the Euro is surely worth mentioning in these articles, because it is large enough that you have to consider the system as a 3-body one

That's another understatement. As AP says, (my emphasis)

China, the world's third-largest economy, escaped the worst of the global financial crisis by ordering $1.4 trillion in bank lending and government stimulus.

implicitly taking the Eurozone or the whole EU as one of the top 2.

I would like to try my hand at a 3-way model of trade, reserves and currency valuations...

The brainless should not be in banking -- Willem Buiter

I think that is their intent, but there may be one factor that you are forgetting. It is assumed widely that the US dollar will decline in value compared to other currencies as it has done over the past decade or so. But the problem for the euro is that while the Yuan gained value, it was less than the drop in value of the dollar. The end result was the euro gained value against the yuan as the dollar dropped. Some articles seemed to show not so pleasant aspects of that for eurozone exports and import competing industries.

Rutherfordian ------------------------------ RDRutherford

I don't know...

1. As you have observed, the way the market works is that you can't just liquidate large holdings at the going price... so likewise it seems that China has some things to lose by liquidating it's dollar holdings...

2. Once you move away from a dollar crash... what harm in a bit of a dollar decline?

3. Or is the Chinese threat... hand over the technology or we keep the dollar high? That's bad for the US economy as a whole perhaps, but the elites are quite happy being "reserve currency"?

But there are ways to devalue and then there are ways to devalue.

Specifically, devaluing your currency has two consequences:

1. It makes it more expensive for you to import other people's stuff. This makes industries that rely on imports for a large fraction of their retail value less competitive (because the imported parts become more expensive faster than the added value becomes cheaper for foreigners).

2. It makes it less expensive for other people to import your stuff. This makes industries that rely on domestically added value for a large fraction of their retail price more competitive (because the added value becomes cheaper for foreigners faster than the imported parts become more expensive).

The problem is that if you devalue on somebody else's timetable, there is no guarantee that you will be able to create new industry of the second kind faster than the industry of the first kind goes belly-up. Whereas if you devalue on your own timetable, you can match the pace of the devaluation to the tools and benchmarks of your industrial policy.

Now, granted, this problem goes away if you impose profit controls (recall Adam Smith's not-so-famous dictum that profit is more harmful to competitiveness than wages because wages grow only linearly with value added while working capital grows exponentially with value added). But if you have sufficient political clout to impose profit controls, then you also have sufficient political clout to devalue on your own timetable.

- Jake

"Terraforming your own planet to make it uninhabitable hardly counts as epic win." - ThatBritGuy

does.not.compute

The brainless should not be in banking -- Willem Buiter

Could they surreptitiously convert their holdings to cash

No. The Fed would notice.

Well, that is to say that the Fed would have all the information they would need to notice. Given the current leadership...

- Jake

"Terraforming your own planet to make it uninhabitable hardly counts as epic win." - ThatBritGuy

US dollars are tap issue. Anyone "surreptitiously" converting such a large amount of US deposits and selling such a large amount of financial assets for cash would lead to banks tapping reserve accounts for cash, and the Treasury would have to print a large amount of dollars to meet the tap issue. It would also substantially reduce the leverage of the US money supply, since currency in circulation are bearer reserves with leverage of 1:1 while most money is primarily financial-asset-backed with substantial leverage on reserves on account.

The massive collapse in the size of the US money supply that is a side-effect of the lead transactions of the proposed operation is probably something even this Fed would notice.


Utsukushikereba sore de ii

... reserves is not what maintains the discounted exchange rate ... its the ongoing operations to depress the value of the ¥RMB against the major floating currencies that maintains the discounted exchange rate.

The Chinese Central Bank could wind down its US$ reserves more slowly over an extended period of time with a "phony peg" where it uses larger offsetting &Euro;, ¥ and £ transactions to maintain the US$/¥RMB exchange rate at a rough balance.

The signal that this was going on, as long as the Chinese themselves were silent (or engaged in active deception) about what they were doing, would be the US$ dropping against the other major trading currencies, with greater volatility in ¥RMB/US$ exchange rates but rough stability in the average rates. Also, because of guanxi, one would also expect substantial numbers of Chinese retail financial institutions to be unwinding US$ holdings at the same time.

So as long as those rough facts were not observed (cough), we could be confident that the Chinese were not pulling that trick.

Remember that the US produces twice the world average oil per person but consumes at five times the world average rate. A substantially lower US$ would give breathing room in world oil markets for everyone else. And the lost income opportunities for Chinese exporters in their second largest market might be offset some by the increased income opportunities in their largest market, the EU.


Utsukushikereba sore de ii

But if China did not want "overheating" of its economy, it would not be maintaining its exchange rates at a steep discount.


Utsukushikereba sore de ii

From ARGeezer in the Salon:

Note well, I don't say this means the US has power, this just seemed like a good place to introduce a really interesting bit of possible data:

ARGeezer:

China's Exporters Hanging by a Thread?  Naked Capitalism

Has the Chinese export sector become hostage to WalMartization, the ability of powerful retailers to squeeze vendor profit margins? Reader Michael Q called our attention to a key remark in a Wall Street Journal story:

   Vice Commerce Minister Zhong Shan, in an exclusive interview Thursday ahead of a visit to the U.S., said that the profit margin on many Chinese export goods was less than 2%.

