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| A V Rajwade: Chinese checkers | | Diversifying China's reserves away from the dollar could threaten both its own growth as well as that of the world |
| A V Rajwade / New Delhi May 18, 2009, 00:10 IST |
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Diversifying China's reserves away from the dollar could threaten both its own growth as well as that of the world.
In the last article, I had raised an issue without discussing it: Restructuring of the dollar reserves by China “would involve converting a portion of the US debt (present? future?) into say SDRs, the reserve asset preferred by the Chinese.” As for the future, the Chinese can themselves place the accretion to reserves into four currencies — the US dollar, the euro, the yen and the British pound, in proportion to their weight in the SDR basket — thereby effectively converting its reserves into SDR. The key problem of course is about the present holdings.
Fred Bergsten, director, Peterson Institute for International Economics, Washington, DC has suggested the following mechanism: “A substitution account at the IMF into which China and other countries could deposit their dollars for Special Drawing Rights (SDRs). The transactions would be completely off-market and thus avoid the exchange rate consequences of Chinese currency diversification that could otherwise be extremely uncomfortable to the United States and the euro area. This would be a much more modest step than replacing dollars with SDRs as the global key currency.” (The Economist, May 9th). He is right about the latter two points he makes — the consequences of a significant re-structuring of China’s reserves into other currencies through the market, and the difficulties in getting SDR generally accepted as a global reserve currency, discussed in my last article.
As for diversification of China’s existing reserves through the market, this would involve a significant sell-off of dollar securities, and using the resultant dollars to buy euros/yen/pounds. This would clearly lead to a sharp steepening of the dollar yield curve, and a general hike in US interest rates, which the still nascent recovery can hardly afford. The second consequence would be a sharp appreciation of the other currencies against the dollar, which would hurt those countries’ economic recovery as well. Clearly, China’s diversification could not only lead to huge translation losses for the Chinese themselves, but also threatens to nip the global economic recovery in the bud (or in its “green shoots”?). On the other hand, if the Chinese are thinking of a major diversification of existing reserves, now is probably a very good time. The drop in interest rates means the prices of existing bonds have gone up, and the dollar still remains surprisingly strong against the euro and the pound.
Bergsten’s suggestion about a substitution account with the IMF, however, has a major question mark. One imagines that, for implementing the proposal, China would “sell” US treasury securities in its reserves to the IMF and be credited with equivalent SDRs. The question is: Who takes the exchange risk on the exchange rate between the dollar and the SDR? Should the dollar fall against the other currencies in the SDR basket after the “swap”, the IMF will have a huge gap between its assets and liabilities. And, it just does not have the financial strength needed to take the risk. Theoretically, the IMF could ask one of the surplus countries to take the SDRs and sell its home currency against this. However, this does not seem feasible, given the scale on which the transaction requires to be done for reducing the global supply of dollars in reserves.
One alternative would be for the central banks of the four major currencies to guarantee to the IMF the exchange rate between the dollar and the SDR: A corollary would be to agree to narrow fluctuation bands between the four major currencies. But managed exchange rates are a sin to market fundamentalists — they describe managed exchange rates as currency manipulation. And, at least the US and UK have for long been wedded to the virtues of market-determined exchange rates — and perhaps remain so despite the dangers of unregulated financial markets manifested in the recent past.
But such issues apart, the basic financial health of the US government is getting even weaker. The outstanding debt is $11 trillion (80 per cent of GDP). Add to that the off-balance sheet liabilities, primarily old-age pensions, estimated at $45 trillion. The current year’s fiscal deficit is estimated at $1.8 trillion, with every prospect of massive continued deficits: President Obama hopes to halve it by the last year of his presidency — assuming of course that all goes well!
A couple of years back, Moody’s, the rating company, had warned that the fiscal imbalances and off-balance sheet liabilities threaten the US’ AAA rating. The overall situation has weakened significantly since then — and is reflected in the increase in spreads in credit default swaps on US Treasury securities.
To come back to the dollar’s external value, to my mind, the biggest single threat is the reserves policy of countries like China, Japan, Saudi Arabia, Russia, Kuwait etc. What an irony that the currency of the sole superpower is hostage to the actions of countries (other than Japan) whose political systems the US, that champion of democracy, hardly likes!
One can only hope that whatever adjustment is needed, takes place without disrupting the global economy already in recession.
avrajwade@gmail.com
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