For a few years now, the large FX reserves of China especially its Dollar holdings (despite China holds as well a lot of other foreign assets) have produced unease among some commentators both in the MSM as in some blogs.
Following recent comments of the Premier of China and today's column by Paul Krugman, I want to add some thoughts about what is sometimes called "The Nuclear Option" - the possibility of a large sell off of China's currency reserves, that presumably have seriously negative effects on both, the US and China.
As Krugman already points out correctly, the reserves don't give China much power over the US. The opposite is true. But actually he is dramatically understating the case, as he points mostly to the effect on exports and imports. But there are other effects, that matter, which in my opinion change the "nuclear option" even into pure self defeating.
The most important things of these other issues are:
- the dollar's status as the most important reserve currency
- the net international investment position and return on foreign investment
- the nature of currency reserves
<H1>The Dollar's Role in Trade</H1>
When talking about the dollar as a reserve currency, people often refer to the fact, that many central banks in the world hold large amounts of dollars. Indeed, this helps to reduce interest rate on debt for the US and therefore is relevant, but mostly for a point I want to discuss later.
Even more important is, that a lot of international trade is denominated in dollar. This does NOT force countries to hold large amounts of dollar, as it is possible to trade in a few millisecond every major currency in the world for dollars. But it does mean, that prices in dollar terms are pretty sticky. If e.g. a US airline buys an Airbus from EADS, the price is negotiated in dollar. EADS has to deliver the airplane, regardless of currency movements in the time between negotiation of the price and delivery.
But not only in cases of long running contracts in dollar denomination prices are sticky. In cases of minor exchange rate turbulence, companies usually don't want to react too fast for not to lose market share in the biggest single currency consumer market in the world.
So what would happen, if the dollar exchange rate would suddenly crash? The largest hits would be taken by all those companies that sell into the US from outside. Companies that produce in the US would easily get away with it, as their largest cost factor - personal - would go down with the exchange rate.
Over time there would be some price adjustment, producing some inflation on imported goods, but in the current situation some inflation pressure might be even good for the US. More over nothing reduces public debt faster than surprising inflation. If inflation is anticipated, the interest rate is increased as to keep real interests rates the same or even positive, but if investors are taken in a surprise, they won't have time to increase.
Will there by an increase in the long term interest rates? Yes, for sure. But not by much. As "the nuclear option" would be an one off event, there would be no reason not to buy treasury bonds for a relatively low interest rate. Or in other words. While such an action would provide surprising inflation in the short run, there is no reason to expect embedded inflation in the long run.
<H1>The Net International Investment Position and Return on Foreign Investment</H1>
Well, with now many years of negative trade balances, you will be hardly surprised, that the NIIP of the US is negative. This means, at currency market rates foreigners hold more assets in the US than US citizens outside the US.
How large is the NIIP position? Between 20 and 30% of US GDP. What might surprise you is, that this actually isn't much more negative than what the EU has, and indeed compared to e.g. Spain or Greece it is a fairly little bit.
How does the NIIP change, if the dollar is devalued? It gets better. A lot!! The assets, that foreigners own in the US are either directly denominated in Dollar, or are highly correlated to the dollar. E.g. a subcompany servicing the local US market of a foreign company is not directly denominated in dollar, but earns dollar, and the earnings will go down with the dollar value. China's assets of course are even mostly direct dollar denominated and would lose enormously.
On the other hand, US citizens have assets elsewhere, which are denominated or correlated to other currencies.
Does the latter matter? Yes, a lot, as the N in NIIP already suggests. Before the crisis the foreigner holdings of US assets was ca. 22 trillion dollar, and the US citizen holdings of foreign assets ca. 20 trillion dollar. Well, cut the holdings of foreigners by one half while devaluing the dollar and you make the US the largest creditor nation in the world instead the largest debtor nation.
Another issue to mention in this context is, that the US continuously has a higher return on its investment abroad than foreigners have on their US investments. This is not so surprisingly, when you figure in, that others hold treasuries for political reasons, that larger markets are more liquid and less liquid markets have a liquidity premium, that the US is politically stable,... and of course, that a large part of finance professionals sit in the US.
Given this flow situation, the US can service easily even much larger foreign debts. Of course there is a real debt issue, but not because of the 20% net foreign debt, but because of the huge imbalance INSIDE the US. The money is there, it is a distributional debt problem, that the US faces, not one versa the rest of the world.
As the last point focuses more on China, here some last thoughts about the impact of the "nuclear option" on the US. How much dollar currency reserves does China has? Well, ca. 10% of US GDP. Lets assume it would take 2 years to sell them off completely. What effect would that have?
Probably my implicit assumption of halving the value of the dollar is much too much. During the current financial crisis many current account deficits moved within one year by several percent - and this in the face of a pretty symmetric shock to the world economy. A dollar devaluation by far less than one half would probably change the current account deficit by 5% relative to the alternative path on which China keeps on buying treasuries. But with such a change simply US savers would pick up from China - explanation see here.
And what about a 'route'? Can the massive sell off of dollars lead to a financial crisis for banks or so...? Well, no. Unlike Iceland and the UK, the US is simply too big and too unconnected. Overall the US is a relatively closed economy. But even in the UK a fat reduction from ca. 70 Euro cent per pound to 90 Euro cent per pound, hardly any negative effects are visible.
<H1>The Nature of Currency Reserves</H1>
Many people think, that the Chinese gov't owns all those currency reserves. And in a way it is true, as the central bank has all those dollars. But what is not told is, that these dollars are initially earned by exporters. And they don't give those dollars for free to the Chinese central bank. They get Yuan in exchange for it.
Now, the whole purpose of keeping the Renminbi low is, to have an advantage at exporting. But if all those Yuan would circulate in China, there would be HUGE inflation, increasing labour costs and thereby killing the original effect. So to prevent this, the Chinese central bank has to keep those Yuan out of circulation. This is done by demanding reserve requirements, sterilisation bonds, etc.
The important point is, the Chinese central bank has not only assets - the dollar holdings - but as well a liability side, which is denominated in Renminbi.
So what happens, if the Chinese central bank sells all those dollars? Well, at that very moment, the Renminbi will dramatically revaluate against the dollar, PRODUCING A LARGE MISMATCH between assets and liabilities at the Chinese central bank. In other words, the central bank will be bankrupt.
Now some people will say, that this cannot happen, central banks can not go bankrupt with liabilities in their own currency. This is true technically, but the result is huge inflation. Given the fragile state of the social contract, this might well be the recipe for revolution. The Chinese Communist Party is supported by all those little and not so little businessmen, provincial politicians etc, that have profitted from the export and investment driven boom. If there assets are devalued, there central leadership risks their head pretty literally.
So why should the Obama administration feel the slightest bit threatened by the idea, that China might sell off dollar bonds? Even the little negative effects like higher import prices will not be blamed by the US population on Obama, but on the Chinese.