Economics, Politics, Social Commentary and occasionally Superstring Theory.

Wednesday, January 26, 2005

The Shot Across the Bow

China has fired the opening salvo on the dollar. The story is here. Speaking at Davos, Fan Gang, the Director of the National Economic Research Institute at the China Reform Foundation, said:

"The U.S. dollar is no longer -- in our opinion is no longer -- (seen) as a stable currency, and is devaluating all the time, and that's putting troubles all the time," Fan said, speaking in English.

Now, this doesn't mean that China is actually going to diversify out of the dollar reserve. It has good reasons not to do so, because it would only devalue the massive dollar reserves it currently holds. It would cause exports to become more expensive in the U.S., stunting export growth. The Asian central banks have been propping up the dollar for a while now, operating in a cartel-like fashion. And anyone who has studied cartels knows how they end: someone cheats. I think China is attempting to announce its intent to break the cartel.

If that is the case, the stampede should begin soon. Runs on currencies are not slow; usually, there's a small break in the dam and then it all comes down. Could the same thing happen to the U.S.? We're running out of people to help us out. So, what would a Chinese diversification look like?

Scenario 1: China does not noticeably dump any of its dollar reserves. Instead, it just starts buying less dollar debt. China will have to put its savings somewhere, though, and will probably go into buying Euro-debt and perhaps some emerging market debt. That'll lower interest rates in those countries, hopefully spurring more demand. Across the Atlantic, it would force the U.S. to raise interest rates to plug the capital hole from China's withdrawal. That would curb demand, and U.S. consumers would probably start substituting cheaper domestic products for more expensive Chinese imports. While the rise in interest rates would put a damper on growth, the U.S. economy is still performing undercapacity anyway. And cheaper domestic products relative to imports only helps U.S. companies and should lead to higher employment. In sum, this scenario is bad for China and good for the U.S. and EU.

Scenario 2: China starts slowly trading dollars for euros and yen. This would fulfill their goal of pegging the yuan to a basket of currencies instead of just the dollar. It'll cause the dollar to depreciate while doing the opposite to the currencies it diversifies into. It would most likely cause the yuan to appreciate along with it. This will not please the host governments of those currencies, as they're already squawking about losing export market competition in the U.S. It should be noted that this will have a more direct effect on the currency markets than Scenario 1, causing a rapid decline in the dollar and concurrent appreciation of the currencies China decides to diversify into. In sum, this scenario is (somewhat) bad for the U.S., somewhat less bad for China, and bad for the E.U.

There are a number of other ways China could move, but these would seem to be the most likely. So, which path will it chose? I'm betting on #1. Why? Because China desperately wants the arms embargo on it lifted. The EU is moving towards doing so. The EU desperately wants the dollar to stop sliding against its currency. If China is going to get out of the dollar, it has to do it in a way that minimizes the slide. The best way to do that is to leave existing reserves as they are and only start limiting future purchases of dollar debt. It will have to be done incrementally, so as to not tip off the private market. That being said, why would China publically fire this shot at the U.S. in Davos?

Maybe China wants something from the U.S. and is attempting to flex its muscle to show how its words can effect the bond market. Maybe its making a good faith show to the EU its serious about protecting EU exports while it revalues its currency. Time will tell. But one thing is certain: it does not bode well for the value of the dollar.


Anonymous Anonymous said...

Yeah flex it's muscles.

7:56 PM


Post a Comment

<< Home