So THAT'S Why It Went Down That Way!

Andy Xie at FT.Com explains something over which I've been puzzling for some time.

Emerging economies such as China and Russia are calling for alternatives to the dollar as a reserve currency. The trigger is the Federal Reserve’s liberal policy of expanding the money supply to prop up America’s banking system and its over-indebted households. Because the magnitude of the bad assets within the banking system and the excess leverage of its households are potentially huge, the Fed may be forced into printing dollars massively, which would eventually trigger high inflation or even hyper-inflation and cause great damage to countries that hold dollar assets in their foreign exchange reserves.

The chatter over alternatives to the dollar mainly reflects the unhappiness with US monetary policy among the emerging economies that have amassed nearly $10,000bn (€7,552bn, £6,721bn) in foreign exchange reserves, mostly in dollar assets. Any other country with America’s problems would need the Paris Club of creditor nations to negotiate with its lenders on its monetary and fiscal policies to protect their interests. But the US situation is unique: it borrows in its own currency, and the dollar is the world’s dominant reserve currency. The US can disregard its creditors’ concerns for the time being without worrying about a dollar collapse.

The faith of the Chinese in America’s power and responsibility, and the petrodollar holdings of the gulf countries that depend on US military protection, are the twin props for the dollar’s global status. Ethnic Chinese, including those in the mainland, Hong Kong, Taiwan and overseas, may account for half of the foreign holdings of dollar assets. You have to check the asset allocations of wealthy ethnic Chinese to understand the dollar’s unique status.
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I remember having several discussions with certain neoconservative assholes back in the 2002-2003 time frame wherein they answered my trepidation about the twin financial problems of the current account balance and growing credit bubble (which, yes, I thought would have collapsed much sooner than it did) with this hoary old chestnut:

When you owe the bank a hundred thousand dollars and you can't pay, you have a big problem. When you owe the bank a hundred million dollars and you can't pay, the bank has a big problem.

This was a snide way of basically saying, "It's less our problem if we can't pay the Chinese the money we owe them than it is a problem for the Chinese who loaned it to us when we can't pay it back. Screw those commie bastards anyway."

I've been wondering why the Chinese haven't dropped the dollar peg yet, and Andy Xie has now helpfully come along to explain to me what's going on. Short summary: the Chinese are rather hoping they can do it gradually so as to limit the pain of moving everybody practically overnight into the renminbi as the reserve currency to replace the dollar. One hopes that the coming secondary wave of foreclosures and mortgage crisis in the U.S. won't force them to accelerate their reforms, because if the Chinese lose faith in the dollar too quickly, especially if the U.S. is too paralyzed in stagflation to be able to leverage its currency collapse into an opportunity to move its productivity into exports, then it's going to be pretty painful around here.