(This interview with Michael Pettis, professor at Peking University’s Guanghua School of Management, explores the impracticality of China’s repeated threats to ‘dump the dollar’; a smaller version of the interview was published in DNA edition dated July 13, 2009.)
China’s recent calls for an alternative to the US dollar as global reserve currency are motivated by political, rather than economic, considerations, says Michael Pettis, a professor at Peking University’s Guanghua School of Management, and a specialist in Chinese financial markets. In an interview to Venky Vembu, 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 keeps us awake at night unnecessarily… It looks like an atomic bomb, but there’s nothing in it.” Excerpts:
You’ve argued that there is no alternative for now to the US dollar as a reserve currency. But Chinese officials have persisted with their calls for an alternative. Why would they do it if it wasn’t feasible?
Much of that discussion is for political purposes, both internationally and domestically. Domestically, there’s been criticism about the mismanagement of Chinese investments abroad. And there is rising concern about this hoard of dollars that the People’s Bank of China has and concerns about excessive easing and excessive borrowing in the US government. One of the things that the (Chinese) government feels the need to do is to indicate domestically that it is very concerned about the value of these reserves and that it is going to do something about it.
But it’s not clear what any of that means. If you think US fiscal expansion will weaken the dollar…. weaken the dollar against what? The euro and the yen – currencies of countries that are seeing slower growth and 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 they are worried and they are doing something about this.
The really surreal point is that the pace of the Chinese adjustment will to a large extent be affected by the pace of the US adjustment in demand contraction. With household demand contracting so rapidly and household savings rates going up so rapidly in the US, the only thing that’s preventing a complete collapse in the US trade deficit is the US government’s fiscal expansion. So the Chinese are in a funny position saying, “We are suffering tremendously from the contraction in Chinese exports as a result of a contraction in US trade deficit, and we don’t want to see this contraction continuing so quickly. But we also don’t want you to use the only possible way of slowing down the contraction.”
This doesn’t make sense. You can ask for more fiscal responsibility from the US, which means China’s export sector will get brutally hit. Or you can ask for a slowdown in the contraction of the US trade deficit – but that means the fiscal deficit will have to grow because it’s US government spending that is slowing down the contraction in demand. You can’t ask for both.
The other thing the Chinese are doing is politically signalling abroad that “we are an important player in the global financial system and we have legitimate concerns and grievances.” In the past, the US has done a good job of arrogant lecturing. And given the way things are now, with the US in the midst of the crisis, and China seeming not to be – and I stress ‘seeming’, because I think it is – this is probably a great opportunity to repay the lecturing.
Every time Chinese officials open their mouths, the markets get spooked and China’s investments in dollar-denominated holdings take a hit. Is that prudent – or have they mentally booked their losses?
When they make comments that are unexpected, there is a short-term weakness in the dollar, 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 that much. All this talk is very unlikely to cause such a significant collapse in the value of the dollar that it starts feeding on itself and so becomes a permanent collapse.
It’s not going to happen?
This talk about replacing the dollar 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. All of these debates have been equally valid or invalid. But if China wanted to hold Special Drawing Rights (SDRs) rather than dollars, why didn’t they? There was nothing to prevent it. The Chinese central bank could have accumulated reserves in the same proportion as in the SDR.
Bu they didn’t because for trade reasons it was impossible. If you want to run very large trade surpluses, somebody has to run large trade deficits – and you have to recycle those trade surpluses. The currency in which you recycle those trade surpluses determines to a large extent where the pressure for the trade deficits are going to be. I would argue that the US is the only market that is deep enough, with a flexible enough financial system, that it is able to run large trade deficits for long periods of time. It’s almost inconceivable that the European economy, given its structural rigidities and given much more political concerns about trade and trade deficits, would have been able to sustain that, and of course Japan was not willing or able to run large deficits while still recovering from its own crisis.
Basically, China accumulated dollars because in order to generate employment growth it needed to force its trade surplus onto some other economy, 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.
From the public articulations by Chinese officials, do you see a consistency in China’s stand in what it wants of the dollar?
It seems that a lot of people simply don’t understand basic balance-of-payments arithmetic, and so all kinds of nonsensical statements come out. For instance, many people believe that the decision to lend dollars to the US government is an independent decision made by the PBoC. It is not. It is the automatic consequence of policies aimed at running trade surpluses. In fact, the confusion exists not just in the Chinese government but in the US government as well, for example in its conflicting claims in favour of closing the US trade deficit while simultaneously begging foreigners, especially the Chinese, to keep buying US dollars. But foreigners can only be net buyers if the US runs a trade deficit. On both sides, we’re seeing statements that suggest more an inability to understand the basics of the balance of payments than any serious proposals.
