JPRI Critique, Vol XI, No. 5 (October 2004)
China Scrutinizes the Almighty Dollar
by Marshall Auerback

After many years of being the subject of intimate dinnertime gossip at the exclusive Group of Seven, China was at last given a place at table on October 1, 2004. Notwithstanding recognition of the country’s increasing importance in the global economy implied by the invitation, China certainly didn’t act like an eager guest overanxious to please its hosts, who were particularly keen to see a faster pace of revaluing the renminbi. In fact, the “guest” was rather ungracious, warning U.S. policy makers not to push too hard for an imminent revaluation, in effect telling U.S. Treasury Secretary John Snow to be careful what he wished for.

The official statements on the part of Beijing (as opposed to the frenzied pre-summit conjecture) were much like the western experience of eating a Chinese meal: satisfying at first, but leaving one rather desirous of something more substantial a few hours later. At a bilateral meeting between U.S. and Chinese officials earlier in the session, China’s monetary authorities repeated their oft-stated commitment to move toward “a flexible, market-based foreign exchange rate.” But, as usual, they did not outline specific plans or a timeline for doing so in spite of ongoing pressure on the part of Mr. Snow.

Zhou Xiaochuan, China’s central bank governor, said the country had more preparatory work to do before the renminbi could be allowed to float freely: “China’s foreign exchange regime could change on certain conditions but we need to do more preparation.” After the meeting, Zhou was more explicit: “It is impossible to change it now.”

U.S. Treasury Secretary Snow welcomed the reforms already implemented by Beijing, but continued to insist that “China is important for maintaining strong global growth, and a more flexible and market-based renminbi exchange rate is an important part of this goal.” In case anybody missed the meaning, he added: “I underscored that I would like to see China move more quickly.”

In fact, rumors of an imminent revaluation of the renminbi always seemed implausible given the Bush Administration’s own longstanding policy of benign neglect towards the dollar. Although Mr. Snow has occasionally paid lip service to the Robert Rubin mantra that a strong dollar is always in the best interests of the United States, he has often undercut this notion by affirming the need for markets to determine its proper level. The latter proviso has generally been seen as furnishing implicit support for a gradual devaluation, with the occasional “strong dollar” remark thrown in to prevent a gentle decline from turning into a freefall. Moreover, the timing for a significant Chinese revaluation would seem odd, as such a dramatic move just prior to the U.S. elections would no doubt incur high risk of upsetting global investors and global financial markets, particularly U.S. fixed income markets.

So why the frantic pre-summit conjectures? The key seems to be a September 28th China Daily article, by Jiang Ruiping, director of international economics at China’s Foreign Affairs University, which likely reflected ongoing concerns that Beijing shares about the future long term course of the greenback:

Many international institutions and renowned scholars have recently warned that the possibility of a U.S. dollar slump is increasing and may even lead to a new round of ‘U.S. dollar crisis.’

Since China holds huge amounts of U.S.-dollar-denominated foreign exchange reserves, the authorities should consider taking prompt measures to ward off possible risks.

It is still too early to conclude if the U.S. dollar is heading towards a crisis. But it is an indisputable fact that it has gone down continually. Its rate against the euro, for example, has dropped by 40 per cent since its peak period and it lost 20 per cent of its value against the euro last year alone.

It is becoming more and more evident that the possibility of a further slump of the U.S. dollar is increasing…

Jiang ominously concludes the following:

At the end of 2000, China's foreign exchange reserve was US$165.6 billion. By the end of 2002, it rocketed to US$286.4 billion before it soared to US$403.3 billion by the end of 2003. By the end of June this year, the reserve was registered at a staggering US$470.6 billion.

About two thirds of the reserve is dominated by the U.S. dollar. As the dollar goes down, China will suffer great financial losses.

Experts estimate that the recent U.S. dollar devaluation has caused more than US$10 billion to be wiped from the foreign exchange reserve.

If the so-called U.S. dollar crisis happens, China will suffer further loss.

The high concentration of China's foreign exchange reserve in U.S. dollars may also incur losses and bring risks.

The low earning rate of U.S. treasury bonds, which is only 2 per cent, much lower than investment in domestic projects, could cost China's capital dearly.

Due to high expectations of U.S. treasury bonds, international investors used to eagerly purchase the bonds, which leads to bubbles in U.S. Treasury bond transactions. If the bubble bursts, China will suffer serious losses.

