La Jornada, Mexico

China, the United States and the Depreciation of the Dollar

EDITORIAL

January 09, 2007

Mexico - La Jornada - Original Article (Spanish)

Several clouds overshadow the global economic landscape. But there seems to be a consensus on the most menacing: the imbalance between countries with high levels of savings and strong surpluses in their external accounts (such as China and Japan), on the one hand, and nations with a very low level of savings and significant external deficit (such as the United States) on the other. This imbalance has the potential to explode behind a global financial crisis with unforeseeable consequences.

The danger of a systemic crisis is real: at some point the world economy will have to adjust to a lower deficits in the current accounts. That is inevitable. The current state of affairs with the increasing deficit as a proportion of GDP, is incompatible with long-term stability. For that reason, the question is not simply whether trade deficits will be reduced, but whether the adjustment will be painful and destructive to the global economy.

The jolt in the mortgage market last year does not create but aggravates a preexisting situation. The mortgage market was being eaten away in the past decade by the irresponsible monetary policy that Greenspan orchestrated out of the recession of the early 90. Today, the crisis has begun to spill into other sectors, as evidenced by the alarming figures on unemployment in our neighboring country [the United States]. Last December, the net creation of new jobs barely reached 18 thousand. Something is really wrong and the effect goes beyond American borders.

Many analysts like to stress one key fact: Now China has become the engine of growth. But that is a little misleading. The United States continues to play an important role, only this time as a buyer of last resort. The savings from countries with surpluses have been used increasingly to finance the expansion of the American deficit through capital flows.. That is what allows its trade deficit to grow, which growth is an important factor for the world economy.

In Washington, it has been thought over recent years that the devaluation could help correct the trade deficit. After all, a change in parity induces a reallocation of resources between imports and domestic goods. But that is not very clear in the United States because even since the dollar began its decline in 2002, the deficit of the current account (whose main component is the trade balance) continued to increase, rising from 4.5 percent to 6.6 percent of GDP from 2002 and 2006.

One of the possible explanations is that the dollar depreciation carries a negative wealth effect, leading to a contraction in the countries that hold more assets in dollars. That means that fewer American products are bought, making it harder to correct the deficit in the balance of trade in that country. That may be true, but it is likely that we are witnessing changes in the composition of trade flows. Such changes reveal a structural weakness of the American economy – which is now not only an importer of consumer goods, but also of capital goods, which means that any recovery will also aggravate its trade performance.

China today holds the equivalent of 1.4 trillion dollars in its reserves. Approximately 70 percent of that amount is in U.S. dollars and assets denominated in that currency. The composition of Chinese reserves in dollars or other currencies does not depend exclusively on economic parameters. It is well known that official investors (for example, those who buy American treasury bonds) behave differently from private investors. They respond to changes in real interest rates, exchange rates and the relative prices of their assets. However, official investors resort to medium-term time horizons and are willing to diversify their asset portfolio in light of other considerations. So China may restructure its portfolio of currencies at any time. And any reconfiguration of Chinese reserves certainly implies a massive sale of dollars, which could trigger herd behavior and panic in the financial markets.

The negative wealth effects associated with the depreciation of the dollar for states that hold enormous amounts of assets denominated in that currency is a troubling problem. These countries have become major stakeholders in maintaining global financial stability and safeguard the role of the dollar as the main reserve currency. That may have beneficial effects from the perspective of Washington. But betting on that fragile basis to sustain global economic stability is a huge stretch.