China's Dollar Deception

Monday, April 6, 2009; Page A15

We are in a race between economic recovery and economic nationalism. At last week's Group of 20 summit, leading nations agreed to roughly $1 trillion of additional lending, mostly through the International Monetary Fund, to help end the worldwide slump. But beneath the veil of consensus, countries are maneuvering to protect their economies and blame someone else for the crisis. Will the world economic order overcome these stresses or give way to a global free-for-all, characterized by rampant protectionism and nationalistic subsidies and preferences?

Emblematic of the tension is a recent proposal by Zhou Xiaochuan, governor of the People's Bank of China (PBOC), to replace the dollar as the world's major international currency. In a paper, Zhou argued that today's crisis reflects "the inherent vulnerabilities and systemic risks" of the dollar-based global economy. The PBOC is China's Federal Reserve; Zhou is no obscure bureaucrat.

It may surprise Americans that, up to a point, his analysis is correct. The dollarized world economy developed huge instabilities -- vast trade imbalances (American deficits, Asian surpluses) and massive, offsetting international money flows. But Zhou's omissions are equally revealing. To wit: China is heavily implicated in the dollar system's failings. By keeping its currency artificially depressed -- as an aid to exports -- China abetted the imbalances it now criticizes.

The Chinese denounce American profligacy after promoting it and profiting from it. Low prices for imported goods (shoes, computers, TVs) encouraged overconsumption. From 2000 to 2008, the U.S. trade deficit with China ballooned from $84 billion to $266 billion. China's foreign exchange reserves are now an astounding $2 trillion.

It's not just that exchange rates were (and are) misaligned. American economists have argued that a flood tide of Chinese money, earned from those bulging trade surpluses, depressed interest rates on U.S. Treasury securities and sent investors searching for higher yields elsewhere. That expanded the demand for riskier securities, including subprime mortgages, and pumped up the housing bubble. So China's policies contributed to the original financial crisis, though they were not the only cause.

For decades, dollars have lubricated global prosperity. They're used to price major commodities -- oil, wheat, copper -- and to conduct most trade. Countries such as Thailand and South Korea use dollars for more than 80 percent of their exports. The dollar also serves as the major currency for cross-border investments by governments and the private sector. Indeed, governments hold almost two-thirds of their $6.7 trillion in foreign exchange reserves in dollars.

But overreliance on the dollar can also backfire, as it now has. It is not just that countries have suffered declines in exports to a slumping U.S. economy. They've also lost dollar loans needed to finance trade with third countries. "When the crisis hit, U.S. banks cut back on dollar credit lines to foreign borrowers," says David Hu of the International Investment Group, an investment fund specializing in trade finance. The extra loans endorsed at last week's summit aim to offset these losses.

Given the dollar's drawbacks, why not switch to something else, as Zhou suggests? The trouble, as even he concedes, is that there's no obvious replacement. The attraction of an international currency depends on its presumed stability, what it will buy and how easy it is to invest. The euro (27 percent of government reserves) and the yen (3 percent) don't yet rival the dollar. As for China, it hasn't made its own currency (the renminbi, or RMB) automatically convertible for Chinese investments.

We're stuck with the dollar standard for a while. To work, it requires that countries with huge trade surpluses reduce the export-led growth that fed the system's instabilities. The Chinese increasingly recognize this. "They're very aware of the need to promote consumer spending," says economist Pieter Bottelier of Johns Hopkins University. In November, China announced a 4 trillion RMB ($586 billion) "stimulus." In addition, says Bottelier, the government is improving health and pension benefits to dampen households' need for high savings.

But China also has a default position: promoting exports. It has increased export rebates; engaged in currency "swaps" with trading partners (the latest: $10 billion with Argentina) to stimulate demand for Chinese goods; and stopped the RMB's slow appreciation. China seems comfortable advancing its economy at other countries' expense. Zhou's pronouncement provides a political rationale for predatory behavior: If we're innocent victims of U.S. economic mismanagement, then we're entitled to do whatever is necessary to insulate ourselves from the fallout. Down this path lies growing mistrust.

The larger point is that the world economy is suspended between the lofty rhetoric of last week's summit and the gritty realities of national politics. Protectionism is rising. A World Bank study found that 17 countries in the G-20 have recently adopted discriminatory policies. Though still modest, they "open the door for a lot of other opportunistic measures," says Gary Hufbauer of the Peterson Institute. And the deeper the recession, the greater the danger.

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