The US dollar fails the Chinese test

So China wants to adopt a basket peg because it no longer thinks the dollar is a stable store of value.

To quote Mr. Fan, Director of China’s National Institute for Economic Research:

The U.S. dollar is no longer -- in our opinion is no longer -- (seen) as a stable currency, and is devaluating all the time, and that’s putting troubles all the time," Fan said, speaking in English.

(thanks to glory for the link)

Maybe the United States’ bankers did not think it was particularly polite for the US President to call them tyrants. Maybe they did not particularly like the new estimate for the FY 2005 budget deficit. Maybe a currency tied to a sinking dollar does not suit their image of a rising China.

Or maybe China’s leadership is not totally immune to international pressure.

It is hard for me to argue with the core point Mr. Fan makes. In the long-run, the dollar pretty clearly will go down further than it already has. A 6% of GDP (and growing) current account deficit and an export base of 10% of GDP usually do not auger good things. The long-run shift in the dollar may need to be larger if David Hale is right, and the United States capacity to produce goods for sale on the world market is already very limited. The real adjustment process won’t start until the dollar falls to the point where investment in the US to produce goods (or services) for the world market makes sense.

If China doesn’t want to keep adding to its dollar reserves, no one else will either. China is the big player in this coordination game, the anchor of the central bank dollar cartel. Thailand will be able to cut the percentage of its reserves in dollars without moving the market far more easily if other central banks are adding to their dollar reserves (Perhaps this should read Thailand was able to ... I am not sure if Thailand announced a done deal, or its intent to reduce its dollar holdings)

It sure sounds like China would rather not continue to add dollars to its reserves at its current pace. On the other hand, so far China’s talk of greater currency flexibility has been a bit like the Bush Administration’s talk of reducing the budget deficit. Sounds nice in the abstract, but darn hard to do.

Mr. Fan put it nicely:

Fan said last year China lost a good opportunity to do revalue its currency, in July and October.

"High pressure, we don’t do it. When the pressure’s gone, we forgot," Fan said, to laughter from the audience. "But this time, I think Chinese authorities will not forget it. Now people understand the U.S. dollar will not stop devaluating."

To be honest, the time for China to have moved to a basket peg was in 2002, before the dollar fell against the euro. I suspect China will find it difficult to reconcile its aversion to a free float, its desire to avoid any large and disruptive changes to the renminbi-dollar, its desire to only move when the market does expect it to move, and its desire to reduce the pace of its dollar reserve accumulation. Moving to basket peg alone won’t do much to slow China’s overall reserve accumulation: the renminbi will still be undervalued, and there will be a strong incentive to bet that renminbi will have to be repegged at a higher level (v. the basket) at a later date.

p.s. I have another post forthcoming that takes on the Economist’s argument that the renminbi is not really undervalued.