Noble prize winner Paul Krugman has an amazing insight about the state of deadlock that we are currently in.
That China realizes that it hold too much USD T-Bills and does not know what to do. http://www.nytimes.com/2009/04/03/opinion/03krugman.html?_r=1
China’s Dollar TrapBy PAUL KRUGMAN
Back in the early stages of thefinancial crisis, wags joked that our trade with China had turned outto be fair and balanced after all: They sold us poison toys and taintedseafood; we sold them fraudulent securities.
But these days, both sides of that deal are breaking down. On oneside, the world’s appetite for Chinese goods has fallen off sharply.China’s exports have plunged in recent months and are now down 26percent from a year ago. On the other side, the Chinese are evidentlygetting anxious about those securities.
But China still seems to have unrealistic expectations. And that’s a problem for all of us.
The big news last week was a speech by Zhou Xiaochuan, the governorof China’s central bank, calling for a new “super-sovereign reservecurrency.”
The paranoid wing of the Republican Party promptly warned of adastardly plot to make America give up the dollar. But Mr. Zhou’sspeech was actually an admission of weakness. In effect, he was sayingthat China had driven itself into a dollar trap, and that it canneither get itself out nor change the policies that put it in that trapin the first place.
Some background: In the early years of this decade, China beganrunning large trade surpluses and also began attracting substantialinflows of foreign capital. If China had had a floating exchange rate —like, say, Canada — this would have led to a rise in the value of itscurrency, which, in turn, would have slowed the growth of China’sexports.
But China chose instead to keep the value of the yuan in terms ofthe dollar more or less fixed. To do this, it had to buy up dollars asthey came flooding in. As the years went by, those trade surpluses justkept growing — and so did China’s hoard of foreign assets.
Now the joke about fraudulent securities was actually unfair. Asidefrom a late, ill-considered plunge into equities (at the very top ofthe market), the Chinese mainly accumulated very safe assets, with U.S.Treasury bills“; T-bills, for short — making up a large part of thetotal. But while T-bills are as safe from default as anything on theplanet, they yield a very low rate of return.
Was there a deep strategy behind this vast accumulation oflow-yielding assets? Probably not. China acquired its $2 trillion stash— turning the People’s Republic into the T-bills Republic — the sameway Britain acquired its empire: in a fit of absence of mind.
And just the other day, it seems, China’s leaders woke up and realized that they had a problem.
The low yield doesn’t seem to bother them much, even now. But theyare, apparently, worried about the fact that around 70 percent of thoseassets are dollar-denominated, so any future fall in the dollar wouldmean a big capital loss for China. Hence Mr. Zhou’s proposal to move toa new reserve currency along the lines of the S.D.R.’s, or specialdrawing rights, in which the International Monetary Fund keeps itsaccounts.
But there’s both less and more here than meets the eye. S.D.R.’saren’t real money. They’re accounting units whose value is set by abasket of dollars, euros, Japanese yen and British pounds. And there’snothing to keep China from diversifying its reserves away from thedollar, indeed from holding a reserve basket matching the compositionof the S.D.R.’s — nothing, that is, except for the fact that China nowowns so many dollars that it can’t sell them off without driving thedollar down and triggering the very capital loss its leaders fear.
So what Mr. Zhou’s proposal actually amounts to is a plea thatsomeone rescue China from the consequences of its own investmentmistakes. That’s not going to happen.
And the call for some magical solution to the problem of China’sexcess of dollars suggests something else: that China’s leaders haven’tcome to grips with the fact that the rules of the game have changed ina fundamental way.
Two years ago, we lived in a world in which China could save muchmore than it invested and dispose of the excess savings in America.That world is gone.
Yet the day after his new-reserve-currency speech, Mr. Zhou gaveanother speech in which he seemed to assert that China’s extremely highsavings rate is immutable, a result of Confucianism, which values“anti-extravagance.” Meanwhile, “it is not the right time” for theUnited States to save more. In other words, let’s go on as we were.
That’s also not going to happen.
The bottom line is that China hasn’t yet faced up to the wrenchingchanges that will be needed to deal with this global crisis. The samecould, of course, be said of the Japanese, the Europeans — and us.
And that failure to face up to new realities is the main reasonthat, despite some glimmers of good news — the G-20 summit accomplishedmore than I thought it would — this crisis probably still has years torun.