[R-G] [BillTottenWeblog] China's empty threat

[Bill Totten]

If Wen Jiabao stops buying US debt, China's currency will rise - which
is what America has wanted all along

by Dean Baker

guardian.co.uk (March 30 2009)


When China's prime minister, Wen Jiabao, expressed concern about the
ability of the US government to repay its bonds, his comments prompted
headlines everywhere. The newspapers were filled with gloomy warnings
that China may no longer be willing to buy up US debt, which supposedly
would have dire consequences for us all.

Unfortunately, too little thought was given to what these "dire
consequences" might be, and who would end up suffering them. Suppose
that China stops buying US government debt. That would mean that the
dollar would plummet in value against the yuan. Chinese imports would
suddenly become much more expensive for consumers in the United States,
making domestically produced items far more competitive.

The opposite would happen in China. Goods and services made in the
United States would suddenly be much cheaper. As a result, we would
expect to export much more to China, and see many more Chinese come to
the United States as tourists or for business purposes. The reduction in
imports from China and the increase in exports would substantially
improve our balance of trade.

In other words, if Wen was threatening to stop buying dollar-denominated
assets and therefore let the yuan rise against the dollar, he was
threatening to do exactly what the US government has been demanding that
China do. He will stop "manipulating" China's currency - meaning he will
stop deliberately intervening in the market to keep the yuan's value
from rising.

There is an alternative interpretation of Wen's threat. Perhaps he will
stop buying long-term government bonds, but continue to buy short-term
debt. This will have some impact on raising long-term interest rates in
the United States, but it hardly provides a basis for panic.

The reason that Wen's threat should not be serious cause for concern is
that if we want to keep long-term interest rates low, we already have a
mechanism: it's called the Federal Reserve Board. Just last week Federal
Reserve chairman Ben Bernanke announced that he was going to buy up more
than $1 trillion in long-term government or agency (Fannie Mae and
Freddie Mac) bonds over the next several months. This purchase far
exceeds any possible purchases of long bonds by the Chinese. If Wen
pulls out of the market, Bernanke can simply increase his purchases to
offset the lost demand.

Does this policy risk inflation? Actually, the Chinese purchase of
Treasury bills and the Fed's buying up the long-term bonds would have
the same impact on inflation. It really doesn't matter whether the
Chinese government or the Fed is buying bonds to hold down the long-term
interest rate - the impact on the inflation rate will be the same. Of
course in a period where there are serious concerns about deflation, a
modest increase in the inflation rate would be a good thing.

There is one other irony about Wen's threat that is worth noting. In
2004, Alan Greenspan began to raise short-term interest rates. He
expressed surprise that long-term interest rates stayed constant or even
fell slightly. He described this as a "conundrum".

There was actually nothing mysterious about the situation at all. As
Greenspan was acting to raise short-term interest rates, the Chinese and
other foreign central banks were intervening directly in the long-term
market, buying up long-term bonds in order to keep long-term interests
down. Did Greenspan fail to recognise the impact of the Chinese
intervention in the same way that he managed to miss an $8 trillion
housing bubble?

In short, Wen has nothing with which to threaten the United States. He
is proposing to do something that Congress and the Bush and Obama
administrations have all urged him to do: stop propping up the value of
the dollar against the yuan.

This will lead to an adjustment process involving some pain on both
sides. In China's case, the reduction in exports to the United States
will require increasing the size of its domestic market, or at least
finding alternative destinations for its exports. In the case of the
United States, we will have to pay more for our imports, which will mean
some increase in the rate of inflation and, in the short term, a modest
decline in our standard of living.

But we always knew that China would not subsidise its exports to the
United States forever. It would have been better for us if they had
stopped a decade ago, before we developed a huge trade imbalance and
developed a housing bubble-led growth path. Still, better late than
never. Wen has made a promise, not a threat - and we should encourage
him to follow through on it.

guardian.co.uk (c) Guardian News and Media Limited 2009

http://www.guardian.co.uk/commentisfree/cifamerica/2009/mar/30/us-economy-china-debt?commentpage=1

QUESTIONS:

Dean Baker's comment's refer only to relations between the United States
and China. But as
http://www.moneymorning.com/images2/foreigncreditors.GIF shows, various
nations hold more three trillion dollars of US Treasury Bonds,
denominated in US dollars. Japan holds 626 billion dollars of those
bonds. All would lose severely from any significant devaluation of the
US dollar vis-a-vis their own currencies.

Wouldn't those losses cripple the credibility of the US dollar and the
US's ability to make up for its paucity of saving and taxation by
borrowing from foreigners?

Would those losses spark a worldwide run on the US dollar?

Bill Totten


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