naked capitalism

Frankly, it is hard to know what to make of the ongoing noise form China regarding the dollar.

The most sensible explanation is that China is playing to a domestic audience. China, after all, purchased dollar assets as a integral part of its development strategy. Independent of the fate of the dollar, successful developing economies feature appreciating currencies. Thus it would be reasonable to expect that over the long term, foreign assets would fall in value in home currency terms. So presumably someone in China fully anticipated this outcome.

But it is an open question as to how widely this perspective is shared. The FX reserves have become a hot issue at home, with Chinese bureaucrats as well as the public taking the view that the US suckered China into buying Treasuries. It is difficult to sympathize with this opinion, given China’s long-standing history of currency intervention. But regardless of how China got into its fix, the point remains that the Chinese populace has come to view the Treasury holdings as an investment (as opposed to a cost of doing business, like price rebates) and care about what happens to them.

Moreover, if the Chinese continue to get what they want, which is greater economic and geopolitical influence, that again implies a lesser role for the dollar. The biggest thing in favor of the US is its reserve currency status, its deep capital markets, and its military dominance. The US has ceded a great deal of manufacturing to Asia, and has also ceded technological leadership in some key industries due to the short term orientation of its companies (advanced batteries, important in green technologies, is one of many examples).

The record of the Great Depression was that over-consuming European countries defaulted on their external debt. While we keep reassuring China that we will take responsible fiscal action, the fact is that if recovery falters, tax revenues will decline, making deficits worse. Indeed, the history of past financial crises suggests that most of the budget deficits resulted mainly from plunging receipts as opposed to discretionary stimulus. In keeping, the usually cautious Jim Hamilton of Econbrowser tells us today, “I’m still looking for, and still not seeing, the economic recovery that everybody is talking about.”

So it is blindingly obvious that the Chinese will continue to lose on their US Treasury holdings, if nothing else due to the long-term prospects for the dollar. Thus the Chinese demands for America to make them whole (which is what this all amounts to) clearly cannot be satisfied. The question is why we indulge even tacitly taking responsibility for the level of the dollar in a nominally floating rate world. The US has not intervened in quite some time, and except for some gaffes in the Bush Administration, has consistently talked up the dollar since 1995. By contrast, China manages its currency.

Given the inability to meet China’s demands on this front. one can presume that China will, in due course, call for other concessions. One has to wonder what those might turn out to be.

The flip side is that the US, in attempting to push Japan into compliance over trade in the early 1990s, threatened to weaken the dollar to the point where the Japanese would cry uncle. The US never got that far. The initial pushback from Japan, which was a key buyer of Treasuries, was pointed, and the US was genuinely concerned that killing Japanese exports to force compliance could put the already stricken Japanese economy into a tailspin, producing plenty of collateral damage.

The problem is that the combative Chinese rhetoric does not suggest much willingness to compromise. This is a broken record negotiating tactic, and the hope is that the other side offers other concessions in lieu of the one it can’t make, and the broken record party simply keeps harping, winning more bennies.

However, it is also important to keep in mind that the Chinese officialdom is driven above all by its desire to stay in power. The US assumes that the Chinese will continue to buy Treasuries to keep their currency cheap and because dumping dollars would only further reduce the value of their holdings. But given the irrationality of asking the US to make empty assurances about the dollar, we should not make the mistake of assuming that what looks rational to us is rational given their political objectives.

There is no obvious way out of the US-China interdependence, and if frictions grow, the dynamic could easily become fractious.

From Reuters:

Beijing is diversifying its overseas investments and pressing U.S. officials for an “exit strategy” from the ultra-loose fiscal and monetary policies that China fears will eventually inflate away the value of its U.S. bond holdings and fell the dollar.

But China’s pragmatic policymakers also know there is no practical alternative to the dollar as the world’s main reserve currency.

Which is why bankers say any rhetoric from Tuesday’s inaugural BRICs summit in Russia about the need for the United States to cede power in global financial institutions should not be taken as a signal that Beijing is positioning the yuan to challenge the dollar’s supremacy…

“Will it replace the dollar?” Dallara asked. “The fact is that I don’t think this is what Chinese officials want.”…

Don Hanna, acting chief economist at Citibank, said China had less to fear from the inflationary potential of the Fed’s quantitative easing than from the dire U.S. fiscal outlook.

Faced with huge future pension and health care liabilities, America’s debt profile was not sustainable, Hanna said. But other rapidly aging developed countries were in the same boat.

“It means that if you’re going looking for other assets that would be ’safer’, there aren’t many of them out there,” he told the IIF conference. “So we should not expect any rapid alteration in the allocation of resources by the Chinese — or aggressive changes by anyone else for that matter.”…

In a related policy innovation, China will soon allow selected firms in the southern province of Guangdong that trade with Hong Kong to settle their transactions in yuan, or renminbi….

Yves here. This is not a new development. Back to the story:

Russia, for one, has expressed an interest in adding the yuan to its reserves once the currency is convertible. Moscow has also floated the idea of settling two-way trade in roubles and yuan.

William Rhodes, the senior vice-chairman of Citi, acknowledged the growing interest in denominating trade in yuan.

But Rhodes, a frequent visitor to Beijing, was circumspect. “All of this happens in stages. The Chinese are very cautious in all of this,” he told Reuters.