Brad Setser

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Ut-oh! Is China starting to blame the US for its currency losses?

by Brad Setser
April 22, 2008

It is commonly argued that growing economic ties tend to create common interests that will reduce tension between nations (see FT’s Alphaville). The enormous amount China has lent to the US — a total that the US data (which tends to underestimate Chinese holdings) now puts above $1 trillion — will, according to this view, prevent other sources of conflict from getting out of hand.

Alas, relations between creditors and debtors are rarely quite so free of tension. Creditors want to get paid back in full. Debtors would rather pay back at little as possible.

Mei Xinyu, a senior researcher under the Chinese commerce ministry writing in a personal capacity for the Shanghai Daily, argues that China needs to put pressure on the US at the Strategic Economic Dialogue to do more defend the dollar. With the dollar at 1.60 against the euro, it isn’t hard to see why.

Mei goes on to argue that if the US doesn’t do more to defend the dollar, it is effectively defaulting on China.

“The negative results of the US dollar’s decline are evident: the rising prices of all primary products, the intensified pressure on inflation globally, the confusion in the settlement of international transactions, etc. Worst of all, this is the US’ disguised way of avoiding paying off its debts to foreign countries.

It should be noted that the US is the biggest debtor country in the world.
… By the end of 2006, the US’ accumulated net debt overseas hit US$16 trillion. As most of the debts were calculated in US dollars, the US is actually welshing on its debts malignantly by allowing the devaluation of US dollars. Since China is the country with the world’s biggest foreign exchange reserves, most of which are calculated in US dollars, China thus is hurt most greatly from the US dollar devaluation.”

One man’s exorbitant privilege is another man’s disguised default. Just think what might have happened it CITIC had invested in Bear and China had gotten back depreciated pennies on its initial dollar … More follows

What’s more, Mei Xinyu’s argument isn’t entirely wrong. The value of China’s investment in the US — an investment that is probably roughly equal to a third of China’s GDP (assuming the US data slightly understates China’s true holdings) — will almost certainly fall in RMB terms. And unless something changes, the US isn’t going to direct its macroeconomic policies towards maintaining the dollar’s external value. Bernanke’s job is price stability and full employment in the US — not protecting the Chinese purchasing power of the dollars that China has lent to the US.

But Mei Xinyu’s argment is still a bit off. China invested in the US knowing quite well that the US wasn’t committed to defending the dollar’s external value. It invested in the US even though the US had a large trade deficit. It invested in the US even though the IMF indicated the dollar was overvalued and would tend to depreciate over time. It invested in the US even though a gloomy American academic and a former Treasury staff economist quite explicitly warned that China would lose money on dollar holdings back in 2004.

Mei’s complaint, in other words, should be directed in part at China’s own policy makers. When they bought long-term US dollar-denominated debt they took the risk that the dollar would depreciate over time. They effectively gave the US the option to pay China back in depreciated dollars. What’s more, they didn’t charge a premium for the option. That was China’s own choice. China wanted to keep the RMB down even if that meant over-paying for US assets.
It has proved to be quite a consequential choice.

Measured by the funds it has available to lend abroad ever year, China is now the world’s biggest creditor. Most creditors tend to lend to the rest of the world in their own currency. That is what the US historically did, back when it was a creditor. Latin countries seeking financing from US investors promised to repay in dollars, not pesos (a promise that created problems of its own, problems well-documented by Dr. Hausmann). That is what Europe does as well — an awful lot of the external debt of the Eastern European countries is denominated in euros. China, for complicated reasons, has decided to lend to the US in US dollars and to lend to Europe in euros and pounds. China’s European lending – incidentally — could prove to be as risky as lending to the US in dollars; SAFE and the CIC are really over paying for euros.

As a result, China is bearing the exchange rate risk. And the size of China’s fx position is now quite large.
This exposure was a consequence of China’s decision to hold more foreign currency reserves than it needs in an effort to hold its currency down. It was China’s own choice. Still, I suspect that as the financial costs of China’s policy become more apparent, more and more Chinese commentators will argue that the US — and perhaps in time Europe — have failed to live up to their side of the bargain by failing to do enough to defend their respective currencies.

