Ut-oh! Is China starting to blame the US for its currency losses?

It is commonly argued that growing economic ties tend to create common interests that will reduce tension between nations (see FT’s Alphaville). The enormous amount China has lent to the US -- a total that the US data (which tends to underestimate Chinese holdings) now puts above $1 trillion -- will, according to this view, prevent other sources of conflict from getting out of hand.

Alas, relations between creditors and debtors are rarely quite so free of tension. Creditors want to get paid back in full. Debtors would rather pay back at little as possible.

Mei Xinyu, a senior researcher under the Chinese commerce ministry writing in a personal capacity for the Shanghai Daily, argues that China needs to put pressure on the US at the Strategic Economic Dialogue to do more defend the dollar. With the dollar at 1.60 against the euro, it isn’t hard to see why.

Mei goes on to argue that if the US doesn’t do more to defend the dollar, it is effectively defaulting on China.

"The negative results of the US dollar’s decline are evident: the rising prices of all primary products, the intensified pressure on inflation globally, the confusion in the settlement of international transactions, etc. Worst of all, this is the US’ disguised way of avoiding paying off its debts to foreign countries.

It should be noted that the US is the biggest debtor country in the world.

... By the end of 2006, the US’ accumulated net debt overseas hit US$16 trillion. As most of the debts were calculated in US dollars, the US is actually welshing on its debts malignantly by allowing the devaluation of US dollars. Since China is the country with the world’s biggest foreign exchange reserves, most of which are calculated in US dollars, China thus is hurt most greatly from the US dollar devaluation."

One man’s exorbitant privilege is another man’s disguised default. Just think what might have happened it CITIC had invested in Bear and China had gotten back depreciated pennies on its initial dollar ... More follows

What’s more, Mei Xinyu’s argument isn’t entirely wrong. The value of China’s investment in the US -- an investment that is probably roughly equal to a third of China’s GDP (assuming the US data slightly understates China’s true holdings) -- will almost certainly fall in RMB terms. And unless something changes, the US isn’t going to direct its macroeconomic policies towards maintaining the dollar’s external value. Bernanke’s job is price stability and full employment in the US -- not protecting the Chinese purchasing power of the dollars that China has lent to the US.

But Mei Xinyu’s argment is still a bit off. China invested in the US knowing quite well that the US wasn’t committed to defending the dollar’s external value. It invested in the US even though the US had a large trade deficit. It invested in the US even though the IMF indicated the dollar was overvalued and would tend to depreciate over time. It invested in the US even though a gloomy American academic and a former Treasury staff economist quite explicitly warned that China would lose money on dollar holdings back in 2004.

Mei’s complaint, in other words, should be directed in part at China’s own policy makers. When they bought long-term US dollar-denominated debt they took the risk that the dollar would depreciate over time. They effectively gave the US the option to pay China back in depreciated dollars. What’s more, they didn’t charge a premium for the option. That was China’s own choice. China wanted to keep the RMB down even if that meant over-paying for US assets.

It has proved to be quite a consequential choice.

Measured by the funds it has available to lend abroad ever year, China is now the world’s biggest creditor. Most creditors tend to lend to the rest of the world in their own currency. That is what the US historically did, back when it was a creditor. Latin countries seeking financing from US investors promised to repay in dollars, not pesos (a promise that created problems of its own, problems well-documented by Dr. Hausmann). That is what Europe does as well -- an awful lot of the external debt of the Eastern European countries is denominated in euros. China, for complicated reasons, has decided to lend to the US in US dollars and to lend to Europe in euros and pounds. China’s European lending - incidentally -- could prove to be as risky as lending to the US in dollars; SAFE and the CIC are really over paying for euros.

As a result, China is bearing the exchange rate risk. And the size of China’s fx position is now quite large.

This exposure was a consequence of China’s decision to hold more foreign currency reserves than it needs in an effort to hold its currency down. It was China’s own choice. Still, I suspect that as the financial costs of China’s policy become more apparent, more and more Chinese commentators will argue that the US -- and perhaps in time Europe -- have failed to live up to their side of the bargain by failing to do enough to defend their respective currencies.

That strikes me as a recipe for future trouble.