This is becoming an ongoing topic of discussion in many circles, certainly when the subject of US-China relations comes up. China currently has a gazillion dollars sitting in the People’s Bank of China, its central bank. The Chinese are concerned that they are now overexposed to dollar fluctuations, which is true, and have said on numerous occasions that they might diversify their holdings. This of course means that the PBOC would purchase fewer dollar-denominated assets (I think the most popular recent purchases by PBOC were mortgage-backed bonds, but this might have changed). Whenever these announcements are made, the dollar heads south on international markets and Washington gets nervous.

Lots of commentators have used this situation to argue that China has a significant amount of leverage over the U.S. Some, like this quite good post on TomPaine.com, use the issue to criticize U.S. economic policy. I agree with the author’s points about U.S. policy, including discussion of the U.S. budget deficit, but I am not so ready to conclude that China has a huge amount of leverage over the U.S.

I remember back a couple years ago when I was in D.C., and I attended a panel discussion at the Center for Strategic and International Studies. I was doing a summer program there while I was getting my MA degree. The panel included all the past US Trade Representatives of the past couple of decades and was impressive. This topic came up, with Mickey Cantor, Clinton’s first USTR, supporting the point made on TomPaine. Charlene Barshefsky, Clinton’s second USTR and the one who concluded WTO negotiations with China, disagreed. I found her argument cogent, which was that the U.S. and Chinese economies are too intertwined these days for one to have a huge amount of leverage over the other. Moreover, she pointed out, any significant drop in the value of the dollar means a big loss on the PBOC’s balance sheet.

Therefore, China may very well wish to diversify its central bank forex holdings, as well they should. However, this must be done in an exceedingly careful manner. A wholesale rush to get out of dollars would be a tremendous blow to China as well as the U.S., and I’m mostly just talking about the PBOC’s holdings here. There would also, of course, be many other detrimental effects on the Chinese economy.

The issue is not as simple as it appears at first glance.