Brad Setser Asks a Question
From Brad Setser:
RGE - A little too late ...: China's premier, Wen Jiabao, has joined the chorus voicing concern about the dollar's recent weakness. Cheng Siwei comments two weeks ago seem to reflect rather widespread worries among China's top leadership. The FT reports:
Premier Wen Jiabao told a business audience in Singapore it was becoming difficult to manage China’s $1,430bn foreign exchange reserves, saying that their value was under unprecedented pressure. “We have never been experiencing such big pressure,” Mr Wen said, according to Reuters. “We are worried about how to preserve the value of our reserves.” China keeps the currency composition of its reserves a state secret, but some analysts believe that more than two-thirds are probably still held in dollars.
Wen certainly has reason to worry. No one has made a bigger bet on the dollar that China's government. I personally suspect that China's state -- counting the assets of the State Administration of Foreign Exchange, the China investment corporation, China's big state banks and the national social security fund -- hold around $1.2 trillion in fairly long-term dollar-denominated debt.... The capital loss on those dollars could be considerable. The dollar hasn't held its purchasing power relative to the euro, or relative to oil. But what should really worry China's leadership is that the dollar is very unlikely to hold its value relative to the RMB. After all, China's government has financed its dollar purchases by issuing RMB debt.... Moreover, the Hu/ Wen policy of only allowing gradual RMB appreciation -- out of fear that fast appreciation would be disruptive -- largely explains why China now holds so many dollars. Back at the end of 2004, China's total reserves were only around $600b ($650b counting Huiijin) and the state banks held a lot less long-term dollar debt. China's total dollar holdings were more like $450-550b.
The majority of China's dollar exposure comes from intervention over the last three years.
That puts Wen in a bit of a bind.
His comments were no doubt intended to tell Washington that it need to start paying more attention to the value of the dollar. Yet domestic US conditions likely call for the Fed to cut rates to support the US economy, not raise them to defend the dollar.... [T]he "arithmetic" doesn't suggest that dollar weakness will contribute that much to inflation.... Wen cannot force the US to direct its policy at defending the dollar's external value anymore than the US can force China to stop intervening in the foreign exchange market. He could, of course, conclude that China can no longer take the risk of holding so much of its wealth in dollars, and stop adding to China's dollar portfolio. But doing so would truly cause the dollar's value to tumble....
Willem Buiter is worried about a scenario where foreign demand for all US bonds -- not just demand for CDOs and riskier bonds -- disappears. He writes: "all the ingredients for a bond-run are in place, and at some point in the near future, the gradual sale of dollar-denominated securities will become a flood." And, as Menzie Chinn notes, the US hasn't locked in low interest rates in dollars forever. What if the US turns out to be borrowing at what amounts to a low initial teaser rate?...
The answer to Brad Setser's question is: as long as the U.S.'s external liabilities are still denominated in dollars--as long as New York hasn't sold lots of dollar puts--it is our currency, but it is their problem.
