China and the Dollar, Thunder but no Rain

Only the suggestion that China could use its vast US dollar holdings to influence American policy managed to rival the dramatic developments in the capital markets for the attention of investors and the media. Of all the things that investors and policy makers have to worry about, China’s dollar holdings should keep any one up at night.

The facts are fairly straight forward. The latest official data indicates China have reserves worth about $1.33 trillion at the end of July. In May, the latest data provided by the US Treasury Dept (the June figures will be released 15 Aug) show that China has about $407 bln worth of US marketable Treasury notes and bonds. Meanwhile bills are making their way through the US Senate that would penalize China if it did not let its currency appreciate faster.

Two relatively junior Chinese officials put in words what others have contemplated. China’s dollar holdings give it significant leverage to influence US policy. Xia Bin, the head of finance at the Development Research Center (a government arm with cabinet status) suggested that China’s dollar reserves can be sued as a bargaining chip. Ha Fan, an official at the Chinese Academy of Social Sciences went as far as to suggest that China could, if it chose, set off a dollar collapse.

Some argued that since the stories appeared in government media that it was an official warning. Yet one does not have to be a Sinologist to appreciate that most of the media is owned and/or run by the government. Moreover, according to reports, Xia had stated explicitly that these were his personal views and not the view of the Development Research Center. And Ha said it was unlikely that China would sell dollars.

However, that US President Bush and Treasury Secretary Paulson found it necessary to comment on such suggestions (“foolhardy” and “absurd”, they said) may have given the junior Chinese officials more gravitas that they deserved. Nevertheless, it touched a raw nerve in the market. Reserve diversification and the related issue of sovereign wealth funds has been an under-current in the foreign exchange market for some time.

News that China actually was a net seller of Treasuries in April and May had already got the chins wagging. In those two months, China’s Treasury holdings fell by about $12.4 bln to $407.4 bln. In May 2006, China held $322.3 bln in US Treasuries, which means they have increased their holdings by more than 26% over the past year. Because of the nature of the data, it is not completely clear what China has really done. For example, if it bought Treasuries say from a German bank, the US data might not pick it up. Alternatively, China may have sold Treasuries and bought US agency paper or even maybe bought higher yielding dollar bonds from Germany’s triple-A-rated KfW.

Lastly, like other economic time series, there seems to be some noise in the data. For example, if there were some bonds that China was holding that were maturing and that it was waiting for a particular duration or price before re-investing, or if the proceeds of a maturing or sold bond were re-cycled into the bill market, the data would look the same and yet the implications completely different.

Yet there are good reasons to believe that China is not about to sell its Treasury holdings. First, if China felt itself a victim of illegal economic action from the US, it has shown a desire to use the conflict-resolution mechanisms of the World Trade Organization. It stands to gain more by trying to appear to be adhering to the multilateral rules.

Second China is such a large holder of dollars that if it were to try aggressively selling them it could potentially undermine the value of their remaining holdings. It would be difficult to sell them quickly. Estimates of the foreign exchange market’s turnover are upward of $2.5 trillion a day. And even if they were able to sell dollars, it is not clear what other market is big enough to absorb the flows. Already China’s reserve accumulation this year is larger than the new sovereign issuance in the US and Europe.

Third, China is a significant beneficiary of the international economy for which the dollar remains the numeraire. China’s economic prowess rests on two legs. The first is the domestic political and economic reforms, which includes attracting foreign investment and technology. The second is liberal international trade regime. The indiscriminate and disorderly liquidation of dollars and purchases of other currencies could disrupt the functioning of the international economy which has been vital to China’s growth and provided an element of social stability.

Play out the scenario. China is angry at what it perceives to be US protectionism, so it sells its Treasury holdings. If it is an effective retaliation US rates will rise sharply and weaken the US economy. Given the interdependency of the economies, a weaker US economy translates into less demand for Chinese goods. In democracies, government’s that oversee a recession frequently are voted out of office. Of course, China is not a democracy. Instead a recession there, which means less than say 5% growth, might trigger social unrest as rising expectations are not met. To mix metaphors, it would be cutting the nose to spite the face and risking killing the goose that has been laying the golden egg.

Yet it is not clear such a move would be effective. The US Treasury market and the larger dollar-denominated bond market are much larger than China. As we have been reminded in recent days, the Federal Reserve often buys Treasury securities from the market (via primary dealers) and the Federal government. It and/or the US Treasury could by Treasuries that Chine was to sell. Other countries and market participants would also likely absorb the selling from China.

Finally, on another level of analysis, the US, with a $14 trillion economy often has found it difficult to translate its economic might into political influence. For example, some of the biggest recipients of US aid often vote against the US at the United Nations. And it is not just the US that has trouble getting political leverage from its economic power. Other countries, like the UK, France, and Japan face similar challenges. There is no reason to expect China to have any better luck.

The text book case of the US successfully using its economic strength to influence a country’s foreign policy was in the Suez Crisis in 1956. Recall that in retaliation for the US and UK reneging on an offer to build the Aswan Dam, Egypt nationalized the Suez Canal. Israel, which was still technically at war with Egypt since 1948, France, who was challenged by Egypt in Algeria, and the Britain, who had been operating the Suez Canal and depended on the canal for its oil, invaded. The US (and Soviet Union) opposed the invasion.

The UK at the time was running a current account surplus but the pound, fixed under Bretton Woods at $2.80 was under pressure and its reserves were running low. It sought US assistance in supporting the pound and want to a relatively large IMF aid package. According to historical accounts then-President Eisenhower threatened to sell the pound in the foreign exchange market and deny the UK IMF assistance. The UK capitulated and, well the rest is history.

Yet this seems episode seems to be exceptional. The UK has specific policy objectives (protecting its reserves and the pound) that the US was in a position to block. China does not appear to be in such a position today. The UK (and France) was reconciling themselves to a new role in the world post-WWII. The development of the US and global capital markets makes it difficult to envisage a country successfully trying to use those markets against to the detriment of the US.

In the final analysis, China has bought US dollars and US Treasuries not out of altruism or to do the US some kind of favor. Rather Chinese officials recognize it to be in their interest. China has done more to support a strong dollar policy, arguably than the US, which has not bought dollars since 1995.