Asian Doubts Regarding the Dollar

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the American public is oblivious to the growing debate over the
future purchasing power of the dollar in international trade,
Asian economists and policy-makers are beginning to discuss it.

Japan and China own hundreds of billions of low-return, dollar-denominated
assets, especially U.S. Treasury bills, Asian policy-makers take
seriously the possibility of a speculative move by currency traders
against the dollar. For the same reasons that stock fund managers
worry about a fall in the U.S. stock market, so do Asian central
bankers worry about the rise of their nations’ currencies against
the dollar. To get stuck with a few hundred billion dollars’ worth
of depreciating assets is no central banker’s idea of a good time.

On September
28, China Daily ran an article by Jiang Ruiping, who is
identified (in broken English) as the director of international
economics at the China Foreign Affairs University. Dr. Jiang had
some disturbing things to say about the future of the dollar.
He began:

Many international institutions and renowned scholars have recently
warned that the possibility of a US dollar slump is increasing
and may even lead to a new round of “US dollar crisis.”

China holds huge amounts of US-dollar-denominated foreign exchange
reserves, the authorities should consider taking prompt measures
to ward off possible risks.

It is
still too early to conclude if the US dollar is heading towards
a crisis. But it is an indisputable fact that it has gone down
continually. Its rate against the euro, for example, has dropped
by 40 per cent since its peak period and it lost 20 per cent
of its value against the euro last year alone.

It is
becoming more and more evident that the possibility of a further
slump of the US dollar is increasing.

Dr. Jiang
does not mention the fact that currency moves, up or down, tend
to continue in the same direction for years. The fact that the
dollar has slumped against the euro is already bothersome for
China’s central bankers, who peg the Chinese yuan to the dollar.
The yuan has also fallen 40% against the euro.

The problem
for the dollar, Dr. Jiang says, is the continuing twin deficits
in the Federal budget and the trade account of the United States.
The Federal deficit for fiscal 2004, which ended on September
30, will be over $400 billion.

From a domestic perspective, the worsening fiscal deficit will
put great pressure on the stability of the US dollar.

In 2001
when the Bush administration was sworn in, the United States
enjoyed a US$127.3 billion surplus. The large-scale tax cuts,
economic cool-down, invasion of Iraq and anti-terrorism endeavours
have abruptly turned the surplus into a US$459 billion deficit,
which accounts for 3.8 per cent of the US gross domestic product

By the
2004 fiscal year, the US Government’s outstanding debt stood
at US$7.586 trillion, accounting for 67.3 per cent of its GDP,
which exceeds the internationally accepted warning limit.

Dr. Jiang
passes over the inconvenient fact that the U.S. government counts
the annual surplus in the Social Security Trust Fund as a windfall
to the Treasury rather than as a long-term obligation of the Treasury,
which it is. So, even under Clinton, there was never a budget
surplus except in the technical accounting sense that Social Security
obligations are counted as off-budget obligations of the U.S.

Dr. Jiang
then goes on to deal with the deficit in the U.S. current account
with its trading partners.

The deteriorating current account deficit of the United States
is another factor menacing the future fate of the dollar.

In recent
years, the US policy that restricts exports of high-tech products,
coupled with overly active domestic consumption and the oil
trade deficit caused by rising oil prices, has deteriorated
the US current account balance. This poses a great threat to
a stable US dollar.

the 1992—2001 period, the average US current account deficit
was US$189.9 billion. In 2002 and 2003, however, the figure
soared to US$473.9 billion and US$530.7 billion respectively.
Experts predict that following its increasing imports in the
wake of its economic recovery and continuing high oil prices,
the United States will hardly see its current account balance


The policy
of China’s central bank is to subsidize this deficit by creating
fiat money domestically and using this newly created money to
buy dollars, which are then used to purchase low-return investment
assets. Other Asian nations have the same policy.

If foreigners
did not invest in the United States, then the deficit could not
continue. The excess of purchases over sales of goods by Americans
is funded by an excess of investment by foreigners. Some of this
investment is direct. But it is now declining.

