Fundmastery Blog

Kurt Brouwer March 16th, 2009

Will China dump the dollar?

We began hearing about this issue quite a bit last year when the dollar was falling sharply versus other major currencies. At that point, the dollar was falling versus the Euro so the question centered on China’s willingness to withstand currency depreciation in its dollar-denominated holdings.

Due to the falling dollar, there was also widespread questioning of the dollar as the world’s reserve currency and questions across the media spectrum on whether China would begin phasing out of the dollar and moving to the Euro as the world’s reserve currency.

Why would China have to move to the Euro or the Japanese yen, if it wanted to sell part of its dollar position? Because China’s financial reserves are big enough that the Chinese government has to have its assets denominated in a very large, liquid currency. And, there are not too many of those around other than the U.S. dollar, the Euro and the Japanese yen.

For a variety of historical and cultural reasons, I doubt if the Chinese would seriously entertain putting most of their foreign currency and foreign assets holdings in the yen, so the choice is between the dollar and the Euro.

Unfortunately, for those predicting the demise of the dollar as the world’s reserve currency, we’ve been having a rather serious financial panic and that has led to a remarkable strengthening of the U.S. dollar. In fact, since July of last year, the dollar has been gaining and the Euro slowly sinking. What’s going on?

Source: Wikipedia Commons

To start, let’s put things in perspective with two charts from the treasure trove of information at the St. Louis Federal Reserve’s web site. The first chart shows the Euro (priced in dollars) since its inception in 1999 until March2, 2009. The low point was in 2001 when it costs 84 cents to buy one Euro. The high point came last year when it cost nearly $1.60 to buy one Euro.

In this chart format, the line going up indicates a time when the Euro is strengthening. When the line heads downward, it means the Euro is weakening versus the dollar. The gray bars indicate times of a recession in the U.S.:

Source: St. Louis Federal Reserve

In the next chart, we see the same information, but over a much shorter time period from January 2007 up to March 2009:

Source: St. Louis Federal Reserve

So, the scenario for China dumping the dollar due to weakness versus the Euro (the other potential reserve currency) is over for now. However, now we are seeing reports of China being concerned, not about the weakness of the dollar, but rather about the overall solvency of the U.S. government.

So, we have the same question — will China dump the dollar? — with a different triggering event as this recent piece from Bloomberg suggests [emphasis added]:

China’s Premier Wen ‘Worried’ on Safety of Treasuries (Bloomberg, March 13, 2009, Belinda Cao & Judy Chen)

China, the U.S. government’s largest creditor, is “worried” about its holdings of Treasuries and wants assurances that the investment is safe, Premier Wen Jiabao said.

“We have lent a huge amount of money to the United States,” Wen said at a press briefing in Beijing today. “I request the U.S. to maintain its good credit, to honor its promises and to guarantee the safety of China’s assets.”

Well, that is an interesting statement. In fact, I suspect many of us would agree with Premier Wen that we would like the U.S. government to maintain its good credit too. The massive budget deficit that is being debated right now is not exactly an austerity budget though.

White House National Economic Council Director Lawrence Summers, asked about Wen’s remarks, said overseas “confidence” in Treasuries would be hurt without the administration’s steps to end the economy’s decline. President Barack Obama is relying on China to sustain buying of Treasuries amid record amounts of debt sales to fund a $787 billion stimulus package.

“China’s purchases of American debt have been one of the few bolts keeping the wheels on the global economy,” said Phil Deans, a professor of international affairs at Temple University in Tokyo. “If China stops buying, where does Obama’s borrowing to fund his stimulus come from?”

Treasuries declined after Wen’s remarks, before recouping the losses later. Yields on benchmark 10-year notes rose as high as 2.96 percent, from 2.85 percent late yesterday, and were at 2.83 percent at 12:27 p.m. in New York…

“Of course we are concerned about the safety of our assets,” Wen said after the annual meeting of the legislature. “To be honest, I am a little bit worried.”

It’s an ironic moment in that the leader of an avowedly Communist government is urging capitalist America to be more financially sound.

As we saw earlier in this post, the Chinese government does not have many currency alternatives. Last year and this year too, China made significant investments in commodities such as energy and energy infrastructure. But, it’s economy is still heavily dependent on the U.S. economy and, therefore, on the U.S. dollar.

This piece from the Wall Street Journal makes a good — though a bit unsettling for the Chinese– point:

Rhetoric aside, it bears repeating that China will find it hard to make a meaningful shift out of Treasurys, the prime current channel for investment of its $1.95 trillion foreign exchange reserves.

Some say China could switch holdings into gold — but that market’s highly volatile, and not large enough to absorb more than a small proportion of China’s reserves. It’s not clear, meanwhile, that euro, or yen-denominated debt is any safer, more liquid, or profitable than U.S. debt — key criteria for China’s leadership.

Most pertinent of all, even if China decided to sell off some of its U.S. Treasury holdings, it would scarcely be able to dump that in large blocks. And a partial selloff would surely lead to a slump in the Treasury market, eroding the remaining value of China’s portfolio…

The Chinese have few options on where to go with its estimated $2 trillion in reserves, of which approximately 70% is believed to be in dollar-denominated assets. So, if the Chinese cannot move their assets out of the dollar, why is Chinese Premier Wen voicing concerns now? Here are three reasons:

• I believe this is just a case of China making sure that China’s need are paramount in the minds of U.S. financial leaders and, of course, President Obama.

• It is also likely that the Chinese wanted to make a point as the global economic conference — the G-20 meeting — gets underway in the United Kingdom. The G-20 is a group consisting of the top economic nations in the world and its members constitute about 90% of the world’s economic output.

• The U.S. is taking lots of steps to stimulate its economy. China is also doing so too. However, the European countries are not doing much in this regard. It may well be that China is also making this point to pressure other governments to do more to stimulate their economies and therefore to stimulate demand for consumer goods from China.

So, the question was: Will China dump the dollar? My answer is, no it won’t. But, will it keep the pressure on the U.S. to be more fiscally prudent? I sure hope so.

Update: Apparently, I’m not the only one who found it ironic that the premier of China suggested the U.S. get its financial house in order. This editorial from Investor’s Business Daily made the same point:

…With China holding a trillion dollars in U.S. government debt, what Wen is worried about is Uncle Sam’s massive spending spree devaluing the U.S. dollar and threatening “the safety of our assets.”

He sounded not like the Communist dictator he is, but like the concerned head of an institutional investment firm warning the management of some troubled insurance company or mutual fund in which he has placed confidence to shape up and start behaving like successful businessmen…

• Business , Economy , Geopolitics , Money , income taxes , inflation
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