Why China hates loving the dollar
By Martin Wolf
Published: January 25 2011 22:50
“The current international currency system is the product of the past.” Thus did Hu Jintao, China’s president, raise doubts about the role of the US dollar in the global monetary system on the eve of last week’s state visit to Washington.
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Moreover, he added, “the monetary policy of the United States has a major impact on global liquidity and capital flows and therefore, the liquidity of the US dollar should be kept at a reasonable and stable level.” He is right on both points.
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In criticising US fiscal and monetary policies and, in particular, the Federal Reserve’s policy of “quantitative easing”, Mr Hu was following a well-trodden path. In the 1960s, Valéry Giscard d’Estaing, then French finance minister, complained about the dollar’s “exorbitant privilege”. John Connally, US Treasury secretary under Richard Nixon, answered when he described the dollar as “our currency, but your problem”. The French and now the Chinese desire exchange rate stability but detest the inevitable result: an open-ended commitment to buying as many dollars as the US creates. Both want to discipline US policies. Both have failed. Are things likely to be different this time? No.
The Chinese and other heavy interveners have a peculiar way of showing their distrust of the dollar. Between January 1999, just after the Asian financial crisis, and October 2010, the global stock of foreign currency reserves increased by the staggering total of $7,450bn. China alone added $2,616bn.
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During the recent financial crisis, global reserves did provide a cushion to holders, falling by just $473bn from July 2008 to February 2009 (6 per cent of the initial stock). But then purchases restarted: between February 2009 and October 2010, reserves rose by another $2,004bn.
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The dollar is not the only reserve currency. But it remains the most important. In the third quarter of 2010, the allocation of only 56 per cent of global reserves was known. Of that, 61 per cent was in dollars and 27 per cent in euros. China does not reveal the composition of its reserves. But it must be heavily invested in dollars, too.
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Why have relatively poor countries made these huge investments in the low-yielding liabilities of the world’s richest countries and, above all, of the US? Why has China, in particular, purchased vast quantities of debt from a country whose policies it distrusts – more than $2,000 for every Chinese and some 50 per cent of gross domestic product?
The answer is that this is the by-product of efforts to keep the currency down and exports competitive. It is no longer, if it ever was, the product of an effort to purchase insurance: the risks to Chinese wealth created by its huge reserves are surely greater than any insurance benefits. That is probably now true of other heavy interveners.
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Is there a plausible reform of the international monetary system that would solve the Chinese dilemma? If, for example, the world were to go on to the classic gold standard, as some recommend, the US would be experiencing a gold outflow and would be forced to adjust via deflation. China might prefer that, although it would not be good for its exports. But to state this outcome is to indicate why it has next to no chance of happening. Since the first world war no important country has tolerated that method of external adjustment. The US is not Estonia.
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Some, including Chinese officials, talk of a shift towards SDRs (special drawing rights) as a reserve asset. But the SDR is merely a basket of major currencies.
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Any reserve holder can grasp that basket today. The SDR is not a currency and cannot replace the currencies of which it is made. For the conceivable future the global currency regime will depend on national fiat (man-made) currencies. SDR issuance may be a supplement; it will not be a replacement. The Chinese do not seem to disagree.
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What about turning the renminbi itself into a global reserve currency? In the very long run, this must happen. But any swift move in that direction would raise two difficulties for China. First, it would only make sense if the currency were to be unpegged from the dollar, in which case the mercantilist strategy would collapse. Second, for a currency to become global it must be freely convertible and traded in deep and liquid financial markets. China would have to abandon exchange controls and liberalise its financial system. It would become impossible to force Chinese people to hold vast quantities of low-yielding bank deposits. Above all, the authorities would lose their most important source of economic control: the banking system. This is surely close to inconceivable in the near term.
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The big point, however, is that China cannot pursue its mercantilist strategy and also avoid accumulating dollar liabilities of doubtful long-term value. This is the “Triffin dilemma”, named after the Belgian economist, Robert Triffin, who pointed out, in the 1960s, that in a fixed-rate system the supplier of reserves will end up running deficits in its basic balance of payments (before monetary financing). These must threaten the system’s stability, as Mr Hu argues.
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The solution for China is to stop buying dollars on the current scale and allow the renminbi to rise faster. That would surely create adjustment problems. But those adjustments are in China’s own interests.
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Otherwise, it will end up accumulating vastly more reserves, continue distorting its own financial system and even risk losing monetary control. Now, with inflation a concern, the case for allowing the currency to adjust much more rapidly upwards is surely overwhelmingly strong.
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In a speech before Mr Hu’s visit, Tim Geithner, US Treasury secretary, noted that “since June of 2010, when Chinese authorities announced they would resume moving toward a more flexible exchange rate, they have allowed the currency to appreciate only about 3 per cent against the dollar. This is a pace of about 6 per cent a year in nominal terms, but significantly faster in real terms because inflation in China is much higher than in the United States. We believe it is in China’s interest to allow the currency to appreciate more rapidly in response to market forces. And we believe China will do so because the alternative would be too costly – for China and for China’s relations with the rest of the world.”
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The analysis is surely right. But the evidence suggests that China is still willing to move only very slowly. That is a mistake. My advice to Mr Hu is simple: if China wants to escape from the tyranny of that dreadful dollar, stop buying. Please.
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