China is really looking at a lot of other options to get away from the U.S. dollar. The latest report is that it has been building huge gold reserves. There is no doubt that China wants to get out and away from the U.S. dollar now. We have heard SDRs, copper and precious metals all mentioned as plays out of U.S. dollars. How this will play out on currency markets and in the U.S. government bond market is not at all clear.
China revealed on Friday that it built up its gold reserves by three quarters since 2003, making it the world’s fifth largest holder of bullion.
The move comes as European central banks continue to sell their gold and the International Monetary Fund has discussed selling some of its bullion reserves.
“This is probably the most significant central bank announcement since the Central Bank of Russia announced at the LBMA gold conference in Johannesburg in 2005 that it wanted to hold 10 per cent of its foreign exchange reserves in gold,” said John Reade of UBS.
Ahead of this month’s G20 meeting in London, China said reliance on the dollar as the world’s reserve currency should be reduced by making greater use of special drawing rights, the synthetic currency run by the International Monetary Fund.
This led to speculation China was considering changing its policy which has seen the majority of its foreign exchange reserves channelled into the US government bond market and other dollar denominated assets.
This has raised the question of whether China plans to increase the proportion of its foreign exchange reserves that it holds in gold and how much it could buy
Now, let’s review the chain of events:
- The U.S. sub-prime mortgage market implodes, causing Fannie and Freddie to go bust. The Chinese start dumping GSE paper. (27 Aug 2008 post)
- Meanwhile, Tim Geithner was putting his foot in his mouth and telling everyone the U.S. was ‘manipulating’ its currency. Vice President Biden had to correct him, but the damage was done and the Chinese went on a rampage, savaging the U.S. at Davos (Geithner: 28 Jan 2009 post ; World Economic Forum: 29 Jan 2009 post)
- Then, in March, the Chinese premier started making the same noises about Treasuries that he had about GSEs earlier (13 Mar 2009 post). Was he bluffing? Marshall Auerback said so at the time. I am a bit more concerned.
- Showing increasing signs that they were not bluffing, the Chinese started avoiding using dollars in transactions in deals with countries like Argentina (31 Mar 2009 post)
- Then, before the G-20 summit this past month, the Chinese start floating the idea that it wants to move to a SDR (special drawing right)-centric world, loosening the U.S. grip on being the world’s reserve currency. Of course, there was the chatter about the Chinese pegging their currency to copper instead of the U.S. dollar. Obviously, they had worked this out with the Russians ahead of time. (1 Apr 2009 post)
- After the summit, the whole lets-not-settle-trade-in-dollars meme continued as the Chinese struck yet more deals to do so (9 Apr 2009 post)
So, here we are, three weeks out from the G-20 and now we learn the Chinese have been buying gold. In my mind, there is no doubt that China is looking to topple he U.S. dollar as the world’s reserve currency. And this will happen over time. The Europeans want it – they are a rival in currency terms. The Asians want it – they want to stick it to an arrogant country which caused great hardship to Asia through the IMF in the Asian Crisis. And the oil exporters like Saudi Arabia, Iran and Venezuela all want it too. It will happen. The question is when and what will replace the dollar.
Another question comes to mind as well. Isn’t this de-stabilizing for a world in a global recession? The economists over at Vox have a few points to provide on that score using France and the United Kingdom as 1920s parallels for China and the United States. I have highlighted some important bits.
China’s “dollar trap” has many analysts worried about its future resolution. This column discusses a similar situation in the in the 1920s when France held more than half the world’s foreign reserves. France’s “sterling trap” ended disastrously. Sterling suffered a major currency crisis, French authorities lost a lot of money, and subsequent policy reactions deepened the Great Depression.
What are the lessons for today? China’s objective function today certainly differs from those of France in the interwar years. But French experiences in the early 1930s are a reminder that when there is growing risk on reserves currencies, foreign reserves can be both a source of instability for the international monetary system, and a burden for large holders.
China’s huge volume of dollar reserves is now at the centre of serious concerns about the future of the US currency. The origin of this situation dates back to the early 2000s, after the East Asian and Russian crises. At that time, accumulating foreign reserves was considered benign policy. Developing and emerging countries were encouraged in this way in order to insure against sudden reversals of capital inflows. China was pegging its currency against the dollar and, due to the US trade deficits, started acquiring US assets.