How much of it is frustration that China has allowed itself to be ensnared in a dollar trap?
There’s been a big debate about that. What happened is 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. The strange thing is that there is still a perception in China that the loss in the value of the reserves will only occur when the renminbi is revalued. That’s wrong on two accounts.
First, if the loss occurs when the renminbi is revalued, that loss is a renminbi loss, which is totally irrelevant for the purposes of the reserves. Because what can you do with reserves except pay for foreign imports or foreign debt? So 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%. You could buy just as much stuff and pay off just as much debt. In that sense, there is no loss.
But, more importantly, if the RMB is undervalued, the loss occurs every single time a Chinese manufacturer exports goods abroad. And the recognition of the loss only occurs when you increase the value of the RMB. In a funny way, an important segment of policymakers are saying that one of the reasons we shouldn’t increase the RMB value is because of the huge losses we will take. The irony is that 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 you think Chinese officials sense that their dollar-denominated holdings are unsafe?
There is real concern about that, but a lot of the thinking is quite muddled. First of all, since the probability of a US default is practically negligible, what other kinds of losses can they take? They can take currency losses, but against which currency? It’s not really clear that the dollar is necessarily going to weaken against any specific major currency. The dollar in theory is supposed to have been weakening dramatically for years and years, but in practice it hasn’t. And if you think that too much debt in the US means the dollar must weaken, all the other relevant governments have even more debt and their economies are growing even more slowly, so their currencies should weaken even more. But all currencies cannot weaken simultaneously.
Others say the real value of the dollar may weaken via inflation. We may at some point see inflation, but I don’t think it will get out of hand. But even that can be protected by buying inflation-adjusted bonds or by staying on the short-term of debt maturities.
One of the things the Chinese seem to be doing is to buy commodities. But that, to me, is just another speculative play. If commodities are at the bottom, of course they should be exchanging dollars for commodities; but we don’t know if commodities are at the bottom – they’re certainly cheaper than they were last year, but by historical standards, they’re still very expensive.
Anyway I would argue that China is already hedged against commodity prices because it’s a huge factor in the commodities market. If China grows quickly, commodity prices will go up. If China stagnates, commodity prices will go down. In that sense, China is naturally hedged. They pay more when things are going well, and less when things are going badly. By stockpiling commodities now, they are doubling up their bet. If China returns to very rapid growth, commodity prices will shoot up again, and they’re going to look like geniuses because they’ve won on both sides – they have rapid growth as well as cheap commodities. But if Chinese growth stagnates, they’re going to lose on both sides.
Do you see China’s purchase of commodities as part of a diversification strategy away from the dollar?
Part of it is that: they want to hold real assets instead of dollars. But as I said to me that is just another speculative play. Instead of speculating on dollars, they are speculating on commodities. But the very act of diversification puts huge amounts of pressure on commodity prices. Furthermore if they’re buying commodities, what are the commodity sellers doing with those dollars? Even they are going to turn around and put the dollars back in the US, in which case we’re going to see monetary expansion in those economies.
Take a simple case: China buys something from Australia, the Australian central bank then either intervenes and buys dollar assets – in which case we have monetary expansion in Australia, which may or may not be good, depending on the conditions. But what if the Australians don’t buy dollars? In that case, the Australian dollar appreciates sharply, and a portion of the US trade deficit shifts from the US to Australia – a country to small to bear it.
The other big commodity exporters – Brazil, Russia – are also all fairly small economies. China can’t really diversify too much without causing significant trade deficits elsewhere.
Do you see anything in the recent developments where China moved towards buying short-tenure US treasuries?
I think if you’re worried about unexpected, rising inflation, you would shorten the maturity of your bonds. If the Chinese really are worried that the US will at some point begin to inflate as a way of dealing with its debt, the way they protect themselves is by moving to the short end of the maturity spectrum.
Are there any domestic or external political or economic circumstances where Chinese leaders might ‘drop the nuclear bomb’ – that is, dump the dollar?
