Thursday, July 21, 2005
cutting the cord
this is certainly a waymarker on the road to the decline of the dollar as the global reserve currency, but is not entirely a surprise -- market rumors that the chinese government had taken out a protective swap to neutralize some of their exposure to dollar holdings last month seemed to indicate the move was coming. and i'm sure there will be rejoicing in washington, where politicians are intent both on diverting blame for the current account deficit and treating its symptoms instead of its root causes. but this is not a healthy development for the united states.
the imbalances that have built up under the peg are truly monstrous -- china is the single largest buyer of american treasury debt, which it has used as a refuge for the immense quantities of dollars it imports as a result of its huge trade surplus with the united states. these dollar reserves are a result of an artificially cheap yuan making chinese products ultracompetitive in an american market in the midst of one of the wildest binges of overconsumption/savings depletion the western world has ever seen. in return for chinese goods, china has accumulated dollars, which it then has reinvested in american treasury debt.
as the yuan now floats higher against the dollar -- as it is widely expected to -- chinese imports will become more expensive in the united states, reducing the flow of dollars to china and thereby its ability and incentive to purchase american debt instruments. as chinese demand for american treasuries slacken, chances are good that american interest rates will rise.
it is key to understand that the american economy is different now than it has ever been before. americans largely don't save money themselves anymore, choosing instead to take advantage of low interest rates to borrow and live beyond their means. simultaneously, the public sector has quit all notion of fiscal responsibility. in the past, when the government ran a deficit for some period, it could sell its debt to private americans, who would use their savings to purchase bonds. now, having no private net savings to draw on, the government is forced to sell its debt overseas, and the effect has been to massively leverage the american economy -- making it extremely sensitive to movements in interest rates.
these points are highlighted in a concise foreign affairs article by brad setser and nouriel roubini that should be mandatory reading.
with america utterly dependent on foreign accumulators of dollars and buyers of debt to continue to stably finance american deficits, the reduction in chinese demand for american debt instruments may have profound effects here at home -- notably in the interest-rate-dependent housing bubble -- thereby sparking (possibly very intense) volatility in the american economy. and the damage may well have global symptoms -- in emerging market bonds, for example -- in this integrated world economy. indeed, america can be said to be in the process of defaulting on the most massive pile of debt ever accumulated, and the fallout from any accident will by noxious and widespread.
the consequences of this very large shift in the macroeconomic environment are probably unpredictable but may indeed be catastrophic. no one should be fooled into thinking that we are not on the cusp of a very great experiment which we are not in control of and do not fully understand. the immensity of american deficits and debt are exactly the kind of imbalances that can force economic crises upon a nation -- indeed, the global economy -- with frightening speed and incredible devastation, changing the place of nations in the world order.
UPDATE: several other se asian nations will follow suit. the economist notes that a slowing chinese economy may mitigate the potential rise in the yuan/renminbi by expanding its trade surplus with america for some time to come. wapo notes that rising surpluses despite a floating currency will confound and frustrate washington, possibly aggravating relations between china and an increasingly insecure american government.
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China also has a HUGE problem that is also facing the U.S. and other low-birthrate western nations, that of an aging population that will need to be supported by fewer and fewer workers. China's one child policy in the past ensured this problem. That doesnt exactly relate, but just an aside on China.
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