‘China cannot really dump the dollar’

China’s recent call for an alternative to the US dollar as a global reserve currency are motivated by political rather than economic, considerations, feels Michael Pettis, a professor at Peking University’s Guanghua School of Management, and a specialist in Chinese financial markets. In an interview to DNA, Pettis, who has worked on Wall Street in trading, capital markets and corporate finance, and has additionally been involved in sovereign advisory work, argues that doomsday scenarios about China “dumping the dollar” are exaggerated. “It’s one of the things that keep us awake at night unnecessarily… It looks like an atom bomb, but there’s nothing in it.” Excerpts from an interview:

China persists with its calls for an alternative to the US dollar as a reserve currency, but many economists say it’s infeasible. What does China hope to achieve?
Much of it is for political purposes, internationally and domestically. Domestically, there’s been criticism of mismanagement of investments abroad. There’s rising concern about the hoards of dollars the People’s Bank of China (the country’s central bank) has… The (Chinese) government feels the need to indicate domestically that it’s concerned about the value of these reserves and that it will do something about them.

But it’s not clear what that means. If you think US fiscal expansion will weaken the dollar, weaken it against what? The euro and the yen? Currencies of countries that are seeing slower growth, more fiscal expansion and higher levels of debt? I don’t think they’ve thought too carefully about what they mean because the purpose is not really to provide an alternative. It’s to indicate domestically that we are doing something.

The other thing China is doing is politically signalling abroad that it’s an important player in the global financial system and has legitimate concerns. In the past, the US has done a good job of arrogant lecturing. This is probably a great opportunity to repay the lecture.

Every time Chinese officials open their mouths, the markets get spooked and China’s investments in dollar-denominated holdings take a hit. Have they mentally booked their losses?
When they make comments that are unexpected, the dollar weakens. But since the Chinese are going to be holding on to these reserves not just for the next few weeks but for many years, the short-term impact of these comments on the dollar don’t really matter. All this talk can’t cause such a significant collapse in the value of the dollar that it starts feeding on itself and so, becomes a permanent collapse.

That’s not going to happen?
This is mostly short-term noise. We hear this every decade or so — with the Deutschemark, the yen, the euro, and now we’re hearing it with the renminbi. If China wanted to hold special drawing rights (SDRs), there was nothing to prevent it. It could have accumulated reserves in the same proportion as in the SDR. Why didn’t it do so?
The reason was that for trade reasons it was impossible. China accumulated dollars because to generate massive employment growth, it needed to force its trade surplus, and the only place it could do so is the US economy. That’s why they accumulated dollars, not because anyone put a gun to their head.

Do you see a consistency in China’s stand in what it wants of the dollar?
A lot of people don’t understand basic balance-of-payments arithmetic. All kinds of nonsense comes out. For instance, many people believe that the decision to lend dollars to the US government is an independent decision made by the PBoC. The confusion exists not just in the Chinese government but in the US government as well.

Does China feel it’s been ensnared in a dollar trap?
There’s a big debate about that. China and the US both got themselves caught in these monetary traps, where the Chinese trade surplus (and therefore reserve accumulation) and the US trade deficit got out of hand. There’s still a perception in China that the loss will occur when the renminbi (RMB) is revalued. That’s wrong on two counts.

If the RMB were to go up by 10%, in renminbi terms you would lose 10% of the reserves - about $200 billion — but the price of everything abroad would go down by 10%. In that sense, there’s no loss.  More importantly, if the RMB is undervalued, the loss occurs every time a Chinese manufacturer exports goods. An important segment of policymakers is saying that one of the reasons China shouldn’t increase the RMB value is because of the huge losses it will take. But by not increasing the value of the RMB, they are actually increasing the losses because they’re accumulating even more overvalued dollars in exchange for undervalued Chinese goods.

Do Chinese officials sense their dollar-denominated holdings are unsafe?
There’s real concern about that, but a lot of it is quite muddled. First of all, the probability of a US default is practically negligible. What other kinds of losses can China take? It can take currency losses, but against which currency? It’s not clear that the dollar will weaken; in theory, it’s been weakening dramatically for years, but in practice it hasn’t. And if you think too much debt in the US means the dollar must weaken, all the other governments have even more debt and their economies are growing even more slowly; so their currencies should weaken even more. Others say the dollar may weaken against inflation. We may, at some point, see inflation, but I don’t think it will get out of hand.

One other thing the Chinese seem to be doing is buying commodities. But that’s just another speculative play. If commodities are at the bottom, they should be selling dollars and buying commodities; but we don’t know if commodities are at the bottom — they’re cheaper than they were last year, but by historical standards, they’re expensive. China is already hedged for commodity prices: if China grows, commodity prices go up; if it stagnates, prices go down...By stockpiling commodities now, they’re doubling up their bet. If China returns to rapid growth, and commodity prices shoot up again, they’ll look like geniuses because they’ve won on both sides. But if Chinese growth stagnates, they’ll lose on both sides.

