Sunday, March 27, 2005

Why China won't let the dollar slide too far

Combustible Knowledge properly accuses the Honolulu Advertiser of cowardice:
...what the editorial staff is saying is that China has the U.S. by the balls because they are holders of a large amount of U.S. debt and that we should tread carefully. The implicit message is the same old liberal philosophy: to appease. It's a good thing that Condi has more balls than the editorial staffs of the Honolulu Advertiser and the Star Bulletin.
I'm not the first to observe that China's leadership is smart, very smart. They're looking decades ahead, when most of our own leaders barely look past the next election. There's a very simple reason that China, Japan and South Korea will do what it takes to preserve a strong dollar: they know doing so is in their self-interest. Ideally it's the Fed who should maintain our dollar's strength, but China, Japan and South Korea will step in if necessary, because a weak dollar will hurt them too.

Huge dollar holdings are a two-edged sword. Some have suggested that since China pegs the yuan to the dollar, China benefits from the dollar's depreciation over the last few years (a weaker currency promotes exports and discourages imports). That much is true, but there's an unseen effect.

China would take a huge hit on its dollar-based investments. At the end of 2004, China had approximately $600 billion in foreign exchange reserves, second only to Japan in size. Not all are in dollars, but China has more than a few nickels in U.S. Treasury securities, and it's even started investing in asset-backed securities. The bottom line is that China needs a strong dollar to maintain the value of its dollar-denominated investments. It's also to China's advantage to promote, or at least maintain, confidence in the dollar. When the dollar depreciates, it becomes harder for China's central bank to main the yuan-dollar peg: it must selling more and more yuan to buy dollars (increasing the dollar's exchange rate versus the yuan). China's central bank can't just print more yuan: woe to the country that tries to inflate its way out of a monetary or fiscal problem.

The dollar had a scare recently when South Korea announced it would diversity its reserve holdings. Now, China has more dollar-denominated holdings than South Korea, so it obviously has more to lose than South Korea when the dollar depreciates. Also, though Japan is the world's top holder of dollar-denominated assets, and China is a somewhat distant second, the yen isn't pegged to the dollar like the yuan is -- so China has more reason than anyone (except the U.S. of course) to defend the dollar's value. In fact, China plugging the leaking dollar dam happened last November 25th. When China Business News reported that China would cut its holdings of U.S. Treasury securities, it precipitated a relatively big dollar slide. China's central bank promptly responded by initiating damage control. One of its top officials denied he knew anything about that, and since he's someone "in the know," the implication is that it was just a rumor.

It worked, not with the euro, but at least with the yen (still, China trades much more with Japan than Europe). On the 26th, the New York Times reported that the dollar had hit a low of 102.18 yen on the 25th, but it had recovered to 102.59 yen. Federal Reserve data don't show an exchange rate for the 25th (or a couple of other days that the dollar seems to have hit lows), but since that bottoming out, the dollar has overall recovered quite a bit. My own gut feeling is that the Bank of Japan sees 100 as a benchmark, the point where they will definitely intervene, but they're being too cautious. Are they waiting to see how much the Fed will tighten monetary policy?

The dollar's performance against the euro since then has been a different story, quite a roller coaster ride. But I don't think it's that the dollar is too weak against the euro so much as the euro is too strong. I'm a bit of a monetarist in believing the European Central Bank should initiate loose monetary policy and kickstart the EU's stagnated economies. This, though, would need simultaneous tax cuts to have any real effect. But these would be short-term boosts, and not enough to overcome their severe demographic problem that's worse than American baby boomers' impending retirement. Several European nations, like France and Germany, have shrinking populations. Under two births per woman just isn't enough. Japan is in the same rut, perhaps even worse.

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