China's foreign exchange reserves and the dollar

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CurrencyTrading.net have written a useful introductory article outlining the main issues around China's vast forex mountain and what they are spending it on.

Fundamentally, China investing in US paper is a bad move - they would be better off investing it at home on education, health of social security given the low returns they are getting from US paper. Or it should be invested in worldwide equities (there are moves in this direction). US paper investments could end up being be the largest wealth destruction mechanism in history.

Whilst a good start this article gives China a little too much credit and suggests China wields more power that it really does.

For example, this statement is simply not true (although it does make a good headline).

Nowhere is this more apparent-and frightening-then in China’s economic relationship with the United States, which is very much at the mercy of China when it comes to prices, wages, interest rates, most importantly, the value of the Dollar.

One could argue that the value of the dollar is nowhere near as important as prices and wages. What does the value of a currency really tell us? If the dollar falls the US will export more (and import less) and their companies will make greater profits (input prices will however rise). More tourists will flood into the US spending money on in the US service sector and thus creating jobs. The problem, as the article points out is the possible effect on interest rates. A rise in interest rates could push the US into recession (linked to the housing market and the huge level of individual debt).

Here are some of the highlights:

How China Could Crash the US Dollar on a Whim

As the Dollar has depreciated over the last five years, many Central Banks have begun “diversifying” their forex reserves, by switching from Dollar assets to assets denominated in other currencies. This is problematic for the Dollar for two reasons. First, switching from US assets to European assets, for example, directly causes the Dollar to depreciate. Second, the bulk sale of US treasury securities (whether or not they are replaced with other US-assets) causes US bond prices to decline and hence, yields to increase. Thus, if China suddenly decided to diversify its reserves, for economic and/or political reasons, it could potentially crash the Dollar and send US long-term interest rates skyward. Since mortgage rates are tied directly to government bond yields, a rise in interest rates would probably also affect US real estate prices. Higher interest rates would make borrowing for a home more difficult, which would lower the demand for houses and thus, the value of American real estate.

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Coupled with its growing role as the world’s factory, China’s cheap currency has made Americans wealthier, by increasing their purchasing power. As production of labor-intensive goods was outsourced to China over the last decade, prices for finished products began to fall both in real terms and in nominal terms. While the effect on US employment trends is debatable, its effect on prices has been unambiguous. Thus, even while the American economy boomed, inflation remained relatively modest by historical standards. This allowed the Federal Reserve Board to hold interest rates down and foment economic growth.

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