We Risk Calamity unless China Safely Offloads Unwanted Dollars

Letter to the Editor of the Financial Times

April 22, 2009

William Jacobson and Ernest Preeg raised a key question about my thesis, "We Should Listen to Beijing's Currency Idea" (April 8), in their letters of April 13. Both argue that the world should not relieve China of the currency risk emanating from the huge dollar hoard it has accumulated by running massive current account surpluses for the past five years, including by maintaining a substantially undervalued exchange rate for the renminbi.

I fully share their concern over China's major role in the continuing global imbalances, which were an important cause of the current crisis, as indicated in my article. Two practical considerations compel me nevertheless to support the proposal by Zhou Xiaochuan, the People's Bank of China governor, to create a substitution account at the International Monetary Fund. China and other monetary authorities could convert their dollars via this account into Special Drawing Rights through off-market transactions that would have no effect on exchange rates or any other economic variable.

The first is that the fear of further capital losses on its dollar reserves clearly does not deter China from currency intervention to support its large external surpluses. It has already experienced considerable losses, only part of which have been reversed, as the dollar slid substantially from early 2002 to early 2008 and heavy intervention continues. One suspects that the Chinese authorities view these costs as inevitable consequences of the subsidies they provide to exports and jobs via the exchange rate. We cannot force or even induce them to adjust by jeopardizing their asset valuations.

The second and more operational consideration is that circumstances could easily arise in domestic Chinese politics under which the authorities felt compelled to dump large portions of their dollar holdings, despite the severe disruption that could result for the world economy. Such conditions could occur if the US Congress were to pass, or even severely threaten, protectionist legislation against Chinese exports (notably including their currency driver) or if there were a renewed flare-up in the Taiwan Straits or over the Dalai Lama. It would greatly behoove the United States and the world economy as a whole to provide an alternative disposition for China's unwanted dollars, especially since it could be done at very little or no real cost, rather than risk the very unpleasant consequences of such a scenario.