America to China: Stop Buying Our Dollars! And Another Thing: Please Buy Our Dollars!

It is ironic that the dollar has strengthened rather than weakened over the last year.

• The sub-prime mortgage crisis originated in the United States;
• The crisis has severely undermined the credibility of American financial institutions – both in the narrower sense that leading investment banks have now disappeared and in the broader sense that American modes of corporate governance have lost value as role models (rating agencies, accounting systems, executive compensation, and so on);
• The response in Washington has included further acceleration in the already-rising national debt plus an expansion of the US money supply and reduction in policy interest rates that, though appropriate, are unprecedented.

Under normal conditions, any country on the receiving end of three such bullet-points would see its currency go down in flames. Yet the dollar has appreciated.

The explanation is not a mystery. The world’s investors have in two years gone from inordinately low perceptions of (and aversion to) risk and illiquidity, to inordinately higher perceptions of (and aversion to) risk and illiquidity. Virtually all assets other than US Treasury bills look risky and illiquid. That there has been a flight to quality is not surprising. What is perhaps surprising is that US Treasury bills continue to be perceived as the safest of safe havens and the US dollar continues to be the preferred international currency. The flight to the dollar shows up in both the strength of the dollar and the low level of US interest rates. For those of us who warned that the unsustainable current account deficit could eventually lead to a decline in the international role of the dollar at the hands of the euro… that day is not today.

The most noteworthy flows into the dollar and into US treasury securities come in the form of purchases by foreign central banks. The People’s Bank of China recently reached $2 trillion in international reserves, which it continues to hold predominantly in dollars. Other central banks among Asian exporters of manufactures and Gulf exporters of oil have been behaving similarly. The American public is increasingly being made aware that the United States has grown dependent on the Chinese authorities for its funding.

(The accompanying cartoon says it all… except that China’s reserves have increased by half again since then, and that, as Shang-Jin Wei points out, the sign should really say “Float the Yuan” instead of “Fix the Yuan.”)

Source: KAL’s cartoon From The Economist print edition - Aug 9th 2007 - Illustration by Kevin Kallaugher

There is another irony, however. Even while the US has grown increasingly dependent on purchases of dollars by the People’s Bank of China, US politicians maintain their demands that the People’s Bank of China abandon its purchases of dollars. They don’t usually phrase it this way, because the logical contradiction would be too glaring. Instead the US policy has been, and apparently still is, that China should allow its currency to appreciate. But it is elementary economics that PBoC purchases of dollars over the last six years are the force that has prevented the Renminbi from appreciating. The American insistence that the RMB appreciate is an insistence that the PBoC should stop buying dollars.

The authorities in Beijing have in various ways taken some steps in the direction that Americans have demanded. I have written in the past on the details of what exchange rate policy the Chinese have actually followed over the last four years, and I plan to update that analysis in a successor post tomorrow.

My position on what policy the Chinese should follow regarding the Renminbi has been roughly in the middle of a contentious range of commentators over the last few years:

On the one hand, I have argued:

(i) that it is foolish for American politicians to place so much emphasis on this issue in our bilateral relations

(ii) that it is dangerous to ignore the flip-side implications for funding of US deficits, and

(iii) that it is unwise to use language such as “unfair manipulation” or “violation of international rules.”

On the other hand, I have argued that an appreciation was both

(i) in the interest of China, for a number of reasons, and

(ii) in the interest of the world, to help address the global imbalances problem.

The balance of arguments has now shifted. Overheating is no longer the problem for the Chinese economy that it was as recently as a year ago, having been pushed aside by an abrupt fall in exports. Global imbalances are no longer the most important problem for the world macroeconomy, having been supplanted by the inadequacy of demand. If American politicians are still inclined to make demands on China, it would be more logical to ask for increased fiscal stimulus. Given that China often reacts adversely to foreign pressure, however, perhaps it is just as well that American politicians have been asking for the wrong thing.

Comments

[Boon:]

I like the comic!!

The worst thing that could happen now is if the Chinese economy goes into a freefall. Then the government will have to spend more money to boost demand, which will mean selling dollars + treasuries, which will throw America's economic model of surviving on debt into chaos.

Mar 10 05:35 AM

[MarkitWacha:]

Full disclosure: Long TBT

The Chinese can improve the lot of their people by letting the yuan appreciate at some point. Many people don't realize that the human rights issues will improve when this happens. The government there is right to act slowly, though. Instability in a country of a billion people needs to be managed.

I think that, eventually, when the treasury bubble bursts, the Chinese will purchase less treasuries in favor of commodities, and that's when we'll see a ginormous transfer of wealth from West to East.

Can anyone verify this? :

"Beijing, China -- The United States of America has tendered to China a written agreement which grants to the People's Republic of China, an option to exercise Eminent Domain within the USA, as collateral for China's continued purchase of US Treasury Notes and existing US Currency reserves"

Mar 10 09:10 AM

[Lok Sang Ho:]

Many observers are paranoid. They don't know exactly what they want.

What the world needs now is more trade. That means more imports and exports from and to each country. That means exports need to be profitable. Corner exchange rates that make exports unprofitable for any country are destructive of trade. The whole world should guard against that!

Mar 10 09:36 AM

[User 371080:]

Why, IF as so many in the west like to point out, China is a third rate country are so many in the west so worried about what the Chinese are doing? Why all the rhetoric? Why send spy ships? Why have SECTREAS accuse them of currency manipulation? Who stands to benefit from demonizing the Chinese?

