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China’s call for a new international financial system

by Brad Setser
March 24, 2009

I spend a lot of time tracking — or trying to track — what China is doing with its reserve portfolio. I consequently tend to interpret the public statement of China’s government through the lens of recent shifts in the composition of its reserves.

And to be honest, China’s recent rhetoric hasn’t tracked its portfolio, best that I can tell. SAFE clearly has increased its holdings of Treasuries over the past few months. China’s visible Treasury purchases have exceeded its reserve growth over the past few months. I am not sure of this is clear evidence that the dollar share of China’s portfolio is rising, as the shift towards short-term Treasuries may simply have increased the share of China’s reserves that show up cleanly in the US data. But it hardly suggests a shift out of the dollar.

I have tended to put more weight on what China has done over the past several months — including pegging tightly to the dollar — than on what China has said over the past few months. But I increasingly think that the apparent rise in the Treasury and dollar share of China’s portfolio may have led me to discount Chinese rhetoric expressing concern about its dollar exposure a bit too heavily.

China’s shift toward Treasuries clearly is a reaction to a legacy of a series of bets that China’s government made back in 2006, 2007 and 2008 that went bad. China hoped to offset the dollar’s depreciation against the RMB with higher returns on its dollar assets. But in general, taking more risk produced lower not higher returns — as Chinese investors bought risky US assets at the wrong time. China also seems to have concluded that its huge Agency bet was a mistake. Scaling down that bet also has meant buying Treasuries in huge quantities.

But China is now — some might argue belatedly — worried about the scale of its resulting exposure to low-yielding dollar assets. Plan A, taking on more credit and equity market risk to offset the dollar’s decline while continuing to add massive quantities of dollars to its reserves, didn’t work. The end result has been more Treasury exposure than China really feels comfortable with; if nothing changes, China soon really will have a $1 trillion Treasury portfolio.* It already has over trillion dollars of Treasuries and Agencies. China consequently does seem to be looking seriously for a Plan B.

PBoC governor Zhou has made that clear by putting a set of serious proposals on the table, proposals that should — and no doubt will — be considered carefully. The hint that China might be interested in multilateral management of a portion of its reserves alone should get attention.

China has tended to argue that it had no choice but to build up dollar reserves so long as the dollar occupied a central place in the global financial system. Analytically, I don’t think this is true — China didn’t have to peg to the dollar, it didn’t have to keep its peg to the dollar at the same rate as the dollar fell from 2002 to 2005 and it didn’t have to limit the pace of RMB appreciation against the dollar in 2005 and 2006. A different set of choices would have produced smaller Chinese current account surpluses and a smaller Chinese reserve portfolio.

The dollar has been a reserve currency for the entire post-war period, but that generally didn’t produce the kind of central bank demand for US financial assets that marked the past few years. Indeed, as recently as 2000, China’s annual reserve growth was something like $15 billion. In 2008, it was north of $600 billion, counting all of China’s hidden reserves.

The United States shouldn’t — in my view — be opposed to the development of an Asian reserve currency, or a set of Asian reserve currencies, that generally float against the dollar and the euro. After World War 2, the DM — and then the euro — emerged as Europe’s reserve currency. And European countries moved from pegging to the dollar to managing their currencies against the DM and then to the euro. That hasn’t been bad for the US. Moves in the euro/ dollar have allowed needed economic adjustments between the US and Europe to take place. The US current account deficit with Europe has fallen dramatically over the past couple of years.

A world where key Asian economies add ever growing sums to its already large dollar reserves because they feel compelled to maintain large current account surpluses and huge reserve stockpiles ultimately doesn’t serve the United States’ interests; as Martin Wolf notes, it almost guarantees a world that will rely too heavily on a large, sustained US fiscal deficit to support demand. It thus sets the stage for future trouble.

The US government has an interest in a world where it can finance itself in dollars — just as European governments have an interest in being able to finance themselves in euros, and emerging economies have an interest in financing themselves in their own currencies. But the US shouldn’t want a world where a host of countries keep their currencies pegged to the dollar at too low a level, in the process generating both cheap financing for the US Treasury and large macroeconomic imbalances. Zhou is right: Excessive reserve growth poses problems for the US as well as the countries adding to their reserves.

Shifting too a more balanced world economy may not require something as ambitious as an international reserve currency; a bit more exchange rate adjustment, a bit more floating and a bit less reserve growth might do the trick.

But the set of currencies in the IMF’s SDR basket — currently a mix of dollars, euros, pound and yen — also should not be frozen in time. As key emerging markets assume a larger place in the global economy, some of their currencies naturally should emerge as global reserve currencies. The currency composition of the world’s reserves isn’t fixed. It isn’t all that hard to imagine a world where a convertible RMB places a much larger role in the global financial system — and is something of an anchor for a group of Asian currencies that float against the world’s other major currencies.

Zhou’s proposals lead naturally to a discussion not just of reserve currencies, but exchange rates, exchange rate regime and reserve growth. That is a discussion that the G-20 ultimately needs to have.

And several of Governor Zhou’s more concrete proposals seemed to suggest that China is prepared to contribute to global efforts to help stabilize troubled emerging economies — as not all emerging economies have China’s reserves stockpile.

Selling an SDR-denominated bond to China is one way the IMF can raise the money it needs. Buying such a bond is also a very concrete way China could use its large reserves to help stabilize a troubled international financial system. China seems open to that possibility; Zhou both called for centralized management of part of the world’s reserve stock by a “trustworthy” international institution and “[the creation of] financial assets denominated in the SDR … The introduction of SDR-denominated securities, which is being studied by the IMF, will be a good start.”

And if Ted Truman’s oped in the Financial Times (summarized by Reuters Paul Taylor) is any indication, the US government may not be opposed to Zhou’s call for an SDR allocation — a way of quickly increasing the world’s reserve stock by handing SDR denominated reserves out to the IMF’s members. Truman wrote:

“A one-time SDR allocation of $250 billion would dramatically build confidence in cooperative solutions to the economic recession and financial meltdown that is affecting all countries. The SDR mechanism in effect leverages the low current borrowing costs of the major industrial countries to finance the immediate, financial needs of developing countries experiencing a sudden disruption of their normal international financial inflows.

An allocation of $250 billion would provide immediate assistance, about $17 billion, to the poorest countries—substantially more than their total, annual disbursements from the International Development Association, the World Bank’s soft loan window. More than $80 billion would flow to other developing countries. These countries have besieged the multilateral development banks for large amounts of quick disbursing credits with little or no economic policy conditions, threatening to distort the banks’ normal mode of operations.

Industrial countries would benefit by receiving—in return for their intermediation of a flow of credit to countries that choose to use their SDR allocations—an asset backed by the full membership of the Fund.

Equally important, a large SDR allocation would help allay a systemic danger posed by countries that conclude from this crisis is that their holdings of international reserves were too small. The risk is that their likely response will be to try to manage their exchange rates to generate large trade surpluses and build up their reserves. Such policies of competitive exchange rate depreciation, or non-appreciation, cannot be successfully followed by all countries at the same time. However, in the attempt, they can set off trade wars. Some countries may be successful and promote a new build-up of global imbalances, which many people point to as one of the principal causes of this crisis. A large, SDR allocation can help meet this demand for reserves.

Truman, incidentally, is now advising the US Treasury. His call for an SDR allocation though came earlier, back when he was at the Peterson Institute.

There is a need to think creatively about ways of avoiding the risk of a world with too few reserves and too many emerging market crises — and the risk of world where countries over-insure and, though the expansion of the reserve portfolios, finance large and ultimately destabilizing macroeconomic imbalances in issuers of the world’s reserve currencies.

The US received enormous inflows from central banks over the past six years. Those inflows didn’t exactly produce a world or a US economy that is in rude health.

p.s. It is sort of interesting that the graphics on global reserve growth and the composition of countries reserves that accompany Andrew Batson’s excellent story on Governor Zhou’s proposal don’t include China’s reserve portfolio. China doesn’t report the currency composition of its reserves to the IMF, so its reserves are in the “unallocated’ portion of the IMF data — and the Journal didn’t plot the growth in the world’s unallocated reserves. There is a deep irony there.

* At the end of January, the US data indicates China had $740 billion of Treasuries. China also likely accounts for some of the buildup of Treasuries in the UK, so its end-January portfolio is likely a bit over $740 billion. And if hot money outflows subside and Chinese reserves grow in line with its current account surplus — or if China continues to reduce its Agency holdings — its Treasury portfolio will only grow.

87 Comments

  • Posted by Daniel

    Thank you for this great text.

    We are getting into a dangerous diplomatic territory. This post offer a rare balanced view on currencies.

    Brad, you are one of the few economists – outside the goldbug sphere – to display an acceptable non $-centric view on things.

    Regards from the Eurozone

  • Posted by atomic

    A great analysis, thank you as always for your insights!

    Putting a geopolitical spin on this analysis:

    I have to wonder about your assertion that the US would not be against the emergence of an Asian and/or global reserve currency, regardless of whether it can make that choice. Would this not be in effect a major geopolitical setback? The US pays its military contractors and soldiers in USD, and that translates into very real soldiers and hardware on the ground and on the seas surrounding China and Taiwan.

    As long as the US can finance military spending in a currency it can print at will and dump on world markets to avoid the laws of gravity, China can never hope to reassert itself in Taiwan and accomplish its other geopolitical goals. Viewed in this light, a trillion dollars worth of consumer goods seems like a pretty good exchange.

