Brad Setser

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The US dollar fails the Chinese test

by Brad Setser
January 26, 2005

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.


  • Posted by anne

    Well, I can make no sense of Andy Xie. Happily Alan Greenspan has ruled out sacrificing the domestic economy for the sake of the dollar.

  • Posted by glory

    i know nothing! ‘cept that his speeches are even more sleep-inducing than greenspan’s πŸ˜€ he’s more greenspan than greenspan! he’s very greenspan-like πŸ˜€

    BUT, i’m a fan, so i’m rooting for his nomination…

    my first choice would’ve been mcculley if kerry had won it, but mcculley is even more of a democrat, so i like to think there’s an outside chance… like ferguson’s the kind of low-key, but competent and respected — battle-tested even! — guy that markets and both sides of the aisle would like… maybe?

    i dunno πŸ˜€

  • Posted by Ian

    TIPS also have other flaws. The liquidity available is much less then in the regular treasuries. So they don’t behave exactly like run of the mill govts. Also, while TIPS can not be inflated away, they can certainly be “hedonically adjusted” away. Various estimates of the understatement of inflation are out there, from people like Bill Gross, and the view seems to be that CPI is at least a percentage point under in measuring inflation. Of course that opens up the whole can of worms about what is inflation? House prices? Bond prices? Maybe inflation isn’t just what’s measured by the CPI ex-everything.

    I agree with others on this board and elsewhere that remnimbi revaulation will not the panacea for all that ails the global economy. It is ludicrous for me to think that China is ready for a true floating exchange rate, given the state of their financial system (Does anyone really think that the big banks are going be cleaned up in time for an IPO late this year or early next?). My best guess is some sort of crawling band a la Brazil ’98.

  • Posted by Ian or someone should give odds on the next fed chairman. I agree with Krugman that the fact that Bernanke is going to be moving into the Bush Administration to chair the CEA (whatever its called) is sort of a trial for possible fed chairmanship. I think that Bernanke is now the major intellectual weight in the FOMC and he would enhance the institutional credibility of the Fed after Greenspan. So he’s the horse I’m backing….

  • Posted by glory

    re: make them go up in smoke – default!

    great point! like if china or anyone were to say (maliciously? /paranoid πŸ™‚ dump treasuries, what’s to keep the US from (selectively) not honoring its debts?

    like wouldn’t that just be the modern-day BWII equivalent of nixon telling france to shove it in 1971?*

    exorbitant privilege πŸ˜€

    *”This is a great day for France!” -President Richard Nixon, while attending Charles De Gaulle’s funeral, from The 776 Stupidest Things Ever Said

  • Posted by brad

    Ian: and Brazil’s crawling peg in 1998 worked out so well …

    I have never quite understood the “China’s financial system is not ready for a true float” argument, in part b/c I never really thought China would go for the fully monty (a free float and an open capital account). I don’t think they really expect local banks to do things like help firms hedge fx risk in a free float, or even in ASian style managed float in the near future.

    A simple revaluation always seemed more likely, with or without capital account liberalization, or maybe a revaluation, a basket peg and a band. The PBOC would heavily manage the exchange rate in any band or similar structure — there might be some small scale private hedging, but the PBOC’s presence in the market would likely cap the potential risk in a lot of ways.

    p.s. if China recaps the big four banks and sells them, who would it let buy them? I cannot see the nationalistic Chinese letting one of the big four go into foreign hands, and if it gets sold off to someone domestically, that one person becomes a Chinese oligarch … they would intermediate an enormous share of China’s domestic savings … am thinking out loud here.

    glory — love the nixon quote.

  • Posted by Ian

    Ahh Owners equivalent rent….makes up 22% of the CPI, and yet is a completely (IMHO) BS statistic. A measure of what you could get if you did rent out your house, sliced and diced by statistical wizardry. If you get a chance, graph the OFHEO house price index next to the OER component of the CPI. There has been a wide divergence between the two since about 1998. So while house prices shoot up at something like 10% a year, the OER increases at only 2.3%. And it makes up nearly 1/4 of the CPI, more when energy and food are stripped out.

  • Posted by Ian

    brad- Isn’t the current thinking that the Chinese will list those banks in Hong Kong or NY? At least a portion of the shares? Considering that the banking system is the primary tool of economic policy in China these days, I can’t believe they would want to give shareholders much control. Of course, I’m not sure shareholders would approve of all the dodgy loans (state subsidies in a different guise)that these banks have been making. So if they do clean up these banks and float them, does that mean that the Chinese intend to actually use monetary policy as a tool to manage the economy? Instead of the situation now which is basically these banks as giant off budget slush funds for party hacks favored projects…

  • Posted by Jesse

    Default would be fine if one could selectively default by owner of the bonds, and not classification of bonds themselves.

    At last calculation I had done, about a year ago, domestic US money market funds had about an 8 percent exposure to Fan and Fred’s Debt. This is not including the domino factor.

