China Hectors US Again Re the Dollar

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.

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  1. Richard

    In this the Chinese are proving that there are some universals with us humans that extend across cultures. In this case, it is the desire "to have one's cake (the Yuan/reminibi pegged to the dollar at a rate that subsidizes exports to the U.S. and discourages imports) and eat it too (that dollar itself appreciate – despite the chronic current account balance – in value, or at least hold its value, and thereby maintain the value of all those Treasuries China has bought as part of its currency management policy. In this, including the self-righteous hectoring, their policy resembles that the U.S. Government of the 1920s, when it insisted that European countries pay their WWI debts back in gold but at the same time created protectionist trade barriers, thereby preventing those countries from earning through exports the dollars and gold needed to pay the debt back. Instead, the U.S. offered new loans, a credit bubble, to pay the old loans. It did not end well.

    Similarly, U.S. multinationals and Wall Street investment community, chasing the "cake" the potential of higher rate of returns in shifting U.S. manufacturing and technologies overseas and then selling the product to the "rich" U.S. consumer market ("eating the cake"). The unitended consequence of this has been to reduce U.S. real wages and median income, meaning the U.S. consumer is no longer so rich. Again, a credit bubble was used to create the illusion of continuing increase of standard of living in the U.S. And it has not ended very well.

  2. Kelli K

    So it follows that the solution to the crisis is:

    1) Ignore Chinese whining

    2) Quietly rebuild American manufacturing so that we can extricate ourselves from this Chinamerica dyad.

    For either of these to happen we need an entirely new strategy to emerge in Washington, one that favors reinvestment in US private productivity (through tax and regulatory measures favorable to business). What we have now is the exact opposite.

    Oh dear.

  3. frances snoot

    "The problem is the combative Chinese rhetoric does not suggest much willingness to compromise."

    The hubris of the US astounds me. The people of the US seemed unconcerned about the blatant fraudulent business dealings and global imperialism of US banks, corporations, and government entities. JP Morgan Chase, especially, walks unencumbered after foisting toxic or unbacked mortgage securities on foreign banks and municipalities. Where is the outrage from the people of this country against these crimes? Where is the accountability of the criminal elements? Where is the media reporting of the terminal decline of many municipalities in the US due to theft and money laundering by politicians and so-called investment houses.

    We are assuming to take umbrage with the Chinese who ask only that we honor our monetary commitments?


  4. frances snoot

    Geinthner seemed thrilled with the idea of phasing the dollar as reserve currency to an alternative basket of currencies based on sdr drawing rights. He just indicated it would take time. The idea was bounced by the Chief of the Central Bank in China, at the G20, in April. This is Zhou Xiaochua's essay which Geinther thought was well-thought out:

    That is what China wants, because China realized that the US would not maintain fiscal responsibility and honor our commitment to Treasury debt or to the dollar as a stable reserve currency. Trade imbalances were positioned as much by US outsourcing as Chinese currency manipulations.

    The US is all 'yeehaw' foreign militarism; couple the foreign sheenanigans with corporate corruption to get the whole picture.

    In the interregnum, Bric countries are buying IMF bonds with Treasuries:

    No wonder the Chinese students laughed at Geinthner.

  5. Yves Smith


    I could be proven very wrong here, but most investor types I know do not see SDRs as a viable alternative as a reserve currency, which begs the question of why the Chinese are touting it.

    You need a deep bond market and enough "currency" in foreign hands for it to serve as reasonable store of value. That (weirdly) requires the issuing country to run trade deficits at least for a while to get distribution of said currency.

    That is why China is not keen re having the RMB as reserve currency, even down the road. They are locked into their mercantilist paradigm.

  6. frances snoot

    Thank-you for addressing my question. You certainly are well-educated and have much experience in the economic sphere. I am merely a reader.

    I wrote: "a basket of currencies based on SDR drawing rights." SDR wouldn't be the reserve currency as I read. The dollar would be devalued by as much as 30% in that scenerio, and our imports would skyrocket in price.

    IMHO (perhaps ignorance is an asset at times for it might enable insight due to no preconditions on thinking :) ) I believe that the BIS is tighting controls and the US is being phased out as reserve currency hegemony. The US will be forced into sovereign default through a tightening noose.

    I'd surely love to hear your imput on the sdrs and how they could tie in, if at all. Perhaps the Chinese were grasping at straws? Didn't Keynes wish the SDR to be a coordinator for currency valuation as a condition to Bretton Woods, but he was overruled?

  7. Purple

    China is a lot closer to being broke than is commonly acknowledged. Their NPL problem didn't just vanish overnight – the garbage got transferred to the state, implicity or explicity.

    Look for the health of NPL auctions to gauge the true state of China's internal finances.

  8. DocG

    Does anyone here see the obvious parallel with a Ponzi scheme? All that's propping the dollar up is the willingness of the Chinese to purchase Treasuries, knowing that if they stop, the value of their investment will tank. Because the only thing backing up their investment is their own willingness to play along.

    Isn't this like an investor in a Ponzi scheme who continues to invest even after it's become clear he's investing in a fraud? Because he's come to realize that his own well being is inextricably tied to the success of the deception?

    How long can this sort of thing go on? Well, how long did Bernie Madoff's scam go on?

  9. Hugh

    I agree with this post. Chinese bankers had to know this was coming. Political leaders should have too, but denial in politics is certainly not an American monopoly.

    In any case, the power centers in China probably were hoping to delay this day of reckoning for as long as possible and are not happy that they have to deal with it now. OTOH I think that their appeals to nationalism and their blaming us for their problems is a good barometer to how insecure the Chinese leadership is feeling. I expect that the Chinese will exploit the situation to continue their crackdowns in Tibet and Xinjiang. I don't see that this would significantly affect the US defense shield re Taiwan although I would not discount some tentative moves in this direction.

    It is just very important to remember that the dysfunctions in our own economy fed into the US-China economic relationship, these were mirrored by complementary ones in China.

  10. Chris

    My thinking is that China may be building a massive hedge portfolio against an imminent unilateral move of theirs. The most visible part of that portfolio consists of surplus commodities, probably other, more opaque positions as well. In dealing with China, you have to expect ruses, and that's not meant in a chiding way.

  11. In Debt We Trust

    I wonder how a game theory matrix would be mapped out w/the potential outcomes.

Comments are closed.