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…

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

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:

http://www.atlantic-community.org/index.php/articles/view/Why_Dump_Dollars_When_You_Can_Own_the_US%3F

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

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.

“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.