Will China Dump the Dollar?

Can China dump the dollar? Probably not, but Chinese officials are actively cautioning (scolding, remonstrating…) the U.S. on its profligate ways. China has an estimated $2.5 trillion in reserves, much of which are invested in dollar-denominated securities.

In terms of currencies, I believe there are only two others — the euro and the yen — that China could look to other than the dollar. Why would China have to move to the euro or the Japanese yen, if it wanted to sell part of its dollar position? Because China’s financial reserves are big enough that the Chinese government has to have its assets denominated in a very large, liquid currency. And, there are not too many of those around other than the U.S. dollar, the euro and the Japanese yen.

For a variety of historical and cultural reasons, I doubt if the Chinese would seriously entertain putting most of their foreign currency and foreign assets holdings in the Japanese yen, so the currency choice is between the dollar and the euro.

Source: Wikipedia Commons

As this piece from the Financial Times [emphasis added] indicates, China has not dropped the dollar in favor of the euro and is still investing heavily in dollar denominated securities:

…China’s official foreign exchange manager is still buying record amounts of US government bonds, in spite of Beijing’s increasingly vocal fear of a dollar collapse, according to officials and analysts.

Senior Chinese officials, including Wen Jiabao, the premier, have repeatedly signalled concern that US policies could lead to a collapse in the dollar and global inflation.

But Chinese and western officials in Beijing said China was caught in a “dollar trap” and has little choice but to keep pouring the bulk of its growing reserves into the US Treasury, which remains the only market big enough and liquid enough to support its huge purchases.

In March alone, China’s direct holdings of US Treasury securities rose $23.7bn to reach a new record of $768bn, according to preliminary US data, allowing China to retain its title as the biggest creditor of the US government…

I believe China will continue to invest in the dollar and in U.S. Treasuries, but that is not a matter for complacency as we saw in the previous post (China: Not So Quiet on the Eastern Front).

The U.S. Treasury is going to issue enormous amounts of Treasury securities to fund our growing budgetary deficits so we need China to continue investing. As a result, U.S. fiscal and monetary policy will be increasingly tied to keeping China happy and that does not bode well for us. It enforces a discipline of sorts, but our policy options are going to be increasingly limited and necessarily reactive, rather than pro-active.

In terms of alternatives for China, there is some evidence that China is stockpiling commodities such as oil and copper as a hedge against inflation and the falling dollar.

Here is a recent post from Brad Setser’s Follow the Money blog (China’s new barbell portfolio: Treasuries and commodities?) in which he discusses China’s dual strategy of buying Treasuries and commodities:

…At the same time, China has sought to ramp up its exposure to commodities. China’s government clearly is adding to its strategic stockpiles — and perhaps encouraging state firms to build up inventory as well. China’s government is encouraging Chinese state firms to invest more abroad, especially in the mining sector. And China’s government is providing financing to cash-strapped commodity exporters (Russia, Kazakhstan, Brazil and no doubt others) to help tide them through a rough patch and, China hopes, to secure future supplies…

Interesting times aren’t they? The U.S. is supposedly a capitalist country, but government debt is growing and our government is moving further and further into the private sectors of the economy (see Federal Deficits & Debt: What’s an investor to do? and GM Means Government Motors). On the other hand, the supposedly communist country of China is exhorting us to be more fiscally responsible.

Disclosure: None

Comments

[tuj:]

And yet China's economy is still export-driven; and that export market remains the US. So without US consumers to buy Chinese stuff, they've got to either consumer internally (going to take time...) or export somewhere else, and that's not the Eurozone...

May 28 10:09 AM

[Chandragupta:]

The question is not 'whether' China will dump the Dollar, but 'when'. Sure they may find they have fallen into a 'dollar trap', but supporting the dollar further is not going to be a solution to it. So sooner or later, they are going to wriggle out of it. As the recent rise in the prices of commodities shows, the process has already begun.

May 28 12:27 PM

[Brent Ritte...:]

Chandragupta,
Your comment is spot on. The days of the U.S. dollar being the only option for large currency reserves is over. The Euro and Yen, as the article states, are both decent alternatives to the U.S. dollar. It makes perfect sense to spread the reserves around. Diversification is a good thing.

