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A CHINA-U.S. RECKONING

Nouriel Roubini, Rachel Ziemba and Adam Towle

Forbes, March 18, 2010

The fault lines in the U.S.-China relationship have been increasingly exposed in recent weeks, with rhetorical barbs exchanged on: trade; the treatment of foreign companies in China; strategic issues such as U.S. support of Taiwan and Tibet's Dalai Lama; responses to Iran's nuclear ambitions; and especially exchange rates. Domestic consensus in the U.S. on the need for action with regard to the renminbi (RMB) is growing. Chinese leaders, including Premier Wen Jiabao, have recently hit back at the U.S. for what they characterize as interference in China's security and economic affairs, and U.S. economic mismanagement.

Today we examine the quest for the new normal between the world's largest creditor and its largest debtor. Given the importance of the relationship to global trade, growth and security, we believe that the two countries will avoid a full-blown confrontation, but uncertain relations and tit-for-tat trade policies could constrain global growth.

The friction suddenly afflicting the world's most-watched bilateral relationship stems from a struggle on the part of both China and the U.S. to deal with the changing dynamics of global economic and political power and influence since the financial crisis. To some extent the financial crisis exacerbated ongoing structural changes that had elevated the role of emerging markets in the global economy and increased their influence in debates on financial regulation, trade and currency policy.

China's ample resources, together with its ability to encourage its banks to lend and its state-owned enterprises to spend, also allowed it to be opportunistic, adding sharply to its resource holdings and supporting cash-strapped countries and companies during the recession. Yet its leverage on U.S. policy seems overstated, particularly as China's willingness to diversify away from U.S. assets remains constrained by its desire for a stable economic policy. Moreover, its economic apparatus is stronger than its security position. In this environment, there is a risk that one or the other player might overplay its hand or badly misinterpret the intentions of the other.

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