Given the huge US current account deficit, the US dollar, if it
is to remain relatively stable, must be backed up by an influx
of foreign direct investment (FDI).

In 1998,
1999 and 2000, FDI that flowed into the United States was US$174.4
billion, US$283.4 billion and US$314 billion respectively. Starting
from 2001, however, global direct investment began to shrink
and US-oriented direct investment also decreased. In 2003, FDI
into the United States was 44.9 per cent less than that in the
previous year.

The decrease
in FDI will put more pressure on the US dollar, which has been
endangered by the huge US current account deficit.

Dr. Jiang
points to the policy of Japan’s central bank of buying dollars.
This, too, is declining.

Internationally, the Japanese Government’s intervention in the
foreign exchange market may become less frequent following the
gradual recovery of the Japanese economy.

To deter
the Japanese yen’s appreciation and promote exports, the Japanese
Government used to intervene in the foreign exchange market
to keep the yen at a relatively low level. In 2003 alone, it
put in 32.9 trillion yen (US$298.76 billion) to purchase the
US dollar. The intervention constituted a major deterrent to
US dollar devaluation.

As the
Japanese economy fares better, the Japanese Government tends
to back away from the market. Since April, it has not taken
any steps to swing its foreign exchange market.

This raises
a question: Where is the investment money coming from today, now
that Japan has ceased buying dollars with fiat yen?


Some of
the demand for dollars results from the oil trade. Oil exporters
demand dollars from would-be oil purchasers. This creates demand
for dollars when the price of oil rises, as it has this year.
The question now is this: Will this continue?

Another factor behind the risks of a US dollar slump is the weakened
role of the so-called “oil dollar.” Given the deteriorating relations
between the United States and the Arab world, quite a few Middle
Eastern oil-exporting countries have begun to increase the proportion
of the euro used in international settlement. Reportedly Russia
is also going to follow suit.

If an
“oil euro” is to play an ever increasing role in international
trade, the US dollar will suffer.

This has
not happened yet. The one oil exporter that broke ranks with OPEC
and demanded payment in euros was Iraq. The
United Nations in 2000 authorized this policy move.
Iraq made
the shift, requiring that two-thirds of its oil exports be paid
for in euros.

On March
5, 2003, as the U.S. invasion of Iraq was beginning, Hillsdale
College’s professor of economics, Richard
Ebeling, commented on Iraq’s oil pricing policy
. (Ebeling
now heads the Foundation for Economic Education, which I worked
for in the early 1970s.)

Last year, a senior Iranian oil representative suggested in a
speech in Europe that European oil purchases might be increasingly
traded in euros in the future. China and Russia have hinted that
they may begin to hold more of their foreign currency reserve
assets in euros in place of dollars.

If the
euro were to increasingly become the alternative international
currency of choice in competition with the dollar, the global
demand for greenbacks would fall, the value of the dollar would
decline, and the U.S. government would find it far more difficult
both to export inflation and to finance its budget deficits.
The financial clout and muscle of the American government would
be dramatically undermined over time with the dollar increasingly
no longer the only global reserve currency in town.

With the
American military serving as the keeper of the oil fields in
an occupied Iraq, the first policy change undoubtedly would
be that all Iraqi oil sales will be once again exclusively in
dollars. This would give the U.S. government the chance to try
to stem the tide toward international use of the euro in place
of the dollar and to put pressure on the Saudi government to
maintain its long-established policy of dealing only in dollars
on the oil market. And at the same time Iranian enthusiasm for
euro dealings might be tempered if the American liberators are
just next door.

This raises
a major issue: the ability of the United States to maintain its
presence in Iraq beyond 2005. I
have written about columnist Robert Novak’s prediction that the
U.S. will pull out of Iraq in 2005.
If this happens, then
Professor Ebeling will have answers to his questions.

It is hard to imagine that in the policy recesses of the State
and Treasury Departments this benefit from a successful war in
Iraq has not been thoroughly discussed in the briefs circulated
among those deciding on war or peace. How else can the U.S. government,
with federal budget deficits looming for years on the horizon,
go on playing its sleight of hand in which it deludes the American
public into thinking that government deficit spending is a continual
“free lunch” that others around the world can be made to pay for?
How else can the American government continue to play dollar diplomacy
in managing its global empire?


