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The China Factor and the US Dollar / Artikel mises.org

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<h3>>The China Factor and the US Dollar</h3>

By Frank Shostak

[Posted
November 30, 2004]

<img alt src="http://mises.org/images3/olddollar.gif" align="right" border="0" width="145" height="334">Rumors
that China's central bank has reduced its holdings of US Treasuries in favor of
European assets is putting more pressure on the already battered US dollar.
After closing at US $1.274 in October, the price of the Euro in US dollar terms
shot up to around US $1.33 on Friday November 26. According to the
Shanghai-based China Business News, China has cut the size of its US Treasury
Bonds holdings to $180 billion.

This decision, according to the
newspaper, was taken by government officials in order to avoid losses from a
weakening US dollar. The latest data shows that China's holdings of US
Treasuries stood at $174.4 billion in September—the second largest foreign
holder of US Treasuries after Japan, which holds $720 billion. Both Japan and
China hold about 48% of US Treasuries held by foreigners.

The possibility that the Chinese
authorities may lower their holdings of US assets and substitute them for
European assets is seen as a major threat to the US dollar and seems to support
the view of most experts. For instance, in his speech
on Friday November 19 the Chairman of
the Federal Reserve Alan Greenspan suggested that foreigners might get tired of
financing the ever-growing US current account deficit, which stood at a record
$166.2 billion in Q2.

<img alt src="http://mises.org/images3/shostak/11-29-2004/1.gif" border="0" width="350" height="309">

At some stage, Greenspan maintains,
foreigners will start shifting their money away from US assets thereby
depressing the US dollars and lifting the interest rate structure. This in
turn will undermine the pace of US economic activity, so it is argued. According
to this way of thinking, as long as the US continues to run a massive current
account deficit the pressure on the dollar and on the US economy will stay
intact. Hence the only solution to this predicament is to devise policies that
can tackle the problem of the growing deficit.

But is it true that the state of the
balance of payments determines the currency rate of exchange?

<h1>Exports and imports in a market
economy</h1>

Every participant in a market
economy is a seller and a buyer of goods and services. In his capacity as a
seller of goods he exports those goods to other individuals. While in his
capacity as a buyer of goods he imports these goods from others. Every
individual in a market economy is both an exporter and an importer.

For instance, a baker that produced
ten loaves of bread and consumes two loaves can now sell, i.e. export, eight
saved loaves of bread to a shoemaker for a pair of shoes. The pair of shoes that
the baker secures for the eight loaves of bread is his import. Note that he paid
for the import with his export, i.e., eight loaves of bread is payment for the
pair shoes.

The essence of this exchange is not
altered if, let us say, the shoemaker resides in Europe while the baker is
located in the US.

The introduction of money does not
alter the essence of what we have said, i.e., that individuals pay for their
imports by means of exports. A producer exchanges the goods he produces for
money and then employs money to secure, i.e. import, goods from other producers.

As with the price of goods, the
supply and demand for money determines the price of money, or its purchasing
power. For a given supply of money an increase in the production of goods
implies that producers will demand more money since more goods must now be
exchanged for money.

As a result of this, the purchasing
power of money will increase. Every dollar will now command more goods.
Conversely, if the supply of money increases for a given stock of real goods,
the purchasing power of money falls since now there are fewer goods per dollar.
The prices of goods and services are set in motion by relative increases in
money against rises in goods and services.

If a given basket of goods is
exchanged in the US for one dollar and the same basket of goods is exchanged for
two euros in Europe, the rate of exchange between the US dollar and the euro
will be set as one dollar for two euros. Any deviation of the exchange rate from
the level dictated by the purchasing power of currencies will set corrective
actions in motion on behalf of buyers and sellers.

