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Why de-dollarize? The greenback serves China's economy well

  • The rush to open up China's capital account could seriously backfire
  • There is no urgent need to abandon the managed dollar-yuan rate
  • Destabilizing the financial system and the economy would set back China's geopolitics
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Admiring the spectacular floral decorations gracing Beijing's Tiananmen Square to celebrate the Communist Party Congress, I had a fleetingly mischievous thought: Where is, I wondered, a dollar-shaped flower pot?

Perish the thought, of course. But think of this.

By intermittently pegging their currency to the dollar, and closely managing the dollar-yuan exchange rate, the Chinese, in fact, had adopted the dollar as an instrument of their prodigious economic achievements. It was not the yuan but the dollar that gave China the correct signals of market-clearing world prices to guide their asset allocations and evaluate the competitive standing of the external sector that accounts for about one-half of the country's GDP (gross domestic product).

China has wisely rejected repeated calls to let its currency free float — an exchange rate regime that would have completely destabilized a developing export-driven economy, with an untested financial system and a large exposure to international trade in goods and services.

No rush. Test the waters first

In my view, China's managed exchange rate system is an intermediary regime that allows a great deal of flexibility to reflect costs and prices, the cyclical position of the economy and external flows of trade and finance. Beijing should not fear accusations of currency manipulations. No world famous New York lawyers, assisted by international economists and highly skilled econometricians, could conclusively prove such a thing. Think of the disputes over time spans of the analysis, price deflators used, etc.

At any rate, allegations of currency manipulation should not be the reason to rush with the opening up of capital account transactions and a swift transition to the free-floating exchange rate. Free trade and trans-border investments are a different story; that part of what the Chinese officials call the "trinity of reforms" can, and should, proceed to prepare the ground for the gradual liberalization of capital flows.

Pushing for new crown jewels of the Chinese economy is an understandable part of celebrating a well-deserved success, but precipitating these events can not only botch the party, but it could also gravely damage China and the rest of the world.

Remember, the world economy needs a world currency that serves as a universally accepted unit of account, means of payment and a store of value. The dollar is the only monetary instrument that can deliver these services on the strength of the U.S. economy and a dollar-based global financial infrastructure.

Not even the solidly managed euro can do all that. Many Europeans, including the French and the Germans, doubt the euro's finality, and the viability of their epochal project of economic and political unification. Paying for your meal with a euro note could be a problematic thing in most parts of the world, but you could readily settle the bill by flashing the greenback of instant recognition.

As things now stand, China's apparent impatience with the dollar-dominated world of finance is more a political than an economic issue.

No inordinate amount of empathy is needed, for example, to understand the feelings of China's President Xi Jinping when President Donald Trump tweets that "I explained to the President of China that a trade deal with the U.S. will be far better for them if they solve the North Korean problem!" China is peremptorily asked to square a circle on American terms. As for the "trade deal," that's a story for another day.

'Win-win' hitting red lines

Meanwhile, the problem of the dollar-yuan exchange rate is placed squarely in the context of intense trade frictions, sanctions-driven global economic warfare, U.S.-China military confrontations in East Asia and China's angst about America's widely publicized prompt global strike capabilities to maintain its unquestioned world dominance.

And in what China might take as a move to rain on Xi's parade on Wednesday, October 18, Washington is stepping up its bomber and nuclear submarine missions over and around the Korean Peninsula, and freedom of navigation forays with a destroyer operating in the vicinity of Paracel Islands that China considers its territorial waters. Beijing had to respond by dispatching to that area a missile frigate, two fighter jets and a military helicopter, in addition to lodging a strong protest with the U.S.

That latest episode in the South China Sea clearly shows that a U.S.-China "win-win cooperation," constantly urged by Xi, is a pipedream. China's maritime borders are not the dotted blue line. For Beijing, it is an inviolable thick and continuous red line, a marker of its territorial integrity. Xi keeps repeating that these borders are a sacred legacy since ancient times to the present generation working on the "Chinese Dream – a great rejuvenation of the Chinese nation." You will probably hear a lot more of that talk this week, when the young and newly-elected cadres in the permanent party committee, the politburo and the central military commission take a pride of place in the Great Hall of the People.

But, as the Asians like to say, never mind. China will extend a warm welcome to Trump during his state visit early next month. Beijing will also hold firmly to its refrain of "win-win cooperation" to (in a theatrical sense) "save the appearances."

It remains to be seen how long that scenario will last. Xi, China's revered "core leader," is expected to come out stronger after the party meeting, with a younger group of enthusiastic supporters. It would, therefore, not be a far-fetched thought to anticipate a much more assertive China.

Under these circumstances, a push for implementing the "trinity of reforms" might appear as a decisive effort to get away from what China perceives as economic, political and strategic constraints imposed by the dollar-dominated global system of trade and finance.

Investment thoughts

China has been trying for some time to reduce its dependence on the dollar. Beijing actively promotes settlements of bilateral trade transactions in national currencies. More recently, it also offered a gold-backed yuan to fund oil trades. China seems firmly determined to de-dollarize by opening up its capital account to underpin the global use of its own currency.

Such a politically-driven policy change does not seem to be dictated by any readily apparent economic imperatives. And no outside observer can reliably judge whether China's present financial system can successfully handle the strain of unfettered capital flows in markets with trillions of dollars in daily turnover. For my part, serious doubts about that are not out of place.

China might wish to think again. That new chapter of its capital account reforms is a totally uncharted territory with ramifications for the entire economic system. Indeed, such a daunting task is replete with risks of shocks and dislocations that could derail China's unique experiment with mixed economy.

And the most sobering thought is this: No matter what Beijing might do, there is no way it could dislodge the dollar as a pillar of the international monetary system for the foreseeable future.

Only the U.S. could do that to itself. The road to such a disaster is paved with assumptions that (a) Washington cannot rev up its nearly stagnant economy, (b) that it will continue to run rising budget deficits and a soaring public debt, and (c) that its half-a-trillion dollar annual trade gaps will soon be pushing America's net foreign liabilities toward $10 trillion – and beyond.

China would not be well advised to take this leaf from American declinists and the hordes of their foreign followers. The flexible U.S. economy can rapidly snap out of its current difficulties — if Trump could get back to his economic agenda with a results-oriented sense of urgency.

Commentary by Michael Ivanovitch, an independent analyst focusing on world economy, geopolitics and investment strategy. He served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York, and taught economics at Columbia Business School.

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