China Needs Strong Dollar for Yuan to Stay Cheap

China Needs Strong Dollar for Yuan to Stay Cheap
August 31, 2009

Many China watchers have been mystified by Beijing’s complaints about the stability of the U.S. dollar. As loud as those complaints may be, they are usually followed by even more Chinese purchasing of the greenback through bonds, T-bills, and other instruments.

China is now the largest holder of U.S. dollar reserves, with its hoard of various dollar-denominated assets believed to be somewhere between $700 million and a trillion dollars. China is followed by Japan with $677 billion in bonds.

China’s ongoing buying of U.S. Treasury holdings is good news for the United States. But why is it still good policy for China?

The usual answer is that China would trigger a collapse of the U.S. dollar if it dumped its holdings. Such a move would effectively destroy the debt-ridden economy of China’s best customer, the United States. True enough. But now there’s more at issue for the Chinese and for the United States.

Growing Anxiety over Dollar

China is becoming increasingly nervous about the stability of the dollar. Zhou Xiaochuan, governor of the People’s Bank of China, warned in March about Beijing’s dissatisfaction with the primacy of the U.S. currency, which Zhou says has caused increasingly frequent global financial crises since the collapse in 1971 of the Bretton Woods system of fixed but adjustable exchange rates.

“The price is becoming increasingly high, not only for the users but also for the issuers of the reserve currencies.” Zhou said. In short, Zhou blamed the United States for the current global financial crisis.

Since then, Beijing has tinkered with various alternatives to the dollar as a reserve currency. It has called on the International Monetary Fund to expand the use of so-called Special Drawing Rights (SDRs) as a new international reserve. It also has expanded the convertibility of the yuan for use as a trading currency in limited areas of Asia and greater China.

All of this talk and activity hasn’t changed much of anything. The yuan is still not readily convertible around the world, and there is little likelihood that predictions of a new global reserve currency in the shape of China’s yuan will materialize in the foreseeable future as some have predicted. Also, the IMF has responded weakly to the call for wider use of the SDR.

Relatively Cheap

So what’s at the heart of this? China needs one thing above all others. The yuan must be kept relatively cheap in order to make the nation’s exports affordable and attractive.

China’s efforts to steer the world away from the dollar as a reserve currency haven’t worked. Beijing even attempted to cut back its dollar purchases for a time, with little effect.

Unable to dislodge the dollar as the world standard, China has only one other choice. It must continue to support the value of the dollar in order to keep the yuan relatively cheap.

That’s why China continues to buy more U.S. Treasury notes (albeit short-term as much as possible). In this time of crisis, Beijing’s dollar-denominated holdings support the greenback—not to avoid crushing the U.S. economy but to prevent the value of the dollar from sliding and that of the yuan from rising.

No Choice

Because of the deep current account deficits in the United States, Washington has little choice but to keep selling dollar-denominated instruments to willing buyers. Beijing has no choice but to buy dollars with its excess foreign reserve in order to keep economic circumstances stable as long as its economy is export-dependent.

Thanks to China, the dollar remains strong for now. But it may decline as China leads the way to economic recovery.

Investment in Chinese companies may be a viable way to hedge against future moves in the dollar as inflation looms over the debt-driven U.S. economy.


Jim Trippon (kdamiani@trippon.com) is editor-in-chief of China Stock Digest (http://www.chinastockdigest.com), a China stock newsletter.