[Viewpoint] China actually hooked on the dollar

It’s perhaps the most tantalizing question in economics: When will China’s yuan replace the dollar?

Chinese President Hu Jintao delighted yuan bulls recently by calling the dollar-dominated world a “product of the past.” Oddly, though, his signature legacy will be solidifying the U.S. currency’s place at the center of the global financial system for many years, if not for decades, to come.

Hu’s presidency ends next year. On the surface, China has stepped up the process of internationalizing its currency: promoting its use in global trade, creating “dim sum bonds” that McDonald’s Corporation and others use to sell yuan debt offshore, encouraging firms to acquire foreign ones with yuan.

Yet two bigger priorities belie China’s hope to scrap the dollar. One, China’s ever-growing appetite for it. Two, China is facing a potentially turbulent year and stability matters more than anything else to its leaders. Both will conspire in unexpected ways to preserve the dollar’s dominance.

China’s economy grew 10.3 percent in 2010, a performance that no doubt annoyed short sellers such as James Chanos, the New York hedge-fund manager. Risks from inflation to property bubbles to the gap between rich and poor are mounting and will come to a head in 2011.

Many of China’s challenges could be addressed with a stronger yuan. Given China’s obsession with control, a big move isn’t likely. A safer bet is that China’s dollar purchases will accelerate to boost the all-important export industries. That patronage is the dollar’s best hope for stability.

“The only plausible scenario for a dollar crash is one in which we bring it upon ourselves,” economist Barry Eichengreen writes in his latest book, “Exorbitant Privilege.” Granted, the United States seems to be doing plenty to achieve just that with its massive borrowings and near-zero interest rates. Yet China’s demand for dollars gives the United States a get-out-of-crisis-free card.

In fact, a few million Americans may owe Asia a big debt of gratitude. Janet Yellen, the Federal Reserve’s vice chairman, reckons the central bank’s two rounds of asset purchases will have helped boost private payrolls by about three million jobs through 2012. By her logic, Asia is offering employment opportunities to another three million people.

China, Japan, Hong Kong, Taiwan, Thailand, Singapore, South Korea, India, the Philippines and Malaysia collectively hold about the same amount of U.S. debt as the Fed’s $2.3 trillion worth of asset purchases. Thanks, Asian central bankers!

It’s not this simple, of course, and one hopes the Fed considers how few jobs asset purchases produced in Japan. Also, China playing sugar daddy will breed complacency in Washington at a time when the U.S. economy needs retooling. Yet all this reminds us that for all the lip service about replacing the dollar, Asia can’t stop loading up on it.

When economists debate “exit strategies,” they typically mean central banks and governments withdrawing stimulus. Little attention is paid to how Asia’s dollar fetish pumps liquidity into an economy that, over time, relies on it more and more.

Any discussion about returning the world to normal must include the trillions of dollars of Asian savings sitting abroad. The region needs to make better use of that wealth back home. But repatriating it will be destabilizing in the short-to-intermediate term. Asia would need to learn to rely less on exports and more on domestically generated growth. America would have to live without Asian subsidies.

The title of Eichengreen’s book comes from an observation by Valery Giscard d’Estaing, France’s finance minister during the 1960’s. His description of the huge benefits the U.S. derives from issuing the reserve currency as an “exorbitant privilege” is truer today than it was decades ago.

Greece, Ireland and Portugal are under siege because of too much debt and a currency they can’t devalue. By issuing the most-used currency, the United States can churn out mountains of IOUs without attracting the ire of credit-rating companies. It’s good to underwrite the linchpin currency of the world economy.

China may someday be in that position. Who knows, the United States one day might even peg the dollar to the yuan. First, China must make it through the current decade without a major crisis.

Overheating risks abound as near-zero rates in the United States, Japan and Europe send hot money China’s way. Friction over trade could unnerve markets. And China’s state-capitalism model in which the government chooses winners and directs banks to lend accordingly will be problematic.

It’s this latter risk to which investors should pay more attention. China will rue the days of the mid-2000’s when it had an ideal opportunity to modernize the banking system, yet moved glacially. Now, as China’s economic clout increases, its markets are more unbalanced and less efficient than investors realize.

As cracks in the veneer of Chinese invulnerability grow, demand for dollars will increase. U.S. Treasury officials needn’t worry about who’s going to buy their bonds over the next few years. China is more hooked on the dollar than Hu would like to admit.

*The writer is a Bloomberg News columnist.

By William Pesek