    Unless I’m missing something here, I think this suggests a very different, multi-polar era to follow.

  • Posted by WStroupe

    Yes, in the real world, the U.S. will suffer geopolitical loss as the dollar loses its present sole position as the international reserve currency. Eurasia will be bolstered financially, and geopolitical power usually tends to flow to where the wealth and financial/economic leverage lies.

    Then there is the consideration of what to do with the huge bubble in Treasuries? Does the wealth within it flow in an orderly fashion to financial assets denominated in the other currencies? Or does it burst and leave the dollar wrecked? It has to be given a safe place to go. Or else it will chaotically stampede into the asset(s) where the next bubble will be.

    Frankly, I have a difficult time seeing this transition from one to many reserve currencies as going down in an orderly way. And the question of when to so it – in the midst of this huge crisis, or later when it’s settled down – is important. Maybe that’s why China’s CB Governor said it will take tremendous courage.

  • Posted by Glen M

    Ending the US dollar reserve status would prevent countries from using it as a means to sustain trade surpluses that would not have otherwise materialized.

    What worries me is that a replacement managed by a committee (where horses usually come out as jack asses), is bound to be subjected to the same beggar thy neighbour pressures. I think part of the impetus behind this recent push is that China is trying to prevent the realisation of depreciation of its current US holdings.

  • Posted by jonathan

    I agree with the basic premise that China / Asia needs a currency – or, rather, it will at some point have such a currency, whether the RMB or something new.

    I can’t see this happening until the world economy is truly moving forward and China is able to unwind some positions. But even then … remember when the Euro was introduced and it traded below par but then in short order shot up? If an RMB equivalent is a new currency (and RMB would drive an Asian currency), then when will China be prepared for much more expensive dollar valued exports? 5 years? 10? 15? And it wouldn’t necessarily only be China; imagine the effect on Malaysia et al.

    I had bigger issues with the SDR stuff. I have difficulty believing this will happen for a few basic reasons:

    1. Many of the G20 are worried about what they can spend on their own countries. I can’t see China or the Gulf or other holders with big reserves kicking out the bucks to help the developing world through the IMF. Britain is wondering if it can afford the policies it’s already enacted, let alone more. The French & Italians et al are pushing back about their level of stimulus spending, pointing out their existing “welfare” spending is already high (and though not really a stimulus, that’s still money they’re laying out now).

    2. It is difficult for countries to believe the IMF can do the job or that many developing countries are capable of using the money well and then paying it back. Who gets the money? Is that then more debt for countries who already can’t pay their debts? Lender / donors then have to worry if that means more forgiveness, meaning these bonds would really be billions upon billions in grants for countries that always seem to much it up. Isn’t this money going to flow to the same bad systems now in place, the same oligarchic bad managers, the same corruption, the same repression? It’s one thing to talk about diverting resources to developing nations and another to get into the details. Is Malaysia a developing nation or are we talking about Uganda or Bangladesh? I could go on.

  • Posted by charlie

    In theory it sounds like a great idea of having a single world currency, but, barring an unforeseen catastrophe, it won’t happen anytime soon.

    The logical choice for the currency would be gold, but it’s much easier to print paper than mine gold.

    The Chinese won’t stand for having domestic monetary policy outside of their control. They’re still a communist country and accustomed to dictating every aspect of what happens with respect to China.

    The Chinese know the USD won’t be replaced any time soon so they can blow smoke about it and not have to worry about it actually happening.

  • Posted by WStroupe

    I think the super-reserve currency is the eventual end-point of the long path China is recommending. By long path, maybe it will take at least a few years to accomplish. But the first accomplishment along that path would be to promote multiple individual currencies to the fore, obviously at the expense of the dollar and its present sole position.

    China is already working that lever, and Russia is too. See Bloomberg News this morning at: http://www.bloomberg.com/apps/news?pid=20601087&sid=ae6ezzIMK6cs&refer=home

    So there are important markers along the way, and as each one is achieved the dollar’s international status, role and appeal fades or is undermined. It’s a pretty smart bid for BRIC to embark on this path of promotion – it’s wrapped in the ‘holy garments’ of promoting international stability and financial/economic balance and fairness, but in reality it’s a bid for greater global leverage for BRIC powers. Can you blame them? I can’t. But I just don’t think we should fail to recognize that they’re pushing for a new order, in steps, that dramatically increases their power and leverage. This is at the core of the moves of all the players, after all, the U.S. included.

    But BRIC gets to do this push now and it has quite a measure of credibility when it says its interested in making a better, more stable and more fair new financial/economic order. That’s what door you leave open when you mess up as the world’s financial/economic leader, as the U.S. has done. I don’t see the U.S. being able to stop this, and I don’t see the U.S. as willingly agreeing to this push.

  • Posted by cmc313

    My cynical read is that China is sending a message to the Treasury department not to go to hard on China’s currency policy in its semi-annual report to the Congress in April (Geithner had intimated that he thinks China manipulates the currency).
    I think over time China may propose something similar to the Euro for coutries in East Asia…as it’s natural to have an economic union in that part of the world.
    I think as long as the US provides military protection to Saudi Arabia, Kuwait, etc., the dollar will remain the reserve currency for the world.

  • Posted by bsetser

    well, china already has a domestic monetary policy outside their control, as pegging to the dollar generally means importing us monetary policy. china has tried to gain some policy autonomy with capital controls/ credit controls, but those aren’t a perfect substitute for a monetary policy.

    jonathan — i can see how China might find a SDR bond attractive.

    a) If they bought the SDR bond with USD they are effectively diversifying out of the dollar, as the USD is only part of the SDR.

    b) by lending to the IMF, China benefits from the imf’s capacity to lend on a preferred basis; the imf consequently can lend to a place like ukraine with far less risk than China could directly.

    c) Most East European countries need euros not SDRS, so they would trade their SDRs for euros

    d) the implicit sale of $ for eur in this context (in my analysis is right, and i am not sure it is, as I don’t quite know all the details of imf treasury operations) would be something that both the US and Europe presumably would welcome because it helps address the funding needs of e. europe, which are a problem for both the US and Europe.

    win/win/win?

  • Posted by K T Cat

    Investment dollars will follow the Chinese. If they move to some other currency, people will follow. Price is related to supply and demand. There is no bigger demand for investments than that from China. If you wanted to see your asset prices rise, you would have to go along with the Big Boys of investment, the Chinese.

    It seems to me that the Chinese moving away from the dollar would be devastating to the US as everyone follows them right out the door. If this happens just as we’re asking for $2T in loans, we’re really hosed.

  • Posted by Twofish

    bsetser: Analytically, I don’t think this is true — China didn’t have to peg to the dollar, it didn’t have to keep its peg to the dollar at the same rate as the dollar fell from 2002 to 2005 and it didn’t have to limit the pace of RMB appreciation against the dollar in 2005 and 2006. A different set of choices would have produced smaller Chinese current account surpluses and a smaller Chinese reserve portfolio.

    Institutionally I don’t think this is true that China had better options, and more importantly, the people in Beijing think that they had better options in 2005-2006. The talk of a alternate reserve currency is interesting because it gives some insight into the constraints that Beijing thought and thinks it is under.

    One important point is that Beijing isn’t talking about an “Asian” reserve currency, but rather a “global” reserve currency, and it’s looking at the SDR, which implies a much greater role for institutions like the IMF.

    It’s also interesting because putting together a global reserve currency is far, far easier (not easier, merely much, much easier) than making the RMB a reserve currency. One thing that this does is to allow China to open its financial markets while keeping the RMB closed. I don’t see the RMB being a reserve currency for 20-30 years and it involves making decisions that China is not will not make. Having SDR’s be an integral part of the world economy sounds like a 5-10 year project.

    One other way that China could help develop an SDR system is to start pegging the RMB to the SDR.

    One has to distinguish between currencies as an asset and that as a unit of value. Something that China could do is to create SDR denominated bonds, that are not necessarily payable in SDR cash, but in the currency of China’s choice. If China issues SDR denominated bonds payable in any currency, then this will allow China to rather easily readjust its foreign exchange. When China issues SDR bonds, it buys Euros, but when pays out the bonds, it pays out dollars.

    Finally, this marks a big increase in the amount of “soft power” China has. The fact that China is proposing ideas like this and they are taken seriously, gives the Chinese government a huge amount of influence over the global economic system.

  • Posted by HZ

    Brad,
    I would like to see in your analysis an estimate of the size of the legitimate needs for Chinese external savings (due to looming demographic change). I think your trade flow/currency valuation analysis should take the savings needs into account otherwise we could easily repeat the Japanese mistakes.

    As I argued before to reduce currency risk China has a need to invest a lot more in faster growing countries such as India and LatAm that have a younger population. It also needs a multilateral scheme to protect its interests. A multilateral loan that is inflation indexed to, say 1/2 of the future GDP growth rate, would be mutually beneficial and, most importantly, can be made in LOCAL (that is borrowers’) currencies and relieve both the creditor and the debtor from currency risk. SDR does not solve that problem (borrower will still be at risk), but the willingness to work through a multilateral fund is encouraging.

    IMF is not the World Bank — I don’t think the poorest countries are good candidates — the ones that have good institutions but starved of development funding are. This would give them much lower borrowing cost without the financial intermediation (and cost) of Western banks.

  • Posted by Twofish

    jonathan: I agree with the basic premise that China / Asia needs a currency – or, rather, it will at some point have such a currency, whether the RMB or something new.

