China signals dollar swap

by Patrice Hill - November 8, 2007

China roiled financial markets around the globe yesterday when it asserted that the dollar is losing its luster as the world's reserve currency and that Beijing will swap some of its $1.4 trillion in reserves out of U.S. dollars and into stronger currencies like the euro and Canadian dollar.

China's verbal assault on the dollar helped trigger a 360-point plunge in the Dow Jones Industrial Average and came as French President Nicolas Sarkozy warned in a speech to Congress that the "disarray" caused by the dollar's steep fall could lead to "economic war."

"The world's currency structure has changed," Xu Jian, a central bank vice director, said in a Beijing conference, according to wire service reports. The dollar is "losing its status as the world currency," he said.

"We will favor stronger currencies over weaker ones, and will readjust accordingly," Cheng Siwei, vice chairman of China's National People's Congress, said at the same meeting.

A spokeswoman for Treasury Secretary Henry M. Paulson Jr. said he remains "strongly committed to a strong dollar," but the Bush administration has done nothing to prevent the currency's recent sharp drop against other major currencies.

Some analysts dismissed the Chinese officials' statements as bluster, but the news left the greenback at a record low near $1.50 to the euro in New York trading, the lowest level in 57 years against the Canadian dollar, and the lowest levels in a generation against the British pound and other currencies.

The dollar's plight added to a raft of woes on Wall Street, where the Dow and other U.S. stock indexes lost 2.7 percent or more of their value amid worries that the weakening dollar is triggering an inflationary spiral in oil and other commodity prices, while making U.S. stocks, bonds and other investments less attractive to foreigners.

"The big issue on any currency is if its rate of depreciation is so fast that it scares away all capital, and the announcement that we heard from China sort of feeds those fears," said Larry Smith, chief investment officer at Third Wave Global Investors.

With the world's largest reserves of dollars, China has been a major investor in U.S. Treasury bonds and debt securities and is the second-largest holder of U.S. government debt next to Japan. China accumulates a lot of dollars because of its lopsided trade surpluses with the United States and its policy of linking its currency to the dollar, which requires it to buy and hold dollars.

While China has been signaling all year that it will gradually change its policies, the blunt and unambiguous statements reported yesterday startled markets.

China already has divested about 5 percent of its $400 billion of Treasury holdings and has set up a $200 billion investment fund to diversify its investments by purchasing stocks and equity ownership positions in companies around the world. The government plans to devote more of its reserves to such alternative investments.

Chinese officials told reporters at the Beijing conference that they are not signaling China will dump dollars and buy euros. But since China continues to fix its currency against the dollar, the practical effect of Beijing's moves away from the dollar is to force up the value of the euro and other currencies that float freely against the U.S. currency, analysts say.

China's policies have helped feed a gigantic run-up of the euro — the European currency has gained nearly two-thirds against the dollar since 2001 — which European leaders say is hurting exports and economic growth on the continent. They have pleaded with the Bush administration to do something about the wild currency swings, and Mr. Sarkozy made his case personally in Washington yesterday.

"Those who admire the nation that has built the world's greatest economy and has never ceased trying to persuade the world of the advantages of free trade expect her to be the first to promote fair exchange rates," Mr. Sarkozy said in his congressional address, alluding to the possibility of economic retaliation by European states stung by the falling dollar.

The French president also blamed China for unfairly undervaluing its currency, but he said that is no excuse for the U.S. failing to act. The Bush administration has been adamant that currencies should be allowed to float freely.

"The dollar cannot remain 'someone else's problem,'" Mr. Sarkozy said. "If we are not careful, monetary disarray could morph into economic war. We would all be its victims."