Perhaps even more important than the relative size of the Chinese or Japanese or whichever creditor’s position is why they have lent us so much and why that isn’t likely to change overnight. When a country imports a lot more than it exports, the importing country’s currency should fall. For example, when we buy something made in China, we pay in dollars. The Chinese seller doesn’t want dollars, so they must trade the dollars for Yuan. If China is accumulating dollars because we are buying more than we export, then the Chinese will have lots of dollars to sell. All that selling will cause the dollar to weaken and fall. As the dollar falls it can buy less and consequently we can’t buy as much from China as before. Now, China’s number one goal is to grow fast and employ as many peasants as possible. In order to keep growing, the Chinese central bank manipulates the exchange rate (by buying our debt) so the Yuan doesn’t rise too much relative to the dollar. This keeps the dollar artificially strong and Americans buying cheap Chinese goods.
Given that the U.S. consumer is the ultimate destination for most of China’s exports, the Chinese are dependent on our buying. The last thing the Chinese want is for the dollar to weaken so much that we stop buying from the Chinese. This is precisely why China has recycled all those dollars into our debt- it is a safe place to park those dollars while supporting the exchange rate so they can continue to grow. Japan and other countries have also followed a similar strategy. (Now, there is another issue not addressed here, which who is going to buy all the debt to be issued in the next few years. We'll address this next time as it does not relate to China specifically.)
Can the dollar lose its reserve currency status?
For the sake of discussion, let’s assume something goes awry and the world decides it wants another reserve currency in lieu of the dollar (which will happen someday). Replacing the dollar as the world’s reserve currency is not as simple as a central bank committee making a choice between this or that currency. A “reserve currency” is a currency that is held in significant quantities by governments and central banks to help stabilize their own currency. For example, in most systems currency is an obligation of the central bank. Here in the US, our bills say “Federal Reserve Note” on them. The note has value because we trust that the Fed has the authority and assets to keep those bills valuable. People aren’t so trusting of smaller countries and their money however. A country like Brazil or South Korea will occasionally have to “defend” their currency. They are able to “prove” it has value by showing that the bills are backed up by more than just a promise; rather those bills are backed up by a giant vault of cash from another country. The value of the foreign money can’t be tinkered with and so it “backs up” the home country’s currency.
64% of the world’s official reserves are currently in U.S. dollars. If you are a Brazilian, South Korean, Yemeni or Indian central banker for instance, what currency are you going to hoard in order to protect your own country’s money? You’d look for a currency with a giant, liquid market so it can always be traded. Since that reserve currency needs to be secure, the country must be able to defend itself and its interests regardless of what happens. No one holds the Ukrainian Grivna as a reserve currency, because who knows if they will be around in a few years? Or if Russia decides to cut off their natural gas, what can the Ukraine do to protect its economy? A reserve currency must also hold its value because the country issuing it is an economic powerhouse. Despite bumps and potholes in the road, does the country have the stability, natural resources, economic system and culture that will enable it to be and remain prosperous in the long run?
The answers to all these questions point only to the United States. Is a central bank going to trust the Chinese, who are command and control communists that regularly manipulate their currency? Or the Yen, when the Japanese debt is double the amount of ours, the population is shrinking and they can’t defend themselves? The Russians who play energy politics? Maybe the Euro is the alternative- and indeed it is- the Euro is roughly 27% of the world’s reserves. However, the Euro is really just an experiment, not a currency. It is not supported by one country or government; its member states have wildly different agendas; the European Central bank was more or less powerless to help European banks during this crisis; and let’s not forget that the Europeans have never gotten along with each other for more than a half century or so. In sum, reserve currencies are born, not agreed upon. The U.S. dollar is the only currency that can currently serve this role and its position has actually increased since the crisis began.
Next up: Part III: Can the Dollar weaken anyway?
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