PEOPLE ARE beginning to worry about the strategic consequences of the United States' large current-account deficit. A deficit that has been sustained in no small part by the unprecedented buildup of dollar assets by central banks and sovereign wealth funds of other states. Worse, many of them are not U.S. allies. Could China and the major oil producers use their growing financial leverage to pressure the United States? Flynt Leverett, for one, does not shy away from strong claims. "The intersection of ongoing structural shifts in international energy markets with strategic trends in global financial markets poses the most profound challenge to American hegemony since the end of the Cold War," he wrote in these pages not long ago.

It is useful to draw attention to these "strategic trends" in global markets. The U.S. current-account deficit expanded significantly between 2002 and 2006 in dollar terms and relative to U.S. GDP. Yet private demand for U.S. assets from investors abroad-net of U.S. demand for foreign assets-fell after the dot-com bubble burst. The recent rise in the U.S. deficit coincided with a strong increase in central-bank reserves and an associated increase in "official"-central-bank and sovereign-wealth-fund-demand for U.S. assets, not a surge in private demand. Moreover, the set of countries now adding to their assets most rapidly overlaps heavily with the set of countries that would be left out of a concert of the world's democracies. China, the Gulf countries, Singapore and Russia will likely add about $900 billion to their central banks and sovereign funds in 2007-not counting the $100 billion or so likely increase in the foreign assets of China's state banks.

Have these shifts increased the scope for collaboration between the oil-exporting economies in the Gulf and the oil-importing economies of Asia-leading to a "world without the West" or at least an "axis of oil" that could force the United States to alter its policies if they clashed with major interests of its creditors? While the "world without the West" may seem a stretch, a visitor to a city like Dubai could easily leave with a perception of a "world without the United States." The cars on the road are Japanese or German. The labor force is South Asian or British. The sunbathing tourists are British, German or Russian. The big buyers of property come from Iran, Pakistan, Britain and the other Gulf states. The U.S. military presence that protects the emirates is kept out of sight, whether on aircraft carriers floating in the Gulf or air bases in the desert.

But the potential for an axis of oil that unites the Gulf with oil-importing Asia can be easily overstated.

First, the financial linkages along the axis of oil-or what UBS investment bankers have called the new Silk Road-remain far less developed than the trade linkages between East and West Asia. The physical flow of goods from East Asia to the Gulf and of people from South Asia to the Gulf has yet to be matched by comparable financial flows. Both the Gulf and East Asia (notably China) run current-account surpluses and consequently do not need external financing. China has accepted some investment from the Gulf: the major Gulf sovereign funds participated in the IPOs of the major Chinese state banks (perhaps an auger of a world without private investors?); and the Saudis and the Chinese have teamed up to build a refinery for Saudi heavy crude. But the reallocation of the Gulf's portfolio toward the East is still in its infancy. The bulk of both the Gulf's assets and China's assets are still invested in the United States and Europe. So long as both regions manage their currencies and, in the case of the Gulf, their fiscal policies, in ways that result in large current-account surpluses, a financial "world without the West" is impossible. The West is needed to absorb, through its deficit, the large combined current-account surplus of Asia and the Middle East.

Second, there are many cases where the strategic interests of East Asia and the Gulf diverge rather than converge. Iran offers the most obvious example. Iran is viewed as a strategic threat by the Arab countries on the southern and western shores of the Gulf. Iran, with the most people relative to its current oil production of any Gulf country, has the greatest need for external financing to develop its oil and gas resources. It consequently is likely to offer the most opportunities to Indian and Chinese state oil companies looking to increase their investments abroad, whether to profit from Asia's rising energy demand or as part of a strategy to try to secure Asia's energy supply. The potential for discord is obvious.

Third, the financial interests of creditors can also diverge. This is the core insight of the literature that has developed to explain bank runs. Each depositor is a creditor of the bank. Yet each depositor also has an individual interest in getting out of a troubled bank before other depositors: the first depositor out gets out whole, the remaining deposits take all the losses. In 2004, Barry Eichengreen argued that the central banks financing the United States through the buildup of their dollar reserves were in a similar position to the depositors in a troubled bank. The first government to shift its reserves out of the dollar would reap windfall gains. The last government would be stuck holding a deeply depreciated asset. Russia and India took Eichengreen's advice to heart-both likely reduced the dollar's share of their rapidly growing reserves. China and the Gulf, though, likely still keep most of their reserves in dollars.¹ Smaller economies might be able to manage their currencies against the dollar without holding a lot of dollars. But any major Chinese-or Saudi-sales of dollars for euros risk putting pressure on the market. That is why Bernard Eschweiller of JPMorgan argues, "If you shadow the dollar, you have to hold dollars."

