The Chinese authorities face a rather difficult, and potentially very hazardous, task. How can they reduce their US dollar dependency without hinting too much that they are doing so?
Remember, over the previous decade China has accumulated more than two trillion US dollars in foreign exchange reserves, most of it in dollar-denominated fixed-income investments like government and agency bonds. Until recent years, this dollar dependency and lack of diversification of these foreign exchange reserves were not thought to be problematic. However, the financial crisis and the way the US government and the Federal Reserve have reacted to it has made it clear that the well-being of US creditors ranks rather low on the priority list of the US authorities.
The Chinese are painfully aware of this. In March 2009, People’s Bank of China Governor Zhou Xiaochuan commented that: “An international reserve currency […] should be disconnected from economic conditions and sovereign interests of any single country.” This is clearly a requirement that the US dollar as the current major, if not only, international reserve currency is currently not fulfilling.
What can the Chinese do though? Just selling their dollar reserves for some alternative currencies and/or reserve assets, like gold, is not a viable option. Doing this in plain sight would tremendously weaken the greenback and hence the purchasing power of the accumulated Chinese reserves. This could result in a full-blown worldwide currency crisis and push the still-fragile financial markets back into a tailspin. Even worse, the surge of US and worldwide interest rates that would attend such a sell-off would increase the risk of a fall-back of the US and other developed economies into recession. This, in turn, would certainly lead the Federal Reserve to print even more money and thereby exacerbate the dollar weakness further.
For now, the Chinese seem to have decided to take small, almost innocuous steps. At the beginning of 2009, the Chinese started to sign swap agreements in yuan with several countries including Argentina, Indonesia, Malaysia and South Korea. In May, the Chinese and Brazilian Presidents, Hu Jintao and Luiz Inacio Lula da Silva, signed an agreement to drop the dollar for use in bilateral trade and instead use their local currencies, i.e., the yuan and the real. Finally, at the beginning of September, China announced it would buy notes issued by the International Monetary Fund and denominated in Special Drawing Rights (SDRs).
Another less direct way to reduce the dollar dependence stems from the fact that the Chinese government now explicitly encourages its domestic companies to use their earned dollars for mergers and acquisitions of overseas companies (especially in the energy and commodities sectors) instead of parking those dollars into US fixed income investments.
For the time-being, the sums involved are relatively small. The swap agreements involving yuan amount to roughly 100 billion US dollars, the bilateral trade between Brazil and China was somewhere north of 25 billion US dollars in 2008, the SDR investment will be around 50 billion US dollars and the ten largest Chinese direct investments overseas so far in 2009 were according to our estimates slightly below 25 billion US dollars. Those numbers are obviously dwarfed by the trillions of US dollars in Chinese foreign exchange reserves.
Nevertheless, one should not underestimate the power of symbolic measures. Following China’s SDR investment announcement, several other emerging markets, among them Brazil and Russia, also expressed an interest in an alternative reserve currency. While the days of the US dollar’s dominance as the unique world currency are not over yet, 1,000 small cuts have begun to scratch its shine.
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