China Flexes Its Monetary Muscles

We all know that the US dollar has traditionally served as a world reserve currency as also a hedge in times of economic uncertainty. For China, the US dollar has also served as a major investment destination in the form of US treasuries. The trade surplus created by an export led boom generated billions of dollars for the Chinese economy, while the biggest importer of its products, the US saw a sweeping increase in its current account deficit. Theoretically, the value of the US dollar should have depreciated with an accumulating current account deficit as a high deficit indicates higher demand for foreign currency for imports. However, a two fold process helped keep the dollar propped up. Firstly, the US does not need to buy foreign currency to pay for its imports as a majority of international trade is dollar denominated. Secondly, China has been pumping back billions of dollars of its trade surplus into US treasuries propping the demand for the dollar and financing the nation’s current account deficit. This uneasy relationship also kept the US dollar high and the Chinese Yuan artificially low, making Chinese exports to the US cheap and accelerating the process of Chinese purchase of US treasuries via an accelerated accumulation of a trade surplus. It has been estimated that China holds close to $ 1.9 trillion in US government paper.

Now, with the global economy passing through a rough phase, and the US dollar showing signs of weakness, it appears that the Chinese are getting shaky about the value of their holdings in US treasuries. It may also be noted that the Chinese economy is one of the only few economies that continues to have a positive growth rate, which implies that it will continue to have surplus dollars to invest in instruments like US treasuries. This also gives China the economic clout to assert its monetary prowess like few other nations at this point of time. The other big investor in US treasuries, Japan is reeling under the weight of a contracting economy.  

In line with its new found prowess, China asserted that though it will continue to buy US treasuries in support of the US dollar, the Special Drawing Rights (SDR), a currency of the International Monetary Fund (IMF), should get a greater boost and be used increasingly as a reserve currency. According to the Chinese central bank governor, Zahou Xiaochuan the role of the IMF currency needs to be enhanced as the US dollar has been leading to frequent crises since the collapse of Bretton Woods in 1971. The SDR can be positioned as a super sovereign currency and be used to manage global liquidity. According to Zahou, this can help reduce the risk involved with dependence on sovereign currencies, which cause global repercussions, with a change in national monetary policies. Zahou also stated that China will continue to buy US treasuries, but will also consider buying bonds of the IMF, which can be targeted towards financing global recovery. It is evident that China cannot make a sudden withdrawal from US treasuries as that step can cause the US dollar to drop sharply. Such a drop will reduce the value of current Chinese US treasury holdings and impact the national savings of China.

In any case, whether the SDR finds a new status or not, the Chinese Yuan needs to adjust its value upwards in relation to the US dollar due to the massive trade surplus China holds. This is likely to devalue the huge Chinese holding in US treasuries in Yuan terms, something that China wants to avoid. China has kept its currency artificially undervalued far too long and it may be time for that correction to take place. Such an adjustment will also make Chinese exports less competitive and hamper the heated growth that the Chinese economy has experienced. But it may be time for China to let go and allow the invisible hand of Adam Smith to find a new equilibrium.