Paul Krugman: China’s Dollar Trap

It’s time “to face up to new realities”:

China’s Dollar Trap, by Paul Krugman, Commentary, NY Times: …The big news last week was a speech by Zhou Xiaochuan, the governor of China’s central bank, calling for a new “super-sovereign reserve currency.”

The paranoid wing of the Republican Party promptly warned of a dastardly plot to make America give up the dollar. But Mr. Zhou’s speech was actually an admission of weakness. In effect, he was saying that China had driven itself into a dollar trap, and that it can neither get itself out nor change the policies that put it in into that trap in the first place.

Some background: In the early years of this decade, China began running large trade surpluses and also began attracting substantial inflows of foreign capital. If China had had a floating exchange rate — like, say, Canada — this would have led to a rise in the value of its currency, which, in turn, would have slowed the growth of China’s exports.

But China chose instead to keep the value of the yuan in terms of the dollar more or less fixed. To do this, it had to buy up dollars as they came flooding in. As the years went by, those trade surpluses just kept growing — and so did China’s hoard of foreign assets. …

Aside from a late, ill-considered plunge into equities (at the very top of the market), the Chinese mainly accumulated very safe assets,… U.S. Treasury bills… T-bills are as safe from default as anything on the planet… But … any future fall in the dollar would mean a big capital loss for China. Hence Mr. Zhou’s proposal to move to a new reserve currency along the lines of the S.D.R.’s, or special drawing rights, in which the International Monetary Fund keeps its accounts. …

S.D.R.’s aren’t real money. They’re accounting units whose value is set by a basket of dollars, euros, Japanese yen and British pounds. And there’s nothing to keep China from diversifying its reserves away from the dollar, indeed from holding a reserve basket matching the composition of the S.D.R.’s — nothing, that is, except for the fact that China now owns so many dollars that it can’t sell them off without driving the dollar down and triggering the very capital loss its leaders fear.

So what Mr. Zhou’s proposal actually amounts to is a plea that someone rescue China from the consequences of its own investment mistakes. That’s not going to happen.

And the call for some magical solution to the problem of China’s excess of dollars suggests something else:… China’s leaders haven’t come to grips with the fact that the rules of the game have changed in a fundamental way.

Two years ago,… China could save much more than it invested and dispose of the excess savings in America. That world is gone.

Yet the day after his new-reserve-currency speech, Mr. Zhou gave another speech in which he seemed to assert that China’s extremely high savings rate is immutable, a result of Confucianism, which values “anti-extravagance.” Meanwhile, “it is not the right time” for the United States to save more. In other words, let’s go on as we were.

That’s also not going to happen.

The bottom line is that China hasn’t yet faced up to the wrenching changes that will be needed to deal with this global crisis. The same could, of course, be said of the Japanese, the Europeans — and us.

And that failure to face up to new realities is the main reason that, despite some glimmers of good news — the G-20 summit accomplished more than I thought it would — this crisis probably still has years to run.


Originally published at the Economist’s View and reproduced here with the author’s permission.

4 Responses to "Paul Krugman: China’s Dollar Trap"

  1. John Maynard   April 3, 2009 at 2:45 pm

    The Chinese are either stupid or disingeneous. They don’t have a dollar problem. The non chinese who think they do are … well let’s say I have serious doubts about the epistemological eptitude (no typo, I like to create my own words, just as I prefer using my own neurones) of some Nobel laureates (economics subset) such as K., B&S, et. al.What they have is a deep war-chest of some of the best performing financial assets of the last few years, in a currency whose purchasing power has doubled in less than a year, and the yuan/$ rate is as relevant to the matter as the infamous duet B&S aforementioned is for running a bank

  2. Anonymous   April 4, 2009 at 12:43 am

    A very rich man views the role of money in different perspective. Rich man invests money in different way compared to the way a poor man invests. When the rich man invests money, sometimes he lets himself loses money, sometimes he decided to gain back and later deliberately make loses again, in a way to keep things in control. China will juggles between making and losing money when investing in US treasury bonds, in order to control the US economy. What china buys with its foreign exchange reserves(consisted of government bonds, gold, foreign currencies, commodities etc) that worth nearly 2 trillion US dollar is power, not goods.US government can print the US dollar as much as its wants. Other governments such as China, can also print their own currency as much as needed, in order to exchange/get US dollar from its own population. As long as its local economy can afford to absorb its own printed currency, government can print it as it wishes without inflation. Country like china with huge population and high saving rate can afford to do so without big risk of inflation. Can the US with its 300 million populations able to do that without big inflation? If the demand of US treasury bonds is so liquid and deep, in other word: big demand for US dollars….then why don’t the US government just print more dollars without need to worry about inflation, instead of borrowing money by selling more treasury bonds ? With borrowing, comes responsibility, why the government want to do that???Logically in a daily business life, if we have 100 dollars and somebody wants to borrow 70 or 80 dollars from you, will you lent to him/her knowing that the chances of the person’s ability to pay back is next to none. In our personal daily life, we won’t do such a thing. Maybe we would lent him/her if the amount that the person borrowed is like 20-30 dollar(20%-30% of our total money), so if the person not able to pay back, it doesn’t affect our economic life. But why in global political life and survival, country such as China want to risk lending so much? I suspect that the percentages of China foreign exchange reserve that are being used to lend the US is lower than the percentage that people in the west predicted/want to assume. The exact amount and composition of China foreign exchange reserve is unknown until today. There might be unreported fund. Will you, if you are a rich man, let everybody knows exactly how much you own without worrying the risk of schemed created against you such as extortion or fraud?