Mar 10 10:03 AM

[Billy Gee:]

The purchase of Chinese goods has been paid for in U.S. dollars by importers into the U.S. The grand bargain we made with the Chinese of trade under certain grand rules has been a huge disappointment. The promise of their market for U.S. goods and services has been manipulated by the Chinese as a grand master mercantile puppeteer.
The U.S.-China Economic and Security Commission has reported to Congress for many years the illegal trade actions and barriers the U.S. has with the Chinese market. What do stimulus programs in China include? More export credits, increased tariffs and more incentives to domestic manufatcurers of exports to use Chinese made equipment.

What is the net result? A dead-end of currenty in the China Investment Corporation (soverign wealth fund). The veolicty of money effect that we hoped for in vibrant two-way trade between China and The U.S. is not going to happen apparently. The big show of a few large deals for tractors and jets by high Chinese officals does not mask the true intentions of the Chinese anymore. The market for Chinese currency is a highly effective mercantile tactic that is played out to near perfection for Chinese exporters by their government.

Mar 10 12:09 PM

[Tesa:]

Worldwide the current currency valuation method are political and ambiguous and they are not working. Most and most countries are now unable to control their inflation or correct trade issues to fix their economy because of currency issue that have become increasing complex and irrational.

For the world to resolve the currency issue, there is a need to valuate currencies against a virtual index that is function of commodities, basic materials and other material factors that help to sustain life.

The valuation currencies relative to an index should allow for resolution of currency dilemmas worldwide and simply it. Each country can regulate the factor by which they would float their currency against the index. The outcomes will be more/less exports, more/less imports, higher/lower inflation and countries will get to choose and driving factors of their economy rather than some exchange trader.

Mar 10 12:13 PM

[Mad Hedge F...:]

You can't have your cake and eat it too! There is more speculation that China may lead any upturn in the global capital markets. China’s holdings of US government bonds leapt by $250 billion last year, through capital appreciation alone, taking their current market value to roughly $1.25 trillion. To finance a domestic reflationary program, China need only sell some Treasuries, not print money, as the US must. This would involve converting a sizeable chunk of the Middle Kingdom’s productive capacity away from US oriented exports to domestic consumption, particularly accelerated much needed infrastructure spending. This would be painful in the short term, to say the least, but is necessary for the long term. This would enable the Chinese stock market to lead the world out of the current morass. Buy the iShares FTSE/Xinhua China 25 ETF (FXI).

Mar 10 12:28 PM

[Duude:]

While allowing the Yuan to appreciate would result in a higher standard of living within China for some, its really short term thinking as the Chinese understand it. Due to its population and still existent government-run corporations dotting the landscape of the Chinese economy, we aren't going to see any sudden and substantial changes to the Yuan for years to come. China still has a great number of rural dwellers who haven't yet moved into the working class due to lack of work. That keeps them from becoming part of the consumer class. The Government-run corporations are socialist holdovers that still provide employment for a great number of Chinese workers. These are inefficiently run companies that the government would love to close but can't till enough private employment is available for all. The wage disparity in China is absolutely huge. The Chinese know they need to remain a low cost manufacturer to the world for years longer before they can pragmatically allow the Yuan to appreciate naturally. In the meantime, they will allow some appreciation now and then but only to reduce foreign criticism. I do expect the Chinese as well as other Foreign governments will lower their treasury bidding so as to get better interest on their investment but it will be a balancing act as fewer buys will lead to the Yuan appreciating which they don't want.


On Mar 10 09:10 AM MarkitFreeek wrote:

> Full disclosure: Long TBT
>
> The Chinese can improve the lot of their people by letting the yuan
> appreciate at some point. Many people don't realize that the human
> rights issues will improve when this happens. The government there
> is right to act slowly, though. Instability in a country of a billion
> people needs to be managed.
>
> I think that, eventually, when the treasury bubble bursts, the Chinese
> will purchase less treasuries in favor of commodities, and that's
> when we'll see a ginormous transfer of wealth from West to East.

Mar 10 12:38 PM

[Conan the B...:]

Both the USD and Yuan have appreciated over 25% against other currencies since Aug.,2008.

The USD has gone from roughly 71 to 89 while the Yuan has maintained a rough equilibrium with the USD trading in a range of about .681 to .685. The only currency which had been doing better was the Yen, Japan is in the process of depreciating the Yen as its economic GDP dropped over 10%.

I've run accross something of interest for those who believe the Yen will continue to drop but are not Day Traders...YCS. DD

The Yuan will not be allowed to Appreciate further. Not if the Chinese Government has anything to say about it. IMHO

Mar 10 01:54 PM

[Moon Kil Woong:]

This is a very insightful look at the RMB problem by Jeff Frankel. The last thing we really want is tighter credit and higher interest rates on our debt (the result of not easily floating out treasury notes), inflation (the result of rising prices from overseas which would be the result of a higher RMB), and or a drop in business from China (higher prices in the US and a drop in demand for US goods in China).

Can we afford a trade war? No. Can we really afford a higher RMB? No. Will a higher RMB bring back manufacturing to the US? No. More than likely it will just accelerate the shift to move production to even lower wage countries like Vietnam, etc.

Yes, what we would really like is for China to develop a strong consuming middle class rather than a collection of Communist party members hoarding all the assets of the country for themselves? The odds of that happening are about 0%. But that is their problem not ours. After all, they are the ones that go through purges when their economy tanks.

Mar 10 11:00 PM

[bcncv:]

It's always hard to separate political rhetoric from real policy. Most politicians on both sides of the Pacific realize that they speak to what people want to hear, and act towards the outcome they would actually prefer. Since currency markets are confusing to most, it is easy to make noise about with zero action.

Mar 10 11:03 PM

[Steve Rogers:]

www.rense.com/general8...
Please read and take your lives seriously. Educate yourseleves and start living up to responsibilities and expectations as Americans not stereotypes. The problems are intricate yet the solutions are simple. I have great faith in this nation

Mar 17 01:48 PM