China's Calculated Currency Rhetoric
One of the more popular conventional wisdoms is that the United States is in decline and that it is a simple matter to select options that will edge the United States out of its dominant position in the world. In an editorial published Tuesday, Chinese central bank governor Zhou Xiaochuan spoke to one of the more popular financial conspiracy theories in this vein when he wrote that the time had come to establish a new scrip to replace the U.S. dollar as the global reserve currency. The issue is close to Beijing’s heart: The Chinese reserve fund is a significant holder of U.S. debt, with some $750 billion in U.S. T-bills.
China does not purchase U.S. debt out of choice, but out of a lack of choice. China is a state with serious social stability issues that are mitigated only by state intervention in the economic structure to maintain mass employment. Since there isn’t much internal demand for the goods these employed masses produce — due in part to a high savings rate and low incomes — China must peddle its goods abroad. The U.S. consumer market, with annual sales of approximately $10 trillion, is roughly equivalent in bulk to the next six consumer markets combined. Sales to the United States and other countries hardwired into the American supply chain — which includes the bulk of East Asia — are the only reasonable option. And so the Chinese yuan has a de facto peg to the U.S. dollar.
That is hardly the extent to which the Chinese are bound to the dollar, however. Because China lacks the financial and industrial infrastructure needed to metabolize the massive revenues generated by exports, the income must be stored in some sort of non-Chinese asset. Outstanding U.S. T-bills currently total $11 trillion, which — with the notable exception of Japanese government debt, which very few foreigners even touch — is greater than the next five government debt issues combined, by a ratio of two to one. U.S. debt outsizes combined euro-denominated government debt by more than three to one.
Corporate debt isn’t much of an option either, even though the combined global corporate debt market is sufficiently large to absorb China’s currency reserves. Whenever an investor holds a substantial portion of any company’s debt, market liquidity is constrained and trading dynamics are altered. The solution is a highly diversified — and therefore actively managed — portfolio. But the administrative cost of a trillion-dollar portfolio so diversified that it does not affect the value of any particular asset would be staggering. In contrast, U.S. government debt is a one-stop shop that requires — at most — minimal management.
That China’s income is primarily in either dollars or dollar-linked currencies only strengthens the rationale for pouring surplus income into American assets in general, and U.S. government debt in particular. Plainly put, China cannot put its income anywhere else because there is no other option available. There have been some mild attempts to diversify, but a dearth of options means that “mild” is about as dynamic as a diversification program for China can get.
As to a world beyond the dollar, the issue is that a reserve currency is not decided upon; it creates itself. Two things are needed to create a reserve currency. First, there must be sufficient liquidity to support a global system. That requires a central bank with an enormous amount of autonomy from a state government, and the U.S. Federal Reserve is unparalleled on this count. Not even the European Central Bank can compete. Second, the economy upon which the currency is based must be large enough to withstand fluctuations caused by other economies buying and selling its assets in massive amounts. Again, the United States is the only economy that potentially could qualify.
Part and parcel of any replacement of the U.S. dollar would be a large-scale abandonment of U.S. T-bills as the core of Chinese currency reserves, which — as the conventional wisdom holds — would force intractable economic problems upon the United States. But a closer look reveals that this is not the case. First, selling U.S. T-bills en masse simply is not possible. Every seller requires a buyer, and the volumes at hand cannot be exchanged quickly. Second, starting down that road would cause the value of the securities in question to plummet, destroying the savings the Chinese have been building up for years. The so-called “nuclear option” really is not an option at all.
So why are the Chinese bringing this up in the first place? Beijing clearly has done the math already and knows that this idea — even if it had broad support — is a nonstarter. There are two reasons. First, officials in Beijing know that any direct confrontation — whether military or financial — with the United States would end in disaster for Chinese national interests. Therefore, they wants to foster anything they can that would create an international structure to restrain American power; failing that, something that just gets people thinking in that direction will have to do. Second, China is more severely affected by the ongoing financial crisis than it would like the world to register. The Chinese need sustained international demand to maintain their export industries and, consequently, their high employment levels. Espousing rhetoric that makes it appear that you have more options than you do, while redirecting attention toward a foreign power, always plays well at home.