Brad Setser Asks a Question

From Brad Setser:

RGE - A little too late ...: China's premier,  Wen Jiabao, has joined the chorus voicing concern about the dollar's recent weakness.   Cheng Siwei comments two weeks ago seem to reflect rather widespread worries among China's top leadership.  The FT reports:

Premier Wen Jiabao told a business audience in Singapore it was becoming difficult to manage China’s $1,430bn foreign exchange reserves, saying that their value was under unprecedented pressure. “We have never been experiencing such big pressure,” Mr Wen said, according to Reuters. “We are worried about how to preserve the value of our reserves.” China keeps the currency composition of its reserves a state secret, but some analysts believe that more than two-thirds are probably still held in dollars.

Wen certainly has reason to worry.   No one has made a bigger bet on the dollar that China's government.   I personally suspect that China's state -- counting the assets of the State Administration of Foreign Exchange, the China investment corporation, China's big state banks and the national social security fund -- hold around $1.2 trillion in fairly long-term dollar-denominated debt.... The capital loss on those dollars could be considerable.   The dollar hasn't held its purchasing power relative to the euro, or relative to oil.  But what should really worry China's leadership is that the dollar is very unlikely to hold its value relative to the RMB.   After all, China's government has financed its dollar purchases by issuing RMB debt.... Moreover, the Hu/ Wen policy of only allowing gradual RMB appreciation -- out of fear that fast appreciation would be disruptive -- largely explains why China now holds so many dollars.   Back at the end of 2004, China's total reserves were only around $600b ($650b counting Huiijin) and the state banks held a lot less long-term dollar debt.  China's total dollar holdings were more like $450-550b.  

The majority of China's dollar exposure comes from intervention over the last three years.

That puts Wen in a bit of a bind.  

His comments were no doubt intended to tell Washington that it need to start paying more attention to the value of the dollar. Yet domestic US conditions likely call for the Fed to cut rates to support the US economy, not raise them to defend the dollar.... [T]he "arithmetic" doesn't suggest that dollar weakness will contribute that much to inflation.... Wen cannot force the US to direct its policy at defending the dollar's external value anymore than the US can force China to stop intervening in the foreign exchange market. He could, of course, conclude that China can no longer take the risk of holding so much of its wealth in dollars, and stop adding to China's dollar portfolio. But doing so would truly cause the dollar's value to tumble....

Willem Buiter is worried about a scenario where foreign demand for all US bonds -- not just demand for CDOs and riskier bonds -- disappears. He writes: "all the ingredients for a bond-run are in place, and at some point in the near future, the gradual sale of dollar-denominated securities will become a flood." And, as Menzie Chinn notes, the US hasn't locked in low interest rates in dollars forever.  What if the US turns out to be borrowing at what amounts to a low initial teaser rate?...

The answer to Brad Setser's question is: as long as the U.S.'s external liabilities are still denominated in dollars--as long as New York hasn't sold lots of dollar puts--it is our currency, but it is their problem.

Comments

[shah8]

I will contradict you with something simpler, converted from a phrase about orphans:

Liabilities are fungible.

[Barkley Rosser]

Well, I shall throw something in here that has not been mentioned much. The entire global exchange rate structure looks badly out of kilter in several ways. In particular, while the various Asian currencies have been held by skim and by scam not to go up too much against the dollar (particularly the yen and the yuan/rmb), the euro, the loony, and the pound sterling have soared high, probably too high relative to ppp against the dollar, and especially too high against the major Asian currencies. There are massive shifts of trade going on in Europe, and a lot of screaming in the closets and the factories is going on as the Chinese imports are surging in, which may not be viewed as a problem in Beijing, but certainly is in many capitals in Europe. Many may be crowing about the rise of the euro, but they are increasingly not doing so in Europe itself, with Sarkozy berating the ECB for not moving the euro down globally to preserve European jobs.

So, expect the euro to go down eventually against at least the yen and the yuan/rmb, if not necessarily the dollar, along with the loony and the pound, but expect the yen and the yuan/rmb to go up aainst the dollar. How this is done, especially in the face of the cessation of long-term private fdi inflows into the US, documented graphically by Brad Setser, well, we can all hold our collective breaths.

[bigTom]

If you owe the bank a million dollars you are in serious debt. If you owe the bank a billion, you own the bank. When you owe the bank a trillion who owns whom?

