UBS COMMENT
DR. ANDREAS HÖFERT
For the past two decades, the US and China have mirrored each other in a dance of deficits and surpluses. The US grew a massive current account deficit while China's current account swelled. Normally, such an imbalance should correct through exchange rates. The dollar should have fallen against the yuan, but the Chinese didn't let this happen. Through currency market interventions and especially by buying US Treasury bonds, the yuan was effectively pegged to the dollar. The result: China holds a whopping two trillion US dollars in currency reserves.
With the onset of the financial crisis, this imbalance grows ever less sustainable. Squeezed by the crisis and the worst recession in sixty years, the US has no choice but to devaluate the dollar. And this threatens to erode the purchasing power of China's dollar reserves. Thus, China is also caught in a vise. They are looking for remedies, but it's far from easy to get out from under the dollar mountain, as we shall see.
In a profound, widely cited paper in March entitled "Reform the International Monetary System," People's Bank of China President Zhou Xiaochuan urged replacing the US dollar as the world's reserve currency with a diversified basket of major currencies controlled by the International Monetary Fund. Zhou’s idea is provocative, well-reasoned and utterly improbable, since America is unlikely simply to retire dollar from its position of power.
Maybe, some suggest, China could circumvent the dollar by increasing its gold reserves. Gold bugs around the world are abuzz that China has being buying the precious metal in a big way lately. However, despite recently increasing its holdings by 454 tons, gold still represents less than 2% of China's total reserves. Raising that share to 10% would require buying five to six thousand tons of gold, more than two years worth of global mining output. Obviously, such a buying spree would drive up the price of gold and that is the rub. Gold is priced in US dollars and a higher gold price simply cuts the purchasing power of China's dollar reserves. And ultimately, with its 8000-ton gold reserves, the US would profit far more than China from such a strategy.
Alternatively, since the Fed stands ready to buy US government bonds, China could try to sell some. With this money, it could then buy bonds denominated in euro or other currencies, allowing the dollar and the pegged yuan to depreciate against selected currencies. That the Chinese so far have not done so is puzzling. Perhaps they still have more faith in the greenback than in any other currency. Or they may simply not want to lessen the goodwill their massive dollar holdings extract from the US.
In the end, China faces a difficult decision. It can allow its currency to float freely and wait for the imbalances to ebb naturally away. Or it can attempt to intervene, though we honestly don't see how. One thing is clear: the longer it waits, the more costly it will be for China and the riskier it will be for the US dollar.
Dr. Andreas Höfert is Global Head, Wealth Management Research, UBS Wealth Management Research.
