America to China – “Stop Buying Our Dollars! And Another Thing: Please Buy Our Dollars.”

It is ironic that the dollar has strengthened rather than weakened over the last year.

· The sub-prime mortgage crisis originated in the United States;

· The crisis has severely undermined the credibility of American financial institutions – both in the narrower sense that leading investment banks have now disappeared and in the broader sense that American modes of corporate governance have lost value as role models (rating agencies, accounting systems, executive compensation, and so on)

· The response in Washington has included further acceleration in the already-rising national debt plus an expansion of the US money supply and reduction in policy interest rates that, though appropriate, are unprecedented.

Under normal conditions, any country on the receiving end of three such bullet-points would see its currency go down in flames. Yet the dollar has appreciated.

The explanation is not a mystery. The world’s investors have in two years gone from inordinately low perceptions of (and aversion to) risk and illiquidity, to inordinately higher perceptions of (and aversion to) risk and illiquidity. Virtually all assets other than US Treasury bills look risky and illiquid. That there has been a flight to quality is not surprising. What is perhaps surprising is that US Treasury bills continue to be perceived as the safest of safe havens and the US dollar continues to be the preferred international currency. The flight to the dollar shows up in both the strength of the dollar and the low level of US interest rates. For those of us who warned that the unsustainable current account deficit could eventually lead to a decline in the international role of the dollar at the hands of the euro… that day is not today.

The most noteworthy flows into the dollar and into US treasury securities come in the form of purchases by foreign central banks. The People’s Bank of China recently reached $ 2 trillion in international reserves, which it continues to hold predominantly in dollars. Other central banks among Asian exporters of manufactures and Gulf exporters of oil have been behaving similarly. Even the American public is increasingly being made aware that the United States has grown dependent on the Chinese authorities for its funding.

(The accompanying cartoon says it all… except that China’s reserves have increased by half again since then, and that, as Shang-Jin Wei points out, the sign should really say “Float the Yuan” instead of “Fix the Yuan.”)


[Source: KAL’s cartoon From The Economist print edition – Aug 9th 2007 – Illustration by Kevin Kallaugher]

There is another irony, however. Even while the US has grown increasingly dependent on purchases of dollars by the People’s Bank of China, US politicians maintain their demands that the People’s Bank of China abandon its purchases of dollars. They don’t usually phrase it this way, because the logical contradiction would be too glaring. Instead the US policy has been, and apparently still is, that China should allow its currency to appreciate. But it is elementary economics that PBoC purchases of dollars over the last six years are the force that has prevented the Renminbi from appreciating. The American insistence that the RMB appreciate is an insistence that the PBoC should stop buying dollars.

The authorities in Beijing have in various ways taken some steps in the direction that Americans have demanded. I have written in the past on the details of what exchange rate policy the Chinese have actually followed over the last four years, and I plan to update that analysis in a successor post tomorrow.

My position on what policy the Chinese should follow regarding the Renminbi has been roughly in the middle of a contentious range of commentators over the last few years:

On the one hand, I have argued:

(i) that it is foolish for American politicians to place so much emphasis on this issue in our bilateral relations

(ii) that it is dangerous to ignore the flip-side implications for funding of US deficits, and

(iii) that it is unwise to use language such as “unfair manipulation” or “violation of international rules.”

On the other hand, I have argued that an appreciation was both

(i) in the interest of China, for a number of reasons, and

(ii) in the interest of the world, to help address the global imbalances problem.

The balance of arguments has now shifted. Overheating is no longer the problem for the Chinese economy that it was as recently as a year ago, having been pushed aside by an abrupt fall in exports. Global imbalances are no longer the most important problem for the world macroeconomy, having been supplanted by the inadequacy of demand. If American politicians are still inclined to make demands on China, it should be for increased fiscal stimulus. Given that China often reacts adversely to foreign pressure, however, perhaps it is just as well that American politicians have been asking for the wrong thing.

Originally published at Jeff Frankel’s Weblog and reproduced here with the author’s permission.

12 Responses to "America to China – “Stop Buying Our Dollars! And Another Thing: Please Buy Our Dollars.”"

  1. Anonymous   March 13, 2009 at 2:04 am

    How will America pay its debt. The fate of our economy is already sealed. If there is a recovery it will be stifled by unprecedented inflation.

    • Guest   March 13, 2009 at 8:18 pm

      I agree. How do you see the govt. handling things at that stage? Inflation raises the prices of houses and share prices and US Govt. finance costs as well. We are lurching from one bubble to the next.

    • Jeff Frankel   March 17, 2009 at 8:35 am

      I am pretty pessimistic too. But my fear is that the next crisis will be a hard landing for the dollar, more than a big increase in inflation. Of course the former would contribute to the latter.

