Chicken Feet and Chump Change

Don’t worry about the U.S.-China trade war over poultry and car tires. Worry about the coming conflict over T-bills and derivatives.

Has a mini-trade war has broken out between the United States and China? On Sept. 12, the Obama administration imposed a 35 percent tariff on tires imported from China. In response, China said it would look into the prices of chicken feet sent from the United States to China. Last week, the New York Times reported that tariffs have been slapped on U.S. imports of Chinese solar panels. Free-traders have begun to worry that President Obama might be back-pedaling on his commitment to open markets.

They shouldn’t be too concerned. Such tiffs are a permanent feature of the contentious, deep, complex economic relationship between China and the United States. So long as there are unions and domestic manufacturers in the United States and excess manufacturing capacity in China, these conflicts will arise in the future, regardless of who controls the White House. As part of a bid to shore up Republican electoral prospects, the Bush administration in 2002 levied tariffs on steel (including steel made in China) and in 2003 enacted trade restrictions on Chinese-made bras. What’s more, the sums involved are a drop in the bucket. Chicken feet, regarded as garbage in Berrien, Ill., but as delicacies in Beijing, account for nearly 50 percent of the $800 million in American pullet products sold to China each year. The 46 million tires imported from China to the United States in 2008 amounted to about $1.8 billion, according to the United Steelworkers. So far this year, the United States has imported $159 billion in goods and services from China and exported $35.7 billion to the Middle Kingdom.

What’s more, the real area to be concerned about has more to do with commodity futures than chicken feet. That’s because the volume of China-U.S. trade in physical goods is dwarfed—in size and importance—by the trade in financial products. The dollars American consumers and businesses ship abroad for plastic, metal, and cotton goods from China return to these shores through the purchase of financial instruments. In July 2009, China held $800 billion of U.S. Treasury securities, up from $550 billion in July 2008, according to the Treasury Department. China, which has surpassed Japan as the largest foreign holder of U.S. Treasuries, accounts for 23 percent of total foreign holdings. In a period in which the U.S. Treasury is flooding the market with new supply—thanks to the massive deficits we’re running—China is a leading export destination. The same holds true, albeit to a lesser degree, for debt issued by quasi-government agencies such as Fannie Mae and Freddie Mac. (Market analysts fretted in August when it was revealed that China had sold a net $4.6 billion of so-called agency debt in the previous month.)

But it’s no longer just the Chinese central bank buying government debt. Now entities controlled by the Chinese government are buying stakes in American financial intermediaries. China Investment Corp., the sovereign wealth fund that is sitting on nearly $300 billion in assets, owns 10 percent of the Blackstone Group, the large private equity firm. In June, CIC bought $1.2 billion worth of Morgan Stanley shares, bringing its stake in the chastened investment bank to 9.9 percent. (CIC had spent $5.6 billion on Morgan Stanley shares back in late 2007.)

While these transactions raise their own bilateral trade issues—competitors worry that Morgan Stanley and Blackstone might now get a leg up while doing business in China—there’s still another kind of emerging financial arrangement that could be even more worrisome. During the panic of 2008, we learned that derivatives, credit-default swaps, hedging contracts, and other arrangements bind companies all over the world to one another in ways that may not be transparent or even apparent. According to the International Swaps and Derivatives Association, the notional value of credit derivatives outstanding is $31.2 trillion. That’s nearly half the pre-crisis peak, but it still means a lot of money is at stake in those markets. A significant chunk of those obligations to make good on big financial bets rests on the balance sheets of Chinese companies. And that could pose a new set of trade issues that would make chicken feet look like chicken feed.

China may have come of age industrially, but it’s still maturing financially. According to ISDA, in Britain, France, and Japan, 100 percent of large companies use derivatives; in China, only 62 percent do. And many of them may lack the talent and experience necessary to manage such instruments effectively. Several Chinese companies, including some with ties to the government, have taken big losses on derivatives and hedging contracts. CITIC Pacific, which is owned by a state enterprise, last year said it could face loses of up to $2 billion on foreign exchange investments. Airlines like China Eastern and Shanghai Air have similarly taken a bath on jet fuel hedges gone sour.

That’s why markets stood on edge in late August, when Caijing, a Chinese magazine, reported that an investigation into hedging and derivative strategies by the State-owned Assets Supervision and Administration Commission might lead some state-owned companies to simply refuse to honor financial contracts. SASAC hastened to correct the reports and suggested it was simply investigating whether the state-owned enterprises had tread into dangerous financial areas. Yet in mid-September, Caijing reported that, with SASAC’s blessing, several state-owned companies “have sent legal warnings to six international investment banks over derivatives trade losses.” Caijing further reported that, “according to incomplete data, 28 central government SOEs were involved in the financial derivatives business in September, and that most had chalked up losses.”

It’s obvious that the “real” economies of China and the United States are tightly bound to each other—the export/import data prove that every month. But the degree of financial integration and interdependency between the two nations is less understood. Tariffs on snow tires or chicken feet may garner media attention, but they’re a side show. The prospect that China’s central bank might not be such a willing purchaser of U.S. government debt, or that many U.S. and European banks could find Chinese counterparties that are unwilling to honor contracts, is far more serious than tariffs on chicken feet. The merchandise that matters most—to Washington and Wall Street, to Shanghai and Beijing—isn’t the stuff that crosses the Pacific in container ships. It’s the material that courses through the world’s financial system via fiber-optic cable.