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Forex Blog - US-China Dollar Diplomacy

US-China Dollar Diplomacy

 

SAED talks may not be as groundbreaking as Ping Pong Diplomacy in the early 1970’s, but today’s US-China economic talks share some of the same characteristics – emphasize appearance of commonality, leave animosity out of the talks and share nothing sensitive with the press (markets). 

 

By all accounts this week’s talks have lived up to the formula.  No acrimony, congeniality for the cameras and of course nothing substantive to emerge from the meetings.  Geithner said today both sides agreed to correct imbalances…an answer worthy of a contestant in Miss Universe…and pursue world peace. 

 

If there is any behind the scenes issue that deserves greater market attention it is the shift in focus from the yuan to the dollar…the dollar (as in a disorderly decline) seems to be the greater risk to the global recovery than an undervalued yuan.  Surely US officials would take issue with the notion that the USD is at risk, but China’s concerns are more widely shared these days as US policy is unprecedentedly accommodative and China’s reserve position is unprecedentedly exposed to the greenback.  China stands to lose billions in the event of a large decline in USTs (hold to maturity approach to these investments lessens this concern) and billions in the value of reserves vis a vis other foreign currencies. China can and has diversified to an extent by loading up on commodities (they trade inversely to the USD).  It is also considering buying shares in US companies (another inversely correlated asset class to USD value). 

 

At the end of the day China can’t diversify enough out of USTs and USD without causing either or both to implode.  There is something Confucian about this paradox no doubt. 

 

And it is increasingly clear that at this point in time the US needs China more than China needs the US.  Runaway deficits need China on the receiving end of mountains of supply.  China is obliging too as it steps up reserve accumulation in Q2 (on record hot money inflows as banks lend readily to speculators in real estate and equity markets). 

 

If the US has always leaned on China to allow the yuan to rise, since being inaugurated, the Obama administration has shown no signs of this approach – hard to believe Geithner called China a currency manipulator in Congressional confirmation hearing earlier this year. China has held the yuan stable versus the USD for the better part of two years.  Geithner’s relative silence on yuan appreciation need is a sign of who has the upper hand in this diplomacy now.  China is also demonstrating a capacity to print some elevated GDP figures with a US consumer in the fetal position.  Okay that is not sustainable but it is marginalizing the US diplomatic hand with China

 

China also said it will buy more from USA if only the USA would allow more high tech (security sensitive) exports to China

 

Is this a permanent condition ahead?  Probably not.  The US could easily be back on the diplomatic offensive with China if the US savings rate remains elevated and or keeps rising and US fiscal position deterioration subsides (behind positive GDP, spending cuts and revenue measures). 

 

For the time being in a credit constrained world, solvent countries like China acting as the banker to the US hold the power in this marriage of increasingly equals.  Rest assured there will be zero tolerance for US government devaluing its way to prosperity ahead with China its banker and most to lose by an Argentine outcome.

 

David Gilmore    

 

 

 

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