China Sets US Interest Rates Now, Not the Fed

This is the opinion of Paul Craig Roberts, who previous served as Assistant Secretary of Treasury during the Reagan administration, and is often quoted as the “father of Reaganomics”. (You can read the Wikipedia entry about him here.)

Recently there has been discussion about China’s threat to use the “nuclear option”, or and basically destroying the value of the US dollar as a global reserve currency by dumping more dollars on the markets than they can absorb in a short time, forcing the dollar into a free-fall.

The prevailing wisdom among US economists is that China would not make such a move, as the damage to China’s own economy would be too great. Roberts rebuts this claim saying that

American economists make a mistake in their reasoning when they assume that China needs large reserves of foreign exchange. China does not need foreign exchange reserves for the usual reasons of supporting its currency’s value and paying its trade bills. China does not allow its currency to be traded in currency markets. Indeed, there is not enough yuan available to trade. Speculators, betting on the eventual rise of the yuan’s value, are trying to capture future gains by trading ‘virtual yuan.’ The other reason is that China does not have foreign trade deficits, and does not need reserves in other currencies with which to pay its bills. Indeed, if China had creditors, the creditors would be pleased to be paid in yuan as the currency is thought to be undervalued.

In addition, he refutes the claim that China would lose US markets with such a move.

The notion that China cannot exercise its power without losing its US markets is wrong. American consumers are as dependent on imports of manufactured goods from China as they are on imported oil. In addition, the profits of US brand name companies are dependent on the sale to Americans of the products that they make in China. The US cannot, in retaliation, block the import of goods and services from China without delivering a knock-out punch to US companies and US consumers. China has many markets and can afford to lose the US market easier than the US can afford to lose the American brand names on Wal-Mart’s shelves that are made in China. Indeed, the US is even dependent on China for advanced technology products. If truth be known, so much US production has been moved to China that many items on which consumers depend are no longer produced in America.

Roberts then builds a case for China’s dumping dollars as a reaction against US pressure for revaluing the yuan, refuting claims that this is an impossible scenario.

Consider that if China were to increase the value of the yuan by 30 percent, the value of China’s dollar holdings would decline by 30 percent. It would have the same effect on China’s pocketbook as dumping dollars and Treasuries in the markets.

Consider also, that as revaluation causes the yuan to move up in relation to the dollar (the reserve currency), it also causes the yuan to move up against every other traded currency. Thus, the Chinese cannot revalue as Paulson has ordered without making Chinese goods more expensive not merely to Americans but everywhere.

Compare this result with China dumping dollars. With the yuan pegged to the dollar, China can dump dollars without altering the exchange rate between the yuan and the dollar. As the dollar falls, the yuan falls with it. Goods and services produced in China do not become more expensive to Americans, and they become cheaper elsewhere. By dumping dollars, China expands its entry into other markets and accumulates more foreign currencies from trade surpluses.

Basically, Roberts makes a strong case for the argument that the US no longer has leverage over China and global financial markets the way it used to. You can read his whole article here.

Have we reached a tipping point in American power and global influence?

8 Responses to “China Sets US Interest Rates Now, Not the Fed”

  1. Alex says:

    I’d have to disagree heavily with this. The author of your linked article was never the most neutral of writers, remember the book “The Secret Life of Bill Clinton”? First consider the original quote that Roberts ‘interpreted’.

    “Thanks to the trade surplus, China has accumulated a large sum of U.S. dollars and its world largest foreign exchange reserve is mostly in U.S. dollars. Such a big sum, a considerable portion of which is in the form of U.S. treasury bonds, contributes a great deal to maintaining the position of the U.S. dollar as an international currency.

    Russia, Switzerland and several other countries have restructured their foreign exchange reserve and reduced the U.S. dollars they hold. China is unlikely to follow suit as long as yuan’s exchange rate is stable against the U.S. dollar. ”

    Central bank reserves tend to be split along major currency lines. A couple of years ago Goldman Sachs did a report on the ‘optimum’ vs. actual central bank reserves, defining optimum as the level which minimises volatility while maintaining reasonable liquidity. It found actual central bank reserves for several countries were broadly in-line with the optimum reserves, that is about 40% USD, 40% EUR and 20% JPY. China’s central bank reserves are not that diversified, there is a heavy reliance on USD, but that has always been known.

    It is also known, indeed an economic rule, that long term currency rates move in-line with the real economic growth of a country. In the long run everyone is dead, and the future growth of a country is hard to predict, but it’s a good yardstick. This is all economics 101. China’s currency will rise over the long term as long as China keeps growing, that’s a certainty

    China could become more competitive against every other currency if it allows itself to fall with the dollar, but that would be in effect a devaluation, and a devaluation is not what China currently needs, or what will actually happen long term, for the reasons:
    1. The government are trying desperately to control the juggernaut of growth, which is starting to impact inflation (4.4% this month, annual rate). Decreasing the real value of the currency would import inflation in terms of higher commodity prices which the government are already struggling with (i.e. not passing through increases in coal prices this year, due to already high consumer price inflation). It would also increase non-US demand for Chinese products, prompting further wage and asset price inflation. Push and pull inflation.
    2. USD is still USD. Selling just a fraction of the holdings could decrease the remaining holdings disproportionately. The West is mid-cycle, and China is enjoying 20+ years of growth. When economies boom the government accumulate some of that boom to spend when the going gets tough. Spending foreign currency reserves is inflationary, but a burst of inflationary pressure has been shown to be effective at points in history. To suggest USD reserves are worthless for China is somewhat…
    3. If the USD suddenly became very cheap, I would imagine a lot of people rushing to buy US stuff. Long term reversion and all that.