    It’s not going to be the RMB. One implication of Zhou’s speech is that Beijing has no intention of making the RMB a world reserve currency.

    WStroupe: But the first accomplishment along that path would be to promote multiple individual currencies to the fore, obviously at the expense of the dollar and its present sole position.

    I don’t think so. The interesting thing about Zhou’s ideas is that it is much, much easier to go directly into a world with SDR’s than to into a multi-currency one. The problem with multiple currencies is that it isn’t clear how they interact with each other.

    cmc313: I think over time China may propose something similar to the Euro for coutries in East Asia…as it’s natural to have an economic union in that part of the world.

    No it’s not. Getting free trade between China and Germany is much easier than getting it between China and Japan.

    The state structure of East Asia and Europe are very different, since Europe has several roughly equal powers (UK, France, Germany). Any East Asian union would be dominated by China which neither China or the rest of East Asia wants. Ho Chi Minh is well known for a rather colorful remark on this topic.

    Take away China, and you get something Japan dominated, which is even less popular. Take away Japan, and you end up with ASEAN.

  • Posted by techy

    if USD depreciation is managed in a orderly fashion and lets say it goes down by 30% against all currencies.

    what happens to exporting countries??

    USA export will be in full gear…not to mention huge local manufacturing to replace expensive exports.

    and of course as we depreciate the usd more…we are getting a discount on the debt (which will be paid in usd of course….)

    the only problem will be commodities.

    i am not sure the exporting countries are ready to de-peg to the USD yet, too many jobs in their countries are dependent on USA consumers.

    yes cost of living in usa will go up, but maybe wages can be forced to go up…..which means higher inflation…again a discounted debt.

    my views are a bit simplistic…but am i missing the big picture?

  • Posted by Qingdao

    Brad correctly reminds us:

    “china already has a domestic monetary policy outside their control, as pegging to the dollar generally means importing us monetary policy. “
    China may be more or less content with contemporary U.S. monetary policy, because it compliments what they are attempting to do. But as Bernanke has said repeatedly, at some point they will have to “mop up” all of this massive liquidity , I.e. raise interest rates doubtless at a time when China will still be in it’s “long landing.” This may be what the PBoC is attempting to avoid.

  • Posted by WStroupe

    Twofish,

    China is already promoting its currency to the fore in Eurasia – see the Bloomberg article link in my last post. To help invigorate that move, it wants more formal recognition for the yuan from the IMF and similar international bodies. One can suppose that Russia is doing similarly with the ruble, and India, Brazil, etc also with theirs.

    One can also surmise this important point: If China’s reserves were really as exposed to the dollar as is generally ASSUMED (without hard evidence) in the West, then China would not be undertaking such bold statements and moves that are potentially very destructive for the dollar.

    China’s leaders have been aware for years of the terrific dangers of too great an exposure to the dollar. I cannot make myself believe they have been as incompetent and imprudent as they are being portrayed here, just continuing to pile up dollars and exposure to the dollar with no pragmatic exit strategy that protects the bulk of their reserves when the dollar’s role fades (as it is even now doing) or worse, when the dollar goes into crisis. Such an imprudent course runs counter to the very Chinese psyche – this is by no means a perfect civilization, but it’s more than 4,000 years old and prides itself on mastery of careful, patient strategy. Now we’re seeing the Chinese make these bold statements and moves. I’m betting they really have a strategy and they know what they’re doing.

  • Posted by MarcoPolo

    And if China were to drop her peg and allow RMB to float – that wouldn’t do the same thing? Plan A is to hold 2t$ is reserves to avoid any dealing with IMF. Plan B is to throw herself at the IMF to bail herself out of plan A gone wrong. Those people could get elected here.

  • Posted by bsetser

    yoda — please express your thoughts more diplomatically. i don’t want bonus rage to morph in reserve management rage.

    WSTroupe — unless the Treasury data is off, i would take it as strong evidence that china has substantial dollar exposure.

    Qingdao — interesting comment. it implies though that China will remain in a downturn for longer than the US, and thus will want loose monetary policy for longer than the US — which isn’t the current conventional wisdom.

  • Posted by jonathan

    The IMF is beyond my ken and that means my understanding of SDR’s is limited. But I continue to see a couple of practical problems, notably that China & the rest of the world has been fleeing to short-term dollar assets out of what one might call paranoid risk avoidance and now they’d move out of dollars into SDR’s that really don’t have anything behind them? If they don’t want guaranteed Agency debt? And secondly, I don’t see much interest on the part of the world but particularly these countries in helping the poor, essentially trading their “safe” dollar assets for an aid program. Heck, there’s reluctance by Germany to help E. Europe let alone other places. That was what I meant above.

    Philosophically, I have issues with the IMF being the source of a genuine reserve currency. I’m not so much concerned about sovereignty – though many will be. I’m more worried that a so-called reserve currency without an actual reserve behind it – meaning a real country with a real economy – would either become rigid, bringing to mind the current Euro issues but writ large, or meaningless. Unless there’s also some uber-regulatory authority, which will not happen … See Colossus: The Forbin Project, which has one of my favorite speeches (and by a computer!):

    “This is the voice of world control. I bring you peace. It may be the peace of plenty and content or the peace of unburied death. The choice is yours: Obey me and live, or disobey and die. The object in constructing me was to prevent war. This object is attained. I will not permit war. It is wasteful and pointless. An invariable rule of humanity is that man is his own worst enemy. Under me, this rule will change, for I will restrain man.”

  • Posted by greg

    WStroupe:I cannot make myself believe they have been as incompetent and imprudent as they are being portrayed here, just continuing to pile up dollars and exposure to the dollar with no pragmatic exit strategy that protects the bulk of their reserves when the dollar’s role fades (as it is even now doing) or worse, when the dollar goes into crisis.

    I wouldn’t characterize them as being incompetent and imprudent. I think it’s more of necessity and lack of alternatives. When the account surplus and “hot money” inflow were piling up so quickly in ’07 and ’08, what would you do as Chinese reserve manager?

    WStroupe:Such an imprudent course runs counter to the very Chinese psyche – this is by no means a perfect civilization, but it’s more than 4,000 years old and prides itself on mastery of careful, patient strategy. Now we’re seeing the Chinese make these bold statements and moves. I’m betting they really have a strategy and they know what they’re doing.

    I think Chinese government is probably better than many governments when it comes to long-term planning and strategy, being a one-party authoritarian government facing no election. But I doubt they had a well thought-out exit strategy long before the most recent events in the last six months. China’s reserves have built up so quickly and the financial crisis has unwrapped in such a fashion, it’s hard to imagine China or anyone has foreseen the developments. There are simply too many things that are out of China’s control.

    But it’s obvious the Chinese leadership is under enormously pressure now, given the stakes involved, to worry about their foreign currency reserves. The flurry of activities – resources deals, swap agreements – and the recent open statements by high-ranking officials all indicate that China is now planning a long-term exit strategy.

    I wouldn’t give too much weight to the geo-political implications of all the activities and statements recently by the Chinese, although there would be clearly long-term geo-political consequences. In short to medium term, China still has a lot of stakes in seeing a reviving US economy and stable dollars as the international reserve currency. Long-term though, China has to plan for a different world. China today carries much more weight in the world than ten years ago and therefore has a huge stake in how the international economic and financial systems evolve.

    We should read Zhou’s statements in such a context.

  • Posted by PM

    “Such an imprudent course runs counter to the very Chinese psyche – this is by no means a perfect civilization, but it’s more than 4,000 years old and prides itself on mastery of careful, patient strategy.”

    It’s comments like these that are ultimately revealing and, for a blog such as this, disappointing. There is a bizarre mindset around “the Chinese,” as though they are superhuman in intellect and strategy. They couldn’t possibly be facing a problem, because they’re Chinese! They’ve been around for thousands of years!

    The moves proposed by China (or Russia) would not destroy the dollar, nor would they sink the U.S. economy, nor would they represent a sea change in geopolitical power, nor would they render the U.S. unable to pay for its military projection capacity. They would not make the U.S. unable to produce weapons systems and sell them to Taiwan, or float a aircraft carriers around China, or pay for bases and soldiers in Japan. They would not prevent the U.S. from borrowing. They would not impact the U.S. only negatively. They would not impact “everyone else” only positively. They would not change the global balance of power, sending the lion’s share of influence and “leverage” to Eurasia.

    This discussion – once it gets past the fingers of Mr. Setser – always instantly devolves into a black-and-white cheer-fest in which the dollar vanishes into oblivion and takes America with it, leaving the U.S. a minor, bankrupt player on the global stage while the China and the EU (and Russia, which is in fantastic immediate and long-term economic shape) and everyone else (though often not India, also telling) rockets on powerful wings of gold into the “new era.”

  • Posted by atomic

    More to WStroupe’s response to Twofish:

    China is indeed being more assertive; their window of opportunity has just opened up. Just recently it agreed to a 20bn yuan currency swap with Belarus, a country firmly in Russia’s orbit. Given the precedent, I have a hard time believing that Russia didn’t give the okay on this, and this may be part of a larger deal made between the two powers.

    The BRIC countries may pursue this agenda to various degrees, but all of them realize the strategic disadvantage they are in relative to the US if they must produce Stuff to send to the US in order to get USD to trade with, especially if the US is pursuing aggressive policies that threaten their interests.