Are China’s purchases of commodities part of a diversification strategy away from the dollar?
Part of it is that: they want to hold real assets instead of dollars, but it’s just another speculative play. Yet, the very act of diversification puts pressure. If China is buying commodities, what are the sellers doing with those dollars?
Let’s say China buys commodities from Australia; the Australians either buy dollars, in which case we have monetary expansion in Australia…. But if the Australians don’t buy dollars, the Australian dollar appreciates, and a portion of the US trade deficit shifts from the US to Australia. Likewise, with the other big commodity exporters — Brazil and Russia.

Are there any domestic or external political circumstances in which China may ‘drop the nuclear bomb’ — that is, dump the dollar?
You can’t really do it. Let’s go through the different games — China can exchange dollars for commodities, which would probably have some impact on the dollar, but would cause commodity prices to surge. A lot of the commodities-exporting countries would end up recycling that money back into the US. So, it would only have a small impact on the dollar.

Or China could diversify into other foreign currencies. Let’s say China dumps dollars and buys euro. The value of the euro would shoot up against the dollar, the European export manufacturing sector would collapse; there will be disruptions in the US in the short term, but there would be an uproar in Europe. That would lead to trade sanctions, so they can’t do that either.  Alternatively, China could dump dollars against the renminbi; in other words, invest all this money back in China. But the PBoC is the only net buyer of dollars. If it becomes a net seller, the dollar has to collapse against the renminbi — which means the renminbi will soar against all currencies, wiping out China’s export sector.  I keep hearing about this ‘nuclear threat’. Politicians and ordinary people get very nervous about this. But I cannot figure out how you go about doing it in a way that benefits China and disrupts the US. Almost anything you do would cause either trade war, a collapse in China’s export sector and/or a massive transfer of wealth from China to the US, in exchange for some fairly short-term disruptions in the US. It could be a very difficult six months or a year. But at the end of the day, I don’t think it will make such a huge impact on the US. It’s one of the things that keep us awake at night unnecessarily.

Is the ‘nuclear bomb’ a dud?
Yeah, it looks like an atom bomb, but there’s nothing in it.

What are the merits and demerits of having SDRs as the alternative ‘super sovereign reserve currency’ that China wants?
I’d argue that if we were to switch to the SDR, it would have a couple of consequences. One would be that the US would no longer be able to run massive current account deficits. But the flip side is that countries that have generated growth by running massive current account surpluses — China and the Asian Tigers — would no longer be able to do that. If I were an Asian Tiger or an Asian exporter, I’m not sure I’d be in a great hurry to see that.

The other problem is: how do you actually make the transfer? There are two ways. Let’s say China says to the International Monetary Fund: “Here’s 2 trillion in dollars, give me the equivalent in SDR”.

The IMF can do it one of two ways. It can take the dollars and give out SDRs, but it would run a massive balance-sheet mismatch that would bankrupt it in a week. Or it can sell the dollar and buy euro, yen, pound and Swiss franc to create the SDRs that it gives to China. That would be the same thing as China selling the dollar, which would mean that the value of the dollar would drop significantly against the euro, yen, pound and Swiss franc. And all of those countries would find themselves running very large trade deficits while the US may actually run a trade surplus; so they would be absorbing the Chinese trade surplus — and possibly a US trade surplus too. I don’t think they will permit it.

We’ve seen some baby steps towards greater internationalisation of the yuan. Does this accelerate the timetable for making it fully convertible?
It does accelerate the process of making it convertible, but these are, as you say, just baby steps: we’re going from tiny to a little less tiny. We’re in a world where demand has the upper hand. There’s plenty of supply. China is the world champion of supply: it’s got this massive overcapacity that it must export. The world has said it prefers to denominate trade in dollars. China has said that it would like to denominate trade in renminbi…I don’t see how in a world with excess capacity and deficient demand, the world champion of excessive capacity can redenominate international trade.

When is the earliest the RMB can become fully convertible?
It could happen at the earliest in 3-4 years, but will probably take a lot longer. But that doesn’t make it a reserve currency. In the 1980s, everybody thought the yen would be the dominant reserve currency by 2000, but that didn’t happen. I think it’s much easier for the yen to become the dominant reserve currency than for the renminbi — because among other things, we’d need a much more independent banking system and a much more independent financial system. Financial sector reforms are political before they are economic: it needs a significant political change.

If China’s demands for a “super sovereign reserve currency” are ignored, does it increase the risk of a disorderly unwinding of the reserve currency mechanism?
No. These discussions, about doing away with the dollar as the reserve currency, have occurred every decade or so. After 2-3 years we’re not going to be talking about this. One reason we talk about this so much is the massive accumulation of central bank reserves.

But that’s the flip side of the massive US trade deficit. That’s contracting very quickly. In fact, some people believe that in 2-3 years, the US will be running a small current account surplus. If that happens, the rest of the world will be losing dollars. All this feverish speculation about ‘What happens if China has $4 trillion or $5 trillion’… it’s unlikely to happen. Ultimately, we’re going to work our way out of this issue, and my prediction is that in three years we won’t be talking about it.