The dollar and the dragon

FOR several years, American officials have pressed China to revalue its currency.
They complain that the undervalued renminbi represents unfair competition, destroying American jobs, and contributing to the US trade deficit.
How, then, should US officials respond?
Just before the recent G-20 meeting in Toronto, China announced a formula that would allow modest renminbi appreciation, but some American congressmen remain unconvinced, and threaten to increase tariffs on Chinese goods.
America absorbs Chinese imports, pays China in dollars, and China holds dollars, amassing US$2.5 trillion in foreign-exchange reserves.
Much of the reserves are held in US Treasury securities.
To some observers, this represents a fundamental shift in the global balance of power, because China could bring the US to its knees by threatening to sell its dollars.
If China were to bring the US to it knees, however, it might bring itself to its ankles in the process.
China would not only reduce the value of its reserves as the dollar’s value fell, but it would also jeopardise America’s continued willingness to import cheap Chinese goods, which would mean job losses and instability in China.
Judging whether economic interdependence produces power requires looking at the balance of asymmetries, not just at one side of the equation.
In this case, interdependence has created a “balance of financial terror” analogous to the Cold War, when the US and the Soviet Union never used their potential to destroy each other in a nuclear exchange.
In February this year, angered over American arms sales to Taiwan, a group of senior military officers called for the Chinese government to sell off US government bonds in retaliation.
Their proposal went unheeded.
Instead, Yi Gang, China’s director of state administration of foreign exchange, explained that “Chinese investments in US treasuries are market investment behaviour, and we do not wish to politicise them”.
Otherwise, the pain would be mutual.
Nevertheless, this balance does not guarantee stability.
There is always the danger of actions with unintended consequences, especially as both countries can be expected to manoeuvre to change the framework and reduce their vulnerabilities.
For example, after the 2008 financial crisis, while the US pressed China to let its currency appreciate, officials at China’s central bank began arguing that America needed to increase its savings, reduce its deficits and move towards supplementing the dollar’s role as a reserve currency with special drawing rights issued by the International Monetary Fund (IMF).
But China’s bark was louder than its bite.
China’s increased financial power may have increased its ability to resist American entreaties but, despite dire predictions, its creditor role has not been sufficient to compel the US to change its policies.
While China has taken minor measures to slow the increase in its dollar-denominated holdings, it has been unwilling to risk a fully convertible currency for domestic political reasons.
The G-20 is focusing on the need to “re-balance” financial flows, altering the old pattern of US deficits matching Chinese surpluses.
This would require politically difficult shifts in consumption and investment, with America increasing its savings and China increasing domestic consumption.
Such changes do not occur quickly.
Neither side is in a hurry to break the symmetry of interdependent vulnerability, but both continue to jockey to shape the structure and institutional framework of their market relationship.
For the sake of the global economy, let us hope that neither side miscalculates. – Project Syndicate

*Joseph S. Nye, a former US assistant secretary of defence, is a professor at Harvard University and author of the forthcoming book Power in the 21st Century.