Submitted by Edward Harrison of the site Credit Writedowns
China is really looking at a lot of other options to get away from the U.S. dollar. The latest report is that it has been building huge gold reserves. There is no doubt that China wants to get out and away from the U.S. dollar now. We have heard SDRs, copper and precious metals all mentioned as plays out of U.S. dollars. How this will play out on currency markets and in the U.S. government bond market is no at all clear.
China revealed on Friday that it built up its gold reserves by three quarters since 2003, making it the world’s fifth largest holder of bullion.
The move comes as European central banks continue to sell their gold and the International Monetary Fund has discussed selling some of its bullion reserves.
“This is probably the most significant central bank announcement since the Central Bank of Russia announced at the LBMA gold conference in Johannesburg in 2005 that it wanted to hold 10 per cent of its foreign exchange reserves in gold,” said John Reade of UBS.
Ahead of this month’s G20 meeting in London, China said reliance on the dollar as the world’s reserve currency should be reduced by making greater use of special drawing rights, the synthetic currency run by the International Monetary Fund.
This led to speculation China was considering changing its policy which has seen the majority of its foreign exchange reserves channelled into the US government bond market and other dollar denominated assets.
This has raised the question of whether China plans to increase the proportion of its foreign exchange reserves that it holds in gold and how much it could buy
Now, let’s review the chain of events:
- The U.S. sub-prime mortgage market implodes, causing Fannie and Freddie to go bust. The Chinese start dumping GSE paper. (27 Aug 2008 post)
- Meanwhile, Tim Geithner was putting his foot in his mouth and telling everyone the U.S. was ‘manipulating’ its currency. Vice President Biden had to correct him, but the damage was done and the Chinese went on a rampage, savaging the U.S. at Davos (Geithner: 28 Jan 2009 post ; World Economic Forum: 29 Jan 2009 post)
- Then, in March, the Chinese premier started making the same noises about Treasuries that he had about GSEs earlier (13 Mar 2009 post). Was he bluffing? Marshall Auerback said so at the time. I am a bit more concerned.
- Showing increasing signs that they were not bluffing, the Chinese started avoiding using dollars in transactions in deals with countries like Argentina (31 Mar 2009 post)
- Then, before the G-20 summit this past month, the Chinese start floating the idea that it wants to move to a SDR (special drawing right)-centric world, loosening the U.S. grip on being the world’s reserve currency. Of course, there was the chatter about the Chinese pegging their currency to copper instead of the U.S. dollar. Obviously, they had worked this out with the Russians ahead of time. (1 Apr 2009 post)
- After the summit, the whole lets-not-settle-trade-in-dollars meme continued as the Chinese struck yet more deals to do so (9 Apr 2009 post)
So, here we are, three weeks out from the G-20 and now we learn the Chinese have been buying gold. In my mind, there is no doubt that China is looking to topple he U.S. dollar as the world’s reserve currency. And this will happen over time. The Europeans want it – they are a rival in currency terms. The Asians want it – they want to stick it to an arrogant country which caused great hardship to Asia through the IMF in the Asian Crisis. And the oil exporters like Saudi Arabia, Iran and Venezuela all want it too. It will happen. The question is when and what will replace the dollar.
Another question comes to mind as well. Isn’t this de-stabilizing for a world in a global recession. The economists over at Vox have a few points to provide on that score using France and the United Kingdom as 1920s parallels for China and the United States. I have highlighted some important bits.
China’s “dollar trap” has many analysts worried about its future resolution. This column discusses a similar situation in the in the 1920s when France held more than half the world’s foreign reserves. France’s “sterling trap” ended disastrously. Sterling suffered a major currency crisis, French authorities lost a lot of money, and subsequent policy reactions deepened the Great Depression.
What are the lessons for today? China’s objective function today certainly differs from those of France in the interwar years. But French experiences in the early 1930s are a reminder that when there is growing risk on reserves currencies, foreign reserves can be both a source of instability for the international monetary system, and a burden for large holders.
