China, Europe and the US dollar

Following a recent post here on the use of the dollar weapon against the euro, it was pointed out to me that if the US was in the process of using the dollar weapon, the real target was not Europe but China. That the US is trying to force a revaluation of the yuan is almost certainly true; but I believe that both currencies are, in fact, in America’s sights.

In defence of my earlier post, it is easy to exaggerate the importance of the US trade deficit with China. In 2006, the total US deficit stood at $759 billion. Of that, $177 billion was with China. Whilst clearly a huge sum, it is not large enough to support claims that changing the terms of trade with China would solve America’s deficit problems. Moreover, it is not clear that a revaluation of the yuan would make a huge difference to America’s overall deficit. A stronger yuan would not make the US import less, merely source its imports from somewhere else.

Nor would it make America export more. US exports are largely capital-intensive (and so expensive) and consumed primarily by rich countries. Given China is not yet part of this group, a revalued yuan would make little difference to demand for US-made products in that country. A stronger euro, on the other hand, would increase demand for US exports amongst wealthy Europeans. For this reason, reversing the $116 billion deficit with the EU is the priority for the US in its attempts to improve its balance of payments position. 

But this does not mean that China does not matter. Given the symbiotic relationship between Chinese growth and American deficits, the US deficit with China has become highly politically charged in Congress in recent years. This makes the use of the dollar weapon against China a particularly interesting case. As the yuan is fixed (nominally) against a basket of currencies and operates a system of fixed-convertibility, using the dollar weapon does not achieve the immediacy of results it would against a floating, fully convertible currency like the euro. However, it produces a dilemma for China which flouts commonly-held understandings of US-China power dynamics.

It is well known that Chinese purchases of dollar assets help fund the US trade deficit. Many observers imply from this that China holds some sort of veto power over US growth. Seen from the perspective of the dollar weapon strategy, however, the picture changes. When the US talks down the dollar and talks up the need for an appreciation of the yuan, hot money flows out of dollars and into Chinese assets in anticipation of a revaluation. As such, demand for the yuan increases and there is upward pressure on the fixed rate. This leaves China with two options. It can either let the currency appreciate; or to maintain the rate with the US, it can sell yuan and buy dollars, increasing its dollar reserves.

This is a win-win situation for the US. In the first case, the yuan appreciates and the deficit with China lessens (even if the overall deficit does not). In the second, China has to increase its dollar reserves to maintain the rate, effectively funding the US deficit. So either the deficit gets smaller, or China pays for it. In actuality, both have happened, with the yuan appreciating by over 5 per cent against the dollar in 2007, and China’s dollar reserves increasing to $1.4 trillion, both of which suit the US perfectly.

Contrary to much popular wisdom about US dependence on China, maybe China’s not holding all the cards after all.

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