That strikes me as a recipe for future trouble.

68 Comments

  • Posted by Guest

    Did any one tell China that when they "pegged" their currency to others, they decided to manage their economy with one handed (the monetary policy hand) behind their back ?

  • Posted by Anonymous

    the US is going to feed the chinese and world USD so we can enjoy our lifestyle. shut up ching chong and take your USD and be thankful. now make me some freaking nike shoes and plasma tvs. now.

  • Posted by RebelEconomist

    Guest on 2008-04-23 11:20:27,

    I would imagine that Robert Mundell, who has been supportive of the Chinese currency policy, did. Those who accuse China of mercantilism forget that the peg that the Chinese finally let go in July 2005 had been in place since 1994, through 1997 when a floating renminbi might well have depreciated.

  • Posted by Twofish

    Guest: Did any one tell China that when they "pegged" their currency to others, they decided to manage their economy with one handed (the monetary policy hand) behind their back ?

    Yes, but at the time the decision was made in 1993, the Chinese economy was very, very different. In 1993, the Chinese economy wasn’t nearly as embedded into the global market and it really didn’t have much of a system for determining monetary policy.

    Also in 1993, the conventional wisdom in the West was that floating currencies were a very, very bad thing for developing countries since it was better for them to tie their monetary policy to the developed world.

  • Posted by Twofish

    This is one reason that I think it’s a bit unfair to blame China for being slow to reverse policy on the peg. There wasn’t appreciation pressure until 2003/2004, at which point China had to reverse about a decades worth of policy. Also the pressure to appreciate came I think directly from US tax cuts + the war in Iraq.

    The big miscalculation wasn’t made in Beijing. No one in Washington in 2003 thought that the war in Iraq was going to be as long or as expensive as it it turning out to be, and the wealth to pay for it has got to come from somewhere.

  • Posted by RebelEconomist

    I forgot to explain that, at the time, the idea was to import the monetary stability of a well-managed, reliable economy. Oh dear!

  • Posted by AC

    The Chinese should simply think about the trillions of dollar reserves as a gift to their grandchildren. If this money will be spent on US goods in the future, then its value won’t be lost. The grandchildren of the current Chinese generation will compete with the American people for American food, for example, using that money.

    What I don’t understand is why at least the Chinese can’t think more strategically about this dollar reserve. Even if this trillion dollar would be completely lost (as I said, it won’t be lost if it will be spent on American goods in the future), the gain in economic development and power that is made possible by the amassing of those dollars, will far outweigh any possible losses. The value of the economic development, the 10-20 million new jobs created every year, the 4-5 million new students at the universities every year, the 50 thousand PhD per year by 2010 (more than in the US) etc. is unimaginably high. China should simply forget to worry about its dollar reserves. If that is the price for economic development and power, then they should pay it without thinking for a second. It is a much better bargain than even the buying of Manhattan was.

  • Posted by Guest

    How can you say that the Chinese invest in Treasuries so they don’t lose money and then agree that investing in dollar denominated assets is a sure way to lose money due to the dollar’s depreciation. I would think buying into a business, in short buying stocks would be far wiser in the long run, even if the stocks go down short term, than investing in a depreciating currency that will likely never recover.

  • Posted by Yuk

    Twofish: "Public criticism and private criticism are very different things".

    Except under a regime of censorship. What you call private criticm in China is only criticm that was let through by censors.

    Twofish: "WTO, UN peacemakers in Lebanon, cooperation over North Korea says that you are wrong".

    Iran, Darfur, Burma, Zimbabwe says that I am right. As regards WTO, we have obviously not the same reading of the ongoing debates and the role China plays…

    Twofish: "The problem is that China is simply not willing to be part of a multilateral process if multilateral means that the West tells China what to do, and I don’t see anything wrong with that, and China really doesn’t have that much interest in telling the West what to do."

