China unwilling to hoard US dollars?what?s the implication?

March 27th, 2007

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A week ago, the Chinese indicated that they do not ?intend to go further and accumulate reserves? (see China to halt accumulating foreign reserves). While the financial markets were overly engrossed with the Fed?s interest rate policy, this event was very much overlooked. Ominously, we believe China?s intention will have a much more significant long term impact on the US economy than the content of last week?s US Federal Reserve Open Market Committee Statement. Thus, it is possible that the likely impact of China?s decision has not yet been fully factored into the financial markets.

What is the implication of this?

First, we have to be aware that China holds more than $1 trillion of foreign reserves, much of which are parked in US Treasury bonds. If the Chinese Central Bank decides to go berserk and sell all of their US Treasury bonds, we will see the US dollar collapse and long term US interest rates skyrocket. Since the US mortgage rate is very much dependent on long term interest rates, we can expect the housing bubble to burst spectacularly, crunching economic growth and triggering mass insolvency. A collapsing US dollar will at the same time result in runaway price inflation (see What can we expect in a US dollar decline?). This hypothetical scenario is Ben Bernanke?s ultimate nightmare?cutting short term interest rates may (and we stress the word ?may? because we believe even this measure is likely to fail) possible help in economic growth, but it will exacerbate price inflation, even leading to hyperinflation. Raising interest rates, on the other hand will exacerbate the weakness in an already very weak economy. This is the terrifying stagflation scenario.

Of course, it is unlikely for the Chinese Central Bank to go berserk. It is not in their interest to see their accumulated US$1 trillion of reserves go up in smoke. However, it is also not in their interest to further accumulate increasingly overvalued (maybe ?worthless? is a better word) US dollars (see Will the US dollar collapse? for more on this dilemma that China faces). Hence, we are hardly surprised at the latest Chinese indication. But, we have to understand that the Chinese cessation of US dollar accumulation will still lead the US economy to a similar path (though far less dramatic) as the nightmare scenario that we drew up just now. If China still receives a lot of US dollars from their trade surplus to the US, what are they going to do with their excess US dollars since they do not intend to accumulate them? Previously, they accumulated US Treasuries with surplus dollars. But now, no matter what they do to get rid of their American fiat money, it will end up in the foreign exchange market. This can only mean one thing?the US dollar will fall. In addition, if the Chinese no longer demand US Treasuries, who will pick up the slack? If no one is willing to do so, it will mean that long term US interest rates will rise.

Again, we will be in the look out for the US capital account (see Is the United States running out of credit?).