Suppose that the rate of exchange,
as a result of various transitory factors, was set in the market at one dollar
for three euros. This means that in relation to its purchasing power the dollar
is now overvalued, i.e. too expensive. This gives rise to speculative corrective
actions. It will pay now to sell the basket of goods for dollars then exchange
dollars for euros and then buy more goods with euros—thus making a clear
arbitrage gain.

For simplicity's sake, assume that
one kg of potatoes is exchanged for one dollar in the US and two euros in
Europe. In this case it will pay to sell one kg of potatoes for one dollar,
exchange the one dollar for three euros, and then exchange three euros for 1.5
kg of potatoes, gaining 0.5 kg of potatoes. The fact that holders of dollars
will increase their demand for euros in order to profit from the arbitrage will
make euros more expensive in terms of dollars and this in turn will push the
exchange rate in the direction of one dollar to two euros.

Observe that the underlying rate of
exchange, as set by the relative purchasing power of monies, as such has nothing
to do with the state of the balance of payments. The fact that the baker has
exported eight loaves of bread for the import of one pair of shoes doesn't alter
the respective purchasing power of the dollar and the euro.

As we have seen, the purchasing
power of money is set by the relative scarcity of money in relation to real
goods and services. The fact that the American baker has entered an exchange
with the European shoemaker didn't alter the given stock of money and the given
stock of bread and shoes. It follows then that if the currency rate of exchange
in the foreign exchange market will be set in response to trade balances and in
disregard to the relative purchasing power of monies such a rate of exchange
can't be sustained.

The China Question

How is all this related to the
possibility that China or other countries may shift their asset allocation away
from the US toward Europe? Now, let us assume that this shift, which is
motivated by the growing US current account deficit, runs contrary to the
underlying exchange rate, i.e., as set by the relative purchasing power of
monies. If according to the underlying exchange rate the dollar is not too
expensive (not overvalued), the fall in the dollar on account of non-USD asset
allocation by China will be of short duration. The reason for that, as we have
seen, will be actions on behalf of buyers and sellers that will bring the rate
of exchange in line with the relative purchasing power of respective monies.

On this score between 1994 to 2004
the Euro-zone money printer has been working much faster than its American
counterpart (see chart). In other words, money growth in the Euro-zone relative
to the growth of real goods and services has been much larger than in the US.

<img alt src="http://mises.org/images3/shostak/11-29-2004/2.gif" border="0" width="303" height="270">

This in turn raises the likelihood
that the US dollar is not overvalued against the Euro, implying that the
Chinese factor can only have a short-lived effect, all other things being equal.
Thus a fall in the dollar against the Euro will make it advantageous to sell
goods for Euro's, then exchange Euro's for US dollar. Then with more dollars one
will be able to secure more goods and services. Obviously this will set in
motion corrective forces until the rate of exchange gravitates toward the
underlying rate of exchange.

What about interest rate
differentials? According to popular thinking a relative rise in interest rate in
Europe against the US will prompt investors to sell US assets in favor of
European assets, i.e., selling dollars and buying euros thus raising the euro
rate of exchange versus the dollar. Again, if at a given point in time the
emerging exchange rate on account of the interest rate differential doesn't
correspond to the underlying rate of exchange, arbitrage activities will be set
in motion, which in turn will bring the market rate of exchange in line with
fundamentals.

With respect to the interest rate
factor the latest data is actually favorable for the dollar. For the past eight
months the yield on the US 10-year T-Bond has been higher than the yield on the
10-year Euro-zone government bond. For instance, in October the US yield stood
at 4.025% against 3.87% in the Euro-zone. So far in November in the US, the
yield stood at 4.24% against the Euro-zone rate of 3.77%.

<img alt src="http://mises.org/images3/shostak/11-29-2004/3.gif" border="0" width="320" height="283">

<h1>What is the importance of the
balance payments statistics?</h1>

The balance of payments statement of
a particular company could be of assistance to various present and potential
investors in that company.  But what possible interest can a business have
with the national balance of payments? Will this assist him in his business
conduct?

