Designed by Apple in California, assembled in China...

A couple of years ago, Niall Ferguson - the Harvard economic historian, coined the word "Chimerica" to describe what he saw as the key relationship in the then booming global economy: China and America. Cheap Chinese labour was making US companies highly profitable, while spendthrift American consumers in turn, were keeping Chinese corporations busy with export orders. This relationship was driving not just domestic GDP growth rates in these countries, but was also the engine room of world GDP growth. The words on the back of your iPod - "Designed by Apple in California, assembled in China" start to tell the story. To round out this arrangement the Chinese government was converting export surpluses into dollar denominated reserves (US Treasuries in the main) with the aim of preventing their own currency from appreciating - further helping the competitiveness of it's own exports. The United States had the world's cheapest credit card, with an Annual Percentage Rate unlike (in a good way for them) the rates I get sent from Barclays every month. That was then.

This is now. The relationship has moved through various chilly phases over the past 18 months. It's clear that the relationship has not hit it's tipping point just yet, but there is a heightening anxiety amongst more credible commentators about how things will play out. This week I read three articles from for me (and I'm not alone) credible commentators addressing this issue. The Great Reckoning between the wannabee and the has been is going to come, that is for certain. What is uncertain between these commentators is who holds the upper hand at this point in time. In the blue corner, the US has a mountain of debt which is increasing with each domestic stimulus effort. In the red corner, the Chinese have been the historical funders of this debt mountain and are growing increasingly weary about keeping this line of credit ticking over.

A cat and mouse game is being played - the US are pumping out Treasuries by the bucketload and are effectively printing money to finance them (the Federal Reserve is buying much of the issuance) and over time this policy action will create inflation and erode the value of the dollar. On the Chinese side, there is a kind of catch 22 situation - continue to finance the US deficit in order to protect the value of past investments, or allow the US to print money to finance it's own deficit and in doing so erode the value of the liabilities it has to China. To be sure, China is still piling up those dollar-denominated bonds. In March alone, China's holdings of US Treasuries rose $23.7 billion, but Deutsche Bank recently predicted that Chinese reserves will rise by only $100 billion this year, compared with $418 billion last year. With the US annual deficit looking like it will be in excess of $1.5 trillion this year alone, you don't need to be a Nobel prize winner in economics to know that China's $100 billion loan won't cover much of that lot. Where is the rest of the money going to come from?

Irwin Stelzer in his weekly Times "American Account" discussed this great conundrum that "even Barack Obama can't solve for the US". Republicans in Congress have not yet produced a coherent alternative to the President's deficit spending programmes, or his plan to move the boundary between the public and private sectors to the left. And no, the economic data do not suggest that the President's stimulus package has failed. Stock markets, house prices, consumer confidence, you name it, seem to indicate "green shoots". As Stelzer points out however, "the long term challenge to the president comes from two related places: the bond markets and China." It's all got to be paid for, most probably via the bond markets, and if not via the credit card with China, then who?

Bill Gross, in his monthly PIMCO Investment Commentary, raised the same issue. The build up of US IOUs to the rest of the world is maybe not a problem for the short-term, but it is undeniably a major problem for the future. "To zero in on the US of A, its annual deficit of nearly $1.5 trillion is close to 10% of GDP alone, a number never approached since the 1930s Depression. While policymakers, including the President and the Treasury Secretary assure voters and financial markets alike that such a path is unsustainable and that a return to fiscal conservatism is just around the recovery's corner, it is hard to comprehend exactly how that more balanced rabbit can be pulled out of Washington's hat."

The current annual deficit of $1.5 trillion, as Gross points out, does not even address the proverbial "pig in the python". Private think tanks such as The Blackstone Group promise that spending for Social Security and the various healthcare programmes sponsored by Federal government will collectively increase by 6% of GDP over the next 20 years, leading to even larger deficits unless taxes are increased proportionately. Collectively these programmes represent an approximate $40 trillion liability. That figure added to the current $10 trillion US deficit adds up to a public debt of closer to 300%. As Gross points out - a ratio that is similar to that of Latin American economies like Argentina and Brazil when they defaulted at various points over the past century.

Prior to 2009, it was enough to count on the recycling of the US current account deficit to fund Treasury borrowing requirements. Now, however, it is obvious that the Chinese and other surplus nations cannot fund the deficit even if they were fully on board – which they are not. The concern is, therefore, that this funding gap can be bridged in only two ways – both of which have serious consequences for US and global financial markets. The first and most recent development is the steepening of the US Treasury yield curve and the rise of intermediate and long-term bond yields. While the Treasury can easily afford the higher interest expense in the short term, the pressure this puts on mortgage and corporate rates, whose prices are based off government bond prices, represents a serious threat to the fragile “greenshoots” recovery now underway. Secondly, the buyer of last resort in recent months has become the Federal Reserve, with its near daily purchases of Treasuries and Agencies currently running at a $400 billion annual rate. Basically, the only policy action for the US is to inflate it's way out of it's liabilities - yet another hit to the prudent savers of the world - the Chinese government being the biggest.

In this regard the US hold the upper hand in the short term - inflationary fiscal and monetary policy is in their control and to their benefit. Over the longer term, however, the upper hand is undoubtedly held by China - a point which Niall Ferguson asserted in the Daily Telegraph. The breakdown of "Chimerica" could be one of those great turning points in history "when the balance of power tilts decisively away from an established power and towards a rising challenger...It is possible. Financial crises often accelerate the gradual shifting of the geopolitical tectonic plates; they are to history what earthquakes are to geology."

Ferguson, refreshingly, uses historical context for what it's worth and is hugely credible as a consequence. His recent book The Ascent of Money shows how the cycles of history repeat themselves, and create a great context for understanding the current financial crisis. "Something similar may be happening as a consequence of the American financial crisis that began nearly two years ago. The flapping of a butterfly's wings may trigger a hurricane in the Home Counties; in much the same way, a crisis in the market for subprime mortgages could signal the waning of the US hegemony and the advent of a Chinese century." In short, he says, it may be time to start believing the projections made by the Goldman Sachs economist, Jim O'Neill, who predicted a few years ago that China's GDP could equal that of the US by 2027. Three years ago, China did not have a single bank among the world's top 20, measured by market capitalisation. Today the top three are all Chinese. In 2006, the US had seven of the top 20 banks, including the top two; today it has three, and it's highest, JP Morgan, is only fifth.

In an earlier blog post, back in February (Communist Capitalism or Capitalist Communism) I looked at the situation whereby deflated stock prices around the world were allowing China to pick up strategic national assets on the cheap. I happened to be in Australia at the time, and there was a growing insecurity there at national government level about the potential sales of stakes in big Australian mining companies to Chinese interests. A kind of capitalist imperialism was being embarked upon by communist China - a complicated mess of ideologies, where China was using capitalism against the arch capitalists. This empire building will continue for the foreseeable future, as over the longer term, the Chinese economic and political position in the new world order will continue to rise and rise.

In the short term, to China's detriment, the US holds the upper hand in relation to the financing of it's own current account deficit. The US will pursue highly inflationary policy to limit the damage of it's truly gigantic public spending commitments, and China's holdings of US Treasuries will suffer as a consequence. Twenty years from now, if Jim O'Neill's China prediction holds true and the Chinese are sitting on top of the economic world order, the Chinese government will not have forgotten who broke the "Chimerica" relationship.

However, justifiable as retaliation might be, as one of their own ancient proverbs warns: "The one who pursues revenge, should dig two graves."