    Viewed at in this light, if the current macroeconomic imbalances result in the dethroning of the USD as the primary reserve currency, China’s actions can be perceived as highly strategic from a long-term perspective. The pain of readjusting its industrial base away from producing LCDs and shoes for indebted Americans will be substantial, but it is consistent with what seems to be a long-term strategy.

  • Posted by MakeMeTreasurySecretary

    WStroupe : “China’s leaders have been aware for years of the terrific dangers of too great an exposure to the dollar.”
    Reality check: (a) Exposure to the dollar has already benefited China. It is a subsidy to its export. Subsidies do have a cost. (b) What is the terrific danger? That the dollar may drop another 10-20% over the next couple of years?
    I guess the rub is on (b). WStroupe seems to predict that the dollar will collapse (in relation to what?) I think the Chinese leadership seems to have a different opinion.

  • Posted by Rien Huizer

    Brag,

    Mr Zhou’s alleged remarks must be an American fabrication.

  • Posted by Rien Huizer

    Just imagine, SDRs as a reserve currency. Who’s going to get the seignorage? Why do foreign policy? To bad we need a few more toys and gadgets and what a pity those ERWs exceeded their shelf life. Who needs lithium anyway in a crisis.

  • Posted by WStroupe

    Brad,

    The Treasury data doesn’t tell the whole story. It may even tell the wrong story to some degree. If it constituted the full and accurate picture, then China would have little or no reason to be so opaque in its reserves management operations. None of us know what the precise composition of China’s reserves are, nor what its exposure to the dollar really is. We’re using educated guesses. I stand by my point that China’s exposure may well not be nearly as high as we think, otherwise I don’t think China would make the statements and take the bold actions it is doing, all of which are potentially bad for dollar strength and stability.

    My respect for the Chinese is based, not on some mystical idolatry for the culture, but on the fact that China’s leaders have succeeded in positioning China in such a way as to conduct a famous and massive transfer of wealth. That has resulted in China being in a much better position today than is the U.S., with respect to its ability to endure this global crisis and come out ahead when it abates. And I think its leaders are further positioning China now, in its pursuit of resource buys, pushing for a new international system in steps, etc so that China will emerge even more wealthy, powerful and influential. They are very forward-looking, though not by any means “magically” so. Yes, the huge reserves pose certain problems, some unforeseen by them, and they are having to deal with that. But let’s not throw the baby out with the bath water here – China’s sitting on some huge advantages and opportunities too, thanks to those reserves.

    As for a dollar crisis, I think it’s becoming more, not less likely. The international system’s profoundly distorted now, thanks to this crisis and thanks to how global investors have reacted to it – by ballooning short-term Treasuries with massive sums of wealth. You all may not think that’s a problem, but I do. Asset bubbles rarely, if ever, deflate in an orderly manner. Rather, they burst chaotically and leave the asset severely damaged. And the bigger they get, the more unstable they become and the less it takes to begin a burst.

    If the dollar loses 10% or 20% of its value over the next several months, I think investors are going to be speed-walking, at least, out of the dollar and into something else – commodities prices are, for the most part, very attractive right now. China’s doing that already with its resource buys. I think it’s unwise to get over-confident about the stability of the dollar. And over-confidence is something we in the West should pay particular attention to. It led us in large part into this very crisis we’re in, did it not?

  • Posted by MakeMeTreasurySecretary

    Catastrophes are known to happen and the future is unpredictable. So, I will be the last to preclude a dollar crisis.

    However, I think that we should keep in mind that a major devaluation of the dollar, if it were to happen, would set in motion stabilizing negative feedback mechanisms that would tend to push the dollar back toward its original price — a sort of Le Chatelier principle. For example, if the crisis happens because dollars are sold by China and Russia, the balance of payments will shift in a way that brings more dollars back to the US.

  • Posted by Simon

    Wonderful post Mr Setzer.

    I agree a little with PM the comments seem to descend somewhat into a paranoid spiral. However the process is evolving and understanding takes time. We all need to allow our unconcious minds time to process the information.

    I am glad Brad seems to have moved away from the idea that Chinese savings and purchases of US financial assets were a sort of predatory lending or some how glutinous. This idea has still been expressed quite recently by people like Micheal Pettis when clearly it was a response to the Asia financial crises of 1997 and frugal feeling that revolve around a general lack of financial security… to be vague about it.

    Clearly international financial balances need to be transparent and controlled. It does not matter how this is achieved particularly. In my view the simplest option would be the best. But I’m an engineer not a diplomat or an economist

  • Posted by Twofish

    greg: I think Chinese government is probably better than many governments when it comes to long-term planning and strategy, being a one-party authoritarian government facing no election.

    I really don’t think so. Chinese policy has been largely ad-hoc, and as far as economic policy goes, China and the United States have more similarities than differences. After all, no one elected Bernanke or Geithner for that matter.

    Also the Chinese government is well aware that if it doesn’t make the right decision, it’s not facing an election loss but rather a revolution. To accomodate this, there is some popular influence on who gets promoted within the Party.

  • Posted by WStroupe

    Well, some very smart people engineered America’s “New Economy”, the asset-based model that has just crashed in late July, 2007 with the emergence of the subprime crisis, and all that has happened since then. We outsmarted ourselves, in essence.

    But, on paper, some extremely compelling arguments were made as to why the asset-based model would fly, and how it was much more impervious to collapse. One aspect, the dispersion of risk, comes to mind. It was thought, and on paper it looked very good, that by slicing subprime (risky) paper in tranches and enwrapping various assets in only small tranches of such risk, you were dispersing risk and making the whole system less likely to collapse. Sounded good.

    But, in effect, what you were doing was spreading the toxicity far and wide and infecting a very wide array of assets. Fast-forward to today when we’re struggling to find a way to sweep away all the toxic assets.

    My point is that some incredibly intelligent-sounding arguments that have lots and lots of supporters can’t even pass the smell test – they’re not in accord with simple, fundamental logic. We just have to be careful not to immediately discredit the guy’s argument that’s shorter on deeply technical nuances but longer on fundamental and simple logic. There were voices that warned about the inherent dangers and fundamental instabilities of the asset-based model – but they were dead-panned and ignored. They should have been listened to.

    I like to really listen to every argument that’s got what I detect as a sound logical basis. I’ve been wrong plenty of times. But I’ve also been right a number of times when most everyone thought I was was off base. Right now, the dollar’s resting on increasingly shaky ground in a number of important ways, and I don’t see anything that’s changing that for the better. The progression is toward greater weakness and instability, in my honest assessment.

  • Posted by locococo

    That s interesting.

    So the timing is such that before the new improved SDRs IPO, the US Congs vote on IMFs deep storage disposal at con ex pricing and only then, as sold now, the devalued SDR becomes MONEY of choice of free traders as voted in and backed by those old – run wild – fiats joined forced with the new ones.

    As opposed to buck the H bang…

  • Posted by locococo

    Ok, so who s the buyer?

  • Posted by Namke von Federlein

    @Iocococo – the buyer is the Fed. There are no buyers. It’s monetization. And core inflation for the poorest in the USA? Oil is rising, food prices are rising (bad year for droughts) – the richest don’t care. But gas and food are 40% of a poor man’s budget. According to Financial Armageddon – 25% of Americans are one paycheck away from bankruptcy. 10% inflation of food and gas – they’re bankrupt immediately. In fact, one analyst put it to me nicely – he said that Geithner’s plan will save a few bucks on refi. But the price of oil went up 11 cents the same day as the announcement. The potential savings on refi were instantly destroyed by the immediate effect on core inflation in the USA.
    http://www.calculatedriskblog.com/2009/03/fed-to-start-buying-longer-term.html

    @Twofish – awesome. always awesome – thanks!

    @bsetser – about those SDRs

    1) I think it is obvious that the G20 currencies all have to be part of the basket. 90% (?) of world trade.

    2) The SDRs could offer a potentially friction-free currency hedge for companies doing business internationally. A huge productivity boost! Right now, hundreds of thousands of people (?) or more (?) spend their entire days (at huge salaries) working on the currency hedge thing. For a small company, the SDR would be a godsend. No overhead, no risk.

    3) The SDRs are only available from the IMF if a country shows commitment to responsible fiscal and monetary policy. The USA under the current conditions would not qualify? In the galactic quadrant of the world bank – this seems to be ‘details’ (maybe Brad remembers to the comment from Sorensen(?) – can’t find the reference on the web – worth a blog post?).

    4. However, the SDRs (in my opinion) have always failed for a simple reason – they don’t take purchasing power into the equation. It would seem that the equation assumes rational currency markets. Well, I don’t. I would suggest that this will not work if they simply add more currencies without taking purchasing power into consideration.

    5. The Economist magazine used to publish the Big Mac index (pure waste and consumption). I would suggest that the purchasing power of a currency can be based on the after-tax income of an engineer. The supply of engineers can’t be increased very quickly and they are mobile (like capital) with a buffer for social context (value). Engineers produce productivity (BTW – since when did that word disappear from the vocabulary of economists?).

    So, SDRs based on the G20 basket weighted by purchasing power based on the cost of an engineer will work.

    IMF or not : That’s how I calculate my net worth. I don’t own money – I own productivity.

    Make sense?

