Trump vs. NATO – Watch out for China!
Just recently U.S. President Donald Trump met with China’s President Xi Jinping in Florida. We talked on this blog several times about this special relationship from an economic and financial perspective. We keep this tradition and asked Prof. Rolf J. Langhammer for his opinion on Trump’s take on NATO and how China is affected by this.
GESblog: Prof. Langhammer, Donald Trump called NATO during his presidential campaign “obsolete”. He later changed his opinion, but he still points out that financing the alliance needs to restructured. Other member states should pay more than they have done so far. Is that a fair call?
Prof. Langhammer: At first sight, it seems like a fair call and NATO and its members are discussing this issue. Yet, NATO was founded 68 years ago and Trump should not forget, that the U.S.A. for decades greatly benefitted from being the leader of the alliance, in particular in financial terms.
GESblog: How did the U.S. benefit from NATO in financial terms?
Prof. Langhammer: During the Cold War, America’s allies benefitted from the U.S.-financed nuclear shield, which had to be large and indivisible to develop a credible deterrence. This is how the U.S. came to provide an “international public good,” namely global security. And at first sight, it seems that the U.S. paid for it. As a matter of fact, NATO partners paid for this – not in cash – but with something even more valuable: They helped the U.S. finance its high domestic consumption (including of defense products) by holding more dollars in their reserves than they would have if they had had to pay more for their own defense. This allowed the U.S. to produce a second international public good, the stabilizing effect of a leading global currency.
GESblog: So NATO partners made the military superpower become a fiscal superpower as well.
Prof. Langhammer: Yes, and this means that the U.S.A., for being the world’s policeman, received a lot of compensation its allies, but that does not show up in any budget reports. And, furthermore, even states that don’t belong to NATO also contributed in this way to America’s advantage.
GESblog: So restructuring of NATO’s financial system would affect more states than just the member states.
Prof. Langhammer: There are close links between being the main provider for global security and the world’s leading currency. If the U.S. retreats from their current role, it would lead to a demise of the dollar. This disruption in the global monetary system would impact every country that depends heavily on the U.S. dollar. First and foremost, that would be China.
GESblog: What would the impacts on China be?
Prof. Langhammer: China, until recently, was the leading country holding U.S. government debt, by the end of October 2016 at about 1.12 trillion USD. If the dollar’s role is weakened as the leading global currency, we will see two different sorts of impact.
First, China can benefit from it. It would make it easier for Chinese companies to service their large outstanding dollar-denominated corporate debt. It would also bring relief to China’s exchange rate regime. In the presence of a weakened dollar, markets could no longer easily (and cheaply) bet against a stable exchange rate between the dollar and the yuan, and against the sustainability of China’s currency basket regime, in which the dollar has a large share.
In addition, Chinese capital would flow from the U.S. to Europe and emerging markets. Stronger European currencies would create incentives for Chinese capital to invest in assets denominated in euros or British pounds rather than in U.S. dollars. In Europe, rising domestic consumption and investment triggered by the new defense commitments would fuel demand for Chinese products and investments. As for emerging countries, a weaker greenback would help them service their U.S.-dollar denominated debt and free up fiscal space, for example for infrastructure investments. This would again help Chinese companies that are very active in these countries.
GESblog: And what’s the downside?
Prof. Langhammer: There is also a downside because the value of China’s U.S. debt holdings in yuan would decline and thus aggravate the financing of domestic liabilities in yuan, for instance, those of debt-ridden state-owned enterprises. China would experience a costly “currency mismatch,” declining assets in dollars against rising liabilities in yuan.
GESblog: So, if the Trump administration decides to walk along this path and the financial situation develops as you described, could China step up and fill the gap left by a retreating U.S.?
Prof. Langhammer: The Chinese maybe see themselves in a position to do that. President Xi Jinping advertised his country as a responsible global actor at the 2017 World Economic Forum in Davos. But they are not there yet to produce global security and monetary stability, nor is there any other country able to do that for time being. So, similar to European countries, China would have to struggle to readjust if the U.S. were to withdraw from these commitments.
Rolf J. Langhammer is a Professor of economics, former Vice President of the Kiel Institute for World Economy and expert on China’s economy. An opinion piece by the author on the same topic was first published on the Mercator Institute for China Studies’ blog “European Voices on China”.