Because there is no such thing as US
Inc. that can be bought and sold in the market, the national balance of payments
will be of no use to businesses. Furthermore, it is not the US that exports
wheat, but a particular farmer or a group of farmers. They are engaged in the
export of wheat because they expect to profit from it.

Similarly it is not the US that
imports Japanese electrical appliances, but an individual American or a
particular group of Americans. They import these appliances because they believe
that a profit can be made.

Now, whenever an individual plans to
import more than he exports, the shortfall will be balanced either by running
down existing savings or by borrowing. The creditor who supplies the required
funds does so because he expects to profit from that.

Subsequently, if the debtor, for
whatever reasons, cannot honor his debt, this financial crisis is only of
concern to the parties involved and of little importance to other individuals in
the community. The idea of calculating the so-called national balance of
payments in a free market economy will be absurd.

However, this is not so when
government and the central bank are actively tampering with markets. In this
context the reading of the balance of payments can provide some useful
information regarding the damage that government and central bank policies have
inflicted.

In the US context, the ever-widening
current account deficit is the manifestation of the fact that despite the loose
monetary policies of the Fed foreigners are still happy to be paid with US
dollars. Thus in 2003, holdings of US dollars in foreign exchange reserves by
central banks increased by $441.3 billion after rising by $184.5 billion in the
previous year.

As a percentage of total foreign
reserves, US dollars comprise 69% with Euros about 20%, while the rest is held
in Yen, Pound Sterling, and Swiss Francs. The popularity of the US$ is an
important vehicle for diverting real savings from foreigners to Americans. If
this popularity were to weaken obviously it would be much harder for Americans
to divert real savings from the rest of the world.

By printing the most popular
international medium of exchange, the US central bank enables the first
receivers of dollars that happened to be Americans to divert real wealth from
the rest of the world.

<img alt src="http://mises.org/images3/shostak/11-29-2004/4.gif" border="0" width="300" height="254">

Loose Fed monetary policies have
enabled Americans to engage in consumption without the backup of the production
of real wealth. That is, Americans have been engaged in nonproductive
consumption.

Obviously nonproductive consumption
implies importing without exporting that results in a current account deficit.
In this context the ever-growing current account deficit, which stood at $166
billion in Q2, provides a measure of the magnitude of how far nonproductive
consumption has developed in the US.

So the alarm raised by Greenspan,
whilst valid, should actually be addressed toward his own monetary policies.
Curiously, in all his speeches the Fed Chairman has chosen to ignore the Fed's
contribution to the current currency turmoil. Luckily for the Fed other central
bank's policies are just as bad, thereby providing a support for the underlying
US dollar rate of exchange.

<h1>Conclusions</h1>

China and other countries possibly
shifting away from US assets toward European assets may temporarily weaken the
US dollar against the Euro. It cannot, however, alter the underlying Euro/US
dollar rate of exchange. What sets a rate of exchange in motion is relative
increases in money supply against increases in goods and services.

Over time, relative increases in
money supply set the purchasing power of US and Euro-zone monies and this in
turn sets the underlying rate of exchange. On this score our analysis shows that
since the formation of the Euro-zone its money printer has been working much
faster than its American counterpart.

We suggest this raises the
likelihood that the US dollar is not overvalued (not too expensive) against the
Euro. Consequently, the Chinese factor can only have a short-lived effect on the
dollar, all other things being equal. A fall in the US dollar on account of the
Chinese factor against the Euro will set in motion corrective actions on behalf
of buyers and sellers, which will bring the US dollar toward its underlying rate
of exchange.

<hr align="left" width="33%" SIZE="1">

 

Frank Shostak is
an adjunct scholar of the Mises Institute and a frequent contributor to
Mises.org. Send him MAIL and
see his outstanding Mises.org Daily
Articles Archive. Comment on this article on the Mises
Economics Blog. Dr. Shostak thanks Michael Ryan for helpful comments.