Unless China can exploit its innovation and talent, its foreign assets will remain at the mercy of the rise and fall of US economy

Standard & Poor's downgrading of the US credit rating from AAA to AA+ was a product of the compromise between the Republicans and the Democrats to raise the US debt ceiling and the global stock sell-off triggered by market frustration at the inability of the US government to boost the US economy and rein in fiscal deficits.

So far as the timing was concerned, however, the decision was nothing more than an action after the event. Instead of offering investors any positive help, S&P rushed to show itself as a "responsible" agency, looking to brush under the carpet the infamous role it played in the hideous financial tsunami that originated in the United States in 2008.

In essence, the US credit rating downgrade is totally different from the debt issue in Europe, especially in Greece and Italy. In Europe, debt has been raised for welfare purposes instead of economic growth. The United States borrows from the world to increase its military power and to strengthen its position in science, technology, education and other fields. China may hope to challenge the dominance of the US dollar in the current international monetary system, but is there any currency that can replace it? With the deterioration of the European debt crisis, the defects of the euro have become all the more obvious. Backed by an economy long in slump, neither can the Japanese yen play such a great role. To shield off the excessive demand for the yen from venture capital, the Japanese government recently intervened in the market through a massive sell-off to offset the negative effects on its economy from the continuous appreciation of its currency, without taking the actual consequences of such intervention into consideration.

In the short term the immediate effect of the US credit rating downgrade will be depreciation of its large amount of long-term US Treasury bonds. The basic principle governing any move by China, the largest holder of US Treasury bonds, to control such risks in the present-day climate is to "meet changes with constancy". Otherwise China will suffer great losses. The US government, now unable to offer any financial bailout and with no room for any interest rate cut, will most likely renew its monetary policy of quantitative easing, a move that is harmful to its creditors and extremely unpredictable in its effects.

In the medium and long term the consequences of the downgrade are uncertain. The key here lies in whether a new engine of growth can be found in the US economy and whether its role and vitality as the world's economic leader can be revived to restore the trust and confidence of global financial capital. Whether or not the US dollar will give way to another currency, say, the renminbi or the euro, will depend on whether or not its strength goes noticeably downhill. On the other hand, China and other countries need to seize this opportunity to build up their strength through the exploitation of innovative talent.

As for the indirect effects of the downgrade, we will see the continuous deterioration of the European debt crisis and China's continuation of a tight monetary policy, thus easing some of the cost-driven inflation pressure accumulated so far. If no substantial improvement is signaled in the fundamentals of the global economy in the medium or long term, however, the prices of gold and bulk commodities will hover at a high level as people hoard them to hedge against risks. This will cut deeply into the investment capacity badly needed by emerging markets for development of their real economies. Also, without any other outlet, the liquidity flooding the world may surge into the Asian market, posing an unprecedented challenge to sustainable development and the macro-regulation endeavors of Asian countries.

It is therefore important for China to put up an investment stage for onshore competition with the US as soon as possible. Shanghai should first of all be turned into Asia's market for onshore US dollar deals so as to bypass the bottleneck from the non-marketization of the exchange and interest rates of the renminbi and overcome its sharp shortage of qualified international financial talents and absence of risk control mechanisms, thus keeping its creditor's rights in close hand and securing time and space for constant completion of conditions for the internationalization of the renminbi.

In this connection, we may bring China's voice about reform of the dollar-dominated international monetary system to the summits of the G20, the BRICS and other international bodies, thus joining forces with more countries with common interests to safeguard the due rights of China as the biggest US creditor.

The author is an associate professor of finance in the China Center for Economic Study at Fudan University.

(China Daily 08/29/2011 page8)