China's premier, Wen Jiabao, has joined the chorus voicing concern about the dollar's recent weakness. Cheng Siwei comments two weeks ago seem to reflect rather widespread worries among China's top leadership. The FT reports:
Premier Wen Jiabao told a business audience in Singapore it was becoming difficult to manage China’s $1,430bn foreign exchange reserves, saying that their value was under unprecedented pressure.
“We have never been experiencing such big pressure,” Mr Wen said, according to Reuters. “We are worried about how to preserve the value of our reserves.”
China keeps the currency composition of its reserves a state secret, but some analysts believe that more than two-thirds are probably still held in dollars.
Wen certainly has reason to worry. No one has made a bigger bet on the dollar that China's government. I personally suspect that China's state -- counting the assets of the State Administration of Foreign Exchange, the China investment corporation, China's big state banks and the national social security fund -- hold around $1.2 trillion in fairly long-term dollar-denominated debt. The precise number depends on just how many dollars the banks are currently holding (their holdings of foreign debt securities likely are well over $200b by now) as well as just what fraction of China's roughly $1.5 trillion in formal reserves (China had $1433.6b at the end of September and is steadily adding to its reserves) are in dollars.
The capital loss on those dollars could be considerable. The dollar hasn't held its purchasing power relative to the euro, or relative to oil. But what should really worry China's leadership is that the dollar is very unlikely to hold its value relative to the RMB. After all, China's government has financed its dollar purchases by issuing RMB debt. Willem Buiter argues:
If the dollar falls by another twenty or thirty percent, which is certainly possible, the Chinese and Japanese authorities would each be presenting their tax payers with a further $200bn to $300bn capital loss. That's a heavy price to pay for access to US markets for your exports, especially for a poor country like China
I have a feeling that the current (unrealized) mark-to-market losses on China's investment in Blackstone drew attention to the broader financial risks that China is taking by holding so many foreign assets. China's large holdings of dollars clearly pose a far larger risk than its small stake in Blackstone.
Moreover, the Hu/ Wen policy of only allowing gradual RMB appreciation -- out of fear that fast appreciation would be disruptive -- largely explains why China now holds so many dollars. Back at the end of 2004, China's total reserves were only around $600b ($650b counting Huiijin) and the state banks held a lot less long-term dollar debt. China's total dollar holdings were more like $450-550b.
The majority of China's dollar exposure comes from intervention over the last three years.
That puts Wen in a bit of a bind.
His comments were no doubt intended to tell Washington that it need to start paying more attention to the value of the dollar.
Yet domestic US conditions likely call for the Fed to cut rates to support the US economy, not raise them to defend the dollar. The market now expects a series of rate cuts. Ten year Treasuries yield close to 4%.
As Paul Krugman notes (hat tip Thoma), the "arithmetic" doesn't suggest that dollar weakness will contribute that much to inflation. Imports are still a relatively small share of US GDP and a fall in the dollar doesn't necessarily translate one for one into higher US prices for imported goods. The absence of a stronger link between dollar weakness and inflation makes it hard to build a strong case that the Fed should target the dollar rather than domestic variables.
Wen cannot force the US to direct its policy at defending the dollar's external value anymore than the US can force China to stop intervening in the foreign exchange market.
He could, of course, conclude that China can no longer take the risk of holding so much of its wealth in dollars, and stop adding to China's dollar portfolio.
But doing so would truly cause the dollar's value to tumble. It would dramatically reduce the value of China's existing dollar holdings. As importantly, it would -- absent a change in China's currency policy -- also push the RMB down and push up Chinese inflation.
No wonder Wen is unhappy.
Many of the risks that Dr. Roubini and I highlighted in our rather gloomy 2005 paper seem to be very evident now. The US slowdown has brought a lot of latent tensions to the surface -- in the Gulf (see today's Slater/ Cummins article) as well as in China. Willem Buiter is worried about a scenario where foreign demand for all US bonds -- not just demand for CDOs and riskier bonds -- disappears. He writes:
"all the ingredients for a bond-run are in place, and at some point in the near future, the gradual sale of dollar-denominated securities will become a flood"
And, as Menzie Chinn notes, the US hasn't locked in low interest rates in dollars forever. What if the US turns out to be borrowing at what amounts to a low initial teaser rate?
To be clear, Bretton Woods 2 has not yet cracked. Asian central banks and state oil funds likely provide the US with far more financing now than a year ago, let alone two or three years ago. The US didn't slow down because foreign creditors lost their appetite for US debt. Rather, a US slowdown led foreigners to lose their appetite for risky US debt. The interest rate on Treasuries is still quite low.
But a system where the Gulf, China and some other Asian economies intervene heavily in order to resist market pressure for appreciation -- after all, they have depreciated by almost as much as the US against Europe -- is under a lot of strain. Both China and the Gulf are starting to worry about the all the (depreciating) dollars they now have to absorb to sustain the system, even if they haven't actually balked at buying those dollars.
It consequently really shouldn't be a surprise that a range of countries are now asking the US to take policy actions -- notably steps to defend the dollar -- that will reduce the strain that the system places on them.
But granting their wish would effectively change the nature of the system. Up until now, Bretton woods 2 provided the US with unconditional financing, not just cheap financing. Foreign central banks built claims on the US even thought the US wasn't committed to protecting the dollar's value.
In some sense, the current system seems poised at a knife's edge. That may be a bit too dramatic, but probably only just. After all, the sober FT is warning of the risk of a dollar rout.
There are a set of investors -- China's government, Japan's government, some large oil exporters and for that matter most domestic US investors -- that are significantly overweight US financial assets. That conclusion is true relative to any relevant benchmark, at least for the big Asia holders of dollars, the Gulf and some smaller oil exporters. You can at least argue that US investors should hold most of their wealth in dollars to limit their currency exposure.
If those investors with lots of dollars decide that they already have to many and try to reduce their dollar holdings, watch out. The dollar could fall even further. Indeed, all it would really take is for the big current buyers of dollars to decide to stop adding more dollars to their existing dollar heavy portfolios.
On the other hand, the dollar has already fallen rather substantially against most European currencies. The US/ European trade balance is already falling -- and that is more from a dollar at 1.30 to 1.35 late last year than the dollar's current weakness. At some point investors who are holding lots of euros or pounds might decide that the dollar is cheap. And for that matter, some investors who are already dollar heavy might decide that at this stake, they should double down. China should have bought more euros back in mid 2004 -- or much of 2005 -- at around 1.20. But 1.45 (now almost 1.48) isn't 1.20. Maybe the right strategy for China and other big holders of dollars now is to sell euros and buy dollars to raise the dollar share of its portfolio in the hope that the dollar will rally v the euro ...
I am not sure which outcome -- at attempt by those already over-weight dollars to lighten up, or a decision by others that the dollar already has fallen by too much against the euro -- is more likely. I can see the case for both, though the absence of any real signs of resurgent demand for US financial assets suggests, at least to me, that there is a slightly higher chance of even more dollar weakness.
By contrast, I am pretty confident that it doesn't make sense for the dollar, the riyal, the dhirham, the RMB and a few other Gulf and Asian currencies to all have depreciated by nearly as much as the dollar against the euro ...
Just think how much better off we would all be now if they had taken advantage of the dollar's 2005 rally to move more decisively off the dollar.