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Friday, July 22, 2005

The Saudi Arabia of Money

Billmon and Krugman comment on China's decision to stop pegging its currency to the dollar.

Up until yesterday, the People's Bank had shown an almost unlimited willingness to buy dollars to maintain the yuan peg -- thus mopping up whatever dollars America's other Asian creditors, including Japan, didn't want to hold. This encouraged other emerging countries to stay in the "system," since they knew China wouldn't allow the dollar to fall too far, protecting them from big losses on their reservess.

This is the classic swing role played by the central player in any successful cartel. Thus my nickname for the People's Bank -- "the Saudi Arabia of money."

But the "Saudis" have just signaled that their ability to stabilize the market has reached its limits -- or, more precisely, that domestic economic considerations (and/or a desire to avoid U.S. trade sanctions) now outweigh the importance of stabilizing the market.

Without China as the backstop, though, the other members of the cartel would have less incentive to hold dollars -- and, logically, a greater fear that they would be left holding the bag if China eventually allowed a much bigger decline in the dollar. The longer these smaller players wait to diversify their reserves, the greater the risk that others will do it first, quietly or covertly, leaving them with heaviest losses. The classic "prisoner's dilemma."
[I]t could be the start of a process that will turn the world economy upside down - or, more accurately, right side up. That is, the free ride China has been giving America, in which the world's richest economy has been getting cheap loans from a country that is dynamic but still quite poor, may be coming to an end.