Ten years on, the People’s Bank of China (PBOC) has an extraordinary stock of dollars, and one pressing question: “What to do out of them?” Increasing political tensions have given rise to fears that it might get rid of this huge bulk of securities and precipitate a dollar crash. In August 2007, a Chinese official indeed reminded that Beijing was in a position to provoke a “mass depreciation” of the dollar if it decided to do so. Recent suggestion by Zhou Xiaochuan that China’s central bank might shift from the dollar has put the issue on newspapers’ headlines once again.
But bold statements are one thing, and actual policy another. Up to now, China’s authorities have shown few signs of attempting to weaken the dollar. The reason for this seems straightforward. After all, China is the world’s largest dollar investor, and no one else would have less interest in seeing the value of the US currency plummet. The PBOC might be the promptest to support the dollar, not least because it would suffer a huge capital loss in the event of a dollar depreciation. In a recent New York Times column, Paul Krugman argues that China has “driven itself into a dollar trap, and that it can neither get itself out nor change the policies that put it in that trap in the first place.”
This situation might appear unprecedented. But in truth, all this is not brand-new.
French foreign reserves policy during the Great Depression
Economic history offers one striking example of a country being trapped by the huge volume of its foreign reserves. This country was France, the period was the early 1930s, and the currency at stake the pound sterling. The episode ended up dramatically. Sterling suffered a major currency crisis, French authorities lost a lot of money, and their subsequent policy largely contributed to the Great Depression.
The origin of the problem lay in the government’s decision of 1926 to peg the franc to the sterling and dollar, two years before re-establishing the gold standard. Since the trade balance was in surplus and capital was flowing into the country, this goal was achieved through public purchases of foreign exchange. The Bank of France therefore accumulated a bulging portfolio of foreign holdings. At the end of the 1920s, the country held more than half of the world’s volume of foreign reserves.
French policy over subsequent years has been heavily criticized for being destabilizing. British contemporaries, like Paul Einzig, accused France of using its reserves in order to weaken the pound before the sterling crisis of September 1931. Others have noted that French conversions of foreign assets into gold after 1931, by imposing constraints on their money supplies, put intense deflationary pressures on other countries on the gold standard.
France’s Sterling Trap in 1931
Why did France engage in a policy that had such dramatic consequences? In a recent work, I explore the motivations behind the French reserves policy of this period. Spending time in the archives, I was able first to reconstitute the evolution of the reserves currency composition, and second, to identify the reasons invoked for the allocation decisions. Last, I have combined this information with market indicators of the perceived risk of reserves currencies.
France’s problems were similar to those of China today. The Bank of France was a private institution and its primary objective was to avoid capital losses. Its reserves were allocated between sterling and dollar. From 1929 to 1931, there were fears that the pound might be devalued and the Bank started shifting to the dollar.
However, in implementing this policy, the Bank was also constrained by its position as a large player on the exchange market. So, as sterling’s weakness worsened at the end of 1930, the Bank was in a trap: it could not continue selling pounds without precipitating a sterling collapse and a huge exchange loss for itself. The only workable option left was to support the pound. French policy therefore suddenly turned cooperative. The Bank halted the sterling liquidations, and even intervened on the market in order to support the British currency.
When the pound eventually collapsed, the Bank of France was put into a state of technical bankruptcy. It was only able to survive thanks to a state’s rescue, obtained under tough conditions. Moreover, there were now rising fears over the dollar. The will to avoid further losses therefore led authorities to convert all their dollar assets into gold (figure 2), a policy that heavily contributed to the global monetary contraction of the 1930s.
Lessons for today?
What are the lessons for today? China’s objective function today certainly differs from those of France in the interwar years. But French experiences in the early 1930s are a reminder that when there is growing risk on reserves currencies, foreign reserves can be both a source of instability for the international monetary system, and a burden for large holders.
There are some graphs on Vox’s site associated with this essay that you should have a look at. My analysis is this: The Chinese want to weaken the U.S.’s power derived through its currency status. They have been setting the stage to do so for some time. However, they want to act in a way that benefits them in the short- and long-term. Cutting loose in an uncontrolled fashion now benefits no one with the world economy in dire straits. However, when the economy does right itself, you should see some major changes in the currency markets.
Sources
China reveals huge rise in gold reserves – FT.com
China’s Syndrome: The “dollar trap” in historical perspective – VoxEU