Much of the reporting on the prospect that China will begin shifting from the dollar to the euro as its favored reserve currency has misrepresented some key issues. Here are some quick points to remember: 1) The level of the dollar will not determine China's decision, it is the expected direction of change in the future that matters. This one should be obvious but reporters often get it wrong. A currency is not attractive because it is highly valued, it is attractive if its value is expected to rise. For this reason, the over-valued dollar of the last decade was inherently less attractive than a low-valued dollar that is unlikely to fall further. 2) Switching reserve holdings from dollars to euros will not necessarily hurt Chinese exports. China has been quite consciously propping up the dollar against its currency with the purpose of sustaining its export markets in the United States. If it stops buying up dollars, presumably the dollar will decline against the Chinese currency. This will reduce its exports to the United States. However, if it switches to buying up euros, then the euro will rise relative to the Chinese currency. This will make Chinese goods cheaper for people in Europe, which will presumably increase China's exports to Europe. The rise in exports to Europe may not exactly offset the decline in exports to the United States, but the net effect on China's exports should be relatively modest. 3) China's government has claimed that it wants to slow growth to limit inflation. A higher value of its currency would be an effective way to accomplish this goal. China's economy is now growing at more than an 11 percent annual rate with inflation running at a 5 percent annual rate in recent reports. The central banks has announced several measures aimed at slowing growth which have not been successful thus far. By contrast, a higher value of the currency would slow the growth in China's exports. It would also make oil and other imports cheaper for people in China, helping to alleviate inflationary pressures. In other words, the expected effects of a higher valued currency (and a lower priced dollar) are entirely consistent with the stated economic goals of China's leaders. 4) China will take a hit on its dollar holdings and it knows this. Many reports have claimed that China can't switch away from dollars because it will lower the value of the dollar, which will cause it to take large losses on the huge dollar reserves that its central bank already holds. China's central bank bought up dollars to sustain China's exports, it was not an investment strategy. They knew that they would likely take large losses on their dollar holdings, but felt that the benefits of sustaining the export market in the U.S. was worth this cost. China will only increase its eventual losses by buying still more over-valued dollars, and its central bank understands this fact.
--Dean Baker