Despite their common interest in maintaining the dollar's value-and thus the value of their own currencies-the financial interests of China and the Gulf nonetheless can diverge. For example, the Gulf could gain by diversifying its portfolio away from the dollar-something that likely requires breaking its dollar peg-before China allows more renminbi (RMB) appreciation. A concrete example can help illustrate the concept. In 2007, China allowed the RMB to appreciate a bit faster against the dollar, reducing the purchasing power of the Gulf's existing dollar assets in Asia. The Gulf countries would have been better off if they had reduced the dollar share of their portfolio prior to China's move. China also could gain from diversifying its portfolio more rapidly than the Gulf.

Creditors, of course, also have common interests. Creditors that are "too big to get out" would benefit from joining together to pressure a larger debtor to adopt economic policies that preserve the value of the creditors' claims. China and the Gulf both would prefer a stronger not a weaker dollar, higher not lower U.S. interest rates and possibly a smaller not bigger U.S. fiscal deficit. So far, though, they haven't joined together to demand that the United States direct its monetary policy toward maintaining the dollar's external value rather than stabilizing the U.S. economy. Exerting effective pressure requires a credible threat to reduce the scale of financing in the absence of the desired policy changes. Right now, that threat is absent-in part because both China's and the Gulf's financial interests conflict with their commercial interests. A less-expansionary macroeconomic-policy stance in the United States might reduce U.S. demand for Chinese goods and the price of Gulf oil.

That highlights a limit to Eichengreen's analysis. Individual countries that reduced the dollar share of their reserves after 2004 have benefited financially from that decision. But in aggregate, the emerging world doesn't seem to have diversified away from the dollar. The dollar's share of the reserves of the emerging economies that report data to the IMF has been constant since early 2004, and the countries that do not report-China and in all probability the Gulf-likely hold a higher share of their reserves in dollars than the countries that do report. All signs suggest that emerging-market central banks are adding far more dollars to their reserves now than in 2004.²

Eichengreen's analysis understated the short-term economic cost of defecting from the cartel of emerging markets now adding to their reserves. Countries can only stop adding to their reserves if they stop intervening and let their currencies rise. But so long as China continues to intervene, such a decision risks allowing China to undercut your own manufacturing sector. Ask India. Its decision to allow the rupee to appreciate by more than 10 percent against the dollar early in 2007 generated howls from its export sector-and likely contributed to a dramatic 60 percent or more increase in Indian imports of Chinese goods.

China's own decision to limit the pace of RMB appreciation against the dollar has made it harder for other countries to stop intervening in the currency market, and in the process defect from the group of central banks helping to finance U.S. deficits. China's policy isn't in its financial interest: any trader would tell you that adding to a losing position risks adding to your losses. But pegging to the dollar and building up dollar reserves offers large benefits to China's export sector. Following the dollar down has led to a huge increase in Chinese sales in Europe, which has now displaced the United States as the largest market for Chinese exports. The RMB's weakness also has helped those Chinese sectors that compete with imported goods. Other, less obvious, groups benefit too. China's real-estate developers, for example, like the low interest rates China has adopted to deter speculative inflows. The long-term financial costs of holding far-more reserves than China needs, by contrast, are fairly easy to conceal.

The Gulf's decision to stick to its dollar peg is harder to understand. The Gulf doesn't have to worry about competition from China in the oil market. A move away from the dollar likely would increase the Gulf's own monetary stability-as pegging to a depreciating currency even as oil has soared has predictably meant a destabilizing rise in inflation. Saudi inflation recently topped 8 percent-and that is well below the inflation rate in the rest of the Gulf.

Leverett offers a simple explanation for the Gulf's continued willingness to peg to the dollar: the Saudis view their dollar peg-and dollar pricing of oil-as a central component of their strategic alliance with the United States. The Saudis' reluctance to move, in turn, has shaped the choices of the other Gulf states-who have to consider the impact of any unilateral move on the Gulf's plans for a currency union and their relations with the Gulf Cooperation Council's (GCC) own dominant power. This argument cannot be pushed too far: Kuwait has an even-closer strategic relationship with the United States than the Saudis, but it nonetheless made a small step away from a pure dollar peg in May 2007. But it no doubt helps to explain why the GCC has remained pegged to the dollar, despite the growing economic costs of the dollar peg.

At some point, though, rising inflation will begin to threaten the domestic stability of key Gulf states. A desire not to sacrifice domestic economic stability-and ultimately domestic political stability-for the dollar peg could change the Saudis' strategic calculations. Nor would the strategic consequences of ending the Gulf's peg to the dollar be altogether dire: the United States' strategic commitment to the Gulf stems from the Gulf's oil, not its willingness to hold dollar assets.

The conflicting economic and political interests of the two poles of the axis of oil likely limit the scope for "West" and "East" Asia to cooperate to "balance" American power. However, this shouldn't be a great source of comfort to the United States. The enormous rise in the financial assets in the hands of the Gulf's ruling families and China's government means that they do not necessarily need to cooperate to be in a position to try to influence U.S. policy. China ended 2007 with $1.5 trillion in reserves-a total that rises to $1.7-$1.8 trillion after counting the foreign assets of the state banks and the China Investment Corporation. The Gulf's total assets are a bit harder to add up. The size of two of the largest pools of funds in the Gulf (the portfolio of the Abu Dhabi Investment Authority and the "private" assets of leading Saudi families) hasn't been disclosed. However, a reasonable estimate would put the combined assets of the governments of the Gulf states at around $1.5 trillion and the Gulf's total assets at close to $2 trillion. A major portfolio shift by either China or the big Gulf states would roil global markets.

