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What Can China Do with Its Foreign Exchange Reserves?

My contribution to Project Syndicate:

Taipei Times: When China National Offshore Oil Company tried to buy the US firm UNOCAL two years ago, it set off a political firestorm in the US. When Dubai Ports World bought Britain's P&O Steam Navigation Company, the fact that P&O operated ports inside the US led to more controversy. One would think that a country like the US, with a current account deficit of roughly US$800 billion a year, would realize that such a yawning external gap is inevitably financed only by selling off assets, which means that foreigners with money acquire ownership and control of US-based businesses. But the US -- or at least Congress and the media -- doesn't get it. Americans evidently hope for a world in which they have feckless deficit-generating fiscal policies, a very low private savings rate and a moderate rate of investment, all financed by foreign capital whose owners are happy to bear the risks yet have no control over their assets.

One might think that foreign investors would quake in terror at these terms and shy away from dollar-denominated assets. But this has not been the case. High oil prices have created huge export revenues for Middle Eastern governments, which still want to park their earnings in US assets. The same is true of Russia, whose oligarchs, as well as the huge state investment fund that Finance Minister Alexi Kudrin has created, also want to invest their oil revenues in the US. As for Asia's governments, with China in the lead, the US remains the importer of last resort. The key to their development strategy is to put migrants from the countryside to work making exports destined for the US market. They doubt that an alternative development strategy based on boosting domestic demand would succeed. Thus, the real values of their currencies must be kept low relative to the dollar, which means that their reserves now invested in the US must continue to grow.

Someday, of course, this will come to an end. Perhaps Asian real currency values will rise sharply as a result of a burst of inflation in Asia. Perhaps the dollar will collapse and there will be a burst of inflation in the US as the Federal Reserve Board decides that temporarily abandoning its price-level peg is a lesser evil than the unemployment fallout that will result from a dollar collapse and interest rate spike.

A government that buys political risk insurance by placing an ever-growing stock of reserve assets in dollar securities guards against some dangers. But it is exposed to other risks, especially if it confines its investments to that slice of the asset pool, US Treasury and high-grade corporate bonds, that US politicians are comfortable having foreigners own. Nominal bonds are not well hedged against inflation and, over the long run, assets that are claims to cash without effective control are highly vulnerable to financial vultures. Prudent foreign government and private investors would find some way to diversify.

But how? Buying other countries' bonds would mean abandoning the goal of keeping real currency values low against the dollar. Buying up whole enterprises triggers angry speeches in the US Congress. What are needed are intermediary organizations that will grant a measure of control to foreigners, allow diversification across a wider range of US-located assets, and yet still appear 100 percent American to US politicians.

Enter the Blackstone Group.

China's US$3 billion investment in Blackstone, while insignificant relative to China's US$1.3 trillion in reserve assets -- a sum headed for US$1.5 trillion by the end of this year and likely to hit US$2 trillion sometime in 2009 -- is but a toe dipped in the water, a test run. At the start of the process, China will have small and indirect ownership stakes in a great many US enterprises, and the odds are that the usual objections will be absent. China will gain a measure of risk diversification, reduce the price pressure that has kept earnings on its foreign exchange reserves low and avoid running into political trouble. Blackstone will gain extra cash to deploy and extra fees.

Some observers think that the US political backlash against foreigners "buying up America" is what will bring the current configuration of global imbalances to an end. Deals like China's investment in Blackstone postpone that backlash, but not for long: US$3 billion is equivalent to what China accumulates in reserve in less than three working days.

The question following China's Blackstone investment is this: How far can this process go? And how much control will US investors ultimately realize they have given up?