Stephen King: China takes small steps towards breaking the sway of the US dollar

For nations sitting on piles of dollar assets, the fall in the dollar's value is hardly good news

Reports of the US dollar's death have, so far, been greatly exaggerated. It is still, by far, the most liquid currency in the world. The US has the deepest and most liquid capital markets in the world, despite all its sub-prime and banking difficulties. The dollar is used on one side of the vast majority of currency trades. If someone wants to swap out of Brazilian reals into, say, Korean won, it's typically a two-step process – from reals into dollars and then from dollars into won. Central banks in the emerging world mostly hold their – in some cases, huge – foreign exchange reserves in the form of US dollars. It is, therefore, the international currency of choice. It remains the world's reserve currency.

For the US, this makes life very easy. It can issue huge amounts of dollars knowing that people on the other side of the world will happily stash them away for a rainy day. That means the US can raise funds more cheaply in international capital markets than others can. US trade can be cheaply financed because the US doesn't often have to pay of currency conversion costs. And it can happily run a large balance of payments current account deficit year-in, year-out, without any significant costs to the American people.

For the rest of the world, the dollar's reserve currency status is a mixed blessing. While it's useful for other countries to have access to an international medium of exchange and store of value, the dollar is ultimately under American control. Should there be a conflict between the interests of American voters and foreign creditors, the foreign creditors will probably lose out. Today, those creditors – many of which are emerging market governments and central banks – have built up trillions of dollars of holdings of US assets. Is their money safe? If not, what should they do about it?

When governments were happy to grant central banks independence in the pursuit of price stability, there were few reasons to worry. The credible pursuit of price stability kept domestic voters happy but, at the same time, enhanced reserve currency status. If other nations with no great record on the control of inflation could somehow tie their currencies to the dollar, they might be able to benefit indirectly from the aims of the Federal Reserve. And so it has proved. Although countries like China have been accused of tying their currencies to the dollar for purely mercantilist reasons, the truth is a bit more complex. For the People's Bank of China, the link between the renminbi yuan and the dollar has been an important source of domestic monetary and financial stability.

With the onset of the credit crunch, the relationship between governments and central banks has begun to change. Quantitative easing works either by increasing the money supply or by increasing the velocity of circulation of money. Either way, the idea is to raise the value of output by boosting volume or price. In a closed economy, where there are no linkages with the rest of the world, the impact might be felt through an upward shift in inflation. In an open economy, the impact could just as easily be felt through a fall in the exchange rate. After all, if the supply of dollars is rising relative to other currencies, the value of the dollar should fall.

For all those nations sitting on piles of dollars, this is hardly good news. Having lent the US large amounts of money, they're discovering that America's credit status isn't quite so impressive after all. If the additional dollars released into the US economy succeed only in pushing down the dollar's value against other currencies, the US will, in effect, be defaulting to its foreign creditors. Ultimately, those creditors need their money back in their own currencies. A lower dollar will simply make those foreign creditors worse off and American exporters more competitive.

Not all Americans will benefit from a weaker dollar. It leaves the price of imported goods higher than might otherwise have been the case. That means, for example, higher oil prices.

And for those countries which prevent their currencies from falling against the dollar through even more foreign exchange intervention, the cost will be seen in the form of higher inflation.

Unconventional measures might seem like a magic trick, a "get out of jail free" card for countries with imploding credit systems, but they simply redistribute problems to other parts of the world. Whether the US government should worry about any of this is, of course, another matter.

Ultimately, it's answerable to its voters, not to foreign creditors who, arguably, should have understood the risks a little better. Then again, people bought US assets because they felt that the American economic system had triumphed, a view which Americans themselves were hardly going to challenge. It's only with the economic crisis that a division has opened up between the interests of America's domestic and foreign stakeholders.

That's why the dollar's reserve currency status is under threat. If foreign holders of US assets are being treated as second-class citizens, they may have to re-think their strategy of holding dollars. Admittedly, this is easier said than done. Should the dollar go into free-fall, foreign creditors would make enormous losses on their dollar holdings and the international financial system could implode, threatening a repeat of the instability seen in the early 1970s. A subtle approach is needed. The Chinese may already be taking the first, tentative, steps, as explained in a recent HSBC paper by Qu Hongbin, Zhi Ming Zhang and Steven Sun.

China holds over $1.2trn of dollar assets, most held as foreign exchange reserves, a result of controls on private-sector capital outflows.

These are a kind of dollar "trap". If the renminbi rises against the dollar, the value of China's reserves will fall in domestic currency terms. One way out of the trap is to ensure that when, eventually, the renminbi is untangled from the dollar, China will be benefiting from its own reserve currency status. This process will take many years. Most obviously, China's capital markets are in their infancy.

However, China is already a major trading nation which, until now, has invoiced around 70 per cent of its annual trade in dollars. This is now beginning to change. Over the last few months, China has seen a blossoming of bilateral currency swap deals with, amongst others, Indonesia, Belarus and Argentina. These deals are worth a total of $650bn.

If similar deals proliferate around the world, China will increasingly be able to conduct trade with other nations – notably those in the emerging world – in its own currency and not in dollars. The dollar's reserve currency status is not yet under threat, but China, for one, is already taking the first steps towards a new world which is no longer quite so dollar-dependent.

If successful, the US will eventually find that living beyond its means through the sale of dollars to countries elsewhere in the world will no longer be quite so pain-free.

stephen.king@hsbcib.com