For years, cynics have observed that the American consumer has effectively funded China’s military growth. This statement may be less true now, and in the immediate future, than at any time over the last two decades. Unfortunately, this is not necessarily good news for those who worry about China’s strategic ambitions.

In the first quarter of 2009, the US ran a $50bn bilateral trade deficit with China. This figure extrapolates to an annualised Sino-American trade gap for 2009 of $200bn, or 24% less than the record $266bn deficit of 2008. In 2009, China’s official military budget for 2009 is $70bn, 22% more than 2008’s $58.2bn funding.

Budgets are by their nature set in advance and cannot change at the last minute (and China’s official figures clearly understate actual spending). Nevertheless, China’s expansion of its military budget – at a healthy 19% compound annual growth rate –has stayed remarkably consistent this decade regardless of variations in China’s trade surpluses.

There is a good reason for this. With one exception, the US trade deficit with China has increased by double-digit percentage rates every year since 1986, the last year in which the US managed even a monthly surplus. The exceptional year, of course, was 2001, but even the 9/11 attacks and the subsequent fourth-quarter economic freeze caused the bilateral trade gap to dip by only 1%.

“During 2009, China’s defence spending will probably amount to 35% of its bilateral surplus.”

During 2009, China’s defence spending will probably amount to 35% of its bilateral surplus. This is double this decade’s average proportion: from 2000 through 2008, China’s official military budget stayed between 15% and 21% of its trade surplus with the US. Does this development make the proverbial glass fuller or emptier?

Without trade surpluses, China could pump up military spending only by foregoing some other economic objective (not spending on something else), imposing additional economic burdens (such as higher taxes), or running greater risks (such as inflation).

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To the extent that trade surpluses enable China to avoid hard choices, less is better.

Nevertheless, 35% is still only a third of 100%. Put another way, the bilateral trade deficit would have to shrink by 20% for three more years before it equals China’s military budget for 2009. Asserting that US trade dollars directly pay for China’s military build-up stretches the point. Correlation does not mean causality and China might prioritise military growth to the exclusion of all else, regardless of its aggregate external accounting.

Trade imbalances and military technology

The primary driver of the deficit – the production cost differential between China and the US – is deeply entrenched and quite significant. Because the US and China are huge countries, the Sino-American trade gap is not only large but also ‘sticky’, as suggested by the low variability of the trends already discussed.

Size and stickiness of funding resources are highly significant for defence spending; weapons and military R&D cost huge sums of money over decades-long lifespans, from conception to ultimate use to obsolescence. In particular, major combatant ships tend to be the largest and lumpiest systems on a per-unit basis in defence budgets, which makes stable funding particularly important for naval expansion. If nothing else, China’s ability to depend on bilateral trade surpluses with the US enables it to plan defence spending with multi-year cycles that would be the envy of the US Congress.

“China’s trade dynamics create foreign reserve surpluses that enable it to buy foreign weaponry and fund domestic military R&D.”

Furthermore, China’s trade dynamics create foreign reserve surpluses that enable it to buy foreign weaponry and fund domestic military R&D – and the ability to follow both tracks is synergistic. In principle, buying foreign weapons allows China to imitate, or less politely, copy and replicate, which it does very well. But with weapons, unlike software, China doesn’t even have to steal. The potential size of its orders could enable China to negotiate production- and technology-sharing agreements, which further accelerate the learning curve. Either way, imitation lays the groundwork for innovation, which is the point of R&D.

In turn, vigorous R&D gives China the ability to produce its own increasingly sophisticated weaponry, which then gives it leverage in future negotiations for foreign weapons. Favourable cost terms free up more money for additional spending or research, ultimately creating a cycle that is virtuous unless you happen to be one of China’s neighbours. Australia’s recently announced plan for long-term increases in defence spending, for example, was doubtless motivated by China’s military

This does not imply that China is about to take over leadership in military technology. Technological leadership is often overvalued. Of particular relevance to the economics of military R&D, moving second enables followers to sit back and judge which technologies work and which don’t. Imitators consequently can obtain some advantage in return on investment, in that they can selectively cull the experimental failures and concentrate resources on the successes.

Moreover, control of the ‘low ground’ of component manufacturing may create opportunities that offset ‘high ground’ technological dominance. As documented in a Business Week feature in October 2008, many high-end US systems contain basic components that figuratively use Chinese nuts and bolts, which are often of dubious quality. What happens if quality defects become deliberate rather than a byproduct of cost minimisation by China and profit maximisation by US defence contractors?

“Moving second enables followers to sit back and judge which technologies work and which don’t.”

Compound interest – a powerful weapon?

China’s surpluses have been so big for so long that, even after military funding, China is now the single largest investor in US treasuries. Consequently, China can run surpluses not only on the merchandise side, but also in terms of investment flow. In effect, the US ends up having to divert military funds in order to pay interest to China, which can then use the funds for, among other things, military R&D.

China’s creditor status in relation to the US also enables it to apply economic pressure, which is tantamount to another weapon. For example, China could spike US interest rates to crippling heights by dumping US Treasury bonds. Granted, China would be cutting off its nose to spite its face, but if the stakes were high enough from a Chinese perspective, the benefit might be worth the cost.

Less confrontationally but no less seriously, China could also work toward replacing the US dollar as the global reserve currency with another currency, or basket. This process has already begun: in spring 2009, the governor of China’s central bank Zhou Xiaochuan called for the “re-establishment of a new and widely accepted reserve currency with a stable valuation” to replace the US dollar.

In short, if the US had really wanted to curb Chinese strategic power, it would have focused less on buying more military electronics and more on buying fewer consumer electronics over the past decade. But that ship has probably sailed.