China’s ‘dollar bark’ is worse than its bite

Ahead of a black-tie state banquet being hosted in his honour by US President Barack Obama later today, Chinese President Hu Jintao has ‘thanked’ his host by dropping a rhetorical low-yield thermonuclear device on the front lawns of the White House.

In comments to the US media ahead of his visit, Hu called the dollar-based world order a “product of the past”, and suggested that US dollar liquidity, which is a result of ongoing US efforts to prop up a sagging economy, but which is devaluing the currency, should be reined in. It was the highest level of the Chinese leadership at which disquiet over the dollar’s standing as a global reserve currency has been articulated.

Hu’s comments were rather more moderate than earlier pronouncements on the subject by other Chinese policymakers: one over-the-top hawkish military general publicly ‘warned’ the US last year that China would ‘dump’ its large hoard of US Treasuries, which some economists have likened to “dropping a nuclear bomb” on financial markets. Even so, given the popular (but incorrect) perception of China as a ‘banker’ to the US, Hu’s thoughts revived commentariat chatter about an imminent end to the dollar’s status as the preferred currency of global trade and investment flows.

On the flip side, some analysts cite China’s baby-steps efforts to “internationalise” its currency, the renminbi, as a preamble to a time in the near future when the renminbi will rule the world. Yet, both of these arguments are wildly exaggerated and low on economic wisdom; they also overlook the political agenda underlying them, which accounts for why they find recurrent amplification.

As economist and political scientist Barry Eichengreen notes in his recent book Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System, China has no interest in dethroning the dollar as the global reserve currency; in fact, it has so much invested in dollar-denominated assets that were the dollar to fade away overnight, China would have to book a huge loss on its foreign exchange reserves portfolio.

Even during the past two years, when Chinese policymakers were ‘talking down the dollar’, China was actually increasing its dollar hoard. Its feeble efforts to diversify a portion of its reserves away from the dollar and into the euro have proved less than successful, given the sovereign debt crisis that grips the eurozone.

The reason why Chinese leaders roll out the ‘nuclear bomb’ threat to the dollar from time to time is to beat back the (primarily) US criticism of persistent Chinese undervaluation of the renminbi and of China’s record of human rights abuse. As anyone who’s played xiangqi, the Chinese variant of chess, knows, pre-emptive offence is often the best form of defence.

That strategy is working splendidly: Obama began by walking on eggshells to avoid displeasing China, and is today hosting Hu to a state banquet. In that sense, China’s ‘dollar bark’ is considerably more effective than its bite.

And although the use of the renminbi for trade settlement and cross-border investment will gradually gain greater traction, its time as a preferred reserve currency is at least two decades away.

There’s a reason why Somali pirates today demand that their ransom be paid in US dollars, and why even gangsters in Hollywood flicks get their payoffs in suitcases stuffed with greenbacks. Likewise, it will be a while before henchmen in Bollywood flicks too start mouthing ‘renmin-mumbo-jumbo’.