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The Dollar Trap

By Henry D'Souza

Al-Jazeerah, CCUN, June 16, 2012


         Why do the Chinese think about a “dollar trap” when, some would argue, the American currency has served the world admirably since the end of the Second World War?  And, what have they done to escape this trap?

         Viewed from a Chinese point of view, transactions in a hard currency, like the dollar, were expensive and hard to materialize.  When a country wanted to trade internationally it usually had to convert its currency into dollars and the recipient nation had then to convert the money gained into a local currency.  In much of China’s global trade it had to encounter these double transaction costs. 

In the world’s foreign exchange (forex) market, the US dollar accounted for 70% of the value of trades.  Since 2010 when there was a turning point in world history, this percentage has been reduced to 60%, but still twice as much as its nearest rival, the euro.1   Consequently the Chinese saw an “appreciation against the dollar and depreciation at home.”2 There had to be a better way of doing business.

         Secondly, the Superpower set the rules through international institutions for its own benefit.  It could amass huge debt and print dollars to overcome a financial crisis, as it is doing in 2012.  While Japan’s sovereign debt is $9.7 trillion, the US’s debt is $14 trillion, 3 but in the case of the former 90% of the debt is held domestically, while in the latter, foreigners hold 50%.

It means that, to a certain extent, foreign Central Banks are tied to US Treasuries.  Foreign governments are, in addition, unable to control the vast flow arising from the shadow financial system. The word “derivatives” casts an eerie feeling in the financial community. 

America’s controlling institutions are the World Bank and the International Monetary Fund (WB & IMF) and, to a lesser extent, the Swiss-based Bank of International Settlements (BIS).

Thirdly, the Chinese fear that the US, which does not miss an opportunity of criticizing the ruling party for human rights issues, may default on its debt.  Chinese hawks would therefore like to reduce its $1.3 trillion investment in Treasuries.  But in fact its investment is increasing, to $1.6 trillion, for lack of a safer place to deposit their extra earnings.  China’s total forex amounts to $3 trillion, 70% of which is in dollars.4   According to Min Zeng, a currency specialist, the US Treasury market is the “only market that can absorb the bulk of forex which amounts to $10 trillion.”  German bunds and UK gilts, two major bond markets, attract a mere $1 trillion each.5   It is no secret that the Eurozone is in a financial crisis and is looking to China for assistance.

Moreover, should China withdraw its investments in Treasuries, the dollar might fall in value and the value of China’s assets will also decline.  China cannot kill the golden goose, even if it is an American one.  China could use these assets in the near future as it anticipates investing $2 trillion overseas by 2020.

The dollar trap is not unique.  In 1926 Accominotti6 reminds us that there was a sterling crisis.  The French had amassed half of the world’s forex and had pegged it to the £ sterling.  By suddenly changing course and selling the £ there was a sterling trap in 1929-31.

Even the Greek crisis is not unique.  The Russians experienced this chaos on August 14, 1998.  The RTS fell 67% in six months compared with 63% for Greece.  Hard currency fled the country but when prices fell precipitously investment money returned after a few years, and the country was back on track.7

The Chinese hoped to rectify this imbalance that worked against Asia in two ways: making changes to the current international system and internationalizing the Chinese renminbi (RMB).

It took a decade to introduce the current Chinese financial system.  So they don’t expect quick fixes as they improve their system.  First, it was thought necessary to improve the efficiency, security and stability of the internal system.  The China National Advanced Payment System (CNAPS), a second generation system, dealt with inter-bank settlements and bond transactions.8

The China International Payment System (CIPS) should be out in two years.  It will link domestic and overseas payments.  It will widen its reach from 9 time zones to 17 or 18 and increase the hours of service.  To reduce costs, it will reduce manual transactions.  Smaller banks will use member banks as correspondent banks.  It hopes to use the Society for Worldwide Interbank Financial Telecommunication (SWIFT) to facilitate the increasing use of the yuan.  Eventually China hopes for full convertibility for the yuan.9

China’s trade was valued at $7.9 b in 1991; by 2010, it reached $292.8 b, a thirty-seven fold increase.  By 2011, its cross border trade in yuan reached 2.8 trillion yuan ($410 b) or 10% of China’s total trade.  By the end of the same year, its overseas direct investment in yuan was 20.15 b and its foreign direct investment was 90.72 b.

To speed up trade in the China-Asean Free Trade Area (CAFTA) the Pan-Beibu Gulf Economic Cooperation (PBG) Forum, as one example, introduced the Nanning-Singapore land corridor as a supplement to its marine corridor.  PBG has 7 areas of cooperation: infrastructure, ports and logistics, trade and investment facilities, agriculture, tourism, environmental protection, and bio-diversity.  By 2011, 14 deals were signed worth $7.43 billion.10    At the sixth summit of PBG on August 17, 2012, another 50 billion yuan worth of deals were signed.11

The best example of bypassing the dollar is the trade between the second and third largest economies, China and Japan.  In 2011, this bilateral trade rose by 14.3%, year over year, to $344.9 b, and the savings accrued to China was $3 b. The currency settlements were done in yen and yuan.12

Nasdaq also reported that EU’s largest bank HSBC has started issuing yuan bonds at a yield of 3-3.25% in London. The issue was oversubscribed and raised 2 billion yuan ($ 317m).  London was exalted that it was regarded as the world’s premier financial center: it holds 109 billion yuan ($17.3 billion) of customer and inter-bank deposits. HSBC’s competitors in this field are Market Vector Renminbi (CHLC, symbol) and Guggenheim Yuan bond (RMB).  Selling yuan bonds abroad are a positive sign that the currency is being internationalized; hitherto such bonds were only sold in Hong Kong and China. 

Asians are losing out in trading bulk commodities, like energy, iron ore, and coal, which are usually denominated in dollars.  And, Monan adds, in the absence of a pricing policy, Asians have to pay higher costs – the Asian Premium.  China hopes to eliminate this premium.13

Besides carrying out internal reforms and internationalizing the RMB, China aspires to play a greater role in international organizations, in order to bring about changes.

China wants the IMF to intensify its efforts in poverty reduction across the globe; promote international cooperation and development; democratize the institution; and, increase its effectiveness.  China already invests more than the IMF in 90 countries in a more efficient manner.  So its active participation in international institutions can be enormous.  Starting from the top, Director Christine Lagard’s tax-free salary is being questioned by the 99% in France.

Colin Barr14 quotes an economist at China Center for International Economic Exchanges Xu Hongcai for suggesting a reserve system of multiple reserve currencies overseen in part by the IMF.  The IMF should issue alerts to hold currencies steady and thereby reduce political instability.

Governor of the People’s Bank of China Zhou Xiaochuan has a more principled plan.  He says that a Super-Sovereign Reserve Currency should be a stable bench mark, and issued with a clear set of rules which do not alter with the needs of any one country.  The supply of this currency should be flexible enough to meet changing demand.15




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