EXCELLENT analysis !!!

China's Dollar Opportunity

Pegging the Chinese Renminbi-Yuan to a fixed exchange-rate with respect to the United States Dollar provides by far the most promising strategy for China to achieve the status of an economically advanced nation over the course of the next 30 years. Going by the writings of economists in the Western countries, for example, Professor Martin Feldstein and Professor Kenneth Rogoff, it would appear that China's burgeoning dollar reserves, currently at $2 trillion, are a threat to the Chinese economy in the medium term (4 to 12 years). However, the smart policy-makers in China have realized that, in the medium term, their best option is, in fact, to closely peg their currency to the US dollar. This currency peg implies that the Chinese have essentially adopted the monetary policy of the United States as the de facto monetary policy for their own economy. In addition, China's huge trade surpluses with the United States, have resumed accumulating at nearly the same pace as before the economic crisis (http://www.census.gov/foreign-trade/balance/c5700.html#2009). This means that the American economy serves as the market for the prodigious amount of goods produced by the rapidly growing Chinese economy. In short, the twin policy guidelines, viz., currency peg to the dollar and the export-driven growth model, provide the most stable, steady and the shortest road-map for China to achieve its place among the wealthiest nations of the world, in the next two or three decades.

As a result of adopting the same monetary policy as the United States, the Chinese are the biggest beneficiaries of uncle Ben's largesse. Recall that the the Federal Reserve Bank of the United States has been prusuing an extremely lax monetary policy for the last 15 months or so. Since their aim is to maintain a fixed dollar-yuan exchange-rate, the Chinese policy-makers had instituted their own massive spending program commensurate in laxity with those of the Fed. Since the Chinese economy is experiencing more than 8% real growth in annual GDP, it is able to put to good use, the trillions of yuans of currency-printing that China had to do to keep up with the Fed's dollar-printing. Moreover, since the Chinese economy is growing so fast, China's GDP would more than double in the next ten years. Thus China could comfortably let its dollar reserves grow from the current $2 trillion, to $4 trillion in the next 10 years. In the final analysis what the Chinese policy-makers have done over the course of the last two decades, is simply to stich the Chinese economy and the American economy together, so that the two economies function, for a large part, as a single economic entity.

The concept of 'Chimerica' was already much in vogue by the late 90s, among businessmen, multinational corporations, and small businesses involved in imports-exports. During the financial crisis of 2008, notable historians like Professor Niall Ferguson declared the end of Chimerica, based on considerations of disparity in savings, consumer spending and military might. In fact, many famous economists have been writing about the dangers of global imbalances for several years now. However, these views suffer from a serious flaw. The flaw is that the economists who complain about global imbalances believe that the Chinese policy-makers would like to stop accumulating dollar reserves, in the short or medium term, and instead switch to a more broad-based basket of currencies. In the medium term, nothing is more beneficial to the Chinese economy than to continue accumulating dollar reserves and watch the actions of the Fed closely. It is only in the long term, when China's per-capita GDP, approach the levels of the advanced industrial countries would the Chinese policy-makers need to worry about the depreciation in value of their dollar reserves.

Perhaps economists have been misled by the fact that the Chinese policy-makers been severely critical of America's lax short-term economic policies. Basically, the reason for China's attitude is that the Chinese would like America to conduct its economic policies according to what is best for Chimerica. In the long-term, this is a really wise course of actions for both China and America. However, if the American policy-makers would not agree to it, then China still has a lot of time to move away from the dollar as its main currency of reserves before the long-term arrives. In the meantime, America is already experiencing serious losses because of following an economic policy that is not in the long-term interest of Chimerica, but that is only in the short-term interest of America alone. To wit, the money-printing that the Fed has done has gone largely to finance the rapid economic growth in the rest of the world, including China. Whereas, the American economy is still mired in anemic growth after more than 20 months into a recession. And if the "new normal" folks are to be believed, America is going to suffer anemic growth for many years to come.

Professor Rogoff cites the example of Europe in the 50s and 60s, to dissuade the Chinese from continuing to accumulate their dollar reserves. However, the example of Europe is not really appropriate for the situation that China finds itself in currently. The countries of Europe had about the same per-capita income as the United States in the 50s and the 60s. Between two wealthy nations, subtle variations in their economic fortunes could lead, over the course of a decade or two, to significant differences in their realizing their respective economic potentials. Whereas, considering the vast differences of wealth between China and America, one sees that it does not matter what crises befall America. By simply tying itself strongly to America in economic matters, China is guarateeing itself a road-map towards creating for itself the wealth of the rich nations. Once one envisions an economic entity (viz., Chimerica) that consists of the material resources of America and China put together, along with the 300 million people of America and the 1.3 billion people of China, one sees that modern economic theory suffers from serious deficiencies that cannot be dealt with by the currently fashionable Keynesian theory.

For example, Professor Krugman has recently grown fond of using the Taylor rule to demonstrate that the Fed should not raise interest rates for many months to come (http://krugman.blogs.nytimes.com/2009/10/10/the-madness-of-the-monetary-hawks-wonkish/). However, if one considers Chimerica, then the current zero percent growth rate of the $14 trillion American economy and the 8 percent growth rate of the $3.5 trillion Chinese economy average out to a 1.6 percent growth rate for the $17.5 trillion economy of Chimerica. Again, the current 9.8% unemployment rate among 300 million Americans gets significantly mitigated when one takes into account that there is less unemployment among the 1.3 billion Chinese, in view of the rapidly growing Chinese economy. So, the nominal interest rate specified by Taylor rule for Chimerica is much more than that for America. Modern economic theory is painfully ill-equipped to handle the challenges of the current economic crisis. Unfortunately, as I mentioned in my previous article, the "official consensus" shows no sign of budging from its perennial oscillation between monetarism and Keynesianism.

You would be on solider ground if you offered any evidence that “China” (which is hardly only one thing) does not “realize that it cannot accumulate dollars forever”.

Analysis starting with the false premise.

We do not know how many $ is accumulated in China.

2 T is a level of their foreign reserves.