Indeed, China could cause widespread disruption without selling a single dollar: all it would need to do is to stop adding to its dollar portfolio. China's foreign assets (counting the assets of the state banks) increased by at least $500 billion in 2007-and are increasing at an even-faster pace in the first part of 2008. Maintaining a constant 70 percent dollar share of its portfolio consequently requires that China add several hundred billion to its dollar holdings every year. If that flow stopped, the United States likely would have trouble sustaining its roughly $750 billion current-account deficit. The buildup of the Gulf's dollar assets is also quite impressive, but even with oil at $100 a barrel, the Gulf won't be providing the United States with quite as much financing as China.

These flows have strategic consequences. It is hard-to paraphrase Senator Hillary Clinton (D-NY)-to push for political change in your bankers. This is especially the case when large American financial institutions have turned to the sovereign funds of many nondemocratic governments for emergency capital. There is a good chance that greater democratization in these states might reduce the willingness of their central banks and government funds to supply as much financing to the United States. Governments in China and the Gulf that were more accountable to their citizenry would face increasing pressure to devote more resources to their internal development. A more-democratic and more-transparent Gulf would almost certainly supply less fee income to U.S. and European investment banks, hedge funds and private-equity firms.

The growing financial clout of these nondemocratic governments also constrains the United States' policy options. It, for example, implies that a concert of democracies cannot serve as the basis for global economic governance. An effective coalition for collaboratively addressing the structural imbalances in the global economy now has to include nondemocratic governments.

But does this mean that the United States needs to change or alter its policies to better accommodate the desires of its creditors? Not necessarily. Washington could engage in a game of high-stakes financial and strategic chicken: rather than seeking a strategic accommodation with its creditors that would minimize their incentives to try to balance the United States, the United States would continue to adopt policies that reflect its own perception of its interests and dare its creditors to try to translate their potential financial power into actual leverage.

America's creditors cannot stop financing the United States without incurring domestic costs, costs that they may be unwilling to bear even to secure strategic gains. Less Chinese financing for the United States would mean less U.S. demand for Chinese products-and more Chinese purchases of European assets wouldn't endear China to Europe either. China didn't vote with the United States on the UN resolution authorizing the Iraq War. That didn't prevent the People's Bank of China from buying the treasuries the United States issued to finance that war.

Such an approach runs the risk of a misunderstanding that might lead to a collapse of what former-Treasury Secretary Lawrence Summers called the balance of financial terror. It consequently sounds a bit reckless. But it has some loose parallels with the approach that the United States has adopted toward the financial interests of its creditors. Concerns about the value of the dollar haven't prevented the United States from cutting domestic U.S. interest rates to try to stimulate the economy. Concerns about the United States' rising external debts have not prevented Washington from adopting an aggressive program of fiscal stimulus-a stimulus that likely will be financed in large part by the sale of government bonds to China's central bank and the Saudi Arabian Monetary Agency. China and others might prefer that the United States adopt a set of policies that protected the value of the dollar-and thus protected the value of their dollar-denominated financial claims. But until they insist, the United States retains full freedom of action.

Coordinated action by a new "axis of oil" is unlikely. This though shouldn't give U.S. policy makers too much comfort: the United States' big creditors don't really need to coordinate in order to be in position to try to turn their financial clout into strategic leverage. China now is a big enough player in global financial markets to have substantial leverage even if it acts on its own. The main constraint on China is the difficulty of abandoning the domestic constituencies that benefit from its currency policy of adding dollars to its portfolio no matter what the United States does. But as the domestic costs of China's current policy rise, China's own calculation of its interest may also begin to change.

 

Brad Setser is a fellow for geoeconomics at the Council on Foreign Relations.

 

¹The precise currency composition of China's reserves and the Gulf Cooperation Council (GCC) countries' reserves is a state secret. Nonetheless, U.S. data suggest that China continues to keep most of its reserves in dollars. The Gulf sovereign funds seem to have diversified away from the dollar, but their efforts have been offset by the enormous recent increase in the central-bank reserves of the GCC countries. The limited available evidence suggests that most of these reserves remain in dollars.

²The Gulf's sovereign funds likely have reduced the share of their rapidly growing portfolios held in dollars. However, this shift has coincided with a surge in speculative pressure on the Gulf currencies, pressure that has led to an enormous increase in central-bank-reserve growth. As a result, the Gulf economies likely have not diversified away from the dollar. See Brad Setser and Rachel Ziemba, "Understanding the New Financial Superpower-The Management of GCC Official Foreign Assets" (New York: RGE Monitor, December 2007).

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