Should We Worry About Chinese Dollar Holdings?

by Don Boudreaux on January 17, 2006

in Trade

This story in today’s Washington Post reports that the Chinese now hold $819 billion in reserves of foreign currencies — presumably mostly in U.S. dollars.  And presumably we Americans are supposed to worry.

But I can’t figure out why we Americans (or anyone else, for that matter) should worry.

Take the extreme case: the Chinese continue to stockpile U.S. dollars without every spending them.  What a boon this scenario would be for Americans, for it would mean that the price we paid to China for the many valuable goods that we bought from producers in that country is green-ink-smeared paper.  We got electronics, textiles, and other things that make our lives better; in return, China got lots of miniature, monochrome portraits of dead American statesmen.

Of course, this extreme case doesn’t describe reality.  The Chinese are no fools; nor do they so intensely love American history that they’ll accumulate without end U.S. currency for the sake of possessing U.S. currency.

So they plan to spend this currency.

Does it matter when they spend it?  Not much.

Consider the opposite extreme from the one described above: the Chinese (and other foreigners with whom the Chinese deal) spend each dollar they earn the moment they earn it.  In this case, the Chinese accumulate no dollar reserves.  Each dollar Americans spend on imports from China returns immediately to the U.S. as demand for U.S. goods, services, or assets.  This scenario apparently is the punditry’s preferred one, for in it China holds no dollar reserves.

But how does this spend-their-dollars-immediately scenario differ from what is the likely, actual scenario?  In this most likely scenario, the Chinese accumulate lots of dollars and then spend them over time — sometimes spending them in big lumps (say, to buy several Boeing 777s), other times spending them more gradually, and always holding on to a few as a part of their portfolios or as part of a plan by the Chinese government to keep the dollar’s value higher against the yuan than it would otherwise be.

In both scenarios — one in which the Chinese spend their dollars immediately, the other in which the Chinese spend their dollars eventually — the dollars are spent and return to the U.S. as demand for U.S. goods, services, and assets.  The only difference is the timing.

I know that some people worry that the Chinese will suddenly dump their stash of U.S. dollars on the foreign-exchange market.  A sudden drop in the dollar’s value would indeed be unfortunate.  But the fall in the dollar’s value in this case would be from a height that the dollar reached only because the Chinese accumulated the stockpile of dollars in the first place — the same stockpile of dollars whose sudden dumping on foreign-exchange markets caused the value of the dollar to fall.

Also note: insofar as people with a serious stake in the matter — namely, currency speculators — really are worried about the Chinese suddenly dumping their dollars, these traders would start to short the dollar as soon as their concern became serious.  These actions on world currency markets will tend to smooth out the change in the dollar’s value.  That is, the value of the dollar will start to fall before the Chinese begin to dump their dollars — thus reducing, if not eliminating, the quickness of the dollar’s fall.

It’s possible, of course, that world currency traders and speculators are naive and never accurately anticipate what the Chinese will do with their dollars, but, if so, you’ll pardon me for paying no attention to pundits and politicians who fret about the size of Chinese dollar holdings.

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{ 17 comments }

Aaron Krowne January 17, 2006 at 6:29 pm

I am, in fact, shorting the dollar.

You actually seem to agree with the basic thesis: a rapid shift in the Chinese dollar-retention rate would have an unfortunate impact (on… someone).

Further, you point out the heights that the dollar has reached are because of this retention. But this driving force influenced other things: for instance, the real estate market (bubble).

You don't mention that interest rates will also be adversely effected by dumping of dollar bonds (or even just a slowdown in their uptake–the interest rate is mostly effected by this delta, not anything about absolute quantities).

So let's see. Dollar goes down. Chinese goods get more expensive for Americans. Interest rates also go up. Economy slows (creating unemployment and killing income growth). Consumers squeezed by $1.3 trillion of ARMs. Home equity extractions sieze up. Economy slows even more.

This looks like a n-tuple-whammy-of-badness, to me.

Maybe the article misses the precise mark by focusing on absolute quantities, but there is genuine reason to be worried, here.

So my answer is: rather than holdings, we should be worried about the change in Chinese dollar holdings, which are only the symptom of an imbalanced, unsustainable arrangement.

Don Boudreaux January 17, 2006 at 6:53 pm

Why would the Chinese suddenly dump dollars? The best hypothesis is that something happens in the U.S. economy that makes them not want to hold dollars any longer — but that would be our or Uncle Sam's fault. It's simply implausble to suppose that the Chinese have gone long in the dollar for so long and will suddenly dump them for no reason.

