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.

Essay Types: Essay