The recent bailout package being approved in the US Congress needs to be viewed in the context of the spurt in the accumulation of forex reserves of China by about USD 500 billions in the last six months to about USD 2 trillions in the aggregate. This gargantuan build-up of Forex reserves by China has strangely received very little attention of economists, policy analysts, currency traders and of course geo-strategists around the world.

Why is China engaged in this exercise? What could be its implications on the on going global financial crisis? Could China trip the bailout package announced by the US last week? Crucially what are the implications for the existing global order?

What is intriguing in the Chinese reserve build up is that both trade surplus as well as foreign direct investment (FDI) account only for a part of this huge build up of forex reserves. After adjusting for all known sources of reserve accretion, experts conclude that approximately an excess of USD 200 billions could have flown into China as ‘hot money’ in this period.

Why and how money flows into China...

The Economist in one of its issues in recent months quotes Michael Pettis, an economist working in China who explains how and why hot money flows into China. According to Pettis, hot money comes into China when companies over-state FDI and over-invoice exports.

But where is such money getting parked in China? The Chinese stockmarket, like many of its counter- parts across the globe, continues to plunge. Hence, it may not be an attractive destination for hot money. Some experts suggest that it could have gone into property while the predominant view is that it could simply be the Chinese banks that offer interest rates in excess of 4 per cent on Yuan deposits compared with a lower rate on dollars.

How a 2 per cent interest rate differential results in such cross-border flow of capital requires some explanation. What makes the dollar-yuan exchange rates central to any discussion on global finance is the fact that trade between US and China has burgeoned in the past decade or so. But this is not a two-way trade as would be commonly believed. Most of this is unilateral - ie. exports from China into the US.

In fact, this is the fundamental reason for the burgeoning current account surplus that in turn translates into the forex reserves of China. In the process over the years the US has become extremely dependent on China not only for supplying cheap goods but also for the Chinese to fund such imports by parking their forex surplus within the US.

This twin-dependency on the Chinese for goods as well as money to finance its deficits has always engaged the attention of the US policy framers who till recently were not at all comfortable with this arrangement. And now added to this is the latest aggressive build up of forex reserves by China surely has the Americans in a bind.

The economics behind Chinese yuan

Economists in the US till recently believed that a weak yuan implicitly subsidises the Chinese exports leading to such huge trade imbalances between the two countries. Consequently, they have been pointing to the imperative need for a substantial appreciation of the yuan by a minimum of 20-25 per cent vis-à-vis the USD to remedy the situation. In the alternative they have suggested a countervailing duty of a similar scale on imports from China.

Further, economists are also of the opinion that by constant intervention in the forex market not only does the Chinese Central Bank ensure a weak yuan it also causes competitive devaluation of various currencies in Asia. The net consequence is a domino effect with the result that the USD is artificially valued at higher-level vis-à-vis most Asian currencies. Experts believe that a significant yuan revaluation will ensure a more realistic exchange rate mechanism in Asia as it could force other countries to follow suit.

It is in this connection C. Fred Bergsten of the Peterson Institute in a testimony before the Hearing on the Treasury Department's Report to Congress on International Economic and Exchange Rate Policy in early 2007 stated: "by keeping its own currency undervalued, China has also deterred a number of other Asian countries from letting their currencies rise very much against for fear of losing competitive position against China."

Naturally, most experts anticipate a significant revaluation of the yuan, given the uncertainty associated with the global financial markets that hot money is flowing to a relatively safe destination. After all, China not only offers higher return but also is virtually insured against any downward movement against the USD.

It is a policy to dynamite the American economy?

Is this hot money - read inexplicable flows - flowing into China in anticipation of this revaluation of the yuan? Or is it a simple case of China maintaining trade competitiveness through a weak yuan? Or is there something more to meet the eye and are the Chinese acquiring the dollars with some sinister motives? Does the Chinese strategy of a weak currency over the years have the un-stated policy of dynamiting the American economy?

Mutually assured destruction (MAD)

What is worrying the Americans is that China accounts for about a fourth of the global forex surpluses and are the counterparts of the US current account deficit. Put simply, while China accumulates forex reserves, the US accumulates the corresponding debt. And the Americans are aware that it is the Chinese who are the biggest accumulators of the US treasury bonds using such surpluses.

What is indeed intriguing is that a country - the US - that prides in being ‘independent’ from other countries especially in security affairs, is now caught in a quagmire as it has to be constantly in the good books of the Chinese government if it wants to avoid a sudden shock.

Countries that hold large USD- denominated forex reserves have a powerful tool in their arsenal - they could wreck American financial markets at a mere click of a mouse by selling their dollar holdings. Imagine China with a holding nearly two trillion dollars worth of treasury bonds deciding to sell the same overnight!

And that could instantantly dynamite the global financial system as it could suck liquidity and cause interest rates to shoot through the roof. Remember, the USD 700 billion dollar package announced last week by the US is precisely aimed at addressing the liquidity crunch within the US.

Surely it may have no intent; especially for large countries like China, to do so would be at a cost. But the Chinese would well-understand that no country can ever become a global super power without a cost. As and when the Chinese decide to take a hit on their dollar holdings, global finance could indeed take a roller coaster ride.’

An intriguing geo-political game

Obviously, the Americans’ borrowing from China and the Chinese supply of money to the US is indeed an intriguing geo-political game. Surely, this cannot be simple economics by any stretch of imagination.

Given this paradigm, till date experts opine both are locked in a tight bear hug with the other. According to Lawrence Summers: ‘it is a new form of mutually assured destruction (MAD) that has quietly emerged over the last few years’ implying that China requires the US (for its exports and for parking its forex reserves) as much as the US requires China (for imports and borrowings).

Have the Americans played into the hands of Chinese?

But the recent events in the US last month have turned this MAD paradigm upside down. It is in this context that the recent bailout package needs to be viewed, which seeks to increase liquidity over a period of time by the US government taking over sub-prime assets from financial institutions. That, according to the American thinking, is expected to provide liquidity to the US economy.

Ominous side to Chinese accumulation of reserves

But all these happenings within the US that make this accumulation of forex reserves by China extremely interesting. It may be noted that the Chinese, unlike the others, have always questioned the global order with the US at the helm of affairs. And the Chinese accumulation of forex reserves is surely a strategy that perhaps has an ominous side to it.

And all that is not pure economics as it is made out to be. Rather, it was and remains a well-planned economic, political and military strategy of the Chinese. And in a way it is the mirror image of the star wars programme that US President Reagan unleashed on the erstwhile USSR in the early 1980s that eventually bankrupted the latter within a few years as it engaged in competitive arms build-up with the former.

Statecraft is all about engaging other countries at one's own terms, pace, time and cost. This is what the US did to the USSR in the 1980s and succeeded in dynamiting that country. And that is what China could do to a vulnerable US in the coming months. Crucially, if it doesn't, from the Chinese perspective it would well rue this moment in its history for ever.

The US till date has been depending on the Chinese for imports and to finance them as well for such imports. Now they will have to depend considerably on the Chinese to protect their currency as well as to ensure liquidity in their money markets. And that completely alters the extant global order as the balance of terror till date gives way to one way dominance.