China’s huge volume of dollar reserves is now at the centre of serious concerns about the future of the US currency. The origin of this situation dates back to the early 2000s, after the East Asian and Russian crises. At that time, accumulating foreign reserves was considered benign policy. Developing and emerging countries were encouraged in this way in order to insure against sudden reversals of capital inflows. China was pegging its currency against the dollar and, due to the US trade deficits, started acquiring US assets.
Ten years on, the People’s Bank of China (PBOC) has an extraordinary stock of dollars, and one pressing question: “What to do out of them?” Increasing political tensions have given rise to fears that it might get rid of this huge bulk of securities and precipitate a dollar crash. In August 2007, a Chinese official indeed reminded that Beijing was in a position to provoke a “mass depreciation” of the dollar if it decided to do so. Recent suggestion by Zhou Xiaochuan that China’s central bank might shift from the dollar has put the issue on newspapers’ headlines once again.
But bold statements are one thing, and actual policy another. Up to now, China’s authorities have shown few signs of attempting to weaken the dollar. The reason for this seems straightforward. After all, China is the world’s largest dollar investor, and no one else would have less interest in seeing the value of the US currency plummet. The PBOC might be the promptest to support the dollar, not least because it would suffer a huge capital loss in the event of a dollar depreciation. In a recent New York Times column, Paul Krugman argues that China has “driven itself into a dollar trap, and that it can neither get itself out nor change the policies that put it in that trap in the first place.”
This situation might appear unprecedented. But in truth, all this is not brand-new.
French foreign reserves policy during the Great Depression
Economic history offers one striking example of a country being trapped by the huge volume of its foreign reserves. This country was France, the period was the early 1930s, and the currency at stake the pound sterling. The episode ended up dramatically. Sterling suffered a major currency crisis, French authorities lost a lot of money, and their subsequent policy largely contributed to the Great Depression.
The origin of the problem lay in the government’s decision of 1926 to peg the franc to the sterling and dollar, two years before re-establishing the gold standard. Since the trade balance was in surplus and capital was flowing into the country, this goal was achieved through public purchases of foreign exchange. The Bank of France therefore accumulated a bulging portfolio of foreign holdings. At the end of the 1920s, the country held more than half of the world’s volume of foreign reserves.
French policy over subsequent years has been heavily criticized for being destabilizing. British contemporaries, like Paul Einzig, accused France of using its reserves in order to weaken the pound before the sterling crisis of September 1931. Others have noted that French conversions of foreign assets into gold after 1931, by imposing constraints on their money supplies, put intense deflationary pressures on other countries on the gold standard.
France’s Sterling Trap in 1931
Why did France engage in a policy that had such dramatic consequences? In a recent work, I explore the motivations behind the French reserves policy of this period. Spending time in the archives, I was able first to reconstitute the evolution of the reserves currency composition, and second, to identify the reasons invoked for the allocation decisions. Last, I have combined this information with market indicators of the perceived risk of reserves currencies.
France’s problems were similar to those of China today. The Bank of France was a private institution and its primary objective was to avoid capital losses. Its reserves were allocated between sterling and dollar. From 1929 to 1931, there were fears that the pound might be devalued and the Bank started shifting to the dollar.
However, in implementing this policy, the Bank was also constrained by its position as a large player on the exchange market. So, as sterling’s weakness worsened at the end of 1930, the Bank was in a trap: it could not continue selling pounds without precipitating a sterling collapse and a huge exchange loss for itself. The only workable option left was to support the pound. French policy therefore suddenly turned cooperative. The Bank halted the sterling liquidations, and even intervened on the market in order to support the British currency.
When the pound eventually collapsed, the Bank of France was put into a state of technical bankruptcy. It was only able to survive thanks to a state’s rescue, obtained under tough conditions. Moreover, there were now rising fears over the dollar. The will to avoid further losses therefore led authorities to convert all their dollar assets into gold (figure 2), a policy that heavily contributed to the global monetary contraction of the 1930s.
Lessons for today?
What are the lessons for today? China’s objective function today certainly differs from those of France in the interwar years. But French experiences in the early 1930s are a reminder that when there is growing risk on reserves currencies, foreign reserves can be both a source of instability for the international monetary system, and a burden for large holders.
