Rolf J. Langhammer
A transatlantic shift in financial burden sharing within NATO would reverberate all the way to China. A weaker U.S. role in global security would lead to a weaker dollar – with serious consequences for China’s monetary policy and real economy.
When Donald Trump urges European countries to take on a higher share of NATO defense spending, this is more than a dispute among allies. The impact of a restructuring of NATO finances would be felt far beyond the transatlantic security structure. A U.S. retreat from its role as the main provider of global security would trigger the demise of the dollar as the world’s leading currency. 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.
During the Cold War, America’s allies benefited 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. Trump is however wrong when he claims that allies never paid for the protection provided by the superpower. NATO partners 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.
The world’s policeman receives a big portion of his salary from China
The world’s policeman received his salary from many non-US taxpayers around the world, and not all of them lived under the protective shield of NATO. Until recently, China was the leading country holding U.S. government debt. By the end of October 2016, China’s holdings of U.S. debt amounted to 1.12 trillion USD, even after Beijing had sold dollars in order to defend the yuan against market expectations of a depreciation.
If the U.S. gives up the world policeman’s role, this would result in downward pressure on the dollar, weakening its role as the leading global currency. A weaker dollar would benefit China in several ways. 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 weak 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.
Weaker dollar would redirect Chinese capital flows
The shift would also impact global Chinese capital flows. Capital leaving China would be redirected from the U.S. to Europe and emerging markets, for several reasons. Stronger European currencies would create incentives to invest in assets denominated in euros or British pounds rather than in US 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 US-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.
But the reordering of the global security and monetary balance would also have downsides for China. Due to the dollar depreciation, 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.
All of this begs the question to what extent China could step in to fill the gap left by a retreating U.S. Even if President Xi Jinping advertised his country as a responsible global actor at the 2017 World Economic Forum in Davos, China is not (yet) in a position to produce global security and monetary stability. Though not a NATO ally, it has reaped many benefits from the fact that the U.S. provided these two public international goods over the past decades. And similar to European countries, it would have to struggle to readjust if the U.S. were to withdraw from these commitments.