If China loses faith, the dollar will collapse

By Andy Xie

Emerging economies such as China and Russia are calling for alternatives to the dollar as a reserve currency. The trigger is the US Federal Reserve's policy of expanding the money supply to prop up the banking system and its over-indebted households. Because the magnitude of the bad assets within the banking system and the excess leverage of its households are potentially huge, the Fed may be forced into printing dollars massively, which would eventually trigger high inflation or even hyperinflation and cause great damage to countries that hold dollar assets in their foreign exchange reserves.

The chatter over alternatives to the dollar mainly reflects the unhappiness with US monetary policy among the emerging economies that have nearly $10,000bn (€7,552bn, ￡6,721bn) in foreign exchange reserves, mostly in dollar assets. Any other country with America's problems would need the Paris Club of creditor nations to negotiate with its lenders on its monetary and fiscal policies to protect their interests. But the US situation is unique: it borrows in its own currency, and the dollar is the world's dominant reserve currency. The US can disregard its creditors' concerns for now without worrying about a dollar collapse.

The faith of the Chinese in America's power and responsibility, and the petrodollar holdings of the gulf countries that depend on US military protection, are the twin props for the dollar's global status. Ethnic Chinese, including those in the mainland, Hong Kong, Taiwan and overseas, may account for half of the foreign holdings of dollar assets. You have to check the asset allocations of wealthy ethnic Chinese to understand the dollar's unique status.

The Chinese love of the dollar began in the 1940s when it held its value while the Chinese currency depreciated massively. The renminbi remains a closed currency and is not yet a credible vehicle for wealth storage.

The US could repair its balance sheet through asset sales and fiscal transfers rather than printing money. The $2,000bn fiscal deficit, for example, could have gone to over-indebted households for paying down debts instead of dubious spending to prop up the economy. When property and stock prices decline sufficiently, foreign demand, especially from ethnic Chinese, will come in volume. America's vast and unexplored natural resource holdings could be auctioned off.

The global environment is extremely negative for savers. The prices of property and shares are not yet good value and may decline further. Interest rates are near zero. The Fed is printing money, which will inflate away the value of dollar holdings. Other currencies are not safe havens either. As the Fed expands the money supply, it puts pressure on other currencies to appreciate. This will force other central banks to expand their own money supplies to depress their currencies. Hence major currencies may take turns devaluing. The end result is inflation and negative real interest rates everywhere. Central banks are punishing savers to redeem the sins of debtors and speculators. Unfortunately, ethnic Chinese are the biggest savers. Diluting Chinese savings to bail out failing US banks and bankrupt households will eventually destroy the dollar's status. Ethnic Chinese demand for it is waning already. China's bulging foreign exchange reserves reflect the lack of private demand for the US currency.

US policy is pushing China towards developing an alternative financial system. For the past two decades its entry into the global economy rested on providing cheap labour to multinationals and pegging the renminbi to the dollar. The dollar peg allowed it to leverage the US financial system for its international needs, while domestic finance re-mained state-controlled to redistribute prosperity from the coast to the interior. This dual approach has worked well. China could have its cake and eat it. Of course, the global credit bubble was what allowed the approach to be effective; its inefficiency was masked by bubble-generated global demand.

China is aware it must become independent from the dollar at some point. Its recent decision to turn Shanghai into a financial centre by 2020 reflects its anxiety over relying on the dollar system. The US will not pay attention to something so distant. However, if global stagflation takes hold, as I expect it to, it will force China to accelerate reforms to float its currency and create a single, independent and market-based financial system. When that happens, the dollar will collapse.

The writer is an independent economist based in Shanghai and former chief economist for Asia Pacific at Morgan Stanley

(Source: Financial Times)