push up interest rates. In October 2016, the U.S. Treasury’s average interest rate was a minuscule 2.216%, which is about one-third of the 6.642% in December 2000. The US government’s $432 billion interest payment in fiscal 2016, which make up 13.2% of the federal budget, would have been at least double if interest rates were at the average rates of the 1960-2000 period. Growth rate of interest payments, at 5.3%, is significantly higher than the increase of 0.6% in tax receipts in the same year. Based on the borrowings for planned spending, net interest payments is projected to more than double, rising from 1.4% of GDP in 2016 to 3.0% of GDP in 2026.
If the economy continues to expand proportionately less than the mounting debt level, rising interest costs may even push the US into a Greek-style financial crisis. In 2015 alone, for example, federal debts increased by $1.9 trillion while GDP only went up $599 billion.
Economists who see borrowings of the US government debts as a non-issue argue that the national debts are a relatively small percentage of US’ GDP and can be replaced by new debts and never have to be repaid. That argument, however, is predicated on America's ability to sustain the historically high demand for the US Treasury debt, a risky presumption if the recent sell-offs by foreign governments, which still hold $6.175 trillion, is any indication.
In the period July 2015 – July 2016, for example, a massive $343 billion of US Treasury bills have been sold by foreign central banks. China, which is US’ largest creditor, sold $34 billion in July 2016 alone. It has cut its holding from a high of US$1.3 trillion to $1.16 trillion as of September 2016. China is keen to diversify the risks of the assets held as reserves. Unless it continues to enjoy an excessively high level of trade surplus with the US, it is unlikely to load on more US debts. Japan, the second largest US debt holders, is pushing its own QE programme to the limit and so is EU. Saudis, on the other hand, is also liquidating US debts to finance their deficits arising from lower oil prices.
The biggest problem for the US therefore is not whether it can pay down its existing debt. Rather, it is to find buyers for the $20 trillion of projected new debts over the next 10 years. Already, US Treasury data shows that America’s gross liabilities to the rest of the world rose from $9.8 trillion in 2007 to $17.1 trillion by June 2015, of which $10.5 trillion was debt and $6.6 trillion equity. Foreign holdings of US securities were equivalent to 95% of US GDP in June 2015.
For now, private investors, both domestic and foreign, are reportedly soaking up the US government debts but there is a limit of how much slack they can pick up if the sell-off continues.
Social Security Trust Funds (SSTF), which is the single biggest creditor owning $2.8 trillion worth of government debts, is still buying using the excess of the revenue that it receives from taxes. However, the revenue surplus is projected to turn into deficit by 2018 when SSTF needs to pay out more to retirees than it receives from the working population. By then, the Federal government not only needs to raise taxes or issue more debts to give the money back but also can no longer depend on SSTF to buy more debts. As for pension funds, the current coupon rate is too low to attract them to make a substantial increase in investment. Meanwhile, hedge funds are losing money due to bad performance in recent years.
Finally, there is a limit of how much debt can be monetized by the Fed whose balance sheet already holds $4.5 trillion of Treasury bonds. What was promised at the start of QE1 by the Fed to be a temporary measure became more like a permanent fixture. Even though QE3 had ended in 2014, the Fed not only did not sell a single Treasury bill but also used every penny of interest and principal repayments it received to buy more government debts. Looking forward, even if the US Treasury makes no repayment to the Fed and the debts disappear into thin air upon maturity, it would be like the Fed had printed trillions in new money, which could be hyper-inflationary for not only the US but also the rest of the world.
In short, the US is currently at a very difficult juncture financially because of mismanagement in recent decades by profligate US presidents who had no qualms with deficit spending knowing full well that US could raise more debts and the problem will be inherited at the end of his term by the next president. As an astute businessman who had himself been at the brink of bankruptcy, President Trump knows. This explains his insistence that America’s allies pay more ‘protection money’ through his calls for “a rebalancing of financial commitments”. But most of all, the future of US depends on the continued hegemony of its US dollar, hence the need to curtail the rise of RMB.
