from Follow the Money

China worries the US may want a “competitive” dollar

April 10, 2006

Blog Post
Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

More on:

China

Xia Bin, head of the financial research institute at the cabinet's Development Research Centre, didn't use Martin Feldstein's clever term though.  He worries about a weak dollar policy.

"We cannot underestimate the possible loss to the reserves if, in the long run, the United States adopts a weak-dollar policy and we are still maintaining a high level of dollar reserves," Xia said.

Xia also left out a key point: The US doesn't have a strong dollar policy right now.  China has a weak RMB policy.   At least against the dollar. China is the one actively intervening to support the dollar, not the US.  

The Fed certainly doesn't have a strong dollar policy.  If you read between the lines of all IMF staff reports on the US, the Fed has more or less told the IMF that it expects the dollar to depreciate over time.  That current account deficit and all.  The Fed just doesn't think dollar depreciation will be a problem for the US.  And it certainly won't adjust US interest rates to defend the dollar should it come under pressure.

China may direct its monetary policy at exchange rate stability, but the US hasn't, and won't.

But even if the dollar depreciation isn't a problem for the US, it might be a problem for those who have lent large sums to the US as a result of a "weak local currency" policy. 

Maybe Xia has read Roubini and Setser's missives about the big future losses China's state sponsored global macro hedge fund - otherwise known as China's central bank -- will take on its big dollar position.   Besides playing the RMB dolar carry trade, China's central bank is also operates a distressed debt fund.  But that is a story for another post.  

Or perhaps Xia just did the math.  It isn't hard.  Buying dollars high and selling them low is not a good way to make money.  China's central bank has known that for some time.  And since Xia works for the State Council - which has been the brake slowing the evolution in China's currency policy -  it must knows that China is looking at future losses as well. 

There may have been something to the market rumors last week (see Justin Lahart on Monday) that China has started to sour on US debt.

But so long as China's reserves keep growing, it really has to keep buying US debt (or parking money in US banks).

There are three broad ways China could slow its pace of reserve growth

1. It could reduce its trade surplus.  The most obvious way to do that is to let the RMB appreciate.  Xia hints that this may happen:

"The authorities should keep the yuan's crawling appreciation and "appropriately widen its floating band", Xia said"   

Realistically, if China widens the band, the RMB will appreciate to the upper edge of the band -- unless the central bank steps in before it reaches the upper bound, in which case the stated upper bound isn't the real upper bound.   A bigger band means a revaluation.

Update: the fact that China ran a $10b plus trade surplus in March, driven by 28% y/y export growth, won't exactly help to slow China's reserve growth.

2. China could convince foreign investors that they don't want to bring money into China.    That could mean getting rid of tax breaks that favor foreign direct investment.   It could mean holding Chinese interest rates below US rates - and trying to convince foreign investors that China won't let the RMB appreciate by more than the interest rate differential.  That has been China's strategy since last July - but it increasingly lacks credibility.   Or it could mean letting the RMB appreciate to the point where folks think it won't appreciate any more.

China's problem is that it doesn't want to let the RMB appreciate too quickly, which means that expectations of future appreciation won't go away.   And so long as folks the think theRMB still has further to go, they will want to hold RMB.

3. That leaves China trying to convince Chinese investors that they want to hold dollars, not RMB.  This is a big part of China's stated policy: China's government wants Chinese firms not to sell the dollars they earn exporting to the central bank, but rather to invest them abroad.  It wants Chinese institutions to invest more abroad as well.   But that gives rise to problems of its own.  Think Unocal.  

And if Chinese firms also think the RMB will appreciate, why would they want to hold dollars?   The option to sell dollars earned abroad for RMB at the current exchange rate is rather valuable, at least in the eyes of some.

And it seems that China isn't alone it in its worries.  The Europeans are also worried about a "competitive" dollar.   But the source of the concern is a bit different.  They aren't worried about a change in US policy so much as a change in Chinese policy.  Apparently, the Europeans are convinced that a RMB appreciation against the dollar will trigger a far larger dollar move.   A move that would sweep in Europe.  And right now, Europe doesn't want a stronger euro. 

The EU's worries appeared in the FT last week, and Eric Chaney mentions these worries again today

But I still don't quite understand why Europe is so worried.  

I pretty sure China isn't going to do anything too abrupt.  There is no reason not to believe all the official statements ruling out another step revaluation -- and they didn't exactly opt for a big step revaluation last time.  

And so long as China moves with baby steps, investors will keep on betting on further appreciation, China's reserves will keep on growing and China will keep on fnancing the US.

I am not sure why a stronger RMB implies a stronger Euro  In 2005, the RMB rose (a tiny bit) against the dollar.  And the dollar rose against the euro.  So the RMB rose substantially against the euro - or, put differently, the euro weakened against the RMB by even more than it weakened against the dollar.   

That might happen again.  The RMB could get stronger against both the US and Europe.  As Ted Truman has noted, the China doesn't need a basket peg so much as to appreciate against a broad basket of currencies.

Nor does diversifying into euros -- something that might put a bit of pressure on the dollar/ euro rate -- protect a country like China from capital losses.   The RMB is likely to appreciate against the euro over time as well, not just appreciate against the dollar.  

Of course, there is a risk that a Chinese move might prompt other investors -- whether private investors or other central banks --  to conclude that the US is in a bit of trouble, and shift out of dollars.  But that risk will remain so long as the US trade and current account defict keeps on growing.  

I would think that the Europeans might still want to worry about the risk  that the dollar will start to fall against the euro for reasons unrelated to China. If China continues to maintain its (de facto) dollar peg, the RMB would follow the dollar down.  Ok, there would be a (token) appreciation to show that China has a (token) basket peg, but the RMB might still fall significantly against the euro.  Sort of like 2002, 2003 and 2004.  That hardly served Europe's interests.

Ultimately, everyone has to play their part in resolving an unbalanced world -- Europe included.  And that likely means learning to live with a stronger euro.  Maybe not now.  But at some point.

More on:

China

Close