Moreover, since the Chinese trading regime requires its foreign trade enterprises to convert their foreign currencies into yuan, the more foreign exchange reserves China accumulates, the more yuan the Chinese authorities will need to put in the market. This will exert more pressure on the already serious inflation situation, making it harder for the central authorities to conduct macro-economic regulation.

Besides, investing most of its foreign exchange reserves in U.S. treasury bonds also holds great political risks.

To ward off foreign exchange risks, China needs to readjust the current structure, increasing the proportion of the euro in its foreign exchange reserves.”
(Our emphasis)

That the story was published against a backdrop reported purchases of gold by China added to the fevered speculation that a substantial revaluation was imminent. It no doubt reflects a long term view in Beijing (where reserves have in fact been slowly, but steadily diversified out of dollars into euros, yen and gold), but it takes two to tango: even if China were prepared to accommodate the Treasury’s request, the fact remains that Beijing must find a counterparty that does not share its concerns over the long-run purchasing power of the dollar in order to divest itself of some of its U.S. dollar holdings.

There aren’t many of those around: The European Central Bank has on numerous occasions made statements not too dissimilar to those expressed in the China Daily article over the long run value of the U.S. dollar. The Governor of the Bank of Japan, and his immediate predecessor, have both expressed comparable concerns about the sustainability of the U.S. current account deficit. Consequently, immediate, substantial swaps with these central banks for euro or yen denominated assets are unlikely to be forthcoming. That means the Chinese must find private sector parties willing to accept the Chinese holdings of U.S. dollars and U.S. dollar based financial assets in exchange for non-dollar denominated assets.

That seems even less likely. But for the actions of the official sector, especially the Asian central bankers, the dollar would likely be in freefall if current portfolio preferences of the private sector are anything to go by. The Asian official sector has in effect acted as a buffer between private speculative capital (which continues to wash its collective hands of the dollar), and the Asian and American industrialists, who are deriving benefits from a slowly declining currency, but who would be the first casualties of a dollar collapse (given the deflationary impact of the latter through the sharply higher long rates it would ultimately produce).

It is also unclear whether Mr. Snow’s remarks truly reflect widespread preferences in Washington. The massive dollar support operations of the Asian central banks have preserved low long-term U.S. rates, in effect doing the Federal Reserve’s heavy lifting for them, so one doubts whether Alan Greenspan could be counted on as a strong dollar ally. Similarly, Fed Governor Ben Bernanke has long celebrated the American central bank’s ability to print endless dollars to ward off any incipient deflationary threats. But how much would this capacity be constrained were the Chinese not so accommodating by maintaining the renminbi peg (which allows them to recycle so much of their rapidly growing reserves into dollars)? The Bank of China’s deputy governor, Lu Ruogu went so far as to suggest: “"If you force China to change it will hurt the United States. You destroy a goose that will give you a golden egg."

For all the talk of U.S. pressure (currently being acted out in kabuki-like fashion for purely electoral purposes), America’s monetary authorities are in reality likely to continue to countenance the current dollar-renminbi exchange rate, particularly in light of the horrific data coming out of the Fed’s latest flow-of-funds statement: U.S. total debt has risen 8.2 per cent year-on-year to a record 298 per cent of GDP at the end of the second quarter of 2004. Turning off the Chinese credit spigot, therefore, is certainly not desirable – at least not until after the U.S. election.

China also has its own domestic reasons for moving to revalue very slowly, and on a schedule not subject to intense foreign pressure. Although some token 1-2 per cent widening of the exchange rate band within which the renminbi trades might be countenanced, the fragile state of China’s state-owned banking system makes any sudden revaluation a highly perilous and potentially destabilizing event for Beijing. As Credit Lyonnais Securities Asia strategist Christopher Wood notes, “The official focus in China on removing physical growth bottlenecks, while entirely understandable from the practical bottom-up point of view of an engineer, is without doubt leading to massive overinvestment given the undisciplined nature of the banking system” -- a banking system that must be thoroughly reformed before any precipitous moves in the currency markets can be made.

