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December 7, 2006
The China-Dollar Question: II

Do China's dollar reserves give them huge power over the U.S.? I don't think so. Here's another post from gildertech.com, aswering that widespread worry.

-Bret Swanson
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posted to: Telecosm Lounge
poster: bswanson
date: 12/7/06 2:19:07 PM

I don't think China's large reserves give them much power over the U.S. The Chinese hold these Treasuries because they are safe, liquid assets. It is true China will diversify its dollar reserves, but when China sells Treasuries someone else must buy them. China would not precipitously dump Treasuries in a way that would lead to a price plummet. After all, even with diversification into euros, yen, or won, they will still hold lots of dollars. Why would they want a Treasury plunge that would cut the value of their remaining dollar reserves?

Bond yields are likely to rise (prices fall), but not because of Chinese actions. Buyers and sellers of bonds of course help determine prices in the short term, but the Fed and other
macroeconomic factors ultimately determine yields. It is more correct to say that China is accumulating large reserves because yields are so low rather than to say yields are low because China is accumulating reserves.

Today bond yields are just out of line with other key indicators like commodity prices, forex values, credit spreads, and profit growth. I believe the Fed will be surprised by their backward
looking inflation measures into next year and will therefore be forced to hike Fed Funds in order to achieve their stated inflation target of below 2%. The bond market is expecting no inflation and a severe economic slowdown or even a recession. When that market -- which is expecting rate CUTS -- gets surprised by higher inflation and higher growth, bond yields should move higher. When the Fed finally steps in, the dollar should actually gain strength, not weaken further, which seems to be the key worry about China-reserve-dumping.

The Chinese need us even more than we need them. They need our consumers, our foreign direct investment, and our technology. They would not do anything purposely to damage the U.S. macroeconomy. If our economy tanked, theirs could too. They have yet to bring several
hundred million peasants into the modern economy. A severe slowdown in their growth rate could yield terrible political instability there.

All of these fears of China stem from the perception that they "manipulate" their currency to get ahead. In fact they have pursued exactly the correct monetary policy of the RMB-dollar link. It is difficult for most of us to comprehend how "communist" China has done what's it's done without assuming they are cheating in some way. But China's strength comes from a dramatic embrace of capitalism, entreprneurship, and technology based on sound money and the largest supply-side tax cuts in world history. It is not fake, it is not manipulation. There are many challenges to be sure, and yes, they steal too much IPR. But it is a real boom. And a real boom in the most populous nation on earth has big effects across the world economy.

-BTS
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