Monday, January 17, 2011

The China-US summit

The People’s Bank is in a real bind. Central banks have mandates. The PBC’s dual mandates are difficult to achieve: parity with the dollar and growth without high inflation. Maintaining dollar parity requires the PBC to invest China’s enormous current account surplus in dollars (otherwise, the yuan would rise in dollar terms). The PBC requires exporters to sell their dollars to the bank in exchange for yuan.

As the PBC’s balance sheet expands, so does the money supply and thus inflationary pressures. The PBC is seeking to dampen inflation by curbing bank lending and raising interest rates. The PBC could also fight inflation by allowing the yuan to appreciate, but that it out of the question. Export growth trumps inflation. The PBC’s policies have been very successful. China’s growth and prosperity since 1979 have been remarkable.

But now the PBC and the government have two problems (besides inflation). One is that China is under increasing pressure from the G-20 to allow the yuan to rise. The other is that China is concerned that the value of it’s ~$3 trillion dollar nest egg is threatened by the US’s massive deficits and by QE2, which China believes represents a stealth devaluation.

Yesterday, President Hu made two somewhat contradictory statements (in a written Q&A with the Journal) which highlight his dilemma. First, he said the the dollar’s hegemonic status is obsolete. Then, in the same statement, he said that US monetary policy “has a major impact on global liquidity and capital flows and therefore, the liquidity of the U.S. dollar should be kept at a reasonable and stable level”.

In 2009, the PBC called for a new synthetic reserve currency regime. France has made similar statements. But there is nothing stopping the PBC or the ECB from buying SDRs or diversifying their reserve portfolios.

As I pointed out in my most recent post, I expected the PBC to buy euro-denominated government bonds, and indeed it did so last week in the Spanish and Portuguese auctions. But it is one thing to buy euros and another to stop buying dollars.

The ECB could diversify away from dollars and buy yen, won, sterling, the A$, the C$, etc. But that would be symbolic. Monetary policy on the ECB’s scale cannot be conducted with illiquid, boutique currencies. Buying yuan bonds is out of the question due to China’s exchange controls.

So the PBC and the ECB are exposed to both the US credit risk (still AAA!), and devaluation. And I don’t see that there is much to do about it, other than jawboning the Fed and the Treasury, which hasn’t worked.

President Hu’s summit with President Obama will be highly scripted, and I don’t expect anything major to come out of it.

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