Over the last 30 years, China’s economy has grown at an average annualized rate of nearly 10%. While this statistic alone is jaw-dropping, what is more impressive is the extent to which the nominally Communist country’s economy has become intertwined in the global economy. China now exerts enormous influence over the economies of virtually every country in the world, and a slight change in its domestic economic policy has the potential to send shockwaves rippling throughout the world. Nowhere is this more apparent-and frightening-then in China’s economic relationship with the United States, which is very much at the mercy of China when it comes to prices, wages, interest rates, most importantly, the value of the Dollar.
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Read also business/finance/10-09-2007/96909-us_economy-0">“China may lead US economy to collapse dumping US dollar”
Forex Reserve Diversification
Let’s begin with an examination of China’s forex reserves, which is probably China’s biggest bargaining chip in its economic relationship with the US. Up until two years ago, China’s currency, the RMB or Yuan, was pegged to the Dollar. As with any peg, there often develops a discrepancy between the fixed value of the currency and the value that the market would assign if the currency were permitted to float. As China’s economy surged ahead, especially over the last five to ten years, tremendous pressure began to build under the RMB. In order to maintain the peg and hold down the value of the RMB, China began accumulating foreign exchange reserves by withdrawing foreign currency from circulation. Today, China’s foreign exchange reserves are massive, at $1.4 trillion as of September 2007.
In the eyes of American policy-makers, this presents a problem because the majority of these reserves are held in Dollar-denominated assets, namely in the form of US Treasury securities. The US government theoretically could not be happier that foreign Central Banks are willing to finance its perennial budget deficits. However, this borrowing has reached a point where foreigners now control over 40% of the US national debt. Moreover, long-term US interest rates are market-driven, based on the buying and selling of US government bonds. In other words, the US has gradually ceded control of its long-term interest rates to foreign Central Banks, namely China and Japan.
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