The Geopolitics of the Indian Ocean: Sino-Indian Tensions on the Rise

Yesterday, the Financial Times published an excellent piece on growing Sino-Indian geopolitical tensions.

With China's three decades of uninterrupted economic growth, the country is seeking to expand its influence throughout South Asia - from the Indian Ocean to the Persian (Arabian) Gulf. As the FT notes, often this influence takes the form of infrastructure projects - such as deep water ports, arms deals, energy investments, and diplomatic support.

The so-called "string of pearls" of Chinese influence appear to leaders in New Delhi as elements in a strategy of encirclement. No wonder the Indians are eager to begin sea trials of their first nuclear-powered, ballistic missile capable, submarine later this month.

This portending conflict is a subject that Robert Kaplan expanded upon in the March/April 2009 issue of Foreign Affairs, in an essay titled "Center Stage for the 21st Century: Power Plays in the Indian Ocean."

While it is tempting to believe that the forces of history will inevitably lead to major war between these two powers, it is worth pausing and remembering that history isn't linear. The recent unrest in Xinjiang Province points to the tenuous hold the Chinese Communist Party has over domestic stability. An increase in unrest of any kind within China likely would compel the government to focus on its domestic situation, and forego the uncertain benefits of foreign intrigue. Of course, leaders in Beijing might redirect domestic anger and unrest, by channeling the population's latent nationalism toward a foreign enemy.

Regardless, as David Lampton points out in his excellent book The Three Faces of Chinese Power: with 14 land neighbors, China faces a delicate balance between overt demonstrations of power and influence, and maintaining a peaceful regional environment conducive to its own continued economic growth. If China manifests its power obtrusively, it may find its neighbors bandwagoning against it.

For those interested in geopolitics, competition over resources, the great swath of land stretching from the Near East through South and Central Asia to China, as well as those who believe the world's future lies more with the G-20 than with the G-8, this story is one to watch.

Zhou Xiaochuan and the Future of the International Monetary System

In March 2009, the Governor of the People’s Bank of China (China’s Central Bank), Zhou Xiaochuan, proposed an audacious reform for the international monetary system. Simply put, it was the most important development in international macroeconomics since Richard Nixon’s decision to abandon the Gold Standard in 1971.

As it happened, the story went relatively unreported in the U.S. mainstream media. That the proposal came from China is quite telling: as the largest foreign holder of U.S. debt, China publicly raised doubts about the solvency of the United States and the future value of the U.S. Dollar. In doing so, China called into question the prudence and sustainability of the international economic order.

Since the proposal, Russian President Dmitri Medvedev has joined the fray, calling into question the prudence of using the dollar as a reserve currency (see articles here and here), and the yield on U.S. Treasuries has increased - a sign that investors demand a higher return for higher risks. Reportedly, the leaders of the “BRIC” countries discussed the issue during their meeting in Yekaterinburg, Russia last week.

The Background for Zhou’s Proposal

Part of the background to Zhou’s proposal can be found in the Bretton Woods discussions following World War II. John Maynard Keynes feared that the reliance upon a reserve currency would lead to the “N-1 Problem,” wherein the world would become hostage to the international monetary policies of the United States. To avoid this, Keynes proposed an international currency - the Bancor - that would be linked to 30 internationally traded commodities. This was the fount of Governor Zhoul’s proposal.

Another part of the background to this proposal is China’s inordinate exposure to U.S. debt. As a result of the global financial crisis, the U.S. government has embarked upon expansive debt-financed stimulus programs to revive the U.S. and world economies. In addition, the Obama Administration’s budget proposal had the largest deficit in U.S. history, with forecasted deficits to increase throughout his term. For debt holders in Beijing, the U.S. government’s profligacy raises alarm bells, for not only does the likelihood of a U.S. default increase, but also the future value of the USD decreases with the prospects for future inflation. This ‘tough sell’ led Secretary of State Clinton to implore the Chinese to continue purchasing U.S. bonds during her trip to China in February. Indeed, in U.S. Treasury auctions, demand for the assets has softened, as evidenced by increased yields.

The Chinese are holding $1.35 Trillion of a sinking asset.

The final part of the background to Zhou’s proposal is the increasing internationalization of the Yuan-Renminbi (RMB). China has made overtures to ASEAN countries to invest in RMB-denominated government assets and to issue RMB-denominated debt. Additionally, the role of the RMB as a transaction currency is increasing. The Renminbi is now the settlement currency for Hong Kong-PRC trade, and the Bank of China has extended lines of credit to ASEAN countries to finance Chinese exports - an activity that used to rely upon the USD. Moreover, the Chinese government recently entered into currency swap agreements with Argentina.

What does this mean?

While the RMB’s likelihood of becoming a reserve currency in the near future is unlikely, the trend line is clear: the dominance of the USD is eroding. Certainly there are no substantive alternatives to the USD at present: the Euro area lacks a unified ministry of finance capable of issuing debt; China’s debt capital markets remain underdeveloped. Moreover, the United States has no incentive to forego the benefits of holding the reserve currency. It not only retains the benefits of seignorage, but it also benefits from lower borrowing costs.

Governor Zhou tapped into popular frustrations with the United States, and called into question the foundations of the international economic order. While it would be fanciful to think that a new version of the Bancor would supplant the USD as the world’s reserve currency in the near future, one must take Governor Zhou’s proposal seriously.

If something can’t continue forever, it won’t. The use of the USD as the world’s reserve currency will come to an end. Governor Zhou planted the seeds of what the future may hold in store. A world in which the USD is not the reserve currency will increase borrowing (and thus investment) costs for Americans, and it likely would increase the costs of certain commodities currently priced in U.S. Dollars, e.g. oil. Depending upon the monetary system that emerges, the ability of the United States to pursue an independent monetary policy could be constrained.

Granted, this outcome could help alleviate global macroeconomic imbalances, and a stable world currency could provide greater international financial stability. Yet a big question remains, whither U.S. influence when the dollar is no longer the currency of international commerce and finance?