There’s been a lot of talk lately about how unhappy China has become about its financial dependence on the U.S. Chinese Premier Wen Jibao said he was a “little bit worried” about China’s huge investments in the U.S., and the Chinese central bank even suggested that it might be a good idea if the U.S. dollar was no longer the international reserve currency.
You may be wondering what events 5,000 miles away might have to do with the American consumer. As it turns out, there are two big ways in which Chinese actions could hit Americans in the pocketbook:
- First, and most obvious, are the repercussions should the dollar fall significantly against the Chinese yuan. That would mean higher prices in stores like Wal-Mart and Target, which import lots of goods from China.
- Second, and potentially much more serious, China could grow so concerned about its investments in U.S. Treasury bonds that it might stop buying them — and could even start selling. That would force up U.S. interest rates, hobbling the government’s efforts to stimulate the economy while also making car loans and credit card interest much more expensive. That too could lead to a decline in the value of the dollar, causing inflation in the U.S. to spike upward.
Here’s why I don’t think either scenario seems likely.
The first is the Chinese have huge reserves of U.S. investments. According to Brad Setser, an academic who closely follows what the Chinese do with their money, the Chinese own about $750 billion in U.S. Treasuries, widely considered the safest form of debt, $500 billion worth of bonds from government-controlled mortgage lenders Freddie Mac and Fannie Mae, $150 billion of U.S. corporate bonds and $100 billion in American stocks. If China let the yuan rise against the dollar, all those investments would be worth less in China’s own currency. Needless to say, that’s not exactly in China’s best interest.
However, like every investor in America, the Chinese have recently watched their U.S. bond and stock holdings decline sharply in value. Those losses, in fact, were probably what Wen had in mind when he opened his mouth, not U.S. Treasuries. Anyone with large holdings of U.S. Treasuries lucked out this year, as they were among the world’s best performing assets. While some pundits have expressed the view that the Chinese have fallen in a dollar trap in which the Chinese have no choice but to maintain their U.S. investments, I think they made an extremely good investment decision.
Was this an accident by Beijing? The Chinese likely understood that there was some risk in their dollar investments, especially those volatile stocks, and have since scaled back those investments (like many American investors), according to Setzer. But China also knows that holding all those dollars is good policy because that props the value of the dollar against the Chinese currency. A strong dollar makes Chinese exports cheap for American consumers. As a result, a huge export boom lifted the Chinese economy over the past three decades.
That’s also why the Chinese are unlikely to shift out of dollars into another reserve currency. What would it be? The Chinese plan, outlined by the country’s central bank governor, Zhou Xiaochuan, suggested replacing the dollar with special drawing rights, or SDRs, a hypothetical currency used by the International Monetary Fund. SDRs are basically a basket of currencies — dollars, yen, British pounds, and euros. While SDRs have most fallen out of favor, there’s nothing to stop the Chinese from diversifying their huge reserves into these other three currencies. But they haven’t.
Instead they have opened so-called swap arrangements with a few countries like Argentina, Indonesia and Malaysia. Under these deals, China has lent an estimated $100 billion worth of yuan to these countries’ central banks so that importers in those places can buy directly from China without using dollars. It’s an early sign the Chinese are trying to diversify away from dollar-denominated trade and bears watching. But so far they involve only a tiny component of China’s export market, which continues to depend heavily on the U.S. and Europe.
Like investors worldwide, the Chinese remain afraid that the U.S. will devalue the dollar via inflation — in essence, by printing of trillions of dollars to pay for huge budget deficits. Perhaps it’s not suprising that they should express a “little worry” about their massive dollar holdings. If the U.S. dollar declines, they’ll be among the first to be impacted. Despite those worries, though, China is increasing its U.S. Treasury holdings, a sign that they still have confidence in the U.S. government and its ability to repay its debts. No other currency is so widely used in trade, and all major commodities are still priced in dollars. As a result, it’s still in China’s best interest to maintain a majority of its assets in dollars.