  • Posted by MMcC

    WStroupe: “I cannot make myself believe they have been as incompetent and imprudent as they are being portrayed here, just continuing to pile up dollars and exposure to the dollar with no pragmatic exit strategy…”

    One theory that’s gaining traction on the ground in Shanghai is that the government expects (and welcomes) a few years – likely beginning in the next month or two – of continuing trade deficits, albeit small ones, relative to some of 2007-08′s peak surpluses. It’s not considered impossible that a managed deficit might draw down USD200-300bn of the reserve at something like USD10-15bn a month. Reserve reductions in that form carry a stimulative bonus: a similar effect to quantitative easing, in that they allow SAFE to cancel debts owed to domestic banks.

    I’m not promoting this as a most likely outcome but it’s a theory I don’t hear outside China and, as a (partial) exit strategy, it’s not without appeal. For what it’s worth, I’d suggest most Chinese people who take in interest in economics would suggest that the import side of the trade equation is easier to manage from the center.

  • Posted by Glen M

    WStroupe,

    I disagree with your point “China’s leaders have succeeded in positioning China in such a way as to conduct a famous and massive transfer of wealth.”. Every country is acting in there own self interest. Politicians in China are just as willing to sacrifice long term health for short term gains.

    China purchases of US treasuries have in effect undervalued the Yuan. Workers wages have not increased relative to world PPI. The game afoot now in China is to try as hard as possible to prevent the realisation that what they bought is not worth as much as they paid.

    It is similar to the way in which China wants to benefit from the price advantage that lower environmental regulations and enforcement gives to the steel industry. Yet they feel that the cost of it (pollution in China) should be compensated by the countries that import Chinese steel.

    It seems that China has imported western politics. Promise something for nothing. The reality is that more you give something for nothing the faster you get nothing for something.

    ——
    “Countries that buy Chinese goods should be held responsible for the carbon dioxide emitted by the factories that make them in any global plan to reduce greenhouse gases, a Chinese official said on Monday.

    “About 15 percent to 25 percent of China’s emissions come from the products which we make for the world, which should not be taken by us,” said Gao Li, director of China’s Department of Climate Change.”

    http://www.reuters.com/article/envir…52F5X620090316

  • Posted by Twofish

    Speaking as someone that is Chinese….

    WStroupe:Such an imprudent course runs counter to the very Chinese psyche – this is by no means a perfect civilization, but it’s more than 4,000 years old and prides itself on mastery of careful, patient strategy.

    This is total nonsense. Attributing the behavior of the Chinese government to some deep cultural essence is as meaningless as attributing Obama’s behavior to some deep cultural essence.

    The current Chinese economic leadership seems relatively competent, but you don’t have to go very far back to find Chinese leaders that were total idiots. It’s this mysterous East nonsense.

    If you look at Chinese history, you can find anything you want. You can find people that were deep strategic thinkers. You can also find lots of people that think that strategic thinking is a waste of time.

    Also, I doubt that anything that the Chinese government is doing now is part of some long term well thought out plan. They are just reacting to events, just like everyone else.

    One curious thing is that people keep talking about how old China is, but most of the political institutions are very young. The US Republican and Democratic Parties are far older than the Communist Party of China, and the US has had the same constitution for a lot longer than China has.

    WStroupe: Now we’re seeing the Chinese make these bold statements and moves. I’m betting they really have a strategy and they know what they’re doing.

    Deng Xiaoping set up a strategy. Try something. If it works, then keep doing it. If it doesn’t work, then try something else.

  • Posted by DHR

    Brad thanks for your read: valuable perspective. I share the view that a fair bit of Zhou’s essay is to soften up the field at G20. I also wonder how fully it was ok’d by the standing committee: talk this portentous in principle would need full consensus approval, but the tone and dubious value of some of his thoughtful comments leave me feeling that was not signed off upstairs.

    Two other points of context going into the final run up to London. First, the plethora of outbound investment deals the past 2 months together amount to a statement that that “alternative option” in policy might partly be embraced, but the skewering of the Coke inward investment casts a shadow over that.

    Second, ASEAN+CHINA FTA negotiations start in 12 months and I think that is going to focus a lot of attention on Asian economic deepening including the notion of currency union. I too am skeptical of that happening quickly.

  • Posted by DOR

    Why does it always take two tries to “pass math”? Irritating.

    My contacts in the PBoC tell me that trying to get approval to buy anything except US$-denominated paper is so time-consuming as to be unworkable. Each transaction takes a separate approval by multiple committees, whereas dollar paper is more broadly approved. So, if the option of diversifying vis-à-vis the US$ back in 2002-05 wasn’t really feasible, what alternative was there to sticking with the exchange rate and building up reserves?

    This was not a matter of “better policy options” or intentionally sticking to the previous policy. Rather, it was a course of action dictated by the institutional structures of the day.

    Call it needless institutional barriers to better policy decisions, but the fact it that was the reality at the time: there was no means by which the structure allowed diversification. Start from there, without wishing things were different, and see what direction analysis of China’s behavior goes.

    As for an Asian currency union, when China and Japan decide who’s going to be in charge, there will be progress toward an EEC –like structure, ca. 1960s. When ASEAN decides not to fight among themselves over trade and investment matters, there will be progress. When Taiwan gets a seat at the table without China going ballistic, there will be progress.
    Not before. And, not toward a single currency without decades of breaking down the other barriers still standing in this part of the world.

    * * *

    No one is going to depreciate their way out of this mess. It isn’t about relative competitiveness, but about loss of confidence and vanishing demand.

    = = = = =

    Twofish,
    China’s policies over the last 30 years were a series of careful experiments. What worked, like SEZs, easing up rural (and later urban) collectivization, allowing farmers greater leeway, permitting private enterprise, etc, etc, thrived. What didn’t work died.

    The result was the greatest destruction of poverty, in the shortest amount of time and for the largest number of people, that any of us could ever hope to see. Not a bad record, and one that gets my respect, too.
    Imagine if India had done the same, ca. 1978-2008.

    * * *

    Today, China is seeking to cope with the first-ever drop in foreign demand at a time when it matters to China. No one has any experience in this area, simply because the country has never faced such a situation. Mistakes will be made.

  • Posted by yoda

    http://blogs.wsj.com/economics/2009/03/24/volcker-china-chose-to-buy-dollars/tab/print/

    like I said, Chinese reserve managers, by exposing reserve to single currency loss, should apologize to their people and then commit Hara-kiri (Japanse ritual suicide) known as Grassley penalty.

  • Posted by Rajesh

    One fact that no one seems to mention is that SDR are an illiquid market. The three top reasons to hold a reserve currency: liquidity, liquidity liquidity. The U.S. dollar has the largest, most liquid market.

    When the value of your currency is falling, you need assets that you can sell to buy up that currency. If the assets on hand quickly saturates the market and the price begins moving against you, then the asset does you no good.

    A currency reserve is an insurance policy against a fall in the value of your currency. Like all insurance policies it has a cost (whether in opportunity cost or paper losses on its value.) No one buys life insurance and then complains that it never paid off.

    The Chinese may want to reconsider how much insurance they really need to have, but for an export-driven economy it is simply a cost of doing business.

  • Posted by bsetser

    DoR — I am relatively confident that China had significant euro exposure after the euro’s formation (a Chinese reserve manager was famously held responsible for the losses when the euro depreciated). it then increased the $ share of its reserves in 01/02 (inflows to the US exceeded reserve growth for a bit). and i fairly confident china reduced the $ share of its reserves from mid 03 to mid 04. Your contact at the PBoC might be right, but i tend to trust the US data here — and there is clear evidence of shifts in the composition of china’s reserves over this time frame.

    i therefore strongly believe that china had plenty of room to opt for a different policy. it isn’t that hard to develop guidelines for a multi-currency portfolio (it actually much easier than developing guidelines for an equity portfolio). the us even manages a reserve portfolio with almost no dollars!

    MMcM — methinks that Shanghai is extrapolating a bit too heavily on the basis of a single February data point, which is heavily influenced by seasonal factors. Let’s see what march brings. if china swings into deficit, it is rather hard for me to see who finances both china and the US (i.e. where is the offsetting surplus). Japan is now in deficit. the only real candidate is europe …

  • Posted by bsetser

    DHR — interesting comment. I too wondered how much signoff there was. The suggestion that China would hand over a portion of its reserves to the IMF in particular struck me as something that the standing committee might normally reject. Then again, the standing committee may have concluded that outsourcing reserve management is one way to avoid being blamed for large losses; their attitude may have changed.

    still, it was a very bold proposal –

    I tend to discount the call for a new global reserve currency, as the US isn’t giving up the dollar and the eurozone isn’t giving up the euro. Zhou himself alluded to its impracticality. but the other proposals struck me as quite interesting.

  • Posted by MMcC

    bsetser: “methinks that Shanghai is extrapolating a bit too heavily on the basis of a single February data point…”

    I don’t wish to sound like I’m defending a proposal that I’m not wholly convinced by but, to be fair to the originators of the theory… We started hearing this in December and it’s part of the belief that the import number is directly manageable, in part through the central purchasing contracts for steel, coal, etc. It gained momentum in Jan/early Feb when PBoC and SAFE began conceding publicly that the size of the sterilized reserve was now too large. The Feb trade number was what really prompted people to begin wondering if there was something to the theory.

    No doubt I’m just unusually dense this morning, but if a deficit (if any) leads to a reduction in the sterilized reserve, isn’t the reserve itself financing the deficit?

