China Syndrome - Are we heading for a meltdown?

Zhou Xiaochuan (Reuters) China is rumbling again. As a rising economic power, it chafes at the fact that the U.S. dollar underpins most of the world economy. On Monday, Zhou Xiaochuan, governor of China's central bank, posted an essay on the People's Bank of China website suggesting it is time to start moving toward an independent global reserve currency.

China is not alone in this view. Russia, always looking to make trouble for U.S. interests, floated a similar proposal on March 18th by an "unnamed government source" in RIA Novosti, the official Russian news and information agency.

The Chinese statement comes fast on the heels of critical comments made by Chinese Premier Wen Jiabao at a press conference following the closing ceremonies of the National People's Congress. Said Wen Jiabao:

We lent such huge fund to the United States and of course we're concerned about the security of our assets and, to speak truthfully, I am a little bit worried.

Those are strong words coming from the head of China's government and they express a realistic concern. With almost $2 trillion in dollar-denominated foreign exchange reserves, China stands to lose a bundle should the dollar's value collapse.

Of course, the source of China's dollars--U.S. imports of Chinese-made products--cannot be ignored. But the fact remains that China feels vulnerable. For years they have made rumblings about diversifying their foreign exchange reserves away from dollars. While the threat of that happening immediately is unrealistic, the downside of that happening in the future needs to be dealt with today. 

By looking at currency crises in the emerging markets, we can get a glimpse at what wholesale dollar selling would mean to us:

  • If China sells dollars, the dollar will collapse driving up the price of imported goods including everything from consumer goods to oil. When Argentina devalued the peso in 2002, consumer prices increased 41%.
  • This will cause a massive contraction in the economy. During Argentina's crisis between 1998 and 2002, the economy contracted by more than 20%.
  • If China stops buying U.S. Treasury debt, interest rates in the U.S. will go up across the board, raising the cost of borrowing for homeowners, consumers, corporations and municipalities.

There is a tendency by lawmakers and policy wonks to dismiss China's rumblings as silly or self-serving. I believe we should take them seriously. Unless we are more careful in the future than we have been in the past, we may find ourselves facing a massive financial meltdown--a real China Syndrome.