China Fears US to Adopt Weak Dollar Policy

Following the most recent row between China and the US, and the fallout from China’s selling of nearly $35 billion of US securities from its foreign reserves last December, China now finds itself having to explain its actions. When asked during a press conference last week if there were “political considerations” behind the move to reduce its US exposure, Foreign Ministry Spokesperson Qin Gang noted China’s “perspectives” with respect to its investment practices.

Citing the need to ensure “safety, liquidity, and good value”, Qin noted that safety of funds is the primary directive overseeing China’s foreign reserve policy.

“How much we buy and when we buy depends on the market conditions and our own need”, Qin offered when pressed further.

“On the other hand”, noted Qin, “relevant major reserve currency countries should take credible measures to boost confidence of the international market in their currencies. It is like doing business, you need both a buyer and a seller.”

Not exactly subtle to be sure, but there is no denying the message to the Obama administration – “Don’t do anything that could undermine the value of the dollar”.

China has good reason to fear the adoption of a weak dollar policy as America looks to slow its growing trade gap and put more people back to work. In January’s State of the Union address, President Obama highlighted the need to tackle America’s trade imbalance:

“We need to export more of our goods. Because the more products we make and sell to other countries, the more jobs we support right here in America. So tonight, we set a new goal. We will double our exports over the next five years, an increase that will support two million jobs in America.”

[mserve id=”US_President_Barack_Obama.jpg” align=”right” width=”400″ caption=”US President Barack Obama” alt=”US President Barack Obama” title=”US President Barack Obama”]

Realistically, there is only one way that Obama can hope to double exports in five years and that is to devalue the dollar. A weaker dollar will make American-made products less costly to foreign buyers. At the same time, it will make imports more costly, resulting in a further shrinking of the trade gap.

As the number one seller of consumer goods to America, a weaker US dollar would be highly detrimental to the Chinese economy, and it is unlikely China would accept its fate quietly. China depends on maintaining a trade advantage over the US, and any closing of the trade gap will surely elicit some form of response.

Without doubt, the first move China would make, would be to peg the yuan even more closely to the dollar than it does now. This would effectively negate a cost increase to China’s products for American consumers. The downside of this is an overall loss of real income for China. However, this may be inevitable in order for China to maintain demand for its products in the US.

The second option for China would be to increase its US holdings. Yes, I said increase. Buying US treasuries and sending a strong signal to the bond market that China has faith in the US dollar, would see an uptick in confidence for the greenback. The resulting increase in demand for the dollar as a reserve currency would make it more difficult for the government to devalue the currency.

Now, we all know that China has deep pockets. We also know that the US has no choice but to run yearly deficits for the foreseeable future, but there is a limit as to how much American debt China can absorb. Having said this however, I don’t think we will see a dramatic shift in policy by either party in the short-term. After all, no one wants to rock the boat while the global economy is still trying to gain momentum.

Tempest in a Teacup?

That leaves us with trying to explain the $34.2 billion sell-off. I would argue that, looking at the big picture, it is really nothing more than a minor warning to remind the Obama administration that China is paying close attention to American monetary policy. Consider that published estimates at the end of 2009, placed the total value of China’s foreign reserves at $2.4 trillion. As of November of last year, the US Treasury Department said that China held $789.6 billion in US Treasury securities, which means that US securities make up about 33 percent of China’s total reserves.

Suddenly, $34.2 billion doesn’t look like that big a deal. After all, it represents a reduction of just over 4 percent of China’s total US-denominated holdings, and less than 1.5 percent of its entire foreign currency reserves.

This article is for general information purposes only. It is not investment advice or a solution to buy or sell securities. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading is high risk and not suitable for all. You could lose all of your deposited funds.