In an article titled ‘Sign of strength or evidence of weakness?  China’s dollar reserves‘  Brad Setser comments on Paul Krugman’s views expressed Friday that ‘China’s call for a new reserve currency is a sign of weakness’ and ‘China is hoping for a magical solution that will rescue it from the consequences of its own investment mistakes’. Setser states his agreement with Krugman, but says in his view (and I have taken fairly wide liberty in interpreting and summarizing his comments) that:

• ‘China shied away from the decisions that would have allowed it to avoid accumulating so many reserves, but they weren’t willing to make the policy choices needed to change China’s growth trajectory either;

• now China has a problem. Its dependence on exports meant that it ended up importing unemployment from the rest of the world just when China’s own property boom soured;

• China’s leaders are setting the stage to argue that losses they may realize on their U.S.$ reserves are the fault of bad US policies. They aren’t. They are the result of China’s own policy choices;

• even if China didn’t explicitly plan to build up too many reserves, it now has them – and China’s leaders are no doubt interested in using them to increase China’s influence;

• there are creative ways China could use its reserves to increase its global position – including using its U.S.$ holdings to lobby (my word) to influence US policy;

• China can only exercise leverage if it is willing to accept the consequences of scaling back its dollar bet – a fall in its exports, and an upfront financial loss on its existing reserve portfolio. If China isn’t willing to accept those costs it is ‘stuck’;

• in some ways it makes financial sense for China to take its financial lumps sooner rater than later;

• the Administrations of both China and the U.S. should be thinking through the consequences of letting current trends continue. Simply put, letting China’s U.S.$ portfolio continued to grow won’t make the underlying issues go away; and,

• it isn’t healthy for China to rely so heavily on exports for its growth, or for the U.S. to rely so heavily on the government of a country that now seems ambivalent about the dollar for financing.

Setser ends his article by saying “Let’s hope that China’s stimulus proves strong enough for China to lead the rebound in the global economy – and for Chinese demand to emerge as a true engine for global growth”. I find this interesting, as that statement strikes me as tantamount to suggesting Setser believes the U.S. will be unable to do that. Moreover, as I read Setser’s article it seems to me Setser has reached the conclusion that the U.S.$ is facing serious deterioration in purchasing power. Absent a turnaround in U.S. manufacturing job statistics and an increase in U.S. consumer spending I myself can’t see anything but a rocky road ahead for the U.S.$. That said, if China is seriously concerned about the prospective purchasing power of its U.S.$ holdings deteriorating in the near term they might consider ramping up its strategic acquisition of substantial businesses outside China, stepping up its purchases of inventories and commodity hedges for those commodities necessary to grow infrastructure in China, and purchasing physical gold.

I have not met or talked with Setser, but as I read his posts he seems to me to be one of the more thoughtful economic commentators on the Internet. I suggest you click on the link in this post and read his article in full and in context, as you might interpret his thoughts differently than I have.

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