They can’t really do it. Of course they can’t simply give away dollars or burn dollar bills – they have to exchange them for something, and we can go through the different scenarios: for example, they can exchange dollars for commodities, which would probably have some impact on the dollar, but would causes commodity prices to surge. A lot of the commodity-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 the euro. Let’s say they dump dollars and buy euro. What would happen? The value of the euro would shoot up against the dollar, and the European export manufacturing sector would collapse; there would be disruptions in the US, but these will probably be short-term disruptions, but there would be outrage and uproar in Europe. That would almost certainly lead to trade sanctions of some sort, so they can’t really do that either.
The third thing they could do is to dump dollars against the renminbi; in other words, invest all this money back in China. The problem there of course, besides the huge increase in domestic dent that would require, is that the PBoC is the only net buyer of dollars in China. If it turns around and becomes a net seller of dollars, that means the dollar has to collapse against the renminbi. That’s just another way of saying the renminbi will soar against all currencies, wiping out the Chinese export sector.
So I keep hearing about this nuclear threat, but I’m sure how they can actually do it. Even in the US, if it were to happen, how difficult would that be? Well, this has happened before, funnily enough. In 1914, at the beginning of World War I, the European belligerents dumped enormous amounts of dollar assets to raise gold for fighting the war. It was very painful for about six months in the US, there were major dislocations in the market, and the US stock market actually had to close. But when the dust settled, a huge amount of European investments in the US accumulated over the previous hundred years was liquidated at firesale prices to Americans. To many people, the disruption in the US financial markets in 1914 and early 1915 actually represented a massive transfer of wealth from Europe to the US. I think to a certain extent, the same thing would happen.
If China caused a huge collapse in the value of the dollar, and a huge increase in the value of the euro, Americans would probably sell off European assets and use the proceeds to buy American assets indirectly from Chinese, who would be exchanging very cheap American assets for very expensive European assets, thus representing a massive transfer of wealth from China, which would be holding all these depreciating assets, to the US.
These ideas of “nuclear options” are the sort of things that politicians and ordinary people get very nervous about. But the problem that I cannot figure out is exactly how you go about doing this in a way that benefits China and disrupts the US. It seems to me that almost anything you do would cause either trade war, a collapse in the Chinese 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 keeps us awake at night unnecessarily.
So the ‘nuclear bomb’ is a dud?
Yeah, it looks like an atomic 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?
Everyone talks about the history of reserve currencies indicating that once a creditor nation whose currency is the reserve currency loses its creditor status and becomes a debtor, it loses its reserve currency status. That’s complete nonsense. There is no such history. There has been only one other reserve currency in the world before the dollar: the sterling. So “history” consists of a single data point. That is not history in any meaningful sense.
When sterling was a reserve currency it was during the gold standard period. So the mechanism for creating additional reserves around the world was additional gold mining and from time to time major gold discoveries. Occasionally very disruptive but that was the mechanism.
Under the fiat currency system, the reserve currency has always been a debtor country, that is a country running a current account deficit, because that was the only way for foreigners to accumulate reserves. So when people talk about history telling you this or that, there is no history. There is little we can learn from history about the transformation of reserve currencies because it has only happened once and under radically different circumstances.
I would 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. And the flip side of that is that those countries that have generated growth by running massive current account surpluses – China and the Asian Tigers – would no longer be able to run current account surpluses. So, you would reduce US ability to run these massive deficits, but that’s not necessarily in the best interests of the rest of the world.
In fact, I would argue that it should be the US that should be the prime proponent of eliminating the dollar as the primary reserve currency and creating the SDR. This eliminates the ability of the US to run large trade deficits and the ability of foreigners to create growth by systematically running large trade surpluses against the US. As an American I would like to see the dollar replaced by the SDR because large US trade deficits are not necessarily good for the country, but I’m not sure that if I were an Asian Tiger or an Asian exporter, I would be in a great hurry to see that.
The other problem is: how do you actually make the transfer? You go to the IMF, and let’s say you’re China and you say ‘Here’s 2 trillion in dollars, give me the equivalent in SDR’. The IMF can do it one of two ways. Either it takes the dollars and gives you SDRs, and thereby runs a massive balance-sheet mismatch that would bankrupt it in a week if the dollar were to weaken by even a little. Or it actually goes and sells the dollar and buys euros, yen, sterling and Swiss franc to create the SDRs that it gives to China. That would be the same thing as China selling the dollar against those currencies, which would mean that the value of the dollar would drop significantly against the euro, yen, sterling 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.
Western leaders argue that China’s calls for an alternative reserve currency are hampering economic recovery efforts. Is it?