  2. Anonymous   March 13, 2009 at 11:12 am

    There’s no question of what is rational policy between China and the US. The question is whether Americans can be mature enough to stop using moralistic (rather than rational or at least realist) language when dealing with China. Not only is this true of the exchange rate / trade imbalance, but also of issues such as human rights, Western media commentary on cultural artifacts, spy missions in the South China Sea and the US’s amazingly hypocritical stance on China’s military budget (the US has global military hegemony and has a budget greater than most of the rest of the world combined). When Americans at least stop brainwashing themselves about the morality of their essentially realist actions then maybe the Sino-US relationship can grow into something greater.

    • Jeff Frankel   March 17, 2009 at 8:37 am

      I agree with this.JF

  3. Guest   March 13, 2009 at 8:13 pm

    Great article. I wonder if the US has taken the dollar status for granted. Think of the wonderful game we’ve set up for the world to play…in dollars. How the govt. handles itself now means everything, the entire game is at stake. Otherwise, we are no better than anyone else that can print money with ‘In God We Trust’ on it. I always say we should leave the good Lord out of it but too often in the news the fragility of the entire system is lost to sound bites and an assumption that we will continue forever on a dollar system. Last October, as a trader, I had to wonder about keeping assets in dollars. I wondered about even keeping anything in a bank at that stage! However….even during the chaos of late last year…there was no other currency to move to!!! Honestly, the Euro? Pan-European decision by committee on crucial financial matters, no thanks.Great article, keep them coming.Tim

    • Jeff Frankel   March 17, 2009 at 8:37 am


  4. W.A.Eichler   March 14, 2009 at 12:39 pm

    There is no, “inadequacy of demand.” We are just demandingdifferent things. Money has been shifted to paying down credit cards, auto loans, and building up cash reserves.How else can it be after past income (savings) and future income (debt) have become exhausted? Consumers and business buy what they want or need to purchase. If it is less debt and more savings, then that is the way it will be.

    • Jeff Frankel   March 17, 2009 at 8:40 am

      “Inadequacy of demand” means inadequacy of demand for goods and services. You are quite right that households have — at long last — shifted instead to trying to shore up their balance sheets. Yes “that is the way it will be;” but it didn’t have to be this way. If America had addressed its pathologically low savings rate when times were relatively good, it wouldn’t have to do so under the painful conditions we are experiencing today.JF

  5. Marcus Anonymous   March 15, 2009 at 11:38 pm

    China and the rest of the world invests in the U.S. because of the weaknesses of their own financial systems. They can not absorb their own savings. The U.S. did absorb their savings for many years and kept them in macro-economic balance for a long time: Absorbing their surplus savings and surplus goods like the colonies of some 19th Century European empire.Obviously, the U.S. reached the limits of what we could intelligently absorb a few years ago as our real interest rates on deposits reached ridiculous lows and our idiot and corrupt financial system “perfected” sub-prime mortgages. The inflows were not coming here because of the attractiveness of our investments, but because the rest of the world needed to exhale the build-up of their savings. They will choke on them if we do not take them.But we don’t need Asia’s savings or exports now. Even with our atrophied tradeables sector we would be better off sending them home to China and re-opening our factories. Let the RMB appreciate to 3/$. Walmart will have to buy domestically or from Mexico. We didn’t need this stuff 15 years ago; living without it today will be a net stimulus to our economy in a recession. These flows from China were never free AND BALANCED trade as described by Ricardo. They were the result of the manipulation of the exchange rate by the PBOC to avoid financial reform at home. Let’s keep China from interfering in U.S. financial markets.A very slack American economy does not need China’s savings. Obviously our savings investment balance is currently out of whack. America should have its turn at “export-led growth.” China has been a parasite long enough. And they have certainly been warned long enough. They were irresponsible for 15 years and didn’t care what damage they did to the rest of the world. Not let them suffer the just consequences of their actions. We need to put our own house in order. We cannot carry them any longer.

    • Jeff Frankel   March 17, 2009 at 8:44 am

      Your idea is right that the global imbalances — China’s surpluses and our deficits — now need to adjust, and probably will, one way or another. But I agree with the other commenters, rather than you, as to whether the blame lies predominantly with China. Why do you chose to say that we have been carrying China, instead of the other way around?JF

      • Marcus Anonymous   March 17, 2009 at 8:06 pm

        Because the deficits would never have existed or been much smaller without China’s intervention in exchange markets. Every dollar of reserves that The People’s Bank of China has accumulated was done with the specific, dollar-for-dollar intent of subsidizing its external surpluses. Had China (and the rest of Asia) sat on its hands and not intervened there would not have been the U.S. deficits to finance. These inflows have continued year in and year out when the U.S. had budget deficits and budget surpluses because China manages its aggregate demand by subsidizing export surpluses. We’ve asked them to stop — sometimes politely and sometimes forcefully — but they always refuse. So who is dependent on who? The smoking gun, actually the gunpowder residue test, is the forex reserves of the PBOC. If they stop doing it, our economy will get a welcome jolt of stimulus in time of recession — and without the U.S. Government needing to accumulate more debt.