The Gold Standard  

Geoff Dyer of the FT raises some questions on whether the Renminbi is really ready to become an international currency. I doubt if China desires that outcome any time in the near future. For now, it is just in a desperate mode about the US dollar and is trying to camouflage it with some bravado. So, all these concrete questions are not even on the table].

It is this make-believe ‘bravado’ that is neatly exposed by Harvard’s Arvind Subramanian  (AS). His is probably the best of the recent comments I read on China. This article was posted in Wall Street Journal’s Real Time Economics blog. That is a pity. It should have received publicity. It is far better than many of the ‘heavyweights’ that Brad Setser lists as having commented on this topic.  

Professor AS says that China had its cake and wants to eat it too now. It pursued a deliberate mercantilist strategy and now wants to avoid paying the price for it. He gets it precisely right. He calls both the US and China ‘Siamese twins’.

That brings us to the final article on this topic and that too in FT. The title, China stuck in a ‘dollar trap’ says it all. In fact, the article almost sounds like a response to the FT news item on Brazil and China working to ‘axe the dollar’.

From an international trade perspective, a weak dollar helps China as the Chinese currency is pegged to the US dollar. Therefore, weak dollar = weak yuan and hence better for exports, all else being equal.

All else are not equal. There is no demand in the importing countries. So, a weak currency does not help much. On the contrary, a weak dollar helps to focus attention on the massive dollar reserves that China is holding. China keeps incurring losses on them when the US dollar weakens.

So, to reiterate, China is forced to prevent the dollar from weakening or, at least, slow its depreciation. Towards that end, it will keep buying US assets. It is the same as banks’ ever-greening their loans so that they do not have to acknowledge the reality. Postponing it as long as they can helps.

So, on balance, the US is safe to pursue weak dollar and high inflation as both help its current economic situation. China will actually get increasingly trapped into the dollar. Of course, putting it this way makes it sound like it is a low-cost option for the US and a high-cost one for China. Not so fast.

US might be understandably nervous about experimenting with this should the dollar go into a free-fall. That would accelerate the loss of its monopoly reserve currency status. That would raise its seigniorage costs. Furthermore, it might have other non-economic ramifications in its China relations.

Further, China can make the US sweat a bit by not bidding for Treasury securities at auctions and thus allow the US interest rates to rise. That would raise private sector interest rates too since most of the private sector debt contracts or interest rates are priced off US Treasuries.

This is the economic equivalent of ‘mutually assured destruction’ initiatives that the Soviet Union and the US pursued in Cold War days with one very crucial difference. Then, it remained as a threat (in theory). This one is being actually played out. The winner is far from certain and the odds are reasonably short that both could be losers.

This ‘mutually assured destruction’ is what Brad Setser mentions as ‘balance of financial terror’ (I think the origin of this phrase is credited to Larry Summers) in this comment:

I suspect that the US has a bit more leverage with China than Geithner — almost always a diplomat — lets on. The problem is that it can only exercise its points of leverage at a high cost to itself. China in some sense is in a similar position. It too has options – it actually doesn’t have to finance the US if it changes its exchange rate regime. But it doesn’t have cost-free options. That, at least, is my understanding of the balance of financial terror. [See here for more]

I guess the expressions that yours truly, Arvind Subramanian and Brad Setser (or, Larry Summers?) use say it all: ‘Mutually Assured Destruction’, Siamese twins’ and ‘Balance of financial terror’. Probably, ‘Fatal Attraction’ should be in that list too.

 Update: Came across this interesting comment – simple and straightforward – from Dani Rodrik on the issue of whether China would benefit from US relative loss of economic power.