From a theoretical point of view, I’d say that one of the problems we have now is that risk appetite has disappeared. Markets are simply not eager to take any risk. Anything that increases uncertainty makes it just that more difficult. I may believe that all this to-ing and fro-ing about the dollar is pretty much a waste of time, but to the extent that it adds volatility in the currency market, it is adding uncertainty for businesses. In that sense, it’s probably not a good thing. Right now, most countries and policymakers would agree we need to reduce uncertainty, not increase 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 just baby steps, as you say. We’re going from tiny to a little less tiny.
We’re in a world in which 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.
Now if I’m the only seller and you are desperate to buy what I have, I can pretty much tell how you’re going to do it. But if there are ten of us desperately trying to get you to buy from us, and I impose conditions on you, you’re simply going to turn away and buy it from somebody else. I don’t see why in a world with excess capacity and deficient demand the world champion of excessive capacity is in a position to redenominate international trade.
When is the earliest you see the RMB becoming fully convertible?
It could happen at the earliest in three to five years, but probably a lot longer. But that doesn’t make it an important reserve currency. In the 1980s, many analysts thought that the steps that Japan was taking to make its currency a reserve currency would result in the yen becoming the dominant reserve currency by 2000. But that turned out to be a huge mistake. I think it’s much easier for the yen to become the dominant reserve currency than for the renminbi – because among other things we would need a much more independent banking system and a much more independent financial system in China, and in China financial sector reforms are political before they are economic.
I also think – and people underestimate this – that this is too tough a neighbourhood: relations between China and India have historically not been terribly good, Likewise between China and Russia, Russia and Japan, Japan and China, Korea and Japan, and Korea and China. Given these deep historic enmities I find it a little bit hard to believe that any of these major countries would be eager to see any other one of these countries have the dominant reserve currency. For example, China would never accept the Japanese yen as the dominant currency, and I doubt Japan will ever embrace the renminbi. Would India?
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. I think all these discussions of doing away with the dollar as the reserve currency have occurred every decade or so. After two or three years we’re not going to be talking about this. One of the reasons we talk about this so much is the massive accumulation of central bank reserves, and that’s simply the flip side of the massive US trade deficit.
But that deficit is contracting very quickly. In fact, there are people who believe that in two or three years, the US will be running a small current account surplus. If that happens, the rest of the world will be reducing its dollar holdings. So, all of this feverish speculation about ‘What happens if China has $4 trillion or $5 trillion’… it’s very unlikely to happen. The crisis reflects the fact that US households got themselves into enormous amounts of debt while running a massive current account deficit. As US debt contracts – and it is contracting: people look at the US government debt and say it is expanding, but household and corporate debt is contracting – consumption growth will be slower than GDP growth for many years. That means the US trade deficit is going to contract very quickly, and so foreigners will stop accumulating dollars.
Is there any mechanism that can accommodate the competing interests of those who favour a continuance of the dollar reserve currency arrangement, and China, which wants an alternative?
The continued use of the dollar. I would argue that it is in China’s interest that the US continues running large trade deficits. And the only way the US can continue running large trade deficits is if it is easy for countries to accumulate dollars. I think it should be the US that should be putting more pressure on reducing the automatic ability of the US to run large current account deficits .
Do you see that happening?
In the US, we have a very old conflict between the internationalists and the domestic guys. Basically, the domestic guys are saying we don’t really need this. Let’s opt out. The internationalists are saying, ‘No, we need to continue with the existing system.’ I don’t think the US is directly saying we need to reduce the use of the dollar as an international currency. But President Obama did say that we need to raise household savings rates.
I would argue that’s exactly the same thing, whether people realise it or not. If US savings rates go up, the US trade deficit almost certainly must disappear. And if that happens, the international use of the dollar must contract. So, 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.
What’s the one big takeaway for China from all this: is it that the dollar-based financial order cannot be changed overnight?
I would say that we all need to understand that the “decision” about which currency is the reserve currency is not a “decision”, and has little to do with the political interests or perceptions of interested parties. The world chooses a major currency in which to denominate international trade and reserve accumulation for a variety of very functional reasons – such things as the flexibility and political independence of the domestic financial system, a sense of political non-interference in issues of trade and capital, the ability and willingness of countries to run current account deficits, which in part reflects domestic economic rigidities, a sometimes bewildering variety of geopolitical rivalries, demographic changes (which in China are terrible) and last but certainly not least, sheer inertia. Policymakers cannot somehow just “choose” to shift from one dominant currency to an alternative.