I realize that this is old news, but I have been traveling for the past four days and so was not able to keep up with my blog very well. Nonetheless I did want to return to Premier Wen’s comments earlier this week about the difficulty China is having in managing its reserves given the steep drop in the value of the dollar.
“We have never been experiencing such big pressure,” Mr Wen is reported to have said at a conference in Singapore, according to Reuters. “We are worried about how to preserve the value of our reserves.” The market of course took this as a warning that China was going to shift its reserves out of dollars and into “stronger” currencies.
There is an irony here of course in that one of the main reasons for the steep drop in the value of the dollar against the euro (and against every other currency that floats freely) is that several Asian countries, led by China, insist on preventing the value of their own mostly undervalued currencies from rising against the dollar. This means that the full adjustment for any imbalance must be made by those currencies that float – and as the main alternative currency, this means the euro. The drop in the dollar is caused in part by a currency regime which China is still unable substantially to modify without creating a whole set of domestic problems, and which must necessarily result in China’s continued accumulation of dollars.
So what can China do to protect the value of its dollar hoard? Precious little, it seems to me. They cannot very well diversify out of the dollar. If they were to do so, even at the margin, and if no one else were to take their place as the big buyer of dollars (and in so doing replicate China’s out-of-control monetary expansion), the US trade deficit would automatically decline.
Since China’s trade surplus is structural, and caused primarily by its domestic monetary policy, with or without the help of US consumers the rest of the world would have to run the same (or, more likely, a growing) trade deficit with China, which means essentially that Europe would have to absorb the trade deficit that the US, until now, has been absorbing. I think that this is politically and economically very unlikely. Europe simply cannot begin to take on much more of the trade imbalance, and anyway as China accumulated euros instead of dollars, the growing European trade deficit would simply set the euro up for an equally violent fall.
So why signal so publicly a dilemma against which they can do nothing except make matters temporarily worse? Perhaps they just want to make political points by pointing out that other countries have currency problems too (although surely they must know that at least part of the reason for the euro surge is their own doing). If China were run by traders I would see something a little clever in these remarks. The dollar is clearly undervalued relative to the euro and it is only a question of time, in my opinion, that the dollar begins to run up again.
Could the Chinese be considering buying more dollars, and making these negative noises so that they can buy even cheaper (and then be hailed as heroes when they announce that they have stepped in to stabilize the dollar and save the world)? I doubt it, but not because I think it is a stupid trade. I just don’t think politicians or central bankers ever think like traders, and anyway continued dollar depreciation is likely to worsen trade relations between China and Europe without helping trade relations with the US. That can’t be a smart move politically.
But wouldn’t it be a good idea to buy dollars now? I know, I know, everyone with any sense knows the dollar has only one way to go – down, down, down until it is worth no more than the paper on which it is printed – but allow me for just a moment the conceit that we haven’t yet arrived at the global apocalypse, that the US isn’t collapsing into a bigger version of Haiti, and that if there is value in buying US assets there will at some point be buyers of US assets. My mother, for example, a very astute French woman who owns a profitable business in Spain, has made a lot of money buying things that were in her opinion a little too cheap.
During her last visit to New York she was shocked at the prices – she couldn’t believe how well Americans lived and at how cheap everything was compared to in Europe, and this was months before the big dollar move downward. She is now converting some of her bank deposits from euros to dollars, and many of her friends — other business owners with money in the bank — are planning to do the same. I am sure others will do so too.
So, aside from the fact that my mom thinks it would be stupid for China to start selling cheap dollars and buying expensive euros, China simply cannot diversify out of dollars in a meaningful way. The global balance of payments must balance, and unless we think that Europe (or Australia maybe? India? Brazil? Canada?) can absorb the kind of trade deficit that the US has for the past several years, China cannot both continue to run its currency regime the way it has AND diversify out of dollars. The math does not work.
As an aside, Barry Eichengreen recently posted (November 19) on his blog an argument as to why the eurozone must survive as a monetary union. I am a huge Eichengreen fan (his Golden Fetters is a must-read book) but I am not nearly as optimistic as he is about the long-term survival of the euro. Monetary unions have a history of working during periods of great global liquidity, but nearly all of them have broken down when the underlying liquidity dried up. To me, the internal problems facing the euro (can Italy really give up the ability to monetize its debts? after its huge liquidity-induced run can Spain accept the costs of monetary adjustment? will the lack of labor mobility and even capital mobility undermine the adjustment mechanisms needed for such a diverse region?) are still large and still unresolved. Until we go through a period of real monetary stress – several years of persistent inflation or a severe monetary contraction – we can’t really argue one way or the other. One thing is for sure, as long as there is a need to argue that the euro cannot fail, there are reasons to be concerned.