    Default by inflation is much easier and more practical. It also does not need to harm the wealthy inordinately. They have better means to hedge it than the middle class, and of course the working poor.

    Think longer term. Think of an endgame approximating Victorian England wherein 2/3’s of the populace were ‘in service.’ Oh yeah, Guv.

  • Posted by brad

    Ian — who will want to buy a portion of the earnings (but no real control) of “off budget slush funds for party hacks”? listing and selling shares does solve the problem of “who controls” the banks by more of less saying “the same people who do now” … though i guess the theory is that the managers will have a new set of incentives. nominaly Communist bankers with stock options, anyone?

    Anne. Long-term creditors always prefer deflation to inflation — it increases their real return. Xie sounds like he wants the US to crucify itself on the cross of the renminbi … the US would solve the PBOC’s balance sheet problem by lowering domestic dollar prices/ wages and bringing about the real adjustment via US deflation (and chinese inflation) not nominal exchange rate adjustment. I.e. US workers earn less in dollar terms, and thereby can afford fewer renminbi goods since the $-renminbi stays constant.

    Fortunately, it is not going to happen, or so I hope. Xie is right that the US needs to adjust, but so does China. Time to go back to Keynes’ notion of adjustment by both the debtor (BOP deficit country) and the creditor (BOP surplus country) …

  • Posted by anne

    Thank you so much, Brad.

  • Posted by p

    Agree that the current account deficit is a problem

    Disagree over who to point the finger at

    The US is not the only guily party here … the world’s export dominate countries are EQUALLY guilty … Trade is a REAL issue in this discussion. Let’s not forget that the US economy is growing faster than most of the devloped world.

    GUILT can also assigned by the fact that Central Banks are doing all the buying of US dollars

    Now what to do
    1) Don’t think taxes … it solves the problem mathmatically but creates HUGE social costs …
    2) Quit blaming Bush … we Americans buy imports … we can blame Bush for exporting 500 pound bombs to Iraq … In addition, this problem is structural and has been coming for a couple of decades now.
    3) Address exports and imports … this is the real currency of the problem … playing with the math is academic at best

    Creative thought … treat and count large exporting nations as states thus eliminating the imbalance (China and Japan should suffice for now … we can add Korea latter)

  • Posted by DF

    Have a look at the latest post from andrew Xie at morgan stanley …
    He’s clearly advocating a US recession. See also a point I’ve been made several times. INflation is way too low presently given : commodity prices, growth level and money creation level.
    The result is asset bubbles

    THe main reason is to be looked in wages lagging productivity (by around 10% in the 90’s up to 2005) thus boosting profits and directing the flow of liquidity into assets.

    As recession hits, do doubt deflation will follow.

  • Posted by jm

    The trade deficit can’t fall unless the savings rate increases. At present, there is little incentive to save, as real interest rates (especially after-tax) are negative. Should it be surprising that there’s no saving?

    Some might opine that bidding up the price of stocks is investment and therefore saving, but actual inflow into the stock market is probably being exceeded by insider sales ($40-50 billion last year), so that what’s really happening is the rubes cashing out the smart money, with net dis-saving. Some also seem to consider the building of excess housing stock as investment and therefore saving, but there’s such a glut of housing that it can’t be rented at a profit. I think this is speculation, not investment (and therefore not saving).

    I can’t see how there can be any increase in saving unless interest rates rise to a level that is positive after taxes and inflation (real inflation, not the government’s phony hedonically-fudged indices).

    There is good reason to believe that a rise of interest rates to such a level would puncture the stock and real estate bubbles (thereby revealing that current stock and real estate prices reflect speculation rather than investment).

    If (when?) these bubbles are punctured, there is likely to be a very severe recession.

    Looking at it from another viewpoint, the trade deficit means that millions of Americans who in a balanced-trade world would be working in factories making things are instead working in warehouses and stores at the distribution and sale of goods imported with borrowed money. Fixing the trade deficit means closing down the warehouses and stores and moving those people back to factory work. We face in this the small problem that we have shipped a lot of the factories to China, so a lot of factory-building is also going to be required. There are going to be many, many empty stores and warehouses, and people who bought into the REITs that own these are going to lose. The investment in factory-building can’t happen without increased saving.

    I don’t see any way our trade deficit can be balanced without a severe recession.

    The flood of liquidity over the last decade has induced massive malinvestment. How can we think that there can be some painless resolution???

    I’m with DF. Overcapacity in the world is so great that no amount of liquidity-pumping the Fed will be ideologically capable of bringing itself to commit will be adequate to prevent deflation.

  • Posted by anne

    Watching America: Will It Listen to Foreigners, or Do as It Pleases?

    DAVOS, Switzerland

    W HAT stresses me most,” the chief executive of Novartis, Daniel L. Vasella, said, “is that we are getting new regulations from abroad without any consultation.”

    This has been the World Economic Forum that the United States government largely passed by. In a world that both respects and fears American power, there is worry that the United States does not care what others think.

