Can China buck the dollar?

The US must be wary as the world's manufacturing center tries to make its currency king.

Ever play with a children's gag toy called a Chinese finger trap, a woven cylinder that snares the index fingers? Then you'll know what China feels being stuck in what is called a "dollar trap."

Beijing has grown very uneasy about owning more than $1 trillion of US debt. It's not sure the dollar will keep its value as America borrows more than it might be able to pay back. But if China starts to dump Treasury bills, such a large sell-off would only push down the value of the dollar. China would lose billions.

In addition, a devalued dollar would only hurt the value of Chinese exports.

What to do? For now Beijing keeps buying more US debt to park its earnings from exports – despite the rising red ink of the US government. Without that money from China, President Obama would