As most people are aware by now, China spoke pretty aggressively against the US dollar as the world’s reserve currency during the G8 summit. But, actions speak louder than words. During the summit, the dollar strengthened against most other currencies other than the yen. It seems foreign central banks aren’t ready to give up the dollar.
In fact, this strengthening of the dollar as a reserve currency has been occurring over the past 6 months. IMF data shows that US dollars are about two-thirds of total reserves, a few percentage points up.
When looking at world reserve currencies, there are two historically significant questions to ask:
- Who am I trading with? Ideally, your reserves should roughly match your balance of trade. If you have 50% US dollars and 25% Euro’s, you should do roughly those percentages in trade with the respective countries (or have a currency they accept).
- Who is politically stable? If China makes up 90% of my countries trade, that doesn’t necessarily mean 90% of my reserves should be in Renminbi. Being that they are a Communist state, Tiananmen was only 20 years ago, and there is a large rural class that isn’t sharing the wealth and getting pretty upset…there is a large question mark over the People’s Republic. Economically they are sound, politically is a different question. The US has stability on it’s side.
Chinese Holdings
Of the roughly $2.5 trillion in Chinese foreign holdings, about $1.5 trillion of that is US related.
So, they are obviously very scared about any moves the US makes that could possibly devalue the US dollar. But they understand the trap they are in. They need the dollar and the dollar needs them.
With the slowing Chinese economy, the old ways of reserve management that created their dilemma are coming under attack. There is no consensus about what to spend the money on, but the idea of simply recycling the money into US Securities is being attacked. That money could be better used for domestic investment or at least diversified investments.
But no one is suggesting a massive sell-off of US holdings. Rather, people are suggesting a systematic and planned process that over-time will diversify their holdings and make them less dependent on America. The gradual shift will ensure that the US economy doesn’t collapse or fall too hard, thus ensuring the Chinese economy, and more importantly the global economy, doesn’t get hurt.
Will China Push the US Off the Edge?
So the chance of China, as shown in the comic below, pushing Mr. Washington off of the cliff is slim to none.
A lot of the alternative options being proposed are long-term solutions that the debt could finance (like infrastructure projects). But even with all of those projects that could be financed, there are strong reasons for China to continue buying US dollars and keep their assets liquid
. A few of them being:
1) The decreasing level of global exports,
2) The continued global recession,
3) The need for other countries to view them as responsible global citizens,
4) The growth, depth, and stability of the US government bond market,
5) Going along with #1, if they don’t want to stockpile US dollars, they need to allow their currency to strengthen… damaging the already slumping exports.
6) One of the most important reasons to take away: If China sends strong signals that they are backing away from the dollar, they would damage the value of their enormous holdings.
To make a long story short, As Arthur Kroeber, managing editor of the China Economic Quarterly, puts it:
“China’s default policy is to pursue stability at all costs. They do not want to rock the boat when things are unstable.”
Changing Times
Where economic and political relations between China and the US used to be one-sided, things are changing. Meetings that used to be us telling them that their under-valuing of their currency was a risk will now also include them letting us know they are concerned with our dollar weakness.
Fiscal conservatives may ultimately have the same goal as Beijing: To cut spending and strengthen the dollar.
The debt-financed growth of the US can only continue as long as China can grow on exports alone. Time will tell how long that is, but it surely isn’t forever.
Thoughts, ideas, comments?
I'm MLR. After graduating from college debt free, I decided to write a blog encouraging people to adapt responsible and sensible personal finance rules.
August 24th, 2009 at 11:06 am |
Not to raise a conspiratorial type scenario, but wouldn’t China’s massive stockpile of U.S. dollars be a great insurance policy against the U.S. Government from devaluing the currency?
If China has massive stockpiles of US dollars, the threat of dumping them on the market (greatly devaluing the US dollar) seems like a reasonable way of preventing the US Government printing more Monopoly money.
To me, it’s almost like an economic version of Mutually Assured Destruction. I’m no where near a Forex expert, but it’s interesting to watch leverage game play out on such a large stage.
Matt SF´s last blog ..Steadfast Finances was Hacked, Now Restored. (Thanks HostGator!)
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MyLifeROI Reply:
August 24th, 2009 at 12:58 pm |
@Matt SF,
That doesn’t sound conspiratorial, it makes perfect sense. That’s what I was getting at towards the end of the article. Any meetings between China and the US is no longer us slapping their hands saying “Bad!”… it will now include their demands and expectations. They have bought a seat at the discussion table, essentially.
However, the threat of them dumping dollars into the market is more of an idle threat. That would cause a much larger global catastrophe than is worth it for them. You have to consider their options. As I said, they could get rid of dollars, but then the renminbi would pretty much have to go up in value. If that goes up in value, their exports would become less valuable. That isn’t good for a country that is based on export-led growth. Add in the fact that biting the hand that feeds you isn’t a good idea, and where do they stand? They don’t want us to devalue our currency (and we don’t want to, either… at least not majorly), but they don’t have much recourse if we do.
Their best move is to move towards a diversified portfolio after the global recession is over.
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August 24th, 2009 at 1:14 pm |
Yes, watch China’s rising middle class, because they will lead the growth of domestic consumption and help China pull away from export dependency. But any way you look at it, it seems the US dollar is getting backed into a corner. What once could have been a merely economic issue is slowly becoming a very political one if the US doesn’t pay back its debts. And if China truly doesn’t have much recourse if the US continues to dilute the dollar, it becomes incumbent on the US to consider the responsibility of their actions, if China is truly an “economic dependent” in that sense. I’m inclined to see China having a bit more economic power than this, though. Especially since they’re doing a good job of acquiring stakes in world resource companies. Which is what they should be doing: that’s capitalism.
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MyLifeROI Reply:
August 24th, 2009 at 4:34 pm |
@MoneyEnergy,
China’s rising middle class could lead to an economic explosion, as you mentioned, or it could lead to a political disaster (and thus an economic concern). As the middle class rises and the rural-ites sit idly by, that could be cause for concern for the people in charge of upholding the status quo.
And I apologize, I didn’t mean to come off as saying they are an “economic dependent.” Rather, I would say there is a lot of economic interdependence… globally, not just for China and the US. The string of webs created by globalism has led to a situation where everyone has some sort of dependence on each other. This can be evidenced by the fact that we influence Chinese decisions and they influence ours.
I just wrote this article to address the concern that China wants to dump our dollar. They have made it pretty clear that their long-term strategy is to diversify as any wise investor should do. But in the short-term and near-term, they aren’t sending many signals that are cause for concern. They have the to be expected jitters about the weakening dollar, but they understand that they aren’t in a place right now to give up our consumption (even if that means continuing to devalue their own currency).
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MoneyEnergy Reply:
August 25th, 2009 at 10:03 am |
Yeah, China is definitely diversifying, which is good. They’re doing it in a smart way, though, more smoothly than the dumping of dollars suggest… buying short-term treasuries, and slightly less of them each time. So when they are paid back with one, they will not necessarily buy the next issue. It seems to be the best way – in order to avoid the shock, etc. suggested above.
MoneyEnergy´s last blog ..Natural Gas Industry Update and Price Forecasts
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