41) China: to love or not to love the dollar...

China’s love-hate relationship with the dollar
David Marsh and Andy Seaman
Financial Times, September 9 2009

The Chinese and US monetary authorities provide the best example of the “Stockholm syndrome” applied to international financial affairs. Cloying dependence between hostages and hostage-takers in drawn-out abductions describes the symbiotic bonds between the world’s biggest debtor, the US Treasury, and the largest creditor, the People’s Bank of China.

Chinese leaders frequently emphasise America’s responsibilities for the stability of the dollar as the premier reserve currency. The Chinese central bank, the guardian of the proceeds from Beijing’s massive current account surpluses, warns obliquely that turning its back on the greenback would risk a monetary catastrophe. It is time, though, for a more balanced debate. To enhance its credibility, Beijing must put its own house in order. In the interests of a more stable monetary system, China needs to open its capital markets and allow broader international access to the renminbi. The US and its allies should insist on this unrelentingly.

China’s finely calibrated warnings about a significant move from the dollar are unlikely to be enacted. About 70 per cent of Chinese reserves of more than $2,000bn (€1,395bn, £1,220bn) are thought to be held in the greenback. Who holds whom hostage? Heavy Beijing dollar sales would hurt its interests as much as America’s.

Senior US figures recognise this conundrum. They say statements about dollar vulnerability from Zhou Xiaochuan, the People’s Bank governor, actually help the Federal Reserve. Beijing’s monetary sternness, partly engendered by traditional antagonism towards the US in the Communist leadership, supports the Fed’s preparations for eventual reversal of steep interest rate cuts and quantitative easing. President Barack Obama can hardly opt for reckless deficit spending when America’s largest creditor is signalling such disapproval of potential US waywardness.

The Chinese even tacitly had a hand in Mr Obama’s decision to extend Ben Bernanke’s tenure as Fed chairman into a second term beyond January 2010. China’s tough statements made it impossible for Mr Obama to replace Mr Bernanke with anyone except a full-scale hawk – and this option was closed for domestic political grounds.

Yet there is more to the US-Chinese monetary relationship than fear of mutually assured dollar destruction. China has called persistently for a new form of composite currency to take over from the dollar as the main reserve asset. (It seems unlikely to press for the euro to displace the dollar – reflecting Chinese doubts about the eurozone economy.)

But China seems to be proposing much more than merely boosting, in its present form, the special drawing right, the International Monetary Fund’s “basket” unit that currently consists of four currencies – the dollar with 44 per cent, the euro with 34 per cent, and the yen and sterling with 11 per cent each. The UK, US, euro area and Japan account for just 28 per cent of world exports. Beijing’s interest lies in broadening the appeal of the SDR by enlarging it to include emerging market economies in line with their much-increased exports. Expanding the constituents from four to 10 would roughly halve the share of the present four SDR currencies. The renminbi and the euro would be the largest two components, each with a little more than 20 per cent of a trade-weighted SDR, while the dollar would have 16 per cent, the yen 9 per cent and the rouble and sterling 5 per cent.

China and other emerging economies would benefit politically from redrawing the SDR when the weights are recalculated in 2010. There is a catch, though. To turn a restructured SDR into a real monetary instrument that other central banks might hold in their reserves, its principal emerging market components – led by the renminbi – need to be made convertible. No stability-orientated central bank will hold renminbi unless it can access a freely tradable Chinese currency linked directly to functioning internal Chinese capital markets. The People’s Bank is taking steps towards internationalising the renminbi – but the road to convertibility will be a long march.

Issuing admonitions about the dollar is easy. Developing a genuine alternative is much more difficult. This is the task China must accomplish – in its own interest and, ultimately, the world’s.

David Marsh is chairman of London & Oxford Capital Markets Andy Seaman is a partner at Stratton Street Capital
Copyright The Financial Times Limited 2009.