China, the collapsing dollar and independence

China is well aware that independence from the dollar is an important step that it needs to make in the next five to ten years. The problem is that there is little alternative at the moment.

There is something I don’t like about this article but cannot quite put my finger on it at the moment. I think it relates to the treatment of ethnic Chinese savers in the text.

The broad issue has been covered in this blog before but it raises some important points worthy of great discussion.

I suspect the US would be happy to inflate away some of its dollar debts with China and petrodollar holders losing. Seems a good way out of the crisis for the US.

Will the dollar really collapse? The problem is that China is in too deep. In a way, China is too dependent on the dollar now so the current situation is “too big to change” for both the US and China.

If China loses faith, the dollar will collapse [FT]

Emerging economies such as China and Russia are calling for alternatives to the dollar as a reserve currency. The trigger is the US Federal Reserve’s policy of expanding the money supply to prop up the banking system and its over-indebted households. Because the magnitude of the bad assets within the banking system and the excess leverage of its households are potentially huge, the Fed may be forced into printing dollars massively, which would eventually trigger high inflation or even hyperinflation and cause great damage to countries that hold dollar assets in their foreign exchange reserves.

The chatter over alternatives to the dollar mainly reflects the unhappiness with US monetary policy among the emerging economies that have nearly $10,000bn (€7,552bn, £6,721bn) in foreign exchange reserves, mostly in dollar assets. Any other country with America’s problems would need the Paris Club of creditor nations to negotiate with its lenders on its monetary and fiscal policies to protect their interests. But the US situation is unique: it borrows in its own currency, and the dollar is the world’s dominant reserve currency. The US can disregard its creditors’ concerns for now without worrying about a dollar collapse.

The faith of the Chinese in America’s power and responsibility, and the petrodollar holdings of the gulf countries that depend on US military protection, are the twin props for the dollar’s global status. Ethnic Chinese, including those in the mainland, Hong Kong, Taiwan and overseas, may account for half of the foreign holdings of dollar assets. You have to check the asset allocations of wealthy ethnic Chinese to understand the dollar’s unique status.

The Chinese love of the dollar began in the 1940s when it held its value while the Chinese currency depreciated massively. The renminbi remains a closed currency and is not yet a credible vehicle for wealth storage.

The US could repair its balance sheet through asset sales and fiscal transfers rather than printing money. The $2,000bn fiscal deficit, for example, could have gone to over-indebted households for paying down debts instead of dubious spending to prop up the economy. When property and stock prices decline sufficiently, foreign demand, especially from ethnic Chinese, will come in volume. America’s vast and unexplored natural resource holdings could be auctioned off.

The global environment is extremely negative for savers. The prices of property and shares are not yet good value and may decline further. Interest rates are near zero. The Fed is printing money, which will inflate away the value of dollar holdings. Other currencies are not safe havens either. As the Fed expands the money supply, it puts pressure on other currencies to appreciate. This will force other central banks to expand their own money supplies to depress their currencies. Hence major currencies may take turns devaluing. The end result is inflation and negative real interest rates everywhere. Central banks are punishing savers to redeem the sins of debtors and speculators. Unfortunately, ethnic Chinese are the biggest savers. Diluting Chinese savings to bail out failing US banks and bankrupt households will eventually destroy the dollar’s status. Ethnic Chinese demand for it is waning already. China’s bulging foreign exchange reserves reflect the lack of private demand for the US currency.

US policy is pushing China towards developing an alternative financial system. For the past two decades its entry into the global economy rested on providing cheap labour to multinationals and pegging the renminbi to the dollar. The dollar peg allowed it to leverage the US financial system for its international needs, while domestic finance re-mained state-controlled to redistribute prosperity from the coast to the interior. This dual approach has worked well. China could have its cake and eat it. Of course, the global credit bubble was what allowed the approach to be effective; its inefficiency was masked by bubble-generated global demand.

China is aware it must become independent from the dollar at some point. Its recent decision to turn Shanghai into a financial centre by 2020 reflects its anxiety over relying on the dollar system. The US will not pay attention to something so distant. However, if global stagflation takes hold, as I expect it to, it will force China to accelerate reforms to float its currency and create a single, independent and market-based financial system. When that happens, the dollar will collapse.

Originally published at the China Economics blog and reproduced here with the author’s permission.

3 Responses to "China, the collapsing dollar and independence"

  1. Anonymous   May 7, 2009 at 2:40 pm

    The following letter in this morning’s Financial Times suggests further reasons why the dollar is unlikely to collapse:A Dollar Collapse will hurt ChinaPublished: May 7 2009 03:00 | Last updated: May 7 2009 03:00From Mr Desmond Lachman.Sir, Andy Xie’s suggestion that an Asian loss of faith in the US dollar could soon lead to a dollar collapse overlooks two basic considerations (“If China loses faith the dollar will collapse”, Comment, May 5).The first is that for the dollar to collapse, it would need to do so against the euro and the Japanese yen, the world’s two other major international reserve currencies. However, the likelihood of a dollar collapse against the euro would appear to be remote.As the International Monetary Fund recently reminded us, the European banks are more than likely in worse shape than those in the US, while any substantial appreciation of the euro would only make it more difficult for Ireland and the eurozone’s Mediterranean member countries, which are all already experiencing deep recessions, to cope with the discipline of the euro.The likelihood of the dollar collapsing against the Japanese yen would appear to be even more remote given Japan’s horrendously poor public finances and the fact that a stronger yen would only add to the deflationary pressure already in evidence on a rapidly contracting Japanese economy.The second consideration overlooked by Mr Xie is that it is hardly in China’s economic interest for the dollar to collapse.This is not simply because of the resulting losses on China’s enormous US dollar international reserve holdings.Rather, it is because any substantial weakening in the US dollar would be associated with a corresponding strengthening in the Chinese renmimbi, which would seriously undermine China’s export-led economic growth strategy.Desmond Lachman,Resident Fellow,American Enterprise Institute,Washington, DC, US

  2. Anonymous   May 8, 2009 at 2:19 am

    It would seem a dollar collapse is/would be merely a precursor to a more general devaluing of all (fiat) currancies. We have already seen that where the US leads the ECB follows. As the USD devalues, so others must follow to remain competitive. In other words your buck – whatever the flavour – will buy less in order to inflate away the overhanging debt globally. Thus commodities (yes, gold) and, dare I say it, property should fare the best in the long term.

  3. Anonymous   May 8, 2009 at 7:39 am

    The global political situation is being overlooked by Lachman in his reply to Xie. WHile not expressly stated by Xie, it is the global political situation that will force the Chinese move to dollar independence and to do so in the near term.Inflating the dollar to take the US out of the present financial crisis is the most probable US response. It has the significant benefit of destroying China: disturbances at home; fewer funds to use for infrastructure development to buy influence in those countries with oil; limitation on military development as well as projection of power. With the Obama driven destabilization of Pakistan, a Chinese neighbor, now accelerating, it appears the administration is not concerned over a wider war in Asia at this time. The only effective defense China has is to take a dollar loss and reduce the US to relative impotence.