China Shouldn’t Count on the U.S. to Guarantee Dollar Asset Values

China is the biggest holder of U.S. government bonds. In December 2008, Chinese government treasury bond holdings reached $696.2 billion, corresponding to 36 percent of China’s foreign currency reserves for this last year.

Because of the security of U.S. government credit, the low risk of default and the steady income they provide, treasury bonds are by far the main asset in China’s foreign currency reserves. America is an economic superpower – its government’s credit is assured. But this author believes that investing in treasury bonds presents risks – apart from the risk of default, there are also risks associated with the currency, inflation and the markets. If the dollar depreciates, the risk of inflation will rise and dollar-denominated assets will lose purchasing power.

For example, since the outbreak of the sub-prime crisis in July 2007, the U.S. economy has deteriorated, the Federal Reserve has continued to cut interest rates, the dollar has continued to weaken, international commodity prices rose for the first half of the year, and China’s foreign currency reserves faced losses. This is the problem we are afraid of.

The risk of the dollar’s depreciation is real. During the age of the Bretton Woods system, the dollar experienced three crises, emerging significantly devalued. Once problems arose in the U.S. economy, America would undertake expansionary monetary policy to stimulate the economy, “softening” its currency. As an international reserve currency, the dollar needed to maintain stability – correspondingly, America would constrain its macroeconomic policy, leading many times to a significant devaluation of the dollar, which presented substantial losses to those holding dollar assets. This is the dilemma facing the dollar as both a national and international currency; it existed in the past and continues to exist now.

Recently, in the name of “stimulus,” America greatly expanded its fiscal policy and intensified its monetary policy. In terms of monetary policy, the Fed continuously lowered the federal funds rate, moving the target rate down to between 0 and 0.25% on December 16th, at the same time making clear that it would maintain the rate at extremely low levels. On the fiscal policy side, Obama passed the $787 billion stimulus plan on February 18th and submitted his first budget plan on February 26th. According to the budget, the total U.S. fiscal deficit will reach $1.75 trillion by September 30th – about 12 percent of GDP.

Recently, due to the hedge features of treasury bonds, the dollar has strengthened. But from a long-term perspective, the expansion of the money supply and the monetization of fiscal deficits will both lead to a depreciation of the dollar. While the dollar declines, international commodity prices will rise and dollar-denominated assets will be at risk.

So, from a long-term perspective, the real price of U.S. treasury bonds may go down, an important problem for those of us holding U.S. government debt. In other words, when the bonds fall, the principal and interest collected may have less buying power than the dollars that bought the bond in the first place. This is like savers putting their money in the bank due to inflation only to have the principal plus interest yield less buying power upon maturity. These kinds of potential losses should be our greatest concern.

China holds a lot of U.S. treasuries. How can it prevent its foreign reserves from shrinking? We can’t count on the U.S. The initiative should rest in our hands. To resolve this issue, we need a system that combines a variety of policies. I would emphasize two points. First, in the short term, we should adjust the structure of our assets, take advantage of falling commodity prices, increase our imports of strategic resources and advanced technology, and expand foreign direct investment. Second, in the long-term, we should increase domestic demand and adjust our industries to be less dependent on exports. At the same time, we should reform the way we manage foreign exchange, allowing more people to hold foreign currencies and overhauling the centralized management of the forex system.