Unlike the article, I don't think the history between China and Japan will preclude China from using the Yen as a reserve currency. China is going to become one of the top economic powers globally. It's just a matter of time. The Chinese government is making some very intelligent decisions in their economic policy, and I'm sure that the government has plans to ease tensions between itself and Japan. Using the Yen as a reserve currency might be a good way to gain some more regional clout.

On May 28 12:27 PM Chandragupta wrote:

> The question is not 'whether' China will dump the Dollar, but 'when'.
> Sure they may find they have fallen into a 'dollar trap', but supporting
> the dollar further is not going to be a solution to it. So sooner
> or later, they are going to wriggle out of it. As the recent rise
> in the prices of commodities shows, the process has already begun.

May 28 01:00 PM

[Ray Winter:]

As a frequent visitor to China, I am continually struck by the number of U.S. Corporations with major manufacturing plants in the country. They are all state-of-the-art and the technical know-how provided to the Chinese must be incalculably valuable to them for the time when they take over from the U.S. as the world's largest consumer market. I just cannot help thinking that the seeds of the West's manufacturing and R&D creativeness decline are being sown and given that the Chinese do not recognise international patents they must be so happy backward engineering all the West's technology. Surely we need a debate on whether a communist country, or India and Singapore, are better places to locate these plants for our long term financial health and security.

May 28 02:34 PM

[HaavBline:]

Actually, Euro zone is the largest trading partner for China since a couple years ago. Even before causing the global financial crisis, the US is not as economicallly dominant as most fellow Americans seem to think.

On May 28 10:09 AM tuj wrote:

> And yet China's economy is still export-driven; and that export market
> remains the US. So without US consumers to buy Chinese stuff, they've
> got to either consumer internally (going to take time...) or export
> somewhere else, and that's not the Eurozone...

May 28 02:48 PM

[dtblount:]

HaavBline, very true about eurozone trading more with China...also, the eurozone has a higher trade imbalance with China. ...however, the eurozone is still a group of sovereign nations that have obvious issues with collectivism. The US, on the other hand, has been a single sovereign unit for quite some time.

I think China will, of course, continue to buy Treasuries with their dollars because they have a positive yield and are basically as liquid as USD...and still risk free...but they will also continue to purchase a growing percentage of hard assets for reserve - and even future use - purposes. This just makes sense in terms of general portfolio and risk management practices.

May 28 03:31 PM

[Gerald Spencer:]

If I owe the bank $500,000.00 and cannot pay, I am in real trouble. If I owe the bank $50,000,000.00 and cannot pay, the bank is in real trouble. China is probably worried that the USA cannot pay.

But right now China is allowed to redeem the freshly printed paper T-Bills, US Bonds, US Securities, US currencies, etc. that they were paid by USA importing, transportation, distributing and retail sales companies such as WalMart, Home Depot, NTB and etc. to manufacture the things that these US businesses imported, distributed, and then sold to the US consumers for title to US real estate, farms, agri-businesses, food suppliers, dairies, forests, industries, breweries, hotels, factories, casinos, financial institutions, retail businesses, and most all of the other assets located in the USA, instead of redeeming these dollars for gold.

Some US government sources estimate that the title to 25% of our assets with recorded deeds and titles are now listed as foreign owned (economyincrisis.org/ar...) and this percentage is increasing rapidly. Our payments to foreign oil, manufactured assembly parts, and foreign raw material suppliers are handled in essentially this same manner. What will we do when we have nothing of value to sell to the foreigners who work to make the things that we consume? Maybe they will work for free.

We are also losing the technology race, and when we become a second rate technology nation, we will have no chance of creating any wealth by reversing the trade deficit. We are dumbing down our education system so that every student will pass everything. We have de-emphasized science and anything technical at every level, and we need to emphasize science & engineering if we want to recreate the technological intelligence base that we had a few decades ago.