There are some graphs on Vox’s site associated with this essay that you should have a look at. My analysis is this: The Chinese want to weaken the U.S.’s power derived through its currency status. They have been setting the stage to do so for some time. However, they want to act in a way that benefits them in the short- and long-term. Cutting loose in an uncontrolled fashion now benefits no one with the world economy in dire straits. However, when the economy does right itself, you should see some major changes in the currency markets.
Sources
China reveals huge rise in gold reserves – FT.com
China’s Syndrome: The “dollar trap” in historical perspective – VoxEU
24 comments
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Guess we know who’s been propping up the price of gold now.
Guess we know who’s been suppressing the price of gold now.
Guess we now know that the Chinese believe that gold is a better investment than the dollar.
China has been on a world-wide buying spree in commodities and commdity production, spending down their dollar and dollar denominated assets. Where would you want to be in five years–trying to buy oil/iron/coal/copper with a devalued dollar, or own those assets, having paid with the soon-to-be devalued dollar?
Thanks for this very useful clarification and analysis.
1054 metric tons. Maybe $35 billion?
As a percentage of reserves, this is not a lot of dosh, really. The significance is that the Chinese are accumulating gold while all other central banks are selling. The BoE has been particularly bone-headed on this score.
Meanwhile the Chinese are doing everything they can to find ways to park their dollars anywhere except treasuries. I see the busted Unocal takeover as a sign of how long they have been trying to diversify their dollar holdings.
There is no reason to believe that China ever bought dollar-denominated bonds because of their investment value. It was only to suppress the value renminbi and prop up the dollar. In other words, to subsidize Chinese exports. This distorted the market and is at least partially responsible for the mess we are in.
It would be great news for the US, the world, and even China if China were to get out of dollar assets.
Tortoise said… “It would be great news for the US, the world, and even China if China were to get out of dollar assets.”
I would restate that as follows: It would be great for the US, the world and even China if China had never gotten into dollar assets.
But now that they’re there, I’d say there’s a problem.
Tortoise, you said, “It would be great news for the US, the world, and even China if China were to get out of dollar assets.”
Please explain.
I have a good friend who tells me that the US would be better off if the dollar were not the world’ reserve currency, particularly relative to oil. I don’t want to anger him so I don’t pick at what makes him think this, but I think that its “petrodollar” status has given the US dollar an undeserved extra value, and that its special status as reserve currency has done the same thing. When the debt hit the fan last fall, debts needed to be settled in dollars, so while stocks were sold off, gold and commodities were plummeting in value, the dollar levitated because people owed each other DOLLARS.
If people could settle their debts just as well in something else, the dollar would be less valuable — it wouldn’t have as much buying power.
I guess that’s equivalent to the effects of inflation, and I guess our monetary policy is inherently inflationary, but that’s not my favorite part.
Are you making things in the US for export? Are US exports more important than the savings of those who Americans have actually put aside money for their future?
How cheap should the dollar be? If the dollar lost half its value, what do you think that would achieve in positive effects?
Do you feel our gasoline is way too cheap and should cost more?
Where’s your logic, please?
Maybe they’d like to buy some banks.
Larry,
I’m sure thy would be interested actually. But the failed Unocal transaction has taught the Chinese that Chinese money is not welcome in the U.S. for buying actual companies or assets. I reckon this event caused a re-think in Beijing about their longer-term thinking vis-a-vis the United States.
Valentine Michael Smith asks what is the logic behind my claim that it would be good if the Chinese government could stop propping up the dollar. I will try to explain. But, first, a disclaimer: Every action results in winners and losers. So, when I claim that some action will have a beneficial effect for the US, I only mean in a certain average sense. For example, if the dollar drops by 20%, someone on a pension may lose a bit and someone who works in the financial sphere may lose a lot.
OK, back to the issue. For several years, the US dollar has been overvalued. Not super-overvalued (as some claim) but sufficiently overvalued to distort markers. Think of it. Most businesses in the real world operate with 5% profit margins. A 10% competitive disadvantage due to an overvalued home currency is catastrophic in the long term. This has led to a huge trade deficit for the US. It has led to destruction to industry, unemployment in the work force, financial and housing bubbles, and other distortions in the US. If foreign governments had not supported the dollar, the dollar would have to depreciate until the trade imbalance would nearly disappear. Just think of the potential benefits to the real economy. In my view, it would not take much depreciation to achieve near balance in trade and tangible improvements in the economy.
