China and the U.S. Dollar

From the Wilson Quarterly (Summer 2009):

You want to know why China won't dump the dollar? It has almost no choice, unless a new worldwide currency is created. Robert Aliber, a University of Chicago professor, explains how America's rising debt has limited both China and America:

By 1980, [America's] net foreign assets (assets minus liabilities) were larger than those of all other creditor countries combined. But the next 20 years brought a reversal of unprecedented proportions. By 2000, America's net foreign liabilities had become larger than those of all other debtor countries combined, and its liabilities were still growing rapidly as foreign savings surged into Treasury bills and other dollar-denominated securities. The shift was amazing rapid. (pps. 56-57)

[Even so,] Beijing is not likely to let market forces determine the value of its currency. And if it were to begin buying many more yen or euros instead of dollars...politicians from Tokyo to Paris would go ballistic. They would accuse the Chinese of following a classic "beggar-thy-neighbor" policy, keeping the value of the yuan artificially low and thus increasing China's exports to their countries. So China's leaders will continue to buy dollars, even as they complain loudly that the United States' trade and fiscal deficits are too large. (pp. 58)

Meanwhile, from 1981 to the present, the Chinese population's savings rose from 20% of China's GDP to more than 50%. (See WQ, pp. 60) Basically, the Chinese started saving more money and had to put the money somewhere. Interest rates were fairly high from 1981 to 2000 in the United States, so America was a natural destination for deposits. How much are the Chinese saving? By some accounts, up to 2.5 trillion dollars per year.

What does it all mean? Probably three things: one, the United States must manufacture more products foreigners need, desire, and can afford; two, the United States may subsidize some types of manufacturing through tax credits to counteract China's currency protectionism; and three, at least for the foreseeable future, the American dollar will remain the world's "least worst" currency, but may still have to increase interest rates sometime this year to mollify investors.

Contrary to public belief, increasing interest rates isn't all bad. Higher interest rates encourage more Americans to save and minimize the risk of inflation; therefore, higher interest rates have positive benefits. I am very upset that my T. Rowe Price money market fund (PRRXX) is giving me near 0% interest; however, I am unsure whether to transfer the money into a Ginnie Mae fund. If the Federal Reserve raises interest rates, the value of the Ginnie Mae fund's shares should decline, so waiting until mid-2010 to invest may be a more prudent path. Absent some clear signal from the Federal Reserve regarding its future interest rate decisions, I bet many Americans will remain on the sidelines, upset but unwilling to make any major moves.

Update on April 30, 2011: on the other hand, consider this question from Caroline Baum, Bloomberg: "A dollar today buys only 45 cents worth of the goods and services it bought in the early 1980s, according to the Bureau of Labor Statistics. Can you explain why, in a time when prices are supposedly stable, the dollar has lost half its purchasing power?"