    This idea is totally wrong and feeds the misunderstanding between Emerging and Industrialzed countries. OECD, IMF, World Bank are actually being reformed and these reforms are clearly inteded to enhance Emerging countries’s participation, in particular China’s. Even before that, EM like China held a sufficient power to at least influence the debate.

    I am not saying that factors of modernization and moderation are not existing in China. Reformist are cleraly a major component of the Chinese Communist Party, which is far from being the monolithic body it seems. This being said, the conservative component remains very strong indeed and is well represented at the highest level of the State and of the CCP. These guys are the ones which keep a hard stance in Foreign Affairs as well as on issues like FX regime – no macroeconomic principle behind that, only political, to PBoC’s utter despair. These guys are the ones who really do disservice to China’s international image by sticking to Maoist rethoric despite the tremendous changes their country has been going through. Plenty of examples these days. Keep in mind that these Conservatives are still in, and powerful, and that they are engaged in a struggle against the Reformists, within the CCP.

  • Posted by Twofish

    Yuk: What you call private criticism in China is only criticism that was let through by censors.

    By private criticism, I mean when a government official sits down with you and asks you what you really think.

    Yuk: OECD, IMF, World Bank are actually being reformed and these reforms are clearly inteded to enhance Emerging countries’s participation, in particular China’s. Even before that, EM like China held a sufficient power to at least influence the debate.

    So of what use to China would be more say in OECD, IMF or the World Bank? As discussion forums, think tanks and academic exchanges work better. China has enough economic ability to prevent the World Bank and IMF from taking policies against the Chinese national interest. As far as aid to emerging nations, China has the money to do things bilaterally.

    I really don’t see the point of increased Chinese participation in IMF or the World Bank. There does need to be a discussion of the international banking system, but that should probably take place through the Basel II framework and the BIS which China is a member of.

    Yuk: This being said, the conservative component remains very strong indeed and is well represented at the highest level of the State and of the CCP. These guys are the ones which keep a hard stance in Foreign Affairs as well as on issues like FX regime – no macroeconomic principle behind that, only political, to PBoC’s utter despair.

    That analysis is dangerously wrong. Viewing Chinese politics as "evil conservatives" versus "good reformers" is just not the way Chinese politics. The fact that someone is in favor or against a floating currency tells you ***absolutely nothing*** about their views on Taiwan, privatization of industries, liberal democracy, or their views toward Mao Zedong. Assuming that people in China fall into two groups.

    Someone can think that China should be very confrontational with the US about Tibet, somewhat non-confrontational about Taiwan, hate Mao, like Marx to some degree, oppose industrial privatization, be in favor of currency liberalization, be moderately against a maxi-revaluation. Like me for example. Am I a conservative or a reformer?

    And you can find someone else, ask them the same sets of questions, and find that people just don’t cluster in two groups.

  • Posted by Yuk

    Twofish: "Someone can think that China should be very confrontational with the US about Tibet, somewhat non-confrontational about Taiwan, hate Mao, like Marx to some degree, oppose industrial privatization, be in favor of currency liberalization, be moderately against a maxi-revaluation. Like me for example. Am I a conservative or a reformer?"

    I’d say you’re probably not a NDRC guy and I’d say if you’re a member of the CCP Standing Committee, bad news: your promotion has been postponed!

    More seriously, I definitely know there is no clear cut between "reformists" and "conservatives". I certainly do not want to slip into such manicheism. Nonetheless, there are well-known lobbies which can be boradly attached to one or the other. My purpose is most of all to underline the existence of a strong conservative line at the highest level, which impact all decision taking process, be it political or economic.

