Fundmastery Blog

Kurt Brouwer May 27th, 2009

Can China dump the dollar? Probably not, but Chinese officials are actively cautioning (scolding, remonstrating…) the U.S. on its profligate ways. China has an estimated $2.5 trillion in reserves, much of which are invested in dollar-denominated securities.

In terms of currencies, I believe there are only two others — the Euro and the yen — that China could look to other than the dollar. 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 Japanese yen, so the currency choice is between the dollar and the Euro.

Source: Wikipedia Commons

As this piece from the Financial Times [emphasis added] indicates, China has not dropped the dollar in favor of the Euro and is still investing heavily in dollar denominated securities:

…China’s official foreign exchange manager is still buying record amounts of US government bonds, in spite of Beijing’s increasingly vocal fear of a dollar collapse, according to officials and analysts.

Senior Chinese officials, including Wen Jiabao, the premier, have repeatedly signalled concern that US policies could lead to a collapse in the dollar and global inflation.

But Chinese and western officials in Beijing said China was caught in a “dollar trap” and has little choice but to keep pouring the bulk of its growing reserves into the US Treasury, which remains the only market big enough and liquid enough to support its huge purchases.

In March alone, China’s direct holdings of US Treasury securities rose $23.7bn to reach a new record of $768bn, according to preliminary US data, allowing China to retain its title as the biggest creditor of the US government…

I believe China will continue to invest in the dollar and in U.S. Treasuries, but that is not a matter for complacency as we saw in the previous post (China: Not So Quiet on the Eastern Front).

The U.S. Treasury is going to issue enormous amounts of Treasury securities to fund our growing budgetary deficits so we need China to continue investing. As a result, U.S. fiscal and monetary policy will be increasingly tied to keeping China happy and that does not bode well for us. It enforces a discipline of sorts, but our policy options are going to be increasingly limited and necessarily reactive, rather than pro-active.

In terms of alternatives for China, there is some evidence that China is stockpiling commodities such as oil and copper as a hedge against inflation and the falling dollar.

Here is a recent post from Brad Setser’s Follow the Money blog (China’s new barbell portfolio: Treasuries and commodities?) in which he discusses China’s dual strategy of buying Treasuries and commodities:

…At the same time, China has sought to ramp up its exposure to commodities. China’s government clearly is adding to its strategic stockpiles — and perhaps encouraging state firms to build up inventory as well. China’s government is encouraging Chinese state firms to invest more abroad, especially in the mining sector. And China’s government is providing financing to cash-strapped commodity exporters (Russia, Kazakhstan, Brazil and no doubt others) to help tide them through a rough patch and, China hopes, to secure future supplies…

Interesting times aren’t they? The U.S. is supposedly a capitalist country, but government debt is growing and our government is moving further and further into the private sectors of the economy (see Federal Deficits & Debt: What’s an investor to do? and GM Means Government Motors). On the other hand, the supposedly communist country of China is exhorting us to be more fiscally responsible.

• Economy , Geopolitics , Money , debt , inflation
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