Oxford SWF Project

Ashby Monk

Not many people would turn to China’s People’s Liberation Army for advice on foreign exchange reserve management. But that apparently doesn’t mean the PLA isn’t willing to offer some. Indeed, it had some pretty inflammatory ideas on the issue yesterday. According to a Reuters article, senior military officers (including two Generals) want China to sell U.S. bonds to punish Washington for its latest round of arms sales to Taiwan.

It’s hard to know what to make of this story. For example, I don’t know what sort of influence these Generals have in Chinese policy making. As Blake Hounshell said this morning,

“Are they on the fringe? Respected insiders? Hard-liners with a growing following? That kind of information would be helpful for those of us who aren’t intimately familiar with internal Chinese politics.”

Still, I think the story is fascinating, especially coming off the news last week that Russia had approached China over the summer with an idea to cause economic mayhem in the USA by selling US Treasuries en masse.

In order to better understand the issue, I turned to an extremely knowledgeable colleague of mine in the UK. This person’s reply was very interesting, so I’ve gotten permission to copy it below (on the condition that I keep this individual anonymous due to some sensitivities associated with  his/her current position):

“As you say, fascinating. But on the surface hardly an outrageous or impossible idea. It presupposes that China is prepared to take any financial loss on the assets as a fair price for the diplomatic gain – but if they do the analysis and are prepared to pay that price, then there is in theory nothing to stop them. As I have said before, the reserves are a national asset and it is quite legitimate to use them in any way China sees fit to achieve their national aims.

The key sentence is [in the Reuters article] “For example, we could sanction them using economic means, such as dumping some U.S. government bonds”. I made this very point at a conference at [deleted]– I asked what the White House would do if it received a call from Beijing saying that “unless the USA did XX or desisted from YY by a given deadline, China proposed to sell all its dollar assets without concern as to price”.

We came to a conclusion then that it was in fact something of a hollow threat. To start with, the US authorities (via the Federal Reserve) can buy any dollar bonds the Chinese wish to sell: it will explode the Fed’s balance sheet, but it can be done. It is more problematic if the Chinese sell dollars on the FX market, as the US authorities cannot simply buy them all, as they do not have enough foreign currency and could not mobilise their gold fast enough. So the dollar’s exchange rate would spike sharply down, before (probably) spiking back up again to near the level it started at – offset a bit because one would assume that having just utilised their dollars in this way, China would not immediately buy them back and so the main forced buyer of dollars would be removed from the market.

But what are the longer term consequences of doing this? Firstly, anyone whose currency is pegged to the USD (and that includes most of OPEC) gets a huge bout of volatility in their national financial management, and secondly, markets generally are thrown into turmoil. And the important point is that it is not only the US that suffers from this; others suffer too, including states that China does actually want or need to keep friendly (eg oil exporters).

So even China is constrained a little bit by the effect of their actions on others. And dumping dollars will most certainly affect others alongside the US.

Incidentally I think China could well do more damage to the US, and at less cost to itself, if it over time decided to demand other currencies for its exports and demand the right to pay in other currencies for its imports. Eventually, when the Renminbi is convertible and a usable international currency, it will demand the superpower’s right to use its own currency in trade, but until then, what do you think the effect would be if they unilaterally declared that they would only accept euro or yen in payment for international trade. They would find ready suppliers of oil priced in euros in Iran, Venezuela and Russia to name but three countries, and it would not take very much more to seriously call into question the dollar’s role as a reserve currency.

But my general conclusion is that it is probably a good thing the PLA are not running China’s FX and reserve management policies!

On the last point, I definitely agree!