  • Posted by Judy Yeo

    Brad

    Have to admit, haven’t read the rest of the responses, so apologies in advance if this is a repeated question. The willingness to allow debtors to pay in the creditors’ home currency might not well be in the control of the creditor for at least 2 reasons; the creditors might not, at the origin of that debt, been nable to enforce repayment conditions or to establish them in the first place, more importantly, debt covenants can only exist if the debt is official, China’s lending/funding of the USA is hardly in the form of an official, traditional debt. Curiously enough, the USA has become the greatest debtor in more ways than one; it is one debtor that dictates to its creditors(the rest of the world) and reserves all rights to modify all conditions of repayment and its creditors are clamouring to lend it money ; can you hones6tly blame the banks for their "infallibility belief"?

    Honestly, Chinese investment in euros looks like a sure bet to lose but well, mebbe they have sharper minds; well they are paying them lots more, so their minds should be sharper!

  • Posted by Twofish

    Yuk: Nonetheless, there are well-known lobbies which can be broadly attached to one or the other.

    There certainly are well-known lobbies, but it is very misleading and dangerous to group those lobbies together. At the highest levels, you can broadly classify people based on whether they have an "interior" outlook or a "coastal" outlook, and there is an effort to balance the two broad groupings.

    Personally, I think it would be a disaster if you had one faction "win" since having two broad tendencies within the Communist Party creates something more or less akin to an internal multi-party system.

    Yuk: My purpose is most of all to underline the existence of a strong conservative line at the highest level, which impact all decision taking process, be it political or economic.

    And my point is that I think that thinking in terms of a conservative/reform dichotomy is highly misleading. In particular, there is the assumption that "reformers" are less nationalistic and less committed to the continuation of one-party rule than "conservatives" and that’s just not the case.

    Someone from the PBC is much more likely to think that China should control inflation via interest rates than someone from the NDRC. But that tells you nothing about their views on foreign policy, and also, maybe the PBC is wrong, and NDRC is right.

  • Posted by Guest

    Yuk:

    I suspect that "these guys" in China don’t much care what you think about their internal arrangements. China resents, although it is not strident about it, "advice" re its internal affairs from the West that used to interfere mightily in its internal affairs. Tired of imperialism, China is not about to listen to your complaints. So you can keep on talking to yourself if you want. Go ahead, but don’t expect the Chinese to listen or care.

  • Posted by Twofish

    Guest: China resents, although it is not strident about it, "advice" re its internal affairs from the West that used to interfere mightily in its internal affairs.

    Chinese government officials and most Chinese are quite happy to listen to advice in the form of constructive criticism. It’s when the tone turns into "you idiots, we know how to run your country better than you do, and we’ll force you to do the right thing for your own good" that you get a bad reaction.

  • Posted by don

    HZ:

    "I think the vast majority of Chinese don’t know or care about the nominal loss of the reserve in exchange rate (unless it is sensationalized as an one-sided loss). Unlike oil from OPEC, labor can not be stored."

    Volcker (Via DC):

    "Financial crises do not happen in a vacuum and the current U.S. banking debacle is linked to imbalances in an economy that favored spending at the expense of saving … You can’t go on forever spending more than you’re producing. You have to rely on unorthodox finance to sustain it."

    These are cogent observations.

  • Posted by don

    Judy Yeo:

    ‘Honestly, Chinese investment in euros looks like a sure bet to lose but well, mebbe they have sharper minds; well they are paying them lots more, so their minds should be sharper!’

    Reasons China might buy euros, besides the interest rate differential or (I hope) misguided fears that the U.S. will eventually renege on its debts:

    The U.S. economy is turning down. Its workers might start to resent being put out of jobs by subsidized imports if things get too bad. So, even though yuan spent on euros won’t buy as much as yuan spent on dollars, China may be looking for other currencies to buy to keep up its exports. The yen is quite cheap now. One wonders why China wouldn’t buy more of them, despite the current low interest rate. My suspicion? They know they would face some sharp objections from Japan.

  • Posted by Bill

    This just shows that Chinese don’t know a thing about monetary policies. Government actions should "stabilize" the currency in terms of rate of rise and fall, not the level where it is at. Currencies are suppose to find their own level naturally in the market.