The US government also needs to "borrow" US dollars from China to pay US government expenses including employee payrolls, government retirement, wars, military jets with active duty military USAF pilots for the personal use of specially privileged members of congress, courts, federal police, pork barrel projects, research contracts, welfare, social security, Medicare, Medicaid, SSI, negative balance of trade balances, failed business bailouts to postpone their bankruptcy, cash bonuses to the Wall Street forgers of SEC documents, Las Vegas corporation junkets, house mortgages for big spenders with bad credit, new multi-million dollar French manufactured personal corporate jets for political contributor's corporations, expensive corporate vacations, new infrastructure, wealth re-distribution, mental health, imported consumer goods and etc., and any other thing that congress and the president decides to use taxpayer money to acquire, build or just give to their political contributors and various other privileged individuals with borrowed US dollars. If taxes taken in each year are not sufficient to pay these expenses, then the government just prints more paper T-Bills, Government Bonds, etc. and borrows US dollars from people who are holding US dollars (foreign manufacturers) in exchange for these freshly printed T-Bills, Government Bonds, etc.

May 28 03:45 PM

[Gerald Spencer:]

I believe that the Chinese renminbi (aka yuan) will replace the US dollar as the world standard for international trade if the US government continues to borrow and then spend a lot of money with the careless abandon of a drunken sailor on shore leave?

This is very disturbing to those very same foreigners that the USA hopes will buy our freshly printed currencies (hopefully at not too much of a discount) to pay for our economic stimulation, our imported consumables, and our government expenses. The discounts offered at public bid by manufacturing nations that have the dollars will depend upon the confidence that we instill these foreigners by our economic actions. Many countries are losing confidence in the dollar as the benchmark for world trade and currency values. Other currencies, like the Chinese Yuan with a more stable value, are now being talked about as a replacement for the US Dollar as the benchmark for international currency values.

May 28 04:03 PM

[tadpole76:]

Unless the yuan can achieve full convertibility it will never achieve reserve currency status. While the Chinese have been slowly working for some time on this; they have enjoyed massive current account surpluses under their current regime because the inflows and outflows of capital are restricted by the inconvertibility. I would presume they're in no hurry until they can figure out a way to make it work for them. It will be years, if not decades if this happens. Another factor to ponder is that convertibility will likely destabilize the yuan exchange rate. The managed peg (I mean float) will be harder to maintain if capital inflows and outflows cannot be restricted as they are now. China knows they are in a dollar pickle with us and cannot end the game they started years ago now. Now, they're currency swapping with other countries like Argentina to reduce dollar dependency (which in the long-run is a shot in the foot for China) and hedging their dollar investments with commodities. This is causing a commodities bubble like last year and the bubble will pop again because the real fundamentals: supply and demand don't support the prices. It is a vicious circle that can only be broken until Uncle Sam puts down his checkbook and quit his 40 year spending spree. The federal government should run an old fashioned campaign to encourage the public to take on some of the debt. If we're going to cry fowl by the government raising federal taxes because SS and Medicare are running dry, then the public should be obligated to help finance these great programs by buying treasuries and bonds. At least this way they'll get their money back on maturity and a little extra.

May 28 07:31 PM

[Gerald Spencer:]

The 40 year US spending spree could go on forever if we were earning and not borrowing the money that we are spending (from people in foreign nations that have a positive balance of trade).

If the US dollar value diminishes to a few pennies on the dollar at some future Federal Reserve Auction, the Chinese Yuan might be the "last man standing".

It does not matter how we reverse the US balance of trade as long as we stop the flow of gold, US dollars, US T-bills, US Government Bonds, title to US located property, and other US assets from this country to other countries in payment for the things that they make and we consume.

May 28 08:57 PM

[Gerald Spencer:]

The US Federal Reserve market bid almost 4% interest on $100bn of freshly printed paper US Treasury securities issued in May 2009 public auctions. This was almost double the Treasury Department expectations/predictions. China, and other wealth generating nations hold a large portion of all US federal debt securities, and they are exchanging these instruments for title to US real estate and most other assets located in the USA, since the US government does not redeem these dollars for gold.

The US government will need to "borrow" $6 trillion more from the industrial manufacturing countries before the end of this year by conducting more US Federal Reserve auctions, to pay for their expenses. Who knows how high the interest rates will be bid at these future auctions.

Jun 03 03:08 PM