Don Boudreaux January 17, 2006 at 6:58 pm

What is unbalanced and unsustainable about Americans' trade with the Chinese? The most plausible candidate that I can find is the fact that the Chinese government buys lots of dollars attempting to keep the yuan's value against the dollar lower than it would otherwise be. This strategy is bad for the Chinese people; it's a bargain for Americans.

And when this strategy ends — when the Chinese stop depressing the value of the yuan relative to the dollar (assuming that they are in fact now doing so) — Americans get a sudden burst of demand for U.S. goods, services, and assets.

spencer January 17, 2006 at 7:18 pm

Last August when Hawaii imposed price controls on gasoline you said you were looking forward to getting picture of people waiting in line to buy gasoline to use in your introductory class.

Did you ever get the pictures?

Can you post them so we can see them?

Aaron Krowne January 17, 2006 at 7:43 pm

Don,

(1) You must have noticed that the Chinese have been putting their country through an intentional period of "hyperindustrialization". This is no conspiracy theory, but is plainly evidenced by the Chinese government's various interventions in the free market: the pegging of currency rates and the holding of dollar-denominated bonds over higher-return assets.

This should worry a free-marketer. This massive intervention must be coming at a cost, and it is. Even China knows they cannot keep it up forever, because:

- these policies are keeping their people poor by placing a "shadow tariff" on all imported goods.
- these policies are greatly diminishing China's return on its central assets.
- the ability of the U.S. to buy goods and fuel the growth will also diminish as our debt burden becomes excessive (our negative savings rate is part of the evidence this has already gone too far.)

Its not that the Chinese are anticipating any particular disaster in the U.S. economy, but that the current arrangement has served its purpose, and eventually will cease to function to the mutual benefit of both parties.

Let me reiterate that I don't actually think the Chinese will "dump" anything. They may never sell a single U.S. bond before maturity. But they've already massively slowed the placement of new assets in this class. They've also not-so-secretly announced that they are looking to diversify their holdings–into gold and other currencies.

I'm not even making predictions at this point; the change has already begun. The story (with data) has even been in the Times.

(2) Malinvestment is whats so bad about the trade imbalance and "excess" Chinese investment here. Our debt is not worth the single-minded uptake it is receiving (thanks to central banks). I can say this with confidence, just as I can say with confidence that homes are not intrinsically worth the doubling or trebling of price they've seen in the past few years (the phenomenon are, of course, connected).

Malinvestment is self-evidently bad. Don't you agree? In this case, the market is being forced by central banks to send spurious price signals. As with much in the market, wherever prices are "wrong", someone is screwing with the economy. And the economy always has the last laugh.

Aaron Krowne January 17, 2006 at 7:53 pm

Oh, one more point.

Every action has an equal-and-opposite reaction, even in economics.

You rightly point out that the unnatural Chinese currency-pegging has resulted in a "boon" for American consumers.

But the system has been shifted from equilibrium. There's a positive and a negative on the Chinese side–surely there must also be a negative on the US side.

And there is: domestic manufacturing dying a not-so-slow death.

I hold no particular affinity for the factory floor, but it seems to me pointless to cause the strife of driving excess manufacturing out of business or to foreign shores.

But we don't exactly have a system that is sympathetic to the working poor. When they're victims of government intervention, I feel just as bad for them as I do for the Wal-Mart corporation in Maryland.

K January 18, 2006 at 2:17 am

We don't know what the effects would be if China suddenly dumped dollar holdings.

It would depend on what other nations did to support or oppose the Chinese action. I don't see why they would want a big change.

Give the Chinese an A+ on handling the deficit so far. They are doing exactly the right thing by signaling and easing into other currencies to let the dollar adjust.

I wish the Japanese had started the same policy about 1975.

Mike January 18, 2006 at 9:39 am

I remember that the US Government did not let the Chinese buy Unocal with their hard earned US dollars … did they? So maybe the US dollar in chinese hands is not worth so much after all??

mark January 18, 2006 at 12:31 pm

Good point Mike, I remember someone saying at the time that preventing the Chinese from buying US owned assets (in Asia) could lead to higher interest rates by depressing Chinese demand for US T-bills.

It would be extrodinarily stupid for the Chinese to take any action that would push the US into recession (which would spill over into all their markets). The Chinese actually have a very good incentive to manage their reserves in such a way that avoids an American recession.