Putting SCS Conflict in Perspective
It is therefore crucial to put in perspective any impending military conflict between the incumbent global superpower bent on preserving its hegemonic geopolitical power and the emergent regional power seeking what it views as its rightful place befitting its rising economic clout.
For the US, the ultimate objective is to weaken China in order to protect the US-led international monetary system and the supremacy of the US dollar which in turn allows it to maintain its expensive ambition of geopolitical hegemony. The Chinese, on the other hand, is defending not only its national sovereignty but also the survival of the regime as well as the integrity of its nation state. If China loses, it faces the prospects of not only a weakened RMB and depleted national reserves but also a disruptive regime change as well as the possible breaking away of the peripheral parts of its territory.
The stakes for the US and China are therefore more than just mining rights, navigational rights and territorial claims. Navigational rights, for example, have never been an issue until the US made it to be so to justify its strategy of pivoting to Asia. Chinese building of islands in South China Sea (SCS) also began only in 2013 as a response to the US’ pivot to Asia.
China knows that, because of the rise of RMB, it is a greater threat to the US today than Soviet Union ever was. The US, on the other hand, sees China as a growing threat that has to be tackled sooner rather than later. Steve Bannon, one of President Donald Trump’s former most trusted strategists, had asserted that there is no doubt that the US is going to war with China in the South China Sea in 5 to 10 years. On the Chinese side, a commentary written on the day of Trump’s inauguration by an official in the Central Military Commission opined that “‘A war within the president’s term’ or ‘war breaking out tonight’ are not just slogans, they are becoming a practical reality.” Xi himself has left no doubt that China will respond if its sovereignty is infringed. He has already been given the authority to fight and he will use it if needed. The political cost of not fighting will be greater than any economic costs from disruptions arising from a physical conflict.
This is therefore a battle for supremacy between two goliaths. There is really no place for a David. The highly controversial President Duterte may be foul-mouth, brash, and even opportunistic but is nonetheless wise enough to understand that this is not a battle for the Philippines as a proxy of the US.
Telling China to respect the territorial claim ruling from the Hague-based Permanent Court of Arbitration thus misses the true picture of what is driving the conflict.
First 10 December 2016. Updated June 2017.
 See Zhou Xiochuan. (2009).
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 See Perkowski, Jack. (2010).
 See Kenneth Lieberthal. (2011). “The American Pivot to Asia.” Foreign Policy. December 21, 2011.
 See Liu Mingfu. (2015).
 See Cooper, Ryan. (2016). “The world wants to pay America to use the dollar. We should let them.” June 10, 2016. The Week.
 Already over 40% of Americans who owe student loan debt are defaulting on their payments. http://ronpaulinstitute.org/archives/featured-articles/2016/april/17/what-did-fed-chairman-yellen-tell-obama/
 Proponents of the tax cuts, however, counters that that the lower taxes would bring about an economic boom of 4% GDP growth translating into a surge in tax revenue. http://www.politico.com/story/2016/11/trump-infrastructure-plan-washington-reality-231649
 “How Much Would Clinton and Trump Increase Our $19 Trillion Gross Debt?” Committee For a Responsible Federal Budget. July 27, 2016. http://www.crfb.org/blogs/how-much-would-clinton-and-trump-increase-our-19-trillion-gross-debt
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 https://www.cbo.gov/sites/default/files/114th-congress-2015-2016/reports/51129-2016Outlook_OneCol-2.pdf The Budget and Economic Outlook: 2016 to 2026. January 2016.
 http://bonnerandpartners.com/howimpreppingforthenextrecession/ “How I’m Prepping for The Next Recession.” April 20, 2016
 Douglas A. McIntyre. (___) “Saudis, China dump treasuries; Foreign central banks liquidate a record $346billion in US paper.” 247Wallst.com.
 http://abcnews.go.com/Business/wireStory/foreign-holdings-us-treasury-debt-3rd-month-43588208 “Foreign Holdings of US Treasury Debt Down for 3rd Month” Nov 16, 2016.
See Sheng, Andrew & Geng, Xiao. (2016).
 Schiff, Peter. (2016).
 See Haas, Benjamin. (2017).
 See Liu Zhen Zhen. (2017).