Telling China to Stop Buying Dollars Now Would Be a Foolish Idea

The current visit of Secretary Tim Geithner to Beijing once again shines the spotlight on the Renminbi (RMB) and on demands by US politicians that the People’s Bank of China (the country’s central bank) abandon the peg to the dollar.

Throughout the period 2003-2008, I, as some others, have thought that demands from American politicians of both parties that China loosen the dollar link have been misguided in a number of particulars. They were misguided in thinking that an appreciation of the RMB would, alone, do much to boost US output or employment. The demands were especially misguided in putting such high priority on the entire exchange rate issue, given that we need China’s help on more important things, such as preventing a nuclear-armed North Korea. But my arguments during this period might reasonably have been viewed by non-wonks as quibbles. After all, I did agree, along with a majority of other economists, that an increase in the flexibility of China’s exchange rate would be a good thing.

Now, in 2009, the situation has changed in some important ways. Continued demands from American congressmen that China should stop intervening in foreign exchange market to keep the RMB fixed against the dollar have become especially foolish. This is because of two developments over the last year.

The first development: in mid-2008, the top leaders in China decided to abandon the policy they had followed in 2007 – which had consisted of the long-desired abandonment of the dollar peg and the placing of a substantial weight on the euro. They changed horses in mid-stream: After mid-2008 they returned to their old policy (e.g., 2005-06) of a fairly close peg to the dollar. Evidently the motivation for the return to the dollar was complaints from Chinese exporters who had lost competitiveness in 2007 as the euro and therefore the new basket appreciated against the dollar. (Barry Naughton, 2008, gives a glimpse inside politburo politics.)

Why, then, are American congressmen wrong to complain that the return of the dollar link has given American firms an additional price disadvantage in world markets? The first reason on the list is that over the last year, the euro (surprisingly) depreciated against the dollar. In other words, at precisely the moment when the RMB jumped back on the dollar horse, the dollar horse and the euro horse changed directions vis-à-vis each other. If the Chinese authorities had kept the (loose) basket policy of 2007 instead of switching back to the dollar peg in 2008, the value of the RMB would be lower today, not higher, and dollar-based producers would be at a greater competitive disadvantage, not lower.

The second development is that, in 2009, the stratospheric rate of rise of China’s foreign exchange reserves has fallen abruptly. In some months earlier this year, the PBoC actually lost reserves. This means that an increase in exchange rate flexibility – in the extreme case, a move to floating – under current conditions might not result in an appreciation of the RMB, and might even result in a depreciation. Again, that does not correspond to what the congressmen actually want, nor to the public opinion that they represent.

In the near future, we could see a return of substantial surpluses on China’s overall balance of payments and a return of the 38-year trend dollar depreciation. In that case, non-intervention would once again imply RMB appreciation against the dollar. But that leads us to the third point.

The third development, this spring, is the appearance in the dollar’s garden of the first “red shoots.” Red as in deficits and red as in China. For decades, the United States has been able to count on foreigner investors, and in a pinch foreign central banks more specifically, to buy dollars to finance US current account deficits. In recent years, the PBoC has been the lead facilitator, piling up $2 trillion in reserves, most of it in dollars. Many argued that this “exorbitant privilege” could continue indefinitely. But during the past two months we have seen the first signals that this might not continue forever. The possibility that rating agencies might eventually downgrade US debt is in the air, and US longer-term interest rates have finally begun to rise over the last month.

The most telling warning shots have come from Chinese officials. Premier Wen in April expressed worry that US Treasury securities would lose value in the future; that required an unprecedented public assurance from President Obama. Then PBoC Governor Zhou in May proposed replacing the dollar as an international currency, with the SDR. Another official told Americans that his countrymen “hate” having to hold a currency that they believe will lose value in the future as it has in the past. Interpreted separately and literally, each of these statements raises interesting economic questions worthy of extended discussion. Taken together, they constitute a simple wake-up call for oblivious Americans. The message is that at a time when big budget deficits lie deep in America’s past (the big debt that Obama inherited from George W. Bush), America’s present (the record budget deficits caused by the current recession), and America’s future (rising medical costs and the retirement of the baby boomers), we are heavily and increasingly dependent on China to buy our treasury securities. If they and other Asian and commodity-exporting countries stop buying our treasuries, the result would almost certainly be a hard landing for the dollar. I define a dollar hard landing as the combination of a big fall in its value together with a big increase in US interest rates. The outcome might be stagflation.

As a general proposition, it is somewhat obtuse to make strident demands on one’s biggest creditor without taking any consideration of the change in the power relationship that debtor status entails. It is astoundingly obtuse to make the demand that the Chinese stop buying dollars, at the same time as we depend on them continuing to buy dollars to finance our deficits. But demanding that they stop buying dollars is precisely what we have been doing for six years, every time we respond to trade concerns by demanding that they stop intervening to prevent the RMB from rising.

