The Magazine

The Dollar's New Best Friend

Beijing warms up to the greenback--because it has to.

Jun 29, 2009, Vol. 14, No. 39 • By GORDON G. CHANG
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Last Tuesday, Brazil, Russia, India, and China--the so-called BRIC nations--met in Yekaterinburg, Russia, for what was supposed to be an anti-American gabfest. The main agenda item for the first formal meeting of the four largest developing economies was the future of the dollar. In recent months, Beijing and Moscow have led a global charge against the greenback, and Brasilia has been a willing co-conspirator in the effort. The BRIC post-summit communiqué referred to the world's currency problems but, to the surprise of observers, did not attack the dollar head on.

What happened? Beijing, apparently, stopped the other nations cold. The Chinese called the tune at the Moscow meeting--their economy is almost as large as the other three combined--and so the surprisingly nonconfrontational tone of the BRIC official statement mirrored Beijing's recent climbdown on the currency issue.

The Chinese government in the last few weeks seems to have radically changed its tune on this issue. In March, Zhou Xiaochuan, the head of China's central bank, called for the replacement of the dollar as the world's reserve currency in a widely reported text released to the public. In May, however, Beijing officials took a different tack, going out of their way to talk about the dollar's unique status.

Why is Beijing acting like the greenback's new best friend? The Chinese of course realize they would sustain massive losses if they triggered a global flight from the dollar, and they do not appear to have any good ideas as to what should replace the world's financial architecture, now built on the American currency. Yet there is more to their newfound sense of responsibility. They are starting to understand that they have little ability to change the dollar-based international system.

Their fundamental problem is that the Chinese economy, for all the talk of "delinkage," is still tightly bound to America. China has an export-dominated economy--perhaps as much as 38 percent of its gross domestic product is attributable to the sale of goods to foreign markets. The country exports to many nations, but there is one market on which it is particularly dependent. In 2007, 97.7 percent of China's overall trade surplus related to sales to the United States, and in 2008 the figure was 90 percent. In short, China runs a trade deficit with the rest of the world, buying raw materials and components, and a surplus against the United States, selling finished goods. Beijing, therefore, is locked into buying Treasuries and will remain so until Chinese manufacturers either find new foreign markets--something they are only having moderate success in doing--or they can sell to Chinese consumers. And consumption growth, despite rosy government statistics, appears to be anemic.

This extraordinary reliance on the American market means that China had--and still has--no real choice but to continue to purchase dollar-denominated obligations with its export earnings. It is, of course, theoretically possible for Chinese technocrats to convert dollar earnings into pounds, euros, or yen, but the markets for those currencies are not big enough to handle the country's outsized purchases.

Beijing has, moreover, a more fundamental problem: Chinese officials cannot at this stage afford to turn their back on the dollar and thereby constrain the American economy. If they constrain the American economy, Americans will not be able to continue to buy Chinese goods. If Americans cannot buy Chinese goods, the Chinese economy will precipitously decline, and if the Chinese economy precipitously declines, the country's political system, dependent on the ongoing delivery of prosperity, will be destabilized. So Beijing, despite its incessant carping, continues to buy dollar-denominated debt. As Dai Xianglong, former central bank chief and now head of the national social security fund, says, China has no choice but to purchase U.S. Treasury obligations. In Beijing, it is known as the "dollar trap."

The central government does occasionally sell Treasuries, but such dispositions are small and always followed by more purchases. Americans are concerned that the Chinese will one day change their mind and dump our debt, thereby throwing our economy--and the global financial system--into turmoil. Beijing, from time to time, hints that is what it could do. For instance, in the middle of 2007, two Chinese officials threatened to employ the "nuclear option" against the United States: sell dollars and U.S. Treasury obligations. "I personally believe we have so many foreign exchange reserves that we should be smarter in setting the issues," said Xia Bin, one of the pair. "It should at least be a bargaining chip in talks." This is the first time that a senior economic adviser in Beijing publicly suggested using China's reserves for political leverage. He Fan, the other official, wrote in the official China Daily about Beijing causing "a mass depreciation" of the greenback.

We should thank Xia and He for revealing the thinking in the inner circles in Beijing and for providing a reminder that we need to pay down our debt and rebalance our economic relations with China. But their remarks, in reality, were not much of a threat. What would happen in the worst case scenario if the Chinese central government decided to dump U.S. Treasuries? Beijing would have to buy something with the proceeds of its sales. As a practical matter, it would have to buy debt denominated in pounds, euros, and yen. The values of those currencies would then skyrocket. London, Brussels, and Tokyo would then have to try to depress the values of their currencies, which means they would have to buy .  .  . dollars. In short, there would be a great circular flow of cash in the world's currency and debt markets.

There would be turmoil in those markets, but it would not last long beyond the time the Chinese ended their dollar dump. And we would end up in just the same place that we are now, except that our friends, instead of a potential adversary, would be holding our debt. Global markets are still deep and flexible and can handle just about anything. The fact that Beijing has not employed its so-called nuclear weapon is an indication that the Chinese know it is not, as a practical matter, usable.

And the Chinese realize something else. They have been, over the last two decades, the biggest beneficiary of the dollar-based international financial system that Washington maintains. If the dollar were dethroned, there would be turmoil in global markets. That would, in all probability, lead to a reduction in global commerce. And should Beijing get its wish and the renminbi become the world's reserve currency, its value would surely appreciate, thereby choking off China's export economy. A recent estimate says the renminbi is undervalued by about 40 percent against the dollar.

Hillary Clinton once said we can't "get tough" with our Chinese bankers. She's wrong. We can.

Gordon G. Chang is the author of The Coming Collapse of China.