With 20% of the US workforce un- or under-employed, half of capacity idle, the value of housing stock dropping at about 15% per year, etc., I would not be concerned about inflation even if the dollar were devalued by 20%. The retired person may see prices go up a tiny bit but who pays for unemployment benefits or for making savers whole or for keeping state governments? Maybe the same retired person in her role as taxpayer.
I find that the idea that the dollar will lose half its value just because foreign governments withdraw from the dollar rather far-fetched. A more likely scenario is that, after an initial drop, the dollar will stabilize at a level only modestly below where it is now.
By the way, the euro is also overvalued. At some point, it will have to adjust in order to provide relief to German exporters. In fact, I suspect that the dollar will not drop compared to the euro and many other currencies within the foreseeable future even if the Chinese government sells its all its US assets.
What is consider as a more frightening scenario is that foreign governments will continue supporting the dollar. Then adjustment will have to be made in much more painful ways — which is exactly what we are observing right now.
Meanwhile, Tim Geithner was putting his foot in his mouth and telling everyone the U.S. was ‘manipulating’ its currency. The problem with this is that it was said after the damage was already done. At this point the damage is done. Chinese dumping has ensured disinvestment in tradable goods production capacity in the the US for years. I’m sure the free trade fundamentalists will deny all responsibility for the bad results, as usual.
“Meanwhile, Tim Geithner was putting his foot in his mouth and telling everyone the U.S. was ‘manipulating’ its currency.”
I think you mean ‘China,’ says overly anal reader/fan.
The problem with the dollar as a reserve currency is that the market does not set the cost of the US dollar as an asset. It’s artificially set by the Fed as the interest rate. The market should set the interest rate…by the supply of available dollars for investment (ie: US dollar savings). Why anyone would want to hold a US Treasury 30 year bond at these low rates baffles me, do you think the dollar will not collapse? Even if its stable in the short term because the Chinese and everyone else keep propping it up, eventually it will be devalued against hard assets, it has to be. There are too many dollars on the market, too many countries that in the medium term want out of US dollars and the Fed will never be able to quickly adjust to soak up the excess supply. A 30 year treasury is a bad, bad bet. For which no investor is being compensated by the interest rate. This is NOT the safest investment in the world. Yet the Fed is still driving down long term interest rates. The Fiat currencies of the 20th century are not “free market”, not as long as the interest rate is artificially set. Since Nixon closed the gold window, no discipline has been enforced on central governments to keep their debts and houses in order. Having a market set interest rate would do that…Now we just go from bubble to bubble and the policy response is to create new ones and call that progress…
A few corrections:
“China revealed on Friday that it built up its gold reserves by three quarters since 2003, making it the world’s fifth largest holder of bullion.”China is actually the 7th largest holder of bullion, since in addition to four countries, the International Monetary Fund and the SPDR Gold Trust exchange traded fund are also bigger than China.
“The move comes as European central banks continue to sell their gold and the International Monetary Fund has discussed selling some of its bullion reserves.”The ECB actually recommends its member banks to buy more gold.
“China is looking to topple he U.S. dollar as the world’s reserve currency. And this will happen over time. The Europeans want it – they are a rival in currency terms.”What Europeans? The EU was merely a desperate attempt to delay the inevitable demise of Western Europe. The “European Dream” has failed miserably, and it only takes a 30 minute trip outside the touristy spots of Paris, Barcelona, Vienna, Athens, and Rome, to see just how backward Western Europe really is.
Comparing France’s experience with the current US-China situation is foolish. The parasitical British Empire was in freefall in the 1920s and 1930s (as it remains today). This not the situation with the US today. The world still loves American movies, American Starbucks, American big macs, American Apple computers, American Microsoft software, etc, etc, etc. And one more thing: right now there are more General Motors and Ford vehicles on UK’s and continental Europe’s roads than almost any other brand.