This is not to say that China is not planning for a future in which a large write-down of their dollar foreign exchange holdings becomes inevitable. Minmetal’s decision to buy Noranda, Canada’s mining giant, for about $5bn must be analysed in this context. The takeover represents the biggest deal by Beijing to secure resources to feed a voracious industrial appetite. In many respects it is the culmination of a trend, given China’s oft-stated desire to acquire strategic stockpiles of commodities crucial to maintaining the country’s growth momentum. On the other hand, the purchase represents the start of something quite new, given that Chinese state companies have historically concentrated on buying resources themselves, taking stakes in oilfields, gas fields and mineral reserves.

With the Noranda deal, an important strategic shift is evident. The proposed acquisition by Minmetals, one of 53 state-owned enterprises administered by Beijing, shows China’s increased readiness to spend some of its stash of $480bn in foreign exchange reserves to alleviate the country's dependence on foreign-owned resources.

But have they overpaid and does it in fact represent the future? Long-time China observers, such as Simon Hunt, note that China acquired a large range of physical commodities during the 2000-2001 recession (when prices were at rock bottom levels), and have historically been shrewd contrarian buyers. Therefore Hunt casts doubt as to whether this purchase actually represents the start of a significant new trend. He ascribes most of the noise surrounding the purchase (concomitant with the talk of revaluing the renminbi), as symptomatic of the usual speculative frenzy that one sees at the peak of commodity bull markets. Adding to Hunt’s skepticism, he further notes the simultaneous bursting of the housing and automobile bubbles in China, to which the markets have hitherto paid little attention:

“If the USA had seen a 60-70% fall in housing starts between the start of the year and August and a 38% fall in auto sales, markets there would be shaking. And yet markets appear oblivious to the facts.
This is partly because of the way that housing starts – China’s proxy for floor space under construction – are reported. Data is given on a year-to-date with the media comparing 2004 with 2003, which tends to mask what is going on right now. We have broken down the data to a monthly basis, as follows:

The table shows an almost 70% fall in the floor area under construction in August versus the average of the first two months of the year. It is too early to say when and at what pace a recovery in construction will take place.

Given this shaky domestic backdrop, export growth becomes all the more important, particularly (as Hunt notes) because export proceeds of companies are generally remitted within 30 days under the controlled capital account regime. Domestic sales often have to wait for up to one year – in some cases even longer – giving a greater financial incentive to ship goods out of the country, rather than producing for domestic consumption (particularly against a slowing backdrop). At this juncture, the status quo works for China.

Which is not to say that the Noranda transaction was a mistake: from Beijing’s perspective, one of the virtues of the deal is that it need not have any immediate damaging effect on the U.S. dollar exchange rate. As long as sellers of commodities and Western based materials firms are willing to accept U.S. dollars in these transactions, the shift in Chinese government portfolio preferences need not collapse the dollar, which of course would be detrimental to China’s current export led growth path.

Undoubtedly, there will be more of these deals. Hunt himself suspects a major copper company might be next on their list. As for a big imminent shopping spree, Hunt suggests that this, like the plans to revalue renminbi itself, will be done on China’s timetable, not the rest of the world’s.

But what is the likely future response on the part of the G-7 to such transactions? For now, very little; but as trade pressures become more acute, rising protectionism is almost inevitable. By 2005, a restive U.S. Congress might start by bringing up that taboo subject -- tariffs. A newly elected President Kerry or re-elected President Bush (who has not been averse to blatant protectionism in the past) could conceivably inform the world that the United States is prepared to impose a temporary general tariff of 10 or 15 percent on all imports. Such a non-discriminatory tariff is actually allowed under existing trade rules to correct “grave financial imbalances” (a fair characterization of the U.S. today). Every multinational would have to rethink its industrial strategy, because some of its production might be stranded in the wrong country and China may indeed be forced to accelerate its purchases of strategic assets and companies.

This, in turn, would accelerate China’s dollar diversification strategy. The smart money assumes such a momentous reckoning probably won't occur in time to disrupt Bush’s re-election campaign, but it may well become the dominating crisis in the next presidential term, whoever is elected. At that point, the United States (and, by extension, the dollar) will lose its aura of unilateral superiority, and the country will be forced to undergo wrenching change. China might be swept along as well, and future G-7 dinner invitations could find both parties with their plates full, but appetites suppressed by the resultant stress.

MARSHALL AUERBACK is a British-based international financial analyst who writes often for JPRI on economic matters. His last article was “Thailand Wipes the IMF Slate Clean” (September 2003).

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