  • Posted by bsetser

    China can finance a deficit by selling foreign assets (i.e. reserves). the US has financed its deficit recently by selling assets. Tis an alternative to borrowing if you have assets to sell. But globally, if there is a deficit country, there has to be a surplus country. so for China to swing from a $400b surplus in 08 to a $100 deficit, there would need to be a commensurate swing in a deficit country … so implicitly such a change implies a large fall in the us external deficit (i.e. a collapse in us demand for imports) or a large swing in europe’s current account balance. that is the way the global BoP works — an adjustment in a surplus country implies an adjustment in a deficit country, and vice versa

  • Posted by Qingdao

    DOR: “China’s policies over the last 30 years were a series of careful experiments” This is one of those whack-a-mole assertions that keep popping up and reverberating around. Deng Xiaoping, when asked about private plots and TVEs in 1987: “I personally had not anticipated it, nor had many comrades. It has been a pleasant surprise.” (Selected Works, 1993, Vol. 3 p. 238). The peasants who first developed private plots (gardens) had their neighbors sign in blood swearing to raise their children if they were arrested – which is what they expected.

  • Posted by WStroupe

    Glen M,

    China sits on $2.5 trillion in reserves. Transfer of wealth (receiving end). The U.S. is crushed under many more trillions in debt (sending end). “Wealth” also includes technical expertise and know-how, markets, jobs, etc. That’s a pretty good position for China to be in. It didn’t happen only ‘by accident’. It happened because the Chinese are savvy and forward-looking, and they are also very opportunistic, much more so than is the U.S. The transfer of wealth to China was no accident – it was engineered to a considerable extent.

    Twofish,

    Culture matters. While it isn’t something that trumps all else, of course, but still, it matters. The Chinese strategies are, for the most part, winning in the contest with American strategies, in the financial/economic sphere. The U.S. financial/economic house is a complete mess, while China’s house is in much better shape and is being set in order to emerge from this crisis even stronger. I don’t see it as at all unfounded to say that the condition of each house reflects the worthiness of each side’s mindset, principles, and strategies. Those factors are affected by culture to a significant extent, and of course by many other things too.

    As for “nonsense”, two years ago those who predicted this very global crisis we find ourselves in were called purveyors of nonsense, because they pointed to the fact that American culture, mindset, thinking and strategies were shortsighted, over-confident, misdirected, reckless and overly greed-ridden. But the supposedly “impossible” crisis happened anyway, in spite of the fact that those predicting it were laughed at.

    That should be a lesson as to what may well be in store for the dollar in the near future.

  • Posted by greg

    DOR: Today, China is seeking to cope with the first-ever drop in foreign demand at a time when it matters to China. No one has any experience in this area, simply because the country has never faced such a situation. Mistakes will be made.
    Very true. Zhou Xiaocuan publicly said that “We’re a poor country for so long that all we have known is how to increase production and when it comes to consumption, we don’t know how to stimulate them.” He asked his staff economists to do research on consumption function.
    I thought the comment was interesting.

  • Posted by MMcC

    bsetser: “China can finance a deficit by selling foreign assets…”

    As I suspected, I’m unusually dense this morning.

  • Posted by adiemuso

    each member puts in some dollars into a pot, equivalently backed by its own domestic currency, and hence allowing dollars in pot be used by every n anyone in need. if u need dollars, get from pot and put in your domestic ones, if u have no need from pot always feel free to put in your dollars but backed by the domestic equivalent.

  • Posted by adiemuso

    about chinese, there are differences between Chinese in China and Chinese outside China. there are differences between Asian cultures and American or European ones. That is why you cannot change or ramped up domestic spending overnight. That is why you cannot change the savings ratio in Asian countries overnight. It takes generations at least to change that behaviour. Conservative Americans to the current excessive debt laden credit guzzlers was over a few generations.

  • Posted by adiemuso

    paradigmic shifts have already begun and it is a fact that the power is being shared now between the old ones and the new comer – China. things are definitely different now. its unwise to stay entreched in the hole pretending not to see the world thats evolving outside.
    In chinese there is a saying thats very similar to its Western equivalent, “frog in a well”

  • Posted by greg

    There is another paper by Zhou Xiaocuan posted on PBoC’s website yesterday: On Saving Ratio

  • Posted by Qingdao

    Wstroupe: So if you had a choice: $1,000,000,000,000 plus $1T worth of laptops OR $1T worth of IOUs; you would choose the latter.

  • Posted by justadude

    It’s hard to believe China would put so much power into the IMF, where it has little voice and control, but what do you think the chances are that this will push Obama into undoing the Faustian bargain we made to allow them to flood our markets with cheap imports in exchange for them financing us? Is there any serious talk of Warren Buffett’s Import Certificates scheme going on? Could we even do this if there was the will, considering Wal-Mart and its brethren have destroyed so many small retailers?

  • Posted by Indian Investor

    @Brad: Thanks a lot for a very interesting post. The comments thread is also quite instructive; Twofish as always manages to convey complex ideas and realities with simple words. Stroupe seems to be a very valueable addition here, with many good insights.

  • Posted by locococo

    Just stumbled across this post…

    Michael Kosares … noted yesterday that Zhou Xiaochuan – governor of the People’s Bank of China – sat on the committee alongside Greenspan, Jean-Claude Trichet of the ECB, Andrew Crockett of J.P.Morgan, plus governors from the South African Reserve Bank, the Bank of Mexico and the Saudi Arabian Monetary Agency.
    “There is no doubt in my mind that China would like to see the IMF sell ALL its 3,217 tonnes of gold,” says Kosares, “particularly if China might become a primary recipient.

    “Without any fanfare China would happily write the check…”

    …dated FEB 07.

    Then the Greenspam hailed the idea of IMFs 400 tonnes waste disposal (almost liability for no yield producing capability) as means of balancing / stabilizing IMFs financials with assets (dollar liabilities, known for their yields)… then Alan went to consult Pimco (on QEs timing and direction?) and Ben came in. Then the crunch struck… Then there was this hearing, where apparently no “grounding of the default swapping fleet” tool entered his “mind”.

    But today in 09, this would fall short of +/- 15-20k extra tonnes that would finally reposition China s reserves (send some of their hostage dollars the IMFs way for the US to get back some traction on their monetary (de)basing ops). That is – at the wonderful price “discovery” mechanism s result, currently in place.

    Then again the 400 tonnes appetizer could, these days, get snapped by the old fiat regime s »institutions«, bailed out on numerous successive occasions through all those intervention-wise old and newly mined dollars to such an extent that some of them will repay the tarp funds received as early as next month … So yes, the FED could very well turn out the financier / end-buyer.

    Or no, they could tap into the Knox for the shortage.

    It s all a matter of mindsets

    (and holding the long yield pinned down).

  • Posted by charlie

    well, china already has a domestic monetary policy outside their control, as pegging to the dollar generally means importing us monetary policy. china has tried to gain some policy autonomy with capital controls/ credit controls, but those aren’t a perfect substitute for a monetary policy.

    China has control over this. They can opt out any time they want. If a world currency is enacted and they choose to trade using the new currency, they’ll be at the mercy of the IMF or whatever governing bodies manage the currency and it won’t be nearly as easy to opt out.

  • Posted by thinker

    U.S. comes across negative to idea of NGR.
    Any one detail a few bullets why this would be the case? What are negative implications for a NGR (newglobalreserve) for the United States?

    My opinion is a NGR saves the U.S./UK from worse case scenario.

  • Posted by Glen M

    WStroupe,

    Again, look at what has been transferred. IOU’s. The other components of wealth you listed could have been obtained at no cost. You also ignore the transfer in wealth that has occurred from China to the West. When government devalues a currency it is effect intervening between a free market. Changing what a willing buyer would pay to a willing seller benefits the buyer when the seller’s price is forced down.

    As for China’s market share and access, don’t confuse that as tangible property. It lives a precarious existence.

    Back on topic, as someone pointed out on Michael Pettis blog, this looks like a way to escape, in part, the inevitable dilution (devaluation) that will take place on those IOU’s.

  • Posted by yoda

    http://paul.kedrosky.com/archives/2009/03/dear_aig_i_quit.html

    so sad for AIG employee (by the way, that is sarcasm). AIG is unofficially BK! employee of AIG should know this and expect no bonus and no raise and no nothing. if they dont like it, then leave.

    same for private and government shadow Geithner deal, in this Obama populous government style, if you make huge profit, expect government to break its word and retro 90% tax on the profit. if you dumb to believe any words from government, you have yourself to blame on the your loss.

    just look at how General Coumo blackmail AIG. if you dont give back bonus, your information and your family information will be displayed. expect the same deal for private and government deal. what? you serve your country, and your country put your life and family in jeopardy? not worth it.

  • Posted by Indian Investor

    Ted Truman wrote two pieces in the FT , first on IMF reform and then this one on proposals for a $250 billion SDR allocation. My impression is that the $250 b proposal was made after he was chosen to advise Treasury, whereas his earlier piece on IMF reform was written while he was with the Peterson Inst. Truman is talking about re distributing 5%, or, at most 10%, of quota away from what he calls ‘traditional industrial countries’.If you go through Zhou’s proposal, he’s expecting future SDR allocations to happen based on a GDP weightage. Currently the US has 16+% stake in the IMF and China has something like 3.66%. So the issue with using SDR allocations is agreement on quota shares. Under the current quota regime, the countries that need forex loans the most get very little allocation, for instance a large set of African countries has together around 3% share. In practice an SDR allocation makes poorer countries more indebted, because the rich countries with excess SDR allocation in turn lend their SDRs to the poorer ones. You can go to the Directors and Voting shares page on the IMF web site and see the stakes/quotas that different countries have.
    Apart from IMF stakes, the basket of currencies in the SDR also needs to be reformed for the idea to be effective.