Sorry, but rumors of America’s demise have been greatly exaggerated…
Vinny GOLDberg
Tortoise said: “If foreign governments had not supported the dollar, the dollar would have to depreciate until the trade imbalance would nearly disappear. Just think of the potential benefits to the real economy. In my view, it would not take much depreciation to achieve near balance in trade and tangible improvements in the economy.”
But what would keep the dollar from stabilizing at a value lower than the most desirable one (from our point of view)?
Tortoise said: “With 20% of the US workforce un- or under-employed, half of capacity idle, the value of housing stock dropping at about 15% per year, etc., I would not be concerned about inflation even if the dollar were devalued by 20%. The retired person may see prices go up a tiny bit but who pays for unemployment benefits or for making savers whole or for keeping state governments? Maybe the same retired person in her role as taxpayer.”
If the dollar lost 20% of its value relative to commodities (e.g. food, oil) then it takes 20% more net income to live on. You’d have to earn even more than that, of course, what with taxes. (Or if you’re like me, you have 20% less time your savings can hold out. I am involuntarily semi-retired: I have an unsuccessful business, so I still work but I don’t get paid.) Who pays unemployment benefits? Business people like me. Who ‘makes savers whole?” No one!
Tortoise continued, “I find that the idea that the dollar will lose half its value just because foreign governments withdraw from the dollar rather far-fetched. A more likely scenario is that, after an initial drop, the dollar will stabilize at a level only modestly below where it is now. “
I guess I have a more elastic vision of what COULD happen once the allmighty dollar stops having the special status as the World’s Reserve Currency. What’s to keep it from taking a more drastic plunge? I really don’t know enough to know one way or another. But I do think we’ve been making war on other people’s dime as well as gobbling up resources and labor WAY out of proportion to what we produce. If we were to suddenly level the playing field — well, I read that the average salary in China is about one fortieth of what it is in the US.
Like you, I’m aware that not just the dollar but most key currencies have dropped in value. If dollars AND Euros AND other currencies all lose value together, then maybe we wind up on the Petro. Or a “basket of commodities.”
Having watched globalization’s march over time (since the 1980’s began sending factory production to Mexico, while dismantling US factories) I can see the logical outcome is to make the first world more level with the 3rd world.
That’s why destabilizing the dollar is a scary idea, to me. (But — well, I’ll admit think the crew we have in charge in the US is doing the real damage.)
Latchy,
If you’re a credit card company, you can loan out dollars at very high interest rates!
But MY dollars have little or no value over time if I take them to my local bank, where the interest rates are laughably low. This is because bankers don’t need “saved” money. They get their money pretty much free, plus they can make up 90% or more of it out of thin air because the reserve requirements have been thrown out.
So not only does the market not set the interest rate, the whole fiat-money system has pretty much been exposed as a sham lately. It’s that scene in the Wizard of Oz where you see Ben Bernanke behind the curtain….
“no discipline has been enforced on central governments to keep their debts and houses in order”
So who enforces the discipline? Since when do free markets need enforcement?
This goes back to the idea that all economic agents are all knowing. They are not and never will be.
I agree that a change has to be made, but this line of thinking eventually leads back to the same place, someone has to ensure that everything is fair.
Another point, by all measures we are experiencing deflation. Your comment seems to hoist the inflationary flag. Why is it so hard for people who rabidly believe that inflation is just around the corner to see deflation?
A 30 year treasury yielding anything positive is clearly better than the dollar, especially in your inflationary universe.
It all relative, nothing stands still.
“no discipline has been enforced on central governments to keep their debts and houses in order”
So who enforces the discipline? Since when do free markets need enforcement?No agency, the market would enforce the discipline by what it would charge for Governments to borrow, replacing the discipline the gold standard enforced before Nixon.
Another point, by all measures we are experiencing deflation. Your comment seems to hoist the inflationary flag. Why is it so hard for people who rabidly believe that inflation is just around the corner to see deflation?IF deflation comes, it comes in the short term only, the policy responses of the Administration, indeed even the world are inflationary. I agree there is short term risk to deflation…the interventions and the Fed buying Treasury debt are heavily inflationary in the medium to long term.
A 30 year treasury yielding anything positive is clearly better than the dollar, especially in your inflationary universe.This is a preservation of capital move….for 30 years? wouldn’t gold or any commodity be better? With these interest rates there is real risk that inflation will eat up your capital over 30 years.
