What is at stake for China?

Currency Wars follows the actions of governments and central banks to manipulate their currencies and currency denominated securities to their advantage and to the disadvantages of foreign markets. At the present day the focus will be on China and the United States, as China has expressed concerns about the safety and reliability of the US dollar.

 

America has dominated the global financial system ever since July of 1944. During this period, the financial leaders of the western world met in Bretton Woods, New Hampshire, to redesign the financial system in order to mitigate the economic stress that was rampant during the interwar period. This conference saw the creation of the International Monetary Fund, and set the US Dollar as the world’s reserve currency, which foreign governments would hold in their foreign exchange reserves, to use for international transactions. At that time, choosing the Dollar was the obvious choice. Emerging from World War II relatively unscathed, the United States was stronger than ever before. Its currency was stable and reliable. Its economy was a literal powerhouse. The following 20 years would be marked as the golden age of capitalism. The system underwent a few revisions, the most significant of which occurred when the United States went off the gold standard in 1971. However, after the 2008 financial crisis, the system has come under scrutiny by emerging market economies that are worried about the safety of their fragile markets. Spearheading this movement is The Peoples Republic of China, which has been expressing its concerns about the stability of the Bretton woods system and the US Dollar[1]. 

 

China has valid reason to voice these concerns. Since the early 2000’s, with high military spending and low taxes, the US Dollar has experienced a steady decline in value[2]. This has led investors and foreign governments alike to scramble and find other places to invest their money, mainly other emerging markets. Although the situation isn’t necessarily dire, it is definitely worrying to emerging markets such as China.

 

What would happen if China started to decrease its exposure to the United States? China has a very large stake in dollar denominated securities, so by quickly dumping all of their US Bond holdings would hurt the Chinese economy just as much, if not more than, the US economy. Any drastic measures such as this would wreak havoc on the global financial system, which is clearly an outcome nobody wants. China’s best bet is weaning itself off of the Dollar and Dollar-denominated assets, such as US ten-year treasury bonds. Although this approach will take a long time, it will mitigate the damage a drastic fire sale would cause. In fact, China is already engaging in this steady sell-off. In December 2013, China reduced US Bond holdings by the largest amount since 2011[3], following a Federal Reserve announcement that it would reduce asset purchases. However, it is important to note that a drastic sale of dollar denominated assets will disrupt the highly liquid market of the United States, making it difficult for China to unwind its holdings at a preferable pace.

           

If China begins to decrease its exposure to the Dollar, The United States would be pressured to react to limit its exposure as much as possible to China. This of course would be a difficult task to achieve. China is the United States’ largest creditor, losing this creditor would be a fiscal disaster. Regardless, the United States government would be pressured to enact a tariff barrier to prevent the flow of Chinese imports into the country. Subsequently, China will be cut off from the largest consumer driven economy in the world.

 

It is clear by now that there is too much at stake for both parties for them to engage in a trade war. China has been a very valuable trading partner for the United States and vice versa. Although the US dollar is weakening, it is not weakening at a rate high enough to warrant a drastic action. It is still the world’s reserve currency. 85% of global foreign exchange transactions are made in dollars. 80% of all over the counter foreign exchange transactions involving the Yuan are trades made for dollars[4]. It would simply be an impossible feat to change this overnight.

 

With that being said, China’s concerns about the strength of the dollar are not unfounded. The problem lies with China’s course of action. How will China be able to reduce its exposure to the dollar and dollar denominated securities without seriously crippling itself and the global economy? For now, the only viable course of action is for the Federal Reserve to strengthen the dollar by enacting a monetary policy that can achieve that.