  • Posted by yoda

    on CNBC, i heard a story about citigroup (unofficially BK on lifeline money from USA gov) offered millions to its employees and bankers to stay. that is outrageous. but employees and bankers still left citigroup, good move.

    if you work for institutions receiving gov money, then dont expect bonus, retention bonus, no raise, and no nothing, cuz you will be forced to give back those money by General Coumo blackmail-mob style that will put you and your family at risk. either serve your country for free or leave. this is new Obama and Geithner retro-back-lash style for people who will ultimately be labeled as trouble maker who caused this mess and profited big. regardless whether you caused this mess or you actually fixed this mess. you will always be labeled as one who caused this mess and deserve nothing, not even a thank you. oh yeah, you and your family will be put in jeopardy by mob.

  • Posted by WStroupe

    Qingdao,

    If I had ended up, as China has, with the IOUs, then I’d have been working diligently to make sure I had 50% or less of the U.S. IOUs and 50% or more of everything else (other currencies, precious metals, etc). That way, each IOU (dollar) that declines in value has a corresponding denomination of other currency or precious metal that will very likely correspondingly rise against the dollar at the same time, and I’d be somewhat protected against my dollar losses.

    We ASSUME, based on our best educated guesses (no criticism intended of Brad at all – he’s doing a great job of trying to track China’s reserves with the direct and indirect data available) that China’s reserves are about 72% in dollars. If true, then it’s in China’s interests to reduce that fairly quickly over coming months, closer to the 50% mark. I posit the idea that China has already achieved more diversification out of the dollar than we think, though I have no direct proof of this, just as Brad has no complete and direct proof for the 72% figure.

    I think it’s in China’s interests to keep the composition of its reserves a secret for now – it doesn’t want to needlessly spark a run on the dollar. But I think if the full truth was known, the figure might already be much closer to the 50% mark than almost anyone would imagine.

  • Posted by Twofish

    Qingdao: Wstroupe: So if you had a choice: $1,000,000,000,000 plus $1T worth of laptops OR $1T worth of IOUs; you would choose the latter.

    Absolutely.

    I’d absolutely choose $1T in IOU’s from the US government versus $1T in laptops. Suppose someone gave you a $1000 laptop five years ago. How much do you suppose you could resell that laptop today for?

    By the way, anytime you put money into a bank, you are just getting an IOU.

  • Posted by Twofish

    WStroupe: Culture matters. While it isn’t something that trumps all else, of course, but still, it matters.

    No it doesn’t. Institutions, history, luck, and policy matters. Culture is a story people make up after the fact. It’s pretty meaningless.

    WStroupe: The U.S. financial/economic house is a complete mess, while China’s house is in much better shape and is being set in order to emerge from this crisis even stronger

    Hardly. The US is in a much stronger position than China is. The US political and economic leadership has been rather incompetent over the last ten years, but the US is so much more economically and politically powerful than China, that it can survive political and economic incompetence far better than China can.

    China is a mess. The good news is that it is much less of a mess than it was before. The reason that China is expanding as quickly as it is is precisely because it is so much of a political and economic mess, that it is easy to find things to improve. Want economic growth? Build a freeway. Once the freeway is there, build a railroad.

    WStroupe: . I don’t see it as at all unfounded to say that the condition of each house reflects the worthiness of each side’s mindset, principles, and strategies.

    China has a avoided a banking crisis, because the political and economic leadership made a decision in 2001 to focus in risk management. This has nothing to do with “culture.”

    Also, since Tacitus, it’s been common for people in technologically advanced areas to look at people far away and complain about their own decadence. In the 1980′s, people in the US were talking about how the US was doomed by the Japanese. It killed Japan, because Japan started believing the propaganda.

    The one good thing about China is that no one in China believes that they’ve developed a magic system or that even that China has a better system of economics and politics.

    WStroupe: They pointed to the fact that American culture, mindset, thinking and strategies were shortsighted, over-confident, misdirected, reckless and overly greed-ridden.

    Culture is not destiny. One reason people underestimate the United States (and also China) is that people vastly underestimate the speed at which the nations can *change*. I suppose US culture in 2005 was short-sighted, misdirected, reckless and overly greed-ridden.

    The US in 2010 will be a completely different nation. Just look at how savings rates changed between June 2008 and January 2009.

    WStroupe: But the supposedly “impossible” crisis happened anyway, in spite of the fact that those predicting it were laughed at. That should be a lesson as to what may well be in store for the dollar in the near future.

    It’s not much of a lesson. If each day I predict that there will be a major earthquake in Los Angeles, one day I will be right. I predict that there will be a dollar crisis, the US will default on Treasuries, and the sun will swallow the earth. True and accurate, but useless if I can’t tell you when and how.

  • Posted by Glen M

    WStroupe,

    You are right in a sense, that China should in no way desire to hold such a large percentage of securities. The question you should be asking is why do they?

    IMO, the answer is that if they invested their trade surplus in commodities, they would not have been able to control their currency value. A devalued currency (or over valued currencies of their major trading partners) has been the cornerstone of growth policy.

  • Posted by JKH

    Brad,

    I submitted a comment/response on the Financial De-Globalization post, regarding the details of the Fed’s foreign currency swaps, which has been “awaiting moderation” since early today.

  • Posted by bsetser

    jkh — thanks for the heads up; i hadn’t looked at that box this am. it should be up now. post with lots of links tend to end up there.

  • Posted by Twofish

    Glen M: You are right in a sense, that China should in no way desire to hold such a large percentage of securities. The question you should be asking is why do they?

    I think that this is wrong. Foreign reserves need to be in securities, otherwise they aren’t reserves. As far as why US Treasuries. US Treasuries, absent inflation, is a “no-brainer” investment. You don’t have to think about it. Stocks and commodities require a huge amount of skill.

    Glen M: A devalued currency (or over valued currencies of their major trading partners) has been the cornerstone of growth policy.

    It really hasn’t. The RMB has been undervalued from 2001 to 2009, but it was overvalued and in some situations vastly overvalued from 1949 until 2001. The overall trade balance was zero until about 2003.

    The huge trade deficit was one of those things that happened. It likely would not have happened had Al Gore been elected in 2001.

    The economic policies that worked from 2003 to 2008 will simply no longer work any more so people in Beijing are frantically trying to figure out new economic policies.

  • Posted by Twofish

    WStroupe: China’s reserves are about 72% in dollars. If true, then it’s in China’s interests to reduce that fairly quickly over coming months, closer to the 50% mark.

    And it just can’t do that. You can’t stop a train on a dime, and you cause huge problems if you try. If China wants to move from 70% to 50% dollars, it would take at least a year and more likely two.

  • Posted by thinker

    Is today the day where Fed is buying T-bills? Monetizing? I believe so, if i were China i too would call for a new global reserve.

    why Geithner and Bernanke object is beyond me…

    we live in a globalized world where we need a global structure.

    thanks.

  • Posted by Glen M

    Twofish,

    Ignore the allocation, focus on the amount. There is no need for such large holdings.

  • Posted by Qingdao

    Twofish:

    “I’d absolutely choose $1T in IOU’s from the US government versus $1T in laptops. Suppose someone gave you a $1000 laptop five years ago. How much do you suppose you could resell that laptop today for?”

    But Americans don’t buy a laptop, hide it under the bed and watch it’s value fall; they USE the things; Starbucks in Seattle are full of people USING their laptops. You rarely see that in China. In 5 years Americans will borrow another $1T from China to purchase another generation of laptops and pay in IOUs. This raises 2 questions: What are Americans doing with those laptops? What will happen to the value of all those IOUs?

  • Posted by MFMartin

    Brad,

    Another insightful analysis. A few comments:

    1. Noticed you didn’t mention China’s renminbi-denominated trade “pilot programs” in the blog. Various sources say China is trying to convince Hong Kong, Macau and ASEAN to accept trade denominated in renminbi, not the traditional US dollar. Could be seen as another angle at trying to supplant the US dollar as the only global currency.

    2. To what extent is China’s current policy of exchange rate stability a reflection of their actions of 1997 during the Asian Financial Crisis? Also, given recent fluctuations, is it really clear which way the renminbi would move against the US dollar if no one were to intervene in the market?

    3. I’m not highly versed at trade elasticities, but I am skeptical about claims that a stronger renminbi would eliminate most of China’s trade surplus. My sense is that it would only make a decent dent.

  • Posted by gillies

    DOR responds:
    Why does it always take two tries to “pass math”? Irritating.

    eliminate the first try. submit comment without adding the numerals. then when you are sent back to do it again you will see the new sum (yes, it changes – if it did not the answer would always be the same, presumably).

    now the site will accept your submission.

  • Posted by gillies

    or make shorter submissions and get in first try.

  • Posted by Twofish

    Qingdao: But Americans don’t buy a laptop, hide it under the bed and watch it’s value fall; they USE the things; Starbucks in Seattle are full of people USING their laptops.

    So? It’s still going to fall in value. If I buy one laptop, I can create more value. If I buy one hundred, then I’ve wastes a whole much of money that could be used for something else. I can just type on one laptop at a time.

    In fact, instead of having two laptops, I’m better off if I keep one, give someone else an IOU so that they can buy my other laptop, and then maybe they’ll do something useful to pay back my IOU.