[Kien Choong]

While a US dollar devaluation means the Chinese government's investments suffers a loss, will the balance sheet for China as a whole improve since assets in China are now worth more (in US dollars) and therefore Chinese consumers are better off?

So while the Chinese government will make a financial loss, should the Chinese government really fear a devaluation of the US dollar? If the devaluation makes China as a whole better off, isn't that a good thing?

[Matt]

"it is our currency, but it is their problem"

When an economic agent holds more dollars then needed to cover production volatility over the longest outlook period, then there might just be a natural rate of decay in the unspent reserves, just might.

For one thing, when we retool out industries, we tend to forget that some of the old capital stock was held in reserve for potential Chinese demands. The natural decay rate should be measured in inflation.

On a lighter note, the last time I worked for a Chinaman was as a Chinese food delivery boy. I would be glad to go work for them again, but, would they please fix the penalty phase in the social security yield curve, that would help get me off my ass.

[theeconomicfractalist]

US Debt and Reciprocal Money Expansion

This holiday will see a 300 billion or so US dollar increase in the American (and global) economy - a good percentage of those billions as credit card debt. Whether it is deficit spending for the Iraqi oil fields from the empty US social security lock box, buying holiday Chinese Snow Baby eqivalents on credit cards against personal future earnings, or too good to be true deals on 500,000 dollar homes unsupportable by American wage and cost of living inflation realities- deficit spending against furure earnings and tax collections - will temporarily, very temporariy at this point - push the economy on a very overstretched long string and likewise temporarily expand the money supply. The summation money and credit growth is exactly reflected in the daily growth and decay quantum valuation fractals and the summation of the evolving quantum fractal patterns of competing debt, equity, and commodity investment entities. Even the currencies follow the precise fractal growth and decay patterns found in The Economic Fractalist' relative to each other's valuations. The recent fractally predicted change in the valuational direction of the dollar - on the new blog 'Lammert' - against other world currencies is both a currency fractal saturation phenomena and can be qualitatively explained by the fact that most of the world's debt is denominated in US dollars. The fractal saturation area of the Swiss Franc, Euro, and British pound is timed precisely when massive repayment is being called due by lenders and those indebted must sell other currency holdings (and gold) to gain dollars to repay that debt. The non US currency saturation area is also timed with the 11-14 week area of equity devolution - after which the dollar will have much more equity purchasing power. For the composite equities lowly New Century holds the secret of devolution. Observe the evolving New Century fractal pattern. On 30 November New Century closed down over 16 percent at 2 pennies even. (Both the 19 July 2007 and 11 October 2007 Wilshire highs were precisely predicted by saturation quantum fractal analysis.)

[walkingtheline]

Wen Jiabao has a reputation as a decent man, but he is also a relatively weak government figure. This one speech means nothing.

That being said, I hope everyone here is boning up on their mandarin. China will spend its foreign reserves on oil.

[J Thomas]

"When you owe the bank $10,000 and you can't repay it, you have a problem. When you owe the bank a million dollars and you can't repay it, the *bank* has a problem."

Will that bank lend you another million dollars?

If your credit rating will collapse unless somebody lends you another million dollars, will the bank lend it to you? How are they better off if you owe them 2 million dollars you can't repay?

Our debt to them has more than doubled in 3 years. Wil they let it double again in the next 6 years?

Suppose that they let the dollar collapse, and china puts out a lot of renminbis to serve as a substitute world currency. Is there some better way for them to salvage the situation for themselves? They get at least some of the advantages of controlling the world currency. They can't get their money back from us, but at least they get dollars on a par with USSR rubles.

Why shouldn't they cut their losses, when the alternative is to pour more good money into the USA rathole?

[not_scottbot]

'...it is our currency, but it is their problem.'

No it isn't - the world will simply walk away from the dollar as de facto world reserve currency, and then we will discover how much tangible benefit that intangible fact actually meant to us, including the luxury to have the arrogance to repeat such a stupidly trite expression.

Anf though no one knows how the euro will work out over the long term, there is no doubt that a major faction of European euro supporters have their eyes firmly fixed over decades on basking in some of the dollar's advantages as an international reserve currency.

[anne]

Shah, please explain a little.

"Liabilities are fungible." I agree, but what am I to learn from this in relation to Brad DeLong's response?

[anne]

Also, Shah, are orphans fungible? I must look into the possibility of fungible orphans but initially I am doubtful.