Fortunately, Secretary Geithner’s April decision not to declare China guilty of unfair currency manipulation, in the Treasury’s semi-annual report, suggests that he understands the subtleties of the situation. Now if those congressmen would just learn some economics…

Comments

[indeolie]

Abandoning the dollar completely is probably a bad idea but it doesn't make much sense for China to hold the bulk of its FX reserve in USD while their biggest trading partner is Europe.

2009 Jun 02 03:10 AM

[User 353732]

Congress and the US Treasury continues to treat the Chinese as useful idiots who exist for their sole convenience......pretty much, of course, as they treat scores of millions of middle class Americans.
We seem to have trapped ourselves in a delusional time warp where , because we were once the irreplaceable market for Chinese exports we always will be and because the US dollar was once the irreplaceable store of value for Chinese foreign surplusses, it always will be and because once we did all the talking and they did all the listening , that will always be the case.

In public our governing elites lecture China(Russia, Brazil, India etc) on their many faults while dismissing our various and growing economic transgressions. We hector them to change the policies that obviously work for them while refusing to even examine the economic policies that manifestly do not work for us.
We gleefully and repetitively point out the economic/financial motes in the eyes of the Chinese(and many others) while indignantly refusing to heed the beam on ours. If we are not careful(and time will not wait for us) we will painfuly discover that all along it is the Chinese who have been treating US as useful idiots, who exist for THEIR sole convenience..........

Whether it is the Chinese or other rising nations of the Global South or credit markets, or currency and commodity markets, the world in many different languages is persistently sending our elites the same message--The world is not organized for nor does it exist for the convenience of America's self indulgent and self obsessed governing elites---- but our Government is so busy talking and posturing that it refuses to listen much less hear.

2009 Jun 02 05:59 AM

[Clive Corcoran]

Re: 353732
"The world is not organized for nor does it exist for the convenience of America's self indulgent and self obsessed governing elites..."

As Bob Dylan said "The time's they are a changin"

2009 Jun 02 06:28 AM

[William Montague]

Times are changing indeed;

China over the last 15 years has been setting up business worldwide, gaining trade partners, selling in droves to the West, saving money and investing it in the US.

Whilst the US has failing businesses, (banks, insurance companies, vehicle producers), add to that a few wars, both political and miltary.

Perhaps the US should get back to what it has been great at over the last 100 years - business.

2009 Jun 02 07:02 AM

[Moon Kil Woong]

LOL geithner practically bowed down and kissed their feet. Distasteful and does not accurately represent our position. If China wants to hedge dollars sooner or later they must either boost overseas US consumption to moderate the trade deficit or appreciate and start paying their people better. Either way, the US most likely suffers inflation and must cut foreign imports. That's good in the long run but harsh in the short run on both China and the US. However, it's just what the doctor ordered to restore any semblance of long term sustainability.

Also, I never heard China complaining when the US bond rates were dropping and they made $ on bonds hand over fist. If you don't complain on the upside what right do you have to complain on the downside. As they say in the west: easy come easy go.

Or how about these ones: Fast money never lasts. You can't depend on easy money. You can't cheat the system forever. What you do is bound to catch up on you someday (this goes for both the US and China who have been playing unfair trade games with each other for over a decade now).

2009 Jun 02 01:12 PM

[Fighting Yoda]

This hits the nail on its head: "It is astoundingly obtuse to make the demand that the Chinese stop buying dollars, at the same time as we depend on them continuing to buy dollars to finance our deficits."

China like most other creditors are caught in unenviable position. They have a lot to lose if dollar depreciates (further). US as a debtor of course want to propose appreciation of creditor nation currencies - RMB or Yen. Japanese lost 2/3rd of their US investments by Yen appreciations from 300 Yen in early 80s to now below 100. We are simply trying to play the same tactic with China. If we succeed in RMB it would be the last time - stage would be set for US $ losing its position as reserve currency.

Even though there are no specific viable alternatives to $ today, and too many countries have too much at stake to upset the apple cart. But in the end about everyone is convinced that US has abused its position as reserve currency issuer much to the disadvantage of rest of the world. So the world will work for an alternative 2 years/ 5 years would be my estimates.

China/Japan are rumored to be demanding US issue Yen/RMB bonds rather than $ denominated. If that happens – US will stop asking for currency appreciations, and its position would be totally exposed.

2009 Jun 02 11:43 PM

[dybydx]

Fighting Yoda,

the 35 yr plunge of Yen from 300 to 100 is about a 3.2% annual rise. my mutual fund manager charges a MER higher than that. given the corresponding growth in Japan's GDP in the last 35 yrs, it probably exceeded the alpha that many fund managers are so desperately seeking.

2009 Jun 03 01:19 AM