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Monday, July 6, 2009

The New Chinese Threat to the Dollar

Current Chinese and American monetary policies are diametrically opposed.

China has based its growth and rise to economic prominence on an export-led economic model, with the United States as a primary destination for Chinese-made goods. The result of this policy is a two trillion dollar foreign exchange reserve, of which roughly 60percent is denominated in dollars.

The US, on the other hand, has chosen a policy of monetary easing in to fight the current recession. It is running huge budget deficits, part of which is financed through money creation by the Federal Reserve. Such a vast increase in money supply can only lead to a devaluation of the dollar, which reduces the value of Chinese reserves.

The Chinese cannot allow thirty years worth of currency accumulation to evaporate as a result of inflationary US policy. They have sent US authorities repeated messages to that effect, including: top-level statements of concern; massive purchases of strategic metals; announcing their gold reserves are twice the size previously thought; reducing purchases of longer-term Treasury bonds.

The most recent Chinese move has been to start negotiations with Brazil to cut the dollar out of their mutual trade relations, which would rely on national currencies instead.

In response US Treasury Secretary Tim Geithner traveled to Beijing in late May to reassure the Chinese concerning US policies. Perfunctory statements of agreement were exchanged as he left China. But on the day after Mr. Geithner departed, China announced negotiations with Malaysia similar to those with Brazil: no more dollar-denominated trade there either.

In other words, the visit by Mr. Geithner solved nothing. However, it goes way beyond that. The announcement is not just another message to the United States. It can well be the start of a new monetary strategy.

The type of economic transaction under negotiation with Brazil and Malaysia is essentially a barter deal based on the relative values of the two national currencies involved. As China has a large economy involving many buyers and suppliers, such a type of transaction can be expanded to any number of its trading partners, thereby creating a fairly large dollar-free economic zone.

This would in the short term reduce the importance of the dollar as the dominant world currency. The ultimate effect would be much more far-reaching.
The global primacy of the dollar is to a great extent based on the assumption that there is no available substitute for it.

The above strategy of dollar-free transactions, which is quite workable, undermines this assumption by showing that in many cases such a substitute is not needed. All that is required is agreement on the relative value of two national currencies.

Furthermore, if demonstrated successfully between, for example, China and Brazil, such a bilateral commercial strategy could be applied to transactions between countries other than China. Russia and Germany, for example, could in the same manner exchange energy products for engineering goods and services.

Finally, this approach to trade would gradually extinguish the key role of the dollar in pricing commodities, such as oil, sugar, copper or grains. These commodities would de facto come to be priced in terms of a basket of currencies, based on the actual volume of transactions in the various national units of account.

The dollar would then be then reduced to being the national currency of the United States, with significant consequences for this country and for the rest of the world. The US, no longer able to rely on the prominence of the dollar in global finance, would like any other country be fully responsible for the value of its own currency.

The Chinese initiative is therefore no idle threat. Whether the Chinese government will implement this new strategy across the board or even on a large scale is unknown. Very possibly they have no definite plan at this point. But a whole realm of possibilities has been opened.

What is certain is that the US government must now face the fact that its policies, so far dictated strictly by domestic concerns, may in the very near future have a major and lasting impact on the status of its currency.


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