Joke of the week: China wants the dollar replaced as the global currency reserve

October 16, 2013

I was amused to see China’s state-run news agency call for the dollar to be replaced as the global reserve currency.

Why? Let’s step back for a moment and review the basics of “reserve currencies.”

China has very large US dollar (Treasury bond) holdings because it has long been the policy of the Chinese government to print its currency and use those yuan to buy dollars, which it then invested in U.S. Treasury securities (the only liquid investment for the huge dollar accumulations of China).

Why has the Chinese government done this? Not for charity to the U.S. or to obtain leverage over the U.S. They did it to suppress the exchange value of the yuan so that their exports to the U.S. would have lower prices and thus a larger market share and production volume. Which means more manufacturing jobs in China.

In adopting this policy, China has followed the practice of all of the “Asian Tiger” economies since World War II. Japan, South Korea, Taiwan, Singapore, etc. have all had export-driven economic strategies, have sought access to the massive U.S. consumer market, and have employed exchange rate management strategies (large dollar purchases) to implement this common strategy.

The result is all of these countries now possessing large U.S. dollar “foreign exchange reserves.” The fact that the U.S. dollar is the most popular reserve currency is merely a reflection of the size and attractiveness of the U.S. consumer market to the exporter industries in these countries — industries which these governments support.

I chuckled at the headline because it is the Chinese government’s economic policy that has resulted in its holdings of U.S. Treasuries. They explicitly chose this policy and need it to be this way for their economic growth model to work.

Now, China and the other holders of US Treasuries must expect to suffer capital losses on these holding. They will suffer these loses when “the U.S. gets its house in order,” as everyone wants. When that happens, when U.S. economic growth, prosperity, and confidence returns, interest rates and bond yields will rise, as the Federal Reserve ends its quantitative easing program and gradually tightens monetary policy. Higher interest rates and bond yields mean lower prices for US Treasury bonds, including those held by China.

If China undertakes economic reform that doesn’t depend on exports to the U.S., it won’t need to so closely manage the dollar-yuan exchange rate by creating currency reserves.  That’s China’s choice. And if China goes that route, it would have a mix of mildly positive and negative effects on the U.S. economy, spread out over a long period of time.

 

Robert Haddick is an independent contractor at U.S. Special Operations Command. He writes here in a personal capacity. In 2014, Naval Institute Press will publish Haddick’s book on the rise of China’s military power and U.S. strategy in East Asia.

 

Photo Credit: Benjamin Reed