Anshu Sharma January 18, 2006 at 1:42 pm

China has $9,000 BILLION in land reserves!

One thing we forget is that dollars can be exchanged for real assets. So our fear of dollar dumping should also extend to other asset classes. What if China started selling its land assets (or petroleum assets or any other) and essentially dumping it? They would hurt themselves more than anyone else.

Its the same as if Bill Gates owned billions of dollars in assets and could dump it hurting America. The fact is that any owner of assets whether Chinese or American can start dumping and temporarily hurt the market stability.

If we pursue this line of thinking, we should be worried about Iran (dumping oil assets), India (dumping software assets), Germany (dumping manufacturing assets) which are all redeemable for dollars!

This whole thing is silly. Its xenophobia masking itself as trade economics.

-Anshu Sharma
(This is my personal opinion.)

Mike January 18, 2006 at 3:33 pm

Anshu – I agree that there is a xenophobic element to all of this – but I doubt you deny that the Yuan is pegged – right? This peg must introduce some imbalance (ye olde supply/demand curve is out of whack) somewhere – right? And if so …

Anshu Sharma January 18, 2006 at 5:19 pm

Yes, the peg causes imbalances in very much the same way if I were to start undervaluing gold that I own (or my home or my car). Chinese govt is giving you Yuan at a discount to a dollar. Just like if I were Bill Gates I could subsidize coffee for the rest of the world for a long time. However, there is not much you or I can do. I know of no remedy that can prevent me from selling my house/car/coffee/currency at a discount. The only limit is what I can afford. China (or Chinese people) work hard to earn for their produce and their leaders collect some of their earnings to fund a subsidy on Yuan. Its similar to what would happen if South Africa started subsidising Gold.

Look at it this way. You can buy lot of land in China today using your US Dollars than would be possible if the government of China did not put it up for sale (by subsidising Yuan/Dollar). And all of this is funded by either hard work of Chinese people or the hard assets of China. So thank you China for subsidising plastic toys for our poor (and rich) kids.

Anshu Sharma January 18, 2006 at 5:30 pm

Thought experiment. If the China policy is so smart how come other countries like India, Taiwan, Japan, Russia, UK etc. do not follow it. The reason is that these other countries would much rather use the dollars earned to build infrastructure, help their own poor, etc. than try to peg (as opposed to stablize/smooth out) the currency exchange rate. 99% of the world's economies can either not afford China's policies or (more likely) smart enough to realize that it is not a very smart policy.

For example buying a Boeing plane or a Intel processor is more expensive than it needs to be for the citizens of China.

Another thought experiment: Would you like US Govt to use say $100BN dollars of tax money to buy Yuan denominated treasuries of Chinese govt paying 2% return? If the answer is no, QED.

Aaron Krowne January 19, 2006 at 12:34 am

Anshu:

I think you've hit on motivation for the China-side of the dynamic. China is an authoritarian regime: the Party doesn't care much about the "inviolability" of the people–they aren't even a rights-based government!

I think instead they like hyperindustrialization because it allows them to /transition to a capitalist society while retaining power in the form of wealth/. They are very shrewd–they witnessed communism's collapse around the world, they went through Tianamen, and they saw where this all was going. What better way to avoid oblivion than to throw in the towel in a controlled fashion! Yesterday, Fearless Leaders, tomorrow, business tycoons!

But you're missing half of the cause. You see, there /is/ something we could do to prevent this imbalance, because every transaction has a party on each end. When China's central bank buys US bonds, it is because /the US treasury is selling those bonds to China/. We could have simply controlled the pace of these sales, or decided we didn't want to sell them to China, or to foreigners as a group. But no, our government wanted the money (and in fact, has taken on debt at twice the pace of the recorded budget deficit, because of it).

The point is, the US treasury is complicit. It is, in fact, OK with this engineered, interventionist arrangement, with all the repercussions it entails (amply discussed above).

So once again, let's not pretend like its all the invisible hand at work.

KR Duncan January 19, 2006 at 5:13 am

Dollars accumulated by the Chinese monetary authorities show up as reserves within their banking system. These reserves support money and credit growth within their own system and which have created a property bubble in major cities (now bursting in Shanghai) and tremendous over capacity in some part of industry such as steel production. The reserves have, to date, been used to shore up a broken banking system but the remedy may actually be worse than the disease. The Chinese do conduct sterilization operations to offset the increase in money and credit (issuing debt to absorb excess money) but money growth is perhaps now beyond their control since their markets are not deep enough to handle the size of the sterilization operations. There is nothing to stop the Chinese from swapping dollars for any other currency to hold as reserves except that something north of 85% of reserves accumulation has been the result of "hot money" flows which are subject to reversal. As such, if they diversified too much, they could get caught in a dollar squeeze.