[anne]

"Since money is fungible, they often use it to pay for more martyrs, thus creating more widows and orphans."

Ah, I understand, but I do not understand Shah's reference to liabilites being as fungible as orphans.

[Doctor Jay]

You know, this talk of "walking away from the dollar as the worlds reserve currency" doesn't really scare me very much.

It's easy to see that lots of other people in the world would be better off without it. That was George Soros thesis in "The Bubble of American Supremacy". I contend that we as a country would be better off without it. It's a form of subtle subsidy, and feeds our myopia and isolationism.

The weakness of the dollar has as one of its primary components the policy of the Chinese government, led by figures such as Wen Jiabao. Now they want the US government to do what's good for them rather than what's good for the US economy. Suppose they sell off and buy oil. That will hurt. It will raise our interest rates, and the price of oil, too, probably.

But the consequences of that domestically would lead to adjustments in the US economy that I think would be beneficial. A weak dollar will probably mean more jobs at home, rather than buying Chinese made stuff. It's got to be good in Silicon Valley, too, where I live, since it would likely mean less outsourcing to India.

Will it mean some of the electronics manufacturing will come back to the US from China? It might, or it might go to Mexico. Both of those outcomes are good, in my opinion.

[J Thomas]

Doctor Jay, I fully agree that in the long run we'd be better off without the US dollar as a reserve currency that we can manipulate, and without china artificially keeping the dollar high.

My immediate concern is the dynamic effects.

Here's a vaguely-related example that may show the problem -- back when banks in the USA were unregulated, one bank might gradually increase its supply of another bank's obligations. In the short run that was good for the bank that didn't have to pay its obligations -- they could make better use of their money when somebody didn't require them to pay their debts. But then one day the first banker walks into the second bank and demands all his money at once. The second bank has barely enough reserves on hand to pay. The first bank spreads the rumor that the second bank is not sound and starts a run on the bank. When lots of depositors want their money right away the second bank goes bankrupt. It's easier for them to plan when their obligations are presented promptly and taken care of, even though they make a better short-run profit without that. But what's better for them is the stable situation, not the run on their bank. The first bank would make more money in the short run if they called in their debts gradually rather than drive the second bank to bankruptcy and likely have many of those debts go unpaid. But they might feel they're better off without that second bank competing....

China has given us cheap imports, and in the short run that's good for us. In the process they have collected a lot of our debts and not cashed them in. If they choose to cash a lot at once and cause a run on the dollar, we could be hurt very badly. What if, in the short run, we couldn't pay for oil imports? Would Silicon Valley be better off?

We're better off when we do more of our own work instead of importing so much stuff. But if we get a big shock that makes it hard for us to import anything, how will we build the industries to make the stuff we can't import? We might spend some time doing without. We might find ourselves depending on solvent foreign companies to build industry here -- they pay us wages to work in their factories and the profits go overseas, and how long would it take us to change that around?

I hope I'm overstating the case a lot, but I want to make it clear why it's an issue. Were you around for the oil shocks? I talked to a guy who was a hardware clerk back then. All of a sudden when he put in an order for glass the shipment would come in and it would have half what he ordered, or nothing. Or sometimes instead of his order they'd ship him something they happened to have. And the prices were crazy, you ordered something and there was no telling what the price would be by the time it arrived, if it arrived. It was like being in the USSR. That was from a mild oil shock. But if oil exporters aren't convinced we can actually pay for their product, we'd have a big oil shock. Ideally you'd find a way to profit from whatever economic situation comes up, but it's hard to do a good job of filling your economic niche when the gas stations are often out of gasoline and prices are increasing erraticly. You try to do some simple task like drive to work and you have to drive around looking for a gas station that's open because you're down to half a tank, and you get there and wait in a long line, and for most of us this isn't productive time. But you just don't know what to predict. Go to a Waffle House and they don't have any eggs. Not that eggs are too expensive, it's that they ran out and they can't get more. You try to buy some blank DVDs and there aren't any. You buy some blank CD-ROMs and two days later people are telling you they tried to buy those and there weren't any. People pass you stuff on memory sticks, on 4X CD-ROMs, on floppy discs! You pass lots of stuff over the internet, but it's turned slow and also you're suffering from brown-outs. At work your elite company has its own generators and it buys expensive black-market diesel to run them, and they put lots of memos on the intranet telling you to turn off your lights etc.

