Can China Really Dump the Dollar?

The U.S. dollar is on our minds these days because it is weak and getting weaker. We hear reports that Chinese officials are actively cautioning, scolding and remonstrating with the U.S. on its profligate ways because China has a few trillion in reserves -- much of it invested in dollar-denominated securities.

The falling dollar and China’s big stake in dollar-denominated securities raises the question, “Will China dump the dollar?” For investors, I believe a better question is: Can China really dump the dollar?

In terms of foreign currencies, I believe there are only two other actual currencies — the euro and the Japanese yen — that China could look to other than the dollar. China’s financial reserves are big enough that its government has to have its foreign assets denominated in a very large, liquid currency. There are not too many of those around other than the U.S. dollar, the euro and the yen.

For a variety of historical and cultural reasons, I doubt if the Chinese would seriously entertain putting most of their foreign currency and foreign assets holdings in the Japanese yen, so the currency choice is between the dollar and the euro.

The Chinese are investing in the euro, but that is happening in an incremental fashion. As long as the U.S. remains a significant trading partner for China’s exports, the dollar will be a major currency for Chinese central bank activities. There are those who think the Chinese will dump the dollar and buy euros on a wholesale basis, but that is unlikely.

However, one other choice is being discussed — the Chinese currency itself, known alternatively as the yuan or renmimbi. (Let’s go with yuan, but really, why can’t they just make up their minds?)

I have no doubt the Chinese would love to have the yuan as the world’s reserve currency, but I don’t see that happening soon -- unless they really want to wreak havoc and let loose the dogs of currency and trade war.

What If?

Just to finish the thought, what if China did dump the dollar in a significant way? First, the implications of that are obviously negative for the U.S. economy, as the dollar would fall even further under the selling pressure. Other countries along with large investors would dump dollars, putting more pressure on it. In order to shore up the dollar, the Federal Reserve would be forced to raise short-term interest rates and, though that would help the dollar, it would hurt the economy in the short run.

However, consider how these events would affect China. Selling its stake in dollar-denominated securities is something that could not be done quickly, so a precipitous fall in the dollar would reduce the value of all dollar-based securities China continued to hold. Also, assuming the U.S. economy softened under this scenario, exports to America would dry up quite a bit.

Finally, there would be intense political pressure in the U.S. to retaliate by slapping tariffs on Chinese goods and taking other punitive measures. In short, China would also suffer a great deal if it tried to dump the dollar, so I do not believe it can dump the dollar -- but I also believe it's actively seeking other options. In the long run though, it still comes down — and down and down — to the dollar.

What’s Next for the Dollar?

The big difficulty we face now is that the economy is weak and the Fed likes to have very low interest rates to help the economy begin to grow again. Low interest rates are helpful to overall economic activity, but low rates generally hurt the dollar.

If the Federal Reserve wanted to help out the weak dollar, the response would ideally be to raise interest rates. However, due to serious weakness in the economy, the Fed is hampered in its ability to respond to this situation; I believe it will opt to keep interest rates low well into 2012 in order to promote economic growth. Unfortunately, of course, that means we are likely to have a weak dollar for some time as well.

You may hear various politicians or pundits decrying the weak dollar. However, for decades our government’s philosophy during recessions has been to publicly espouse a strong dollar while also cutting interest rates to strengthen the economy and give unemployment a boost. This has traditionally been done despite the fact that lower interest rates generally lead to a weaker dollar. I don’t see anything in the cards that appears to have changed that policy. Therefore, I expect continued pressure on the dollar as the Fed seeks to get economic activity going again.

Huge Deficits Mean More Pressure on the Dollar

With huge budget deficits as far as the eye can see, the U.S. Treasury has to issue enormous amounts of Treasury securities. To absorb these securities, the Treasury needs buyers, so we need China to continue investing. As a result, U.S. fiscal and monetary policy will be increasingly tied to keeping China happy. It enforces a discipline of sorts, but our policy options are going to be increasingly limited and necessarily reactive, rather than proactive.

The Road Ahead

The dollar is likely to be weak until the Fed starts raising interest rates, which is unlikely to happen until later next year, so we will continue to hear lots of noise from Washington and parts eastward about the dollar -- but I do not think anyone in the Treasury Department or the Federal Reserve will do anything meaningful about the dollar soon.

As long as this low interest rate trend continues, the dollar will weaken. However, when the dollar snaps back, as it will (if even temporarily), the move will be very quick.