The Chinese may wish to slow reserve accumulation but that would require some combination of tighter credit conditions, slower growth and/or a higher currency peg. The profitability of their banking system remains poor and, as such, they can't shock the system by terminating reserves growth.

But, if one asks 'why would the Chinese want to sell dollars', you may be asking the wrong question. You maybe should ask the question 'what would force the Chinese to sell dollars' and that would relate to the reversal of "hot money" flows. The Chinese are caught between a rock and a hard place on account of poorly developed domestic capital markets and an unprofitable banking system which still sits on a pile of non-performing and uneconomic loans.

From a U.S. citizens perspective, however, this "stable disequilibrium" of Chinese vendor financing that allows us to buy their products on credit is not a benign situation. It creates a latent inflation bias into our finances since it allows the government sector in the U.S. to expand financed by debt sold to foreign central banks. We are not financing the expansion of government with our own savings so we don't "owe it to ourselves" (as if that were a good rationalization of government spending). As such, there is a strong incentive to inflate our way out of our growing debt and transfering the burden of that inflation to foreign creditors through a devaluation of the dollar.

Before U.S. citizens applaud such an "arbitrage" of the stupid foreign central banks, they should realize that such an inflation will destroy the middle class and be highly redistributive to the Wall Street class. It will also result in a "cash call" on the most leveraged owners of real estate. Nonetheless, the pain would be real. The incentives are strong on the part of the government to do just this, particularly as the end of the decade approaches and the accrual of entitlement promises becomes a real cash burden on government budgets.

The moral of the story – you can't create money and credit at a multiple of nominal income growth (running at 4x in the U.S. across the full cycle) without reaping the consequences of having accelerated consumption on such a scale. Take your pick – inflate or deflate but the status quo is only supported by an acceleration of debt growth relative to income growth. We are leaving our children with a legacy of debt servicing costs that will endanger their standard of living.

The two things that the Founding Fathers warned us against were leaving future generations with our debt and intervening in the affairs of other nations. We have ignored those warnings as our hubris, built on their success, has made us impervious to criticism. Let us see what the consequences of this will be…

Stefan Karlsson January 19, 2006 at 12:48 pm

I don't think we need to worry about the Chinese suddenly dumping all their dollar assets. The Chinese are not kamikazes and know that would create economic disruptions harmkful to them.

I nevertheless think they should give up the peg or alternatively revalue it to a much higher level ( 6 or 7 to the dollar). While I can understand their reluctance to having the yuan subjected to the erratic currency fluctuations we normally see on the currency market, the current situation is unsatisfactory for both sides. The Chinese have become over-dependent upon exporting to the U.S. making them vulnerable to the likes of Senator Schumer during the coming recession. The U.S. on its hand have seen bond yields artifically depressed, helping to fuel a housing bubble. A sharp revaluation would mean that the build-up of Chinese foreign exchange reserves would be dramatically reduced, if not halted or partially reversed, both because of the likely reduction in the Chinese trade surplus and because it would end and indeed reverse the flow of "hot money" now pouring into China betting on a future revaluation.

Gotham Image January 22, 2006 at 5:58 pm

"…for the many valuable goods that we bought from producers in that country is green-ink-smeared paper. We got electronics, textiles, and other things that make our lives better; in return, China got lots of miniature, monochrome portraits of dead American statesmen."

Granted, I don't have your expertise, but neither do most people and ultimately how most people see these issues, will affect how policy evolves. Now, it seems that China is holding, not just portraits of American statemen, but the full faith and credit of the American economy. The actual portraits are not what the currency is about. Also, in exchange for our full faith and credit, we are receiving goods. You note those goods are valuable. But those consumer goods are depreciable assets, while the currency and other intangible assets of a rising economy are appreciable assets. But, if we continue to exchange the value added aspects of our economy and the high wages that manufacturing those value added products, in exchange for the production of depreciable consumer finished goods, from low wage labor overseas, then do we not risk our future economic growth and by being in debt, don't we risk controlling our destiney? Not saying that I know, but I think these are legitimate questions that will be raised because they will be on peoples minds.

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