    Or, as Tony Blair, the prime minister of Britain, put it in a speech to the forum, “If America wants the rest of the world to be part of the agenda it has set, it must be part of their agenda, too.” He added, “What people want is not for America to concede, but for America to engage.”

  • Posted by anne

    Notice that the report showing a slowing of our economic last quarter has sent the long term Treasury note to 4.15%. Make no mistake about it, long term interest rates have been most sensitive to domestic economic reports. Davos did not move long term interest rates.

  • Posted by jm

    In my post above I should have stressed that what is needed is for _real_ after-tax interest rates to rise, and that in a deflationary environment that can come to pass even at a nominal rate of zero. The current low long term Treasury rates may be a harbinger of deflation.

  • Posted by anne


    Interesting supposition. Asset prices have been rising, commodity prices as well, but the price of labor has lagged inflation for some time and labor costs are the decider of production costs. Hmmm.

  • Posted by jm


    Asset and commodity markets are destabilized by having a rate-dependent positive feedback loop which is able to overwhelm the stabilizing influence of negative feedback: the faster prices are rising, the more some people will expect them to rise. This can continue until some other constraining factor halts the rise; prices then start down, and the rate-dependent positive feedback starts working in the opposite direction.

    In electronics, one way to build an oscillator is to construct a feedback-controlled circuit with such a rate-dependent positive feedback loop. The power supply voltages will provide the constraints, resulting in an output that oscllates back and forth between the positive and negative supply voltages with a period related to the time constant of the positive feedback loop. Real estate markets are a nearly direct analog.

  • Posted by anne

    Clever, and sensible in psychological terms.

  • Posted by glory

    re: giant off budget slush funds for party hacks

    speaking of which, saw this on the FT editorial page the other day πŸ˜€

    Koizumi’s challenge

    “The 130-year-old postal service, now a fiefdom of the conservative factions of the LDP, has gradually been transformed into a kind of giant off-budget piggy bank to fund poorly monitored government expenditure. Japan Post has contributed to the sharp rise in government debt, and has thus distorted not only the market for financial services but the country’s whole financial system.”

    “Mr Koizumi has admitted that after privatisation the savings and insurance divisions of Japan Post would no longer have to invest in Japanese government bonds. This goes to the heart of Japan’s post office problem…”

    interesting to me are the parallels with the bush admin:

    “If there is one achievement with which Junichiro Koizumi, the Japanese prime minister, hopes to make his mark on his country’s history, it is the privatisation of the post office.”

    “Outsiders might regard this as a curious choice for a man who has moulded a more assertive Japanese foreign policy and overseen a recovery, albeit fragile, of the world’s second largest economy…”

    like in the economist yesterday:

    Dealing with reality

    “MOST presidents get more defensive and hesitant as they go on. George Bush is getting bolder. Since his re-election, the president has committed himself to transforming, among other things, Iraq, the Middle East, the tax system, pensions and the legal system. Phew. If he were allowed to win a third term, what would he do for an encore?”

    “Yet the gap between Mr Bush’s rhetoric and what is actually happening, or is likely to happen, is embarrassingly wide. The day after his ‘freedom speech’ his officials fanned out to explain that he didn’t really mean anything specific. In Iraq things are not going according to planÒ€”if indeed the administration actually has a plan. Tax reform has been sidelined to a commission, with action this year, next year, sometime. His attempt to privatise part of the Social Security system is in trouble even before it starts…”

    john berry, btw, is really going after bush hard on SS…

    like first he accuses him of making “false claims” last week and today he’s saying he also “ignores reality” …rather strident! (i guess berry is a member of the AARP πŸ™‚


  • Posted by D

    I’ve long said those low nominal rates are precursors of deflation.
    Nominal wages have lagged inflation only these last 2 years.
    The main problem is that real wages have lagged productivity.

  • Posted by anne

    Yes; Nominal wages are lagging inflation, but real wages have lagged productivity increases. If my memory is correct earnings as a sahre of GDP are at historic highs in America. Also, I thought I read this was true for western Europe as well. Please tell me if I am correct about Europe.

  • Posted by anne


    The articles you alert us to are a wonderful help. The ties between the LDP and construction industry in Japan strike me as critical in understanding Japanese budget making.

  • Posted by df

    this is true of europe. I posted a simple analyse of numbers available on the OECD website.
    Wages are lagging productivity everywhere.
    When wages lag productivity there’s only 2 solutions :
    prices decline (deflation)
    Profits (including investment) increases

    the investment boom is behind us, now is the time for profit, and since profits does not generate enough demand… Prices declines are about to follow.

    Unless of course some general strike puts us back on line.

  • Posted by jm

    Wages are lagging productivity and profits increasing as a fraction of revenues in Japan, too.

  • Posted by DF

    wages have lagged productivity by 25 % in the last 15 years in Japan.
    Deflation is deeper in wages than in prices !
    That is a sure sign it won’t end any soon.