    We reached a ‘tipping point’ when the US consumer decided to make themselves spend. It has resulted in a more interconnected world, which I think is a good thing.

  2. […] American economists make a mistake in their reasoning when they assume that China needs large reserves of foreign exchange. China does not need foreign exchange reserves for the usual reasons of supporting its currency’s value and … …more […]

  3. […] This is the opinion of Paul Craig Roberts, who previous served as Assistant Secretary of Treasury during the Reagan administration, and is often quoted as the “father of Reaganomics”. (You can read the Wikipedia entry about him here .) Recently… …more […]

  4. Jeremy says:

    Yes, we have reached the Tipping Point – China is in a much better financial position than the US (no debt, high savings) in both relative and absolute terms.

    The funny thing is, it is almost necessary for China to sell large amounts of US Treasuries to have the $US:RMB relationship get to where the US wants it. The contradictory double speak coming from US politicians and the US Treasury is only now beginning to come to light – that revaluing the currency would actually hurt US consumers far more than it would help them (in the short run… in the long run it might well be the best thing for us). And at some point, it will probably be in China’s best interests (politically & economically) to sell off their holdings of US treasuries – even if it is in exchange for other US assets instead of the debt of other countries (ownership of US companies and/or real estate).

    We reached the ‘tipping point’ when it was decided that extremely risky loans (Subprime AND Alt A) to American consumers, already loaded in debt and consuming beyond their means, were good investments. Why? Let’s see…

    1 – Large amounts of US capital is disappearing and will continue to disappear at a far rapid rate, largely thanks to CDOs & other housing related derivatives (which have already caused trouble with many hedge funds and will continue to wreak havoc with hedge funds & investment banks), mortgage backed securities (which will cause trouble everywhere), mortgage lending companies,
    2 – Once China gets burned on its MBS holdings (some estimates put this at 25% of their overall holdings of US debt obligations), they might question holding even treasuries. Any outright dollar losses on holdings by the Chinese gov’t on MBS will cause an uproar in China much more fierce than the one that the drop in market value of Blackstone caused. Trust me – people in China are worried about the quality of the loans that were made to weak hands in the US (some of my friends are at least)

    The strange thing in today’s world is how intimately interconnected everything is – whether it be a product which is designed and sourced around the entire world, or mortgages made to not so sharp ‘home buyers’ in the US ending up in the hands of the Chinese government.

  5. Not only is the Treasury Secretary clearly delusional, he doesn’t seem to be much of an economist either. The argument that a rise in the Yuan will make all America’s trade-imbalance problems go away is plain ridiculous. American trade imbalance is primarily a cause of low savings rate and high fiscal profligacy. US-European trade provides a precedent: although the Euro has appreciated nearly 40% against the dollar since its introduction, the American trade deficit with the Euro-zone has nearly doubled, from US$64bn in 2001 to US$120bn in 2006. And there are good arguments to be made that even if China was to float its currency, it may not even rise that much.
    Apart from buffing dollar and Treasury bond values, the large scale buy-up of American treasury bonds also keeps the US interest rates lower – to the tune of 1%. At a time when everyone is frantically running in circles about what to do with the shaky US housing market, attacking a financial maneuver that results in such a reduction in interest rates seems, how shall I say….suicidal? Unmentioned is also the fact that there isn’t even much overlap between American and Chinese manufacturing sectors – meaning that American goods would not be able to replace Chinese goods and it would instead have to import from other, more expensive sources, which would undermine the already low American savings rate even further. The low Yuan is all in all therefore more a subsidy to American consumers as it is to the Chinese exporting sector.

    But while I agree that the notion that the US can tell China what to do with its currency has no leg to stand on, the threat that China will start dumping dollars was also a hollow one and China is not stupid enough the make good on it. It knows full well that for all the above mentioned reasons a dollar-dump would have a high chance of resulting in a US recession. And a US recession doesn’t stay a US recession for long – it’s got a tendency to go global. With Wall Street and the London and Tokyo stock markets taking a nose dive, and everyone immediately placing the blame squarely on China’s shoulders for having triggered it, I wonder where China would continue to get the FDI it needs to keep its overheated economy racing. So China will not dump dollars. In fact, the Chinese financial authorities have already rejected this policy shortly after it was voiced. There is a different and bigger threat though: Sovereign Wealth Funds.

    This article:

    provides a very good assessment of what we really should start worrying about – and it’s not overvalued currencies.

  6. Online Trading Software Currency Exchange Free…

    I have to say, that I could not agree with you in 100%, but it’s just my opinion, which could be wrong….

  7. China Sets US Interest Rates Now, Not the Fed | The China Vortex…

    American economists make a mistake in their reasoning when they assume that China needs large reserves of foreign exchange. China does not need foreign exchange reserves for the usual reasons of supporting its currency’s value and paying its trade bi…

  8. Iressa says:

    I started it and in a week I was walking out of my house and greeting my neighbors! I started working and doing things I never dreamed I could do. ,