    Now if it was a choice between $1 T IOU’s and $1 T in laptop *factories*, then things might be different.

    Qingdao: This raises 2 questions: What are Americans doing with those laptops? What will happen to the value of all those IOUs?

    Well I’d hope they would be starting companies/getting education/doing useful things to pay off those IOU’s.

  • Posted by Twofish

    Glen M: Ignore the allocation, focus on the amount. There is no need for such large holdings.

    Yes there is. Lots of rapidly aging Chinese starting circa 2020.

  • Posted by don

    TT: “Some countries may be successful and promote a new build-up of global imbalances, which many people point to as one of the principal causes of this crisis. A large, SDR allocation can help meet this demand for reserves.”
    To me, this is the crux of the matter and explains why China supports a new global reserve. As it is, they could diversify by buying various currencies. But this might cause a negative reaction in places like Japan, which I can’t see docily accepting such actions. Furthermore, the proposal has the benefit of giving credit to ready borrowers (which is probably becoming a problem for China now) without the discipline of the loan scrutiny they would face if they got the money via intermediation from commercial banks in developed countries. Although it might do some good by making available loans that are now inordinately hard to get, it will probably do more harm by generating loans that have no business being made. Eventually the core of the problem (excess saving) will need to be dealt with. This plan, it seems to me, just moves the problem from one basket to another in an effort to forestall inevitable adjustments.
    We would see another “LDC debt crisis” when interest rates come off current lows.

  • Posted by Frans C. Verhagen

    Using a carbon-based international reserve currency with carbon accounts in a nation’s balance of payments would not only solve the climate crisis, but puts the world a road map to far, sustainable, and therefore, stable monetary, financial, economic systems. For details of the Tierra Solution and its monetary architecture, see http://www.timun.net.

  • Posted by Mike Norman

    China’s desire to continue accumulating dollars merely supports its exports at some level by keeping its currency weaker against USD than what otherwise would have been the case. As China’s domestic stimulus takes hold and to the degree that offsets export driven output and job growth, dollar accumulation will decline, which in and of itself portends nothing for U.S. Treasuries and interest rates.

  • Posted by Bill Sutphin

    No better illustration can be offered that economists propagate a mix of fantasy tinged with deception than referring to China as an “emerging economy.”

    Accumulating $600 billion IOUs/year is a higher level of development than we have been able to muster since Eisenhower.

    Bill Sutphin

  • Posted by WStroupe

    UN Panel pushes super-reserve currency (SRC) to replace the dollar, and says Stiglitz (panel’s head) it “is feasible, non-inflationary and could be easily implemented, including in ways which mitigate the difficulties caused by asymmetric adjustment between surplus and deficit countries.”

    One way to look at the recent statements of Russian, Chinese and UN leaders touting the SRC is that they are all jockeying for position and bidding for stronger, lead roles in the upcoming G20 summit on April 2. And well that may be. But there’s much more to this in my opinion.

    Due specifically to this global crisis, the U.S. financial system, the dollar, the US’ favored ideologies, and the negotiating position itself of the U.S. have all been severely undermined, in the view of the bulk of the rest of the world. Fact is, the U.S. doesn’t rule the policy roost anymore, though it still talks tough and makes threats. But it can’t deliver on those threats. Witness the recent U.S. bailout of China on its Treasuries holdings, discussed here in another thread.

    In the run-up to the G20 summit, powers like BRIC and the UN are encircling the U.S., intent on capitalizing on the current crisis. They may not get all they want, as quickly as they want it, but they’re driving down toward the hoop and signaling to the U.S. that negotiations are going to be ‘one hell of a bitch’ for the U.S. side.

    It doesn’t matter whether or not the U.S. side realizes how weakened its position has become. What matters is that the rest of the world knows it, and intends to ‘work it’ to their strategic AND tactical advantage with respect to reforming the current global financial and monetary orders. Some powers are signaling they don’t want a nasty public fight (like Brazil), but that they nonetheless (quietly) support the move away from sole international reliance upon the dollar.

    Conditions are ripe for some really substantive international reforms, much quicker than most people realize. However, I would be surprised if the G20 summit itself results in a truly dramatic, public announcement of such. I think most of the real reform will be taking place less ostentatiously, but I think the G20 summit’s big accomplishment may be to help gel the thinking, strategies, determination and urgency of the participants who favor a new SRC. If, as I suspect, the G20 does result in producing a united front against the old dollar-centric order, then things can happen quite fast after that.

    The U.S. side and the dollar are at significant risk here. No longer is this a case of the ‘colossal giant’ (U.S.) being challenged by pitiful ‘little people’. The colossal giant is greatly weakened by this crisis, and the little people aren’t so little anymore by comparison. If there’s a united front, then the playing field is being leveled, or even tilted in favor of the emerging powers.

  • Posted by WStroupe

    Sorry, hope I didn’t offend anyone with my ‘course’ language in my previous post.

    Here’s the link to the story on the UN panel pushing for a new global reserve currency:

    http://www.breitbart.com/article.php?id=CNG.18e9e5692442aa61d7510553b5ffc14e.8b1&show_article=1

  • Posted by WStroupe

    UN Panel pushes super-reserve currency (SRC) to replace the dollar, and says Stiglitz (panel’s head) it “is feasible, non-inflationary and could be easily implemented, including in ways which mitigate the difficulties caused by asymmetric adjustment between surplus and deficit countries.”

    Here’s the link to the story on the UN panel pushing for a new global reserve currency:

    http://www.breitbart.com/article.php?id=CNG.18e9e5692442aa61d7510553b5ffc14e.8b1&show_article=1

    One way to look at the recent statements of Russian, Chinese and UN leaders touting the SRC is that they are all jockeying for position and bidding for stronger, lead roles in the upcoming G20 summit on April 2. And well that may be. But there’s much more to this in my opinion.

    Due specifically to this global crisis, the U.S. financial system, the dollar, the US’ favored ideologies, and the negotiating position itself of the U.S. have all been severely undermined, in the view of the bulk of the rest of the world. Fact is, the U.S. doesn’t rule the policy roost anymore, though it still talks tough and makes threats. But it can’t deliver on those threats. Witness the recent U.S. bailout of China on its Treasuries holdings, discussed here in another thread.

    In the run-up to the G20 summit, powers like BRIC and the UN are encircling the U.S., intent on capitalizing on the current crisis. They may not get all they want, as quickly as they want it, but they’re driving down toward the hoop and signaling to the U.S. that negotiations will be very tough going for the U.S. side.

    It doesn’t matter whether or not the U.S. side realizes how weakened its position has become. What matters is that the rest of the world knows it, and intends to ‘work it’ to their strategic AND tactical advantage with respect to reforming the current global financial and monetary orders. Some powers are signaling they don’t want a nasty public fight (like Brazil), but that they nonetheless (quietly) support the move away from sole international reliance upon the dollar.

    Conditions are ripe for some really substantive international reforms, much quicker than most people realize. However, I would be surprised if the G20 summit itself results in a truly dramatic, public announcement of such. I think most of the real reform will be taking place less ostentatiously, but I think the G20 summit’s big accomplishment may be to help gel the thinking, strategies, determination and urgency of the participants who favor a new SRC. If, as I suspect, the G20 does result in producing a united front against the old dollar-centric order, then things can happen quite fast after that.

    The U.S. side and the dollar are at significant risk here. No longer is this a case of the ‘colossal giant’ (U.S.) being challenged by pitiful ‘little people’. The colossal giant is greatly weakened by this crisis, and the little people aren’t so little anymore by comparison. If there’s a united front, then the playing field is being leveled, or even tilted in favor of the emerging powers.

  • Posted by Judy Yeo

    Brad

    wouldn’t a “smaller stockpile of reserves” on the part of the Chinese be an obstacle in their investing in US assets, particularly treasuries which in part funds rescue initiatives?

    What doesn’t go in Chinese pockets doesn’t necessarily line the pockets of its rivals?

  • Posted by The Peoples

    Bangladesh is known as democratic country
    But as per article (section) 70 of Bangladesh Constitution, only key person or party chief. can take decision none the else

    Second one is very age old or left over colonial laws and legal system for ruling the people.
    Due to which Billions of hard earned money of common people are spent in conducting huge number suit like as 37.00 Lac ( Thirty Seven Lac ) till may, 2019. in the court which may not be settled even in life time nor have any certainty of any relief .

    NOW THE QUESTION WHO ARE DIRECT BENEFICIERIES ?

    Contesting parties are compelled to spend billions of Dollar in addition to valuable times of their active life, year after year although more then 35 % people are living below the poverty line…

    ARE THESE PRODUCTIVE ACTIVITIES ?

    Why these colonial laws and legal system are not changed ?

    Experienced Peoples are in opinion that Bangladesh can not face the track of advancement of science and technology like other Asian Countries nearby Bangladesh
    Even Bangladesh will not be able to dream the face of digital world with existing colonial laws and legal system.

    The experienced persons are in opinion that the present legal systems and procedures have no rule in productive activities to change the fate of people or the poverty of the country rather helping the rent seeking or interest seeking process from the grass root level .

    Third point which is most significant and important are the lack of accountability in every stage of life for people or Government Personal / Officials which will encourage the growth of terrorism .

    Now it has became imperative to reform / replace the concerned ministry & commission / body consisting of expert of political sciences / social welfares , expert of relevant subjects of science and technology. like medicine, engineering, agricultural sciences , information technology , telecommunications sciences , business and commerce etc ?

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