China Is Trapped

Paul Krugman in the April 3 issue of The New York Times:

… Just the other day, it seems, China’s leaders woke up and realized that they had a problem. …

… They are, apparently, worried about the fact that around 70 percent of those assets are dollar-denominated, so any future fall in the dollar would mean a big capital loss for China. Hence Mr. Zhou’s proposal to move to a new reserve currency …

But there’s both less and more here than meets the eye. … there’s nothing to keep China from diversifying its reserves away from the dollar … nothing, that is, except for the fact that China now owns so many dollars that it can’t sell them off without driving the dollar down and triggering the very capital loss its leaders fear.

So what Mr. Zhou’s proposal actually amounts to is a plea that someone rescue China from the consequences of its own investment mistakes.

Again, this is a story we’ve seen before.

In the 80’s we were worried about Japanese money flooding into the U.S., buying investments everywhere.

That was a very bad sign for Japan: it indicated they didn’t have anything decent to spend the money on at home. The Japanese got burned when our financial system couldn’t continues to supply viable assets for them to buy after the savings and loan system failed.

It' seems like China is in the same spot now.