China cuts back on financing US deficit

There hasn't been much to report lately regarding international finance and the US deficit. It's amazing how consistent are statements coming from the Fed and IMF. Less surprising is the failure of governments to follow the good (though not particularly welcome) advice. With respect to China, my favorite IMF'er gives a particularly lucid statement of what needs to be done and why in a speech this week at the American Economic Association meetings in Boston. In introducing his topic he says: "The basic issue is familiar to most of you. The United States is running a current account deficit approaching 6 1/4 percent of its GDP this year and over 1.5 percent of world GDP. And to help finance it, the United States pulls in 70 percent of all global capital flows. Clearly, such a large deficit is unsustainable in the long run." I recommend you read it if you've time and interest: Financial System Reform and Global Current Account Imbalances by Raghuram Rajan.

A couple of days after Rajan spoke, the world heard that China is having second thoughts about funding the US deficit. Here are extracts from a Washington Post article on the subject.

China Set To Reduce Exposure To Dollar
Move Would Probably Push Currency Down
By Peter S. Goodman
Washington Post Foreign Service
Tuesday, January 10, 2006; Page D01

extracts:

SHANGHAI, Jan. 9 -- China has resolved to shift some of its foreign exchange reserves -- now in excess of $800 billion -- away from the U.S. dollar and into other world currencies in a move likely to push down the value of the greenback, a high-level state economist who advises the nation's economic policymakers said in an interview Monday.

As China's manufacturing industries flood the world with cheap goods, the Chinese central bank has invested roughly three-fourths of its growing foreign currency reserves in U.S. Treasury bills and other dollar-denominated assets. The new policy reflects China's fears that too much of its savings is tied up in the dollar, a currency widely expected to drop in value as the U.S. trade and fiscal deficits climb.

China now boasts the world's second-largest cache of foreign exchange -- behind only Japan -- and is on pace to see its reserves climb past $1 trillion later this year. Even a slight diminishing of the dollar as a percentage of those holdings could exert significant pressure on the U.S. currency, many economists assert.

In recent years, the value of the dollar has been buoyed by major purchases of U.S. Treasury bills by Japan, China and oil-exporting countries -- a flow of capital that has kept interests rates relatively low in the United States and allowed Americans to keep spending even as debts mount. Some economists have long warned that if foreigners lose their appetite for American debt, the dollar would fall, interest rates would rise and the housing boom could burst, sending real estate prices lower.

In 2005, the dollar rebounded against major foreign currencies as the Federal Reserve raised short-term interest rates -- making dollar assets relatively more attractive than others -- but has slid a bit early this year. Meanwhile, China continues to amass foreign-exchange reserves at a pace of roughly $15 billion per month.

Even if a Chinese shift away from the dollar weakened the currency, that would probably not soothe tensions with those in Washington calling for an increase in the value of the yuan to help U.S. manufacturers. Unless China severs the link between the value of its currency and the dollar -- a move Beijing says could destabilize its economy -- then a weaker dollar would simply mean a weaker yuan as well, leaving in place the current debate over whether China's export earnings are being netted unfairly..