I could not agree more, but it is fascinating to hear China indicate that unless something happens, the country will have to reconsider its position as the world’s largest holder of US treasury bonds. Either it is complete nonsense, or else the Chinese authorities are telling us something. The timing is impeccable.
With everybody being busy panicking it is a good time to make important political statements that will not be seized upon by protectionist US politicians.
To repeat the obvious: as long as the Chinese current account is in surplus AND as long as the Chinese government opts for a (very) slow appreciation of the CNY against USD, China has no choice. The Central Bank is forced to purchase USD denominated assets in order to avoid an appreciation of the CNY. As long as the currency peg is maintained, Chinese worries about the value of the dollar are just theatrics.
China has no effective mechanism for absorbing the boost to domestic liquidity that comes when Chinese exporters exchange their dollars for CNY. This huge boost to the domestic liquidity is easily the most difficult issue for Chinese policy makers to control as it drives domestic inflation upwards. It forces the central bank to increase interest rates, when in fact the correct thing to do would be to sell CNY-denominated government bonds to the public.
As long as China does not change her currency policy, the harsh words about the US government and the need to replace to dollar with another reserve currency are simply noise, aimed at positioning China favourably towards their own constituency, a large number of developing countries. But the words will not be followed by actions.
However, something else may be brewing. In a series of articles, Yu Yongding, currently President of the China Society of World Economics, and a former member of the monetary policy committee of the Peoples' Bank of China as well as Director of the Chinese Academy of Sciences Institute of World Economics and Politics has indicated that the Chinese government is ready to move a bit faster towards letting the CNY free itself from the peg to the USD.
There is no doubt that the Chinese leadership finds itself in a dilemma. The USD peg has been instrumental in building up Chinese exports and has created a huge flow of investments into China. But now that policy creates other, insidious domestic problems. Yu Yongding’s articles indicate that a serious discussion is going on inside the corridors of power in China.
Yu Yongding is adamant that a currency reform must happen on “market terms”. Translated to plain talk it means: We will not do it if it can be seen as a result of American pressure.
While this kind of exegesis may seem irrelevant as the stock markets are taking a pounding, it is worth noticing that the symbiosis between US deficits, Chinese surplus and a CNY-USD peg has allowed us all to have lower interest rates than we have really needed. It has been one of the important elements in creating the debt-fuelled boom that burst in 2008 (of course, bad regulation and plain greed were other important drivers).
So if China is now signalling a further, more significant step away from the need to buy USD treasury bonds, the world better sit up and listen. The impact would be far bigger than further downgrades of US debt. The ensuing increase in bond yields would be sufficient to actually force the savings balance of the USA towards an improvement. Not a bad idea. But it would help to keep US growth below trend growth for a decade or so. And the rest of us certainly would not like that.