    Most exporters absorbed the appreciation in the value of the yuan that followed its revaluation in 2005 by boosting innovation and cutting costs, but many were forced to close, he said. A further rise in the currency's value would endanger more exporters' survival, which China can't afford, he said.

As Michael Q, who is an equity analyst, noted:

   2% margins on export-oriented businesses is not representative of any sort of real competitive advantage. A real competitive advantage when it comes to exporting would show double-digits profit margins. This whole sector is hanging by a thread...nearly none of the activity China has engaged in since the downturn is secular or self-sustaining.

Yves here. The implications for China are serious. First, this says that it perceives it has no room to revalue the RMB upwards. Not only are exporters politically powerful, but on a more mundane level, the regime has achieved social cohesion through a promise of rising prosperity. Too much unemployment would undermine the legitimacy of the governing classes.

But second, it also implies China cannot even tolerate much inflation. Remember, inflation will push up the price of good in local currency terms, which in a fixed peg currency regime, translates directly into price increases. Price increases from a country whose selling proposition is cheap prices would lead importers to look for substitutes in other emerging economies. A 2% margin not only says manufacturers have no room to cut prices, it also says they cannot afford much in the way of lost revenue.

This dynamic makes the idea floated on the blog earlier, that China might devalue the RMB , less radical than it might seem.

If Vice Commerce Minister Zhong Shan's claim regarding 2% margins is more than a negotiating ploy....watch out below!

One of WalMart's mottos is "Always lower prices!" Who could have foreseen that this might lead to world-wide deflation when relentlessly pursued by the world's largest and lowest cost retailer?

Key bit:

But second, it also implies China cannot even tolerate much inflation. Remember, inflation will push up the price of good in local currency terms, which in a fixed peg currency regime, translates directly into price increases. Price increases from a country whose selling proposition is cheap prices would lead importers to look for substitutes in other emerging economies. A 2% margin not only says manufacturers have no room to cut prices, it also says they cannot afford much in the way of lost revenue.

Of course, the statement about 2% is bound to be in part a negotiating ploy. But...

My experience with Chinese industry is that it is very much on the Japanese model - you have some headline corporations who look very healthy, but they are built on a supply chain of smaller firms who have much lower margins.

Politically, this matters a lot in China, because a lot of the employment that is crucial to keeping the Chinese government in stable power is in those firms with low margins.

As such, I think we're headed for a real problem in both directions... if the US tries to force a reduction of Chinese mercantilism they'll run up against a brick wall, because the Chinese gov't has other priorities...

but if things carry on as they are, the US economy will stay slow and China's export led boom is going to hiccup (EU shows no sign of pickup up the import slack) - at which point there's big trouble from a lot of unemployed workers in China.

Feels like quick lose vs slow lose for the Chinese gov't at the moment.

First, on currency controls and inflation:  In order to keep a currency undervalued for any sustained period of time, you have to sell more of your domestic currency than you otherwise would in order to buy up foreign currency (and this is true even if you do as the Chinese have been trying and swap out dollars for other currencies to avoid getting stuck with dollar reserves). This means you are consistently flooding your domestic economy with domestic currency, which causes inflation, and in China, inflation has been high for a while now (reduced recently only due to the recession).  That's actually not a bad deal for the Chinese government in the short term because it's a moderate source of taxation on savings, which is high in China, except for the fact that the numbers eventually catch up with you because government costs increase faster than the revenue stream gained from printing more renminbi. If inflation is around 10% or more a year, very soon the costs of government become too much to bear, and things like education, welfare transfers or military spending face real limitations, something which Chinese authorities haven't had to worry about since the dawn of their mercantilism boom.

For the US, it's true that the manufacturing base suffers due to import competition from China, but there are benefits from that too in the form of higher real national income because of lower prices for things. As far as the government is concerned, tax income is higher with lower prices and more trade, but at the political cost of more unequal income distribution as higher paying blue collar jobs become low paying Walmart jobs. If the Chinese would stop propping up the dollar or tariffs on Chinese imports were applied, total tax revenues might suffer a bit, but in the US that would likely be acceptable now because of the needed income distribution gains achieved by increasing domestic manufacturing employment -- something that the US has been unable to solve through policy.

China is going to remain in a dependency situation with the US until it's economy can transform itself from being an export-based one predicated on being a servant to largely American consumer interests into a domestically focused economy whose engine is geared instead to Chinese well-being.  The worst that can happen to America out of it's relationship with China is that it loses its cheap servant and has to employ more of its own labor (or other foreign servants) AGAIN, and that's not really very painful for the economy or political system as a whole.

For Americans it's like, darn, we might have to wash our own dishes again, whereas for the Chinese it's like, holy crap, we might not ever get paid for all the work we've done!  That's a poker hand that puts more pressure on China than it does on the US.