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Monday, May 04, 2009

China and the Dollar

Andy Xie expects the dollar to collapse:

If China loses faith the dollar will collapse, by Andy Xie, Commentary, Financial Times: Emerging economies such as China and Russia are calling for alternatives to the dollar as a reserve currency. The trigger is the Federal Reserve’s liberal policy of expanding the money supply to prop up America’s banking system and its over-indebted households. ...[T]he Fed may be forced into printing dollars massively, which would eventually trigger high inflation or even hyper-inflation and cause great damage to countries that hold dollar assets in their foreign exchange reserves.

The chatter over alternatives to the dollar mainly reflects the unhappiness with US monetary policy among the emerging economies that have amassed nearly $10,000bn in foreign exchange reserves, mostly in dollar assets. ...[T]he US situation is unique: it borrows in its own currency, and the dollar is the world’s dominant reserve currency. The US can disregard its creditors’ concerns for the time being without worrying about a dollar collapse. ...

The faith of the Chinese in America’s power and responsibility, and the petrodollar holdings of the gulf countries that depend on US military protection, are the twin props for the dollar’s global status. Ethnic Chinese ... may account for half of the foreign holdings of dollar assets. ...

The US could repair its balance sheet through asset sales and fiscal transfers instead of just printing money. ... The country’s vast and unexplored natural resource holdings could be auctioned off. Americans may view these ideas as unthinkable. It is hard to imagine that a superpower needs to sell the family silver to stay solvent. Hence, printing money seems a less painful way out. ...

Other currencies are not safe havens either. ... Central banks are punishing savers to redeem the sins of debtors and speculators. Unfortunately, ethnic Chinese are the biggest savers.

Diluting Chinese savings to bail out America’s failing banks and bankrupt households, though highly beneficial to the US national interest in the short term, will destroy the dollar’s global status. Ethnic Chinese demand for the dollar has been waning already. ...

America’s policy is pushing China towards developing an alternative financial system. ... Its recent decision to turn Shanghai into a financial centre by 2020 reflects China’s anxiety over relying on the dollar system. The year 2020 seems remote... However, if global stagflation takes hold, as I expect it to, it will force China to accelerate its reforms to float its currency and create a single, independent and market-based financial system. When that happens, the dollar will collapse.

Barry Eichengreen explains why using SDRs as a reserve currency, as has been suggested by the governor of the People's Bank of China, is not as easy as it might seem:

Commercialize the SDR now, by Barry Eichengreen, Commentary, Project Syndicate: Zhou Xiaochuan, the governor of the People’s Bank of China, made a splash prior to the recent G-20 summit by arguing that the International Monetary Fund’s Special Drawing Rights should replace the dollar as the world’s reserve currency. ...

Sympathizers acknowledged the contradictions... Central banks understandably seek more reserves as their economies grow. But if those reserves mainly take the form of dollars, then their rising demand allows the United States to finance its external deficit at an artificially low cost. In turn, this allows unsustainable imbalances to build up, leading to an inevitable crash. ...

But skeptics question whether the SDR could ever replace the dollar as the world’s leading reserve currency, for the simple reason that the SDR is not a currency. It is a composite accounting unit in which the IMF issues credits to its members. Those credits ... cannot be used in the other transactions in which central banks and governments engage. ... This means that the SDR is not an attractive unit for official reserves.

This would not be easy to change. Despite the trials and tribulations of the American economy, dollar securities remain the dominant form of reserves because of the unparalleled depth and liquidity of US markets. Central banks can buy and sell dollar securities without moving those markets. There is also the convenience factor: dollars are widely used in a variety of other transactions. As a result, not even the euro has seriously challenged the dollar as the dominant reserve currency. ...

If China is serious about elevating the SDR to reserve-currency status, it should take steps to create a liquid market in SDR claims. It could issue its own SDR-denominated bonds. ... Of course, an earlier attempt was made to create a commercial market in SDR-denominated claims ... in the 1970’s... But these efforts ultimately went nowhere. The dollar being more liquid, its first-mover advantage proved impossible to surmount.

Overcoming that advantage now would require someone to act as market-maker ... and subsidise the market in its start-up phase. The obvious someone is the IMF. The Fund could stand ready to buy and sell SDR claims to all comers, ... at narrow bid/ask spreads competitive with those for dollars. ...

Transforming the SDR into a true international currency would require surmounting other obstacles. The IMF would have to be able to issue additional SDRs in periods of shortage... The IMF’s management would also have to be empowered to decide on SDR issuance, just as the Fed can decide to offer currency swaps. For the SDR to become a true international currency, in other words, the IMF would have to become more like a global central bank and international lender of last resort.

For worries about inflation, see Inflation Nation by Alan Meltzer (and also see Krugman's response, A History Lesson for Alan Meltzer).

[Note: A lot of people have noted the apparent contradiction in the concern from Krugman over deflation, and from Meltzer over inflation, e.g. Mankiw for one, but here's an example of this from Mankiw's colleague, Martin Feldstein, within the same article. It's simply a short-run, long-run distinction.]

    Posted by on Monday, May 4, 2009 at 03:29 PM in Economics, Financial System, Inflation, International Finance | Permalink  TrackBack (0)  Comments (27)


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