Friday, December 24, 2010

Can China peg the euro to the dollar?

China has $3 trillion in external reserves (and growing). China is the world’s exporter and investor of last resort. China’s vast reserves are an artifact of its monetary policy: the dollar peg. To prop up the dollar versus the yuan, China must continually buy dollars.

The other big currency in the world is the euro. The relationship of the yuan to the euro is of course identical to the relationship of the dollar to the euro. When the dollar is weak vs the euro, that’s good for China. When the euro is weak vs the dollar, that’s bad for China.

Lately the euro has been weakened by the sovereign debt crisis. It is not in China’s interest for Europe to have a financial crisis, or for the euro to collapse in value. China has said that it will buy the bonds of the troubled eurozone members.

But here is an intriguing question: Does China have the resources to peg the euro to the dollar, in effect resurrecting Bretton Woods by creating a global dollar zone?

Obviously, the ECB could fight such a policy. However, it would not be easy, and more importantly, it might not be in Europe’s interest to fight such a policy. (And the ECB does not have an exchange rate policy.) The ECB would be free to conduct its monetary policy free of foreign exchange concerns, while the People’s Bank would do the heavy lifting of maintaining the euro-dollar peg. (The Fed could make this difficult, but it does not have any exchange-rate anchors or policies either.)

How would this work? First of all, the People’s Bank would never admit that it was targetting a dollar-yuan-euro peg. It would simply buy or sell euros or dollars as necessary. Yes, George Soros could push hard against the People’s Bank, but he doesn’t have $3 trillion. The Chinese would win, so long as they are prepared to stand with an open bid for euros at their preferred exchange rate.

The forgoing is more of a thought-exercise than a prediction, but I am sure that it has already occurred to the Chinese that they may want to informally add the euro to their “price support” program.

No comments: