Smith Faculty Opinion Article	August 13, 2007
By Dr. Peter Morici, Professor of International Business E-MAIL WEB SITE

Chinas Hollow Threat to Dump U.S. Bonds

The Congress is growing impatient with Chinas currency manipulation and export subsidies, and is near passing legislation that would require the Bush Administration to strike back. Faced with the prospect of trade competition on a level playing field--something the Chinese Communist Party fears more than free elections--the U.K. Daily Telegraph reported on August 8 Beijing threatened to dump its hoard of U.S. dollars to panic financial markets and sink the U.S. economy.

Subsequently, the Peoples Bank of China sought to discredit this report. However, given the mess Beijings mercantilist policies have created, and remembering this is the same bunch that blamed American greed for Chinese exports of antifreeze in toothpaste and lead paint on childrens toys, we should examine the real potential menace posed by such a Chinese action.

My conclusion is dont panic. China is as much hostage to the global trade imbalances it has created as the United States.

If the Peoples Bank of China were to sell enough Treasury securities to disrupt financial markets and cast the U.S. economy into recession, where would Chinas factories sell all their stuff? Where would all those Chinese living in cities work if their stuff does not move? What would they do with their time if they were laid off? Oust their government? Riot in the streets? The Chinese Communist Party can make effective threats to disrupt the U.S. economy only if Americans are stupid enough to panic.

More likely than simply dump all its U.S. bonds, the Peoples Bank of China could start selling its holdings just fast enough to make a statement. The Bank would then have lots of dollars instead of bonds on its balance sheet.

This begs the question: What would the Peoples Bank do with all those dollars? Two outcomes are possible.

First, the Peoples Bank could hold the dollars, and then the Federal Reserve could buy enough of the bonds the Peoples Bank sold to leave the amount of dollars in circulation unchanged. The Peoples Bank would have managed to cheat itself out of a lot of interest payments and the U.S. budget deficit would be reduced, because the Fed remits interest earned on the bonds it holds to the Treasury. I like the Fed collecting interest much better than paying it to the Peoples Bank.

Second, the Peoples Bank could buy other currencies with those dollars. It can't buy yuan, because those are not in circulation in large amounts outside of China--the yuan is not freely convertible. The Peoples Bank would have to buy euros, yen and other currencies, which would raise the value of those currencies against the dollar, reduce the U.S. trade deficit and decrease (increase) U.S. trading partners' trade surpluses (deficits).

No doubt, other governments would not like the deterioration in their national trade balances, and their central banks would start buying dollars. Again the Chinese would have managed to rebalance who holds what currencies; however, without great effect other than weakening the dollar against other currencies and only in an amount in proportion to U.S. trading partners tolerance for smaller trade surpluses with the United States.

Most likely, we would get some combination of these two outcomes but neither poses a particular problem. Hence, you dont see Federal Reserve Chairman Ben Bernanke shaking in his boots in response to foolish Chinese threats.

What is alarming, though, is the Bush Administration has been so silent through all of this, and Treasury Secretary Henry Paulson continues to demagogue the China trade issue, calling protectionist people who propose meaningful action against Chinese mercantilism.

The trade deficit with China gives Beijing the cash to buy up key resources around the world and could permit it to buy up key segments of the U.S. economy, if it chooses. The Peoples Bank has enough cash to purchase more than 5 percent of the publicly traded U.S. companies, if we put the value of U.S. equities at about $20 trillion. Through strategic allotment of purchases, Beijing could exercise working control over an even large proportion of the U.S. economy.

Along with the erosion of the U.S. industrial basis and consequent reduced productivity and GDP growth, the compromise of U.S. economic sovereignty is the key long-term threat posed by Chinas massive dollar hoard.

Americans need to remember who they are dealing with in Beijing and not be cowed by Chinese threats. It serves U.S. national interests for Congress to enable measured, responsible responses to Chinese mercantilism.

I have my differences with elected officials like Senators Charles Schumer and Charles Grassley and Congressman Charles Rangel, but I have confidence that they understand the judging eye of history. Whether and how they act will not be much affected by Chinese bravado.

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission. ►More Faculty Opinion Articles