China must tread lightly with attack on greenback

For a country that has accumulated a larger stash of U.S. dollars than even Michael Jackson's lawyers, China sure is down on the greenback. Every time you lift your head, some Chinese official is sounding off on why the buck, still the world's most important currency, is just so 1999.

Only they don't quite say it that way, because state officials in China avoid such direct language. Instead they say things like, "We should have a better system ... so that we can maintain relative stability of major reserve currencies ... and promote a diversified and rational international reserve currency system." It's like listening to a sales pitch from a financial adviser, isn't it? Stability. Diversified. Rational. It hits all the right notes.

Except Dai Bingguo, the Chinese state councillor who said it, isn't selling a mutual fund but a concept. China has been pounding away that the world needs a new reserve currency to replace the U.S. dollar, the one governments and central banks hold in greatest abundance.

This week at the Group of Eight summit in L'Aquila, Italy, China stepped up the pressure. That the idea is completely impractical (except in the very long run) matters less to the Chinese than that they can take a dig at the dollar. Message delivered, but what's the real agenda here?

It's understandable that the Chinese would worry. No foreign country has more riding on U.S. dollar assets. By some estimates, nearly 60 per cent of China's $2-trillion hoard of foreign reserves is still in greenbacks, with the largest slice in U.S. Treasuries that now have skinny yields. This seems like an increasingly bad deal, and the legitimate Chinese fear is that some of its wealth could get burned in the great fiscal bonfire now taking place in Washington. With a U.S. budget deficit of 13 per cent of GDP, it's not a great time to be a creditor of the U.S.

Everyone can see the size of the mess but it's the way the Obama administration will get out of it that could become the problem for the Chinese. What will get the U.S. growing again? Most of the U.S. economy is based on consumer spending - but the consumer's balance sheet is in a horrid state. "The game is up for consumption-led growth," says David Laidler, an economics professor at the University of Western Ontario. "The rest of the world isn't going to lend to what amounted to a giant Ponzi scheme led by the housing market."

So the fixes of the past, such as tax cuts and rebates, aren't going to accomplish much; many American households would just save the extra money. (They have no choice - they've just lost 20 per cent of their wealth!) Because so much of Corporate America is geared to the consumer, business investment will be subdued, too. That leaves the federal and state governments to spend - but in case the financial catastrophe in California hasn't already made it clear, there's only so long they can live beyond their means.

Only one avenue remains for growth. "If the U.S. is going to have a long-term, sustainable recovery, it will have to shift back to exports," says Nigel Gault, chief U.S. economist of IHS Global Insight. For a country whose trade deficit went from $100-billion to $750-billion in the space of 10 years, that would be some shift.

The trouble is that President Barack Obama isn't a magician, no matter what Oprah Winfrey thinks. He can't wave a wand and make Asia buy what the United States is selling. Something's got to give to make the U.S. more competitive again. That something is the value of its dollar - the exchange rate.

China, of course, carefully manages the price of its currency. It has allowed the yuan to rise by about 20 per cent in the past four years to the greenback, an excruciatingly slow pace. The exchange rate has barely moved since last summer. By any measure, the yuan should be a lot higher. But that would cause even more pain to Chinese exporters.

China's in a fix that is partly of its own making. It used its own cheap currency to sell cheap goods to Americans addicted to cheap credit, and accumulated a windfall. Then it got out of hand. Now the Chinese have an unpalatable choice: They can face a more competitive America, or a potentially insolvent one.