This goes back to the idea that all economic agents are all knowing. They are not and never will be.
I concede this point. My schooling does get the best of me sometimes, but I still think the market knows better than most people give it credit for…
Valentine Michael Smith, I share your frustration with central bankers and their long-term inflationary policies. But the issue you and I have been discussing is the collapse of the dollar as a result of foreign central banks selling out their dollar assets (which you fear and consider likely, unlike me).
In your more recent comment, you seem to be concerned that a 20% drop in the dollar will mean a 20% increase in the price of commodities and thus a 20% (or something significant) increase in the cost of living in the US. Both assumptions are wrong, according to empirical evidence. I think you underestimate the ability of economies to elastically adjust. When the price of a good goes up, demand decreases and supply grows. (Sorry for stating what I am sure you find obvious.) The US can produce pretty much everything –even oil, except we consume it at even more ridiculously high rates. The reason we import so much is because the cost of doing business in the US is so high. This crisis is a brutal way to take care of this problem. A simpler solution would be to let the markets find the price of the dollar. So here is where we return to the starting point. I claim that the dollar is over-valued because it is manipulated by the central banks of exporting nations. Many of the problems of the real economy are due to this manipulation.
You also state: “But MY dollars have little or no value over time if I take them to my local bank, where the interest rates are laughably low.” Of course they are. The chain of events that leads to these low interest rates is that foreign banks lend us billions a day without concern on return.
By the way, when I wrote “making savers whole” I meant FDIC insurance. So, the taxpayer pays for that, too.
It seems to me that you, as a businessman, should be the first to hope, even demand, that this manipulation stop and the dollar be allowed to drop. I seems to me that you are simply worried about the wrong problem.
“wouldn’t gold or any commodity be better?”
Maybe, you just have to include the cost of securing and storing that stuff. Gold and oil both COST money to keep once they are taken out of the ground. That is called negative yield. Aka, you would need to spend gold to keep it secure.
The market can and will be wrong. Right now “the market” is saying the dollar is worth more than any other currency, compared to just a year ago.
This goes back to the idea that all economic agents are all knowing. They are not and never will be.
I should also add that this means that all economic agents are rational. They are not.
Does this mean the market is broken?
By your reasoning, everyone should be running from the dollar, they are not. They all have different reasons for wanting them.
“So who enforces the discipline? Since when do free markets need enforcement?No agency, the market would enforce the discipline by what it would charge for Governments to borrow, replacing the discipline the gold standard enforced before Nixon.”
People are still making a free choice to buy treasuries, without what you would call discipline. A lot of them. No one is telling them they have to buy them. And they are buying them. Should this market be “fixed”, its clearly irrational.
If the gold standard were in place, would you make it illegal to destroy gold? In a “free market” you should be able to do what you want with your gold. In the instance of a gold standard, any person destorying gold is removing GDP from the earth. Less gold this year, after I destroyed it.
This is clearly not rational, but sticks with the free market ideology. Everyone else would be stuck in a recession. Destroy enough and what you have left might be worth more. James Bond in goldfinger.
The gold bugs just want to substitute one problem for another, we would end up in the same place eventually, only they have all the gold.
He who has the gold makes the rules.
A country where 40 % of the people make less than 2$ a day is not poised to be a hegemon. Those peasants and migrants are the people Americans almost never see or talk to.
China’s government is only interested in protecting itself from an oft-repeated history of dynasty and implosion. Every action they take indicates this.
They are not interested in ruling the world, nor has China ever been interested in that over thousands of years.
i dunno if you’d pick this up, but it might be a good story…
1. http://singaporemind.blogspot.com/2009/04/confession-of-s-chip-ceo.html
2. http://www.google.com/finance?q=SIN:F12
3. http://www.asiaone.com/Business/My+Money/Building+Your+Nest+Egg/Investments+And+Savings/Story/A1Story20080915-87760.html
4. http://www.straitstimes.com/Breaking%2BNews/Singapore/Story/STIStory_342917.html
5. http://singaporemind.blogspot.com/2009/04/s-chips-from-red-hot-chips-to-rotten.html#c3666404735536329476