We need a better world currency regime. We sure don't need what the chinese are likely to do to us while they prove we're an ex-superpower.

[shah8]

Well, I wanted to KISS...

I was trying for an ultra short way of saying that all value stores have a basis in contextual values. Most of these contextual values are as opaquely handleable as animal spirits.

Failure is an orphan. Failure is the sound of one hand clapping. Success has many parents, many who had a role. Failure though, like elderly orphan children, must be forcibly handed to designated loser(s). The U.S. is not in the position to smoothly guarantee a bagholder.

Overtly, yes, Paulson could tell Wen, that it is their problem. However, it is very much akin to someone suggesting that we boycott all Cuban sugar, or Iranian oil. There wouldn't be a point so long as other nations are willing purchase Cuban sugar and Iranian oil, and allow us to buy sugar and oil that is freed up of demand.

It's the same with dollars. What will happen is that liabilities inherent in the system will try to match up absent any concious will. It's a variation of Gresham's Law. Liabilities are *always* hedgeable! There are a bazillion ways to hedge a dollar being inflated away, and one kind of risk, or oil, or sugar, is as good as, in its way, as another.

What makes the current system possible is a lack of tolerance for certain kinds of innovation. Some innovation in things like CDOs and weirdo derivatives is permitted, and other innovations, such as those that hedge dollar liabilities are discouraged or is explicitly unsupported by financial systems. Thus, by limiting possible demand for those product to boutique shop levels, it is possible to limit China's alternatives for large-scale hedging of their dollar reserves.

This is the thing. Brad Delong is mistaken about the source of control. It's not in having all our liabilities being denominated in dollars, it's in having the kind of massive soft power through stabilizing norms in financial markets. This kind of soft power goes away though, when one explicitly relies on it, because it depends on consensus (as any boycott would), which would dissipate when one partner feels enough taken advantage of.

As a coda, I say look to Nixon in the years leading to the removal of the gold standard. I would also point to Nixon doing the crazy dance and thinking that acting crazy works, when in reality everybody thought he was getting a *little* unhinged.

[piotr]

"US dollar as a reserve currency that we can manipulate, and without china artificially keeping the dollar high."

Here is a question: China indeed "manipulates", because for the last three years it massively buys dollars, effectively financing its trade surpluss. What is OUR manipulation? As far as I can tell, we keep interest rates lower than for Euro. But is it OUR manipulation, or CHINESE?

If Chinese would "bite the bullet", the auctions of US bonds, bills and notes would have quite different results, regardless of Fed rates, unless Fed would start to effectively print money, and that could be seriously inflationary. The question is why Chinese and Japanese do not.

China in particular has banking system that would have to be "saved" because they have rienminbi liabilities and dollar assets. Perhaps the same is true for Japan and the other "tigers". But if they can artificially create demand for ca. 400 billion USDs per year, they should be able to artificially prop their banks when their currency appreciates, say, by 30%. It seems that they play with billions as if it were Monopoly money.

By the way, shah8, who can insure a trillion dollars in liabilities? How can a central bank hedge the currency it controls? Perhaps Tokyo can buy rienminbi puts and Beijing can buy yen puts (are should they be calls, my head is swimming)? Then Tokyo stops massive purchases of dollars, yen goes up and the less valuable dollars are converted to yens at the previous rate using puts (calls?) issued by Beijing, and Chinese banks balance their books in the same way?

I mean, who would be the smart guy to insure a central bank against a possible policy of that bank?

Suppose that Saudi Arabia and Russia would start buying oil puts to insure themselves against the eventuality that they sharply curtail exports. Would you sell it to them? Why not. But would you issue a new put, a "naked option", in such circumstances? And if your options are covered, that means that you have as much oil as they do, because you are ... well, who are you, shah8?

[wood turtle]

It will be much better for us, I think, if we can buy our own debt. I do think that there should be some development for a world currency.

[J Thomas]

Wood, yes, if it comes to the crunch we will buy our own debt. But what will we pay for it? We could sell the sequoyah forests, and sell Yellowstone. We can sell our wheat and oil at firesale prices. We can sell them lots of real estate and rent it back from them. We can sell them farmland and they can pay us to farm it for them.

There are lots of ways for a bankrupt nation to pay off; the world bank and IMF have investigated various of them. Most of them even leave the super-rich locals still rich.