Wednesday, March 25, 2009

PRC to USA: “If you devalue the dollar and with it our savings, we’ll stop saving into dollars! Instead we will... um... er.... we’ll save into ahhh

The battle of wits and words going on now between the United States and China over the nature of the international currency system is the most important thing going on in the world right now. It is bigger than the TARP, bigger than the Geithner Plan, bigger than the stimulus package, bigger than the 2009 Federal budget. The reason for this is that the money for each of those things is going to have to come from somewhere and the debate between the US and China on this subject will decide from where the money will come and at what price.

Last night the Chinese Central Bank published a white paper outlining a potential future monetary system which would rely not on the currency of any individual country but on a “super sovereign” currency. Their candidate for this is the SDR, a synthetic currency created by the IMF in the 1960s which is itself a basket of the US Dollar, the Euro, the Yen, and the Pound Sterling. This is a direct response to the decision by the federal reserve last week to purchase $300 billion of US treasuries which was itself at least partially a response to the Chinese Premier’s comments raising concerns about the safety of US government bonds.

This is a huge deal. Not because the Chinese will be able to replace the US dollar at the international reserve currency with the SDR. They won’t. It is important because what it says about the mentality of the people running China.

The world has to look uncomfortable to the Chinese leadership now. The legitimacy of the Chinese government has come to be connected closely with the rapid economic growth in China. That economic growth has largely been driven by a massive export boom which sees China import raw materials (priced in dollars,) turn them into manufactured goods using low wage low skill labor and then sell them abroad largely to American consumers.

To protect themselves from having their labor cost advantage degraded by an appreciating currency they have fixed the Chinese currency, the Reminbi, to the dollar. This gives them an advantage over Japan. If the Japanese yen appreciates against the dollar the cost of things made in Japan goes up in the US so Americans buy less. The Chinese don’t want to take that risk so they pegged the Reminbi to the dollar. They maintain that peg by keeping large amounts of dollars handy to defend the peg. Thus when they earn dollars by selling goods in the US they don’t sell the dollars, they save them. The best instrument for saving dollars is the US government bond market because of its size. This is how China came to own so much US government debt.

The problem is now that American consumers are deep in debt and so have cut back on consumption in order to work off some of that debt. This means they are buying fewer imports. This is having a massive effect on the Chinese economy and it is slowing very quickly. From the Chinese perspective two things need to happen: 1.) the US economy has to recover so that they can export their way out of their recession, and 2.) the value of their US treasuries has to hold up in case they need to sell them to make up for lost export revenues during the recession.

Sadly for them they have no control of either one of those things. The Chinese probably think, along with a lot of US taxpayers, that the US government efforts to stimulate the economy and repair the financial system are not producing the desired results. The Chinese government has made some comments regarding that. Additionally, in order to finance all this the US government is going to have to sell a HUGE amount of US government debt. This at the same time that the Chinese think –they- may have to sell some of their holdings. What happens when two people have to sell over a trillion dollars of the same thing at the same time? The price goes down. All of this is very bad news for China which is why they wish they could save into an imaginary currency other than dollars but still maintain their dollar peg.

Just because the Chinese are trapped in their US treasures and are stuck with the decisions of the Federal Reserve doesn’t mean that the joke is only on them. It's on us too.

If the Chinese stop buying or start selling US government bonds the US government is going to have to make some difficult choices as well. If the price of US government bonds goes down it implies that the interest rates on those bonds will go up. If interest rates on government bonds go up so do rates on everything more risky than the government, your mortgage for example.

Then the government will have to decide whether to live with higher interest rates and potentially choke off the recovery they are borrowing the money to start in the first place, or to print enough money to fund the government and risk massive inflation and all the social dislocation that goes along with it. We might find ourselves wishing for an imaginary currency ourselves at that point.

1 comment:

Jay said...

looks like the interest rates may be rising already. england's bond sale failed and the USA had less than expected takeup.