Dr. Jiang
then gets around to China. He writes:

In China’s case, its rapidly increasing foreign exchange reserve
will incur substantial losses if the US dollar continues to weaken.

At the
end of 2000, China’s foreign exchange reserve was US$165.6 billion.
By the end of 2002, it rocketed to US$286.4 billion before it
soared to US$403.3 billion by the end of 2003. By the end of
June this year, the reserve was registered at a staggering US$470.6

two thirds of the reserve is dominated by the US dollar. As
the dollar goes down, China will suffer great financial losses.

estimate that the recent US dollar devaluation has caused more
than US$10 billion to be wiped from the foreign exchange reserve.

If the
so-called US dollar crisis happens, China will suffer further

The high
concentration of China’s foreign exchange reserve in US dollars
may also incur losses and bring risks.

How long
will the central bank of China continue to subsidize the dollar?
Answer: for as long as the Chinese government tells the central
bankers what to do. Keeping the yuan fixed to the dollar lets
Americans buy all those low-cost goodies. But this policy has
a price: China’s accumulation of T-bills.

The low earning rate of US treasury bonds, which is only 2 per
cent, much lower than investment in domestic projects, could cost
China’s capital dearly.

Due to
high expectations of US treasury bonds, international investors
used to eagerly purchase the bonds, which leads to bubbles in
US treasury bond transactions. If the bubble bursts, China will
suffer serious losses.

A major
reason why interest rates are low in the United States is the
purchase of T-bills by foreign central banks. The Federal Reserve
System is not the main reason for high demand for T-bills, and
therefore a low price (interest). The adjusted monetary base has
increased by a moderate 5.2% over the last year — well within
the FED’s familiar range. Foreign central bank demand for dollars
is today more important than FED policy. But this is unlikely
to continue for much longer.

Dr. Jiang
understands that China’s central bank is creating yuan in order
to buy dollars. He understands that this has created a domestic
inflationary environment in China.

Moreover, since the Chinese trading regime requires its foreign
trade enterprises to convert their foreign currencies into yuan,
the more foreign exchange reserves China accumulates, the more
yuan the Chinese authorities will need to put in the market. This
will exert more pressure on the already serious inflation situation,
making it harder for the central authorities to conduct macro-economic

He then
offers a policy recommendation. This recommendation bodes ill
for the continuing high value of the dollar in relation to the

To ward off foreign exchange risks, China needs to readjust the
current structure, increasing the proportion of the euro in its
foreign exchange reserves.

the improving Sino-Japanese trade relations, more Japanese yen
may also become an option. During the January—June period
this year, the proportion of China’s trade volume with the United
States, Japan and Europe to its total trade volume was 36.5
per cent, 28.6 per cent and 37.4 per cent respectively. Obviously,
seen from the perspective of foreign trade relations, the US
dollar makes up too large a proportion of China’s foreign exchange

could also encourage its enterprises to “go global” to weaken
its dependence on US treasury bonds.

There is
another use of dollars, he says. “And using US assets to increase
the strategic resource reserves, such as oil reserves, could be
another alternative.” In short, sell T-bills, buy oil, and stick
the OPEC political regimes with a high-risk currency. That would
move the flow of oil toward China rather than the rest of the
world. Better to stock up on oil than T-bills.

This policy
makes sense to me. Will it make sense to the Chinese government?
On the day that it does, the dollar will resume its fall. Interest
rates will rise.


Daily is published on mainland China. The fact that an academic
such as Dr. Jiang is allowed to offer critical comments about
China’s central bank policy indicates how far Communist China
has departed from the ways of Mao.

But there
is another possibility. Dr. Jiang’s article may be serving the
government as a trial balloon. If this is the case, then the days
of dollar supremacy are numbered. If China floats the yuan, buys
oil or euros, and sells off T-bills, the dollar will fall and
U.S. interest rates will rise.

my view, it’s a matter of when, not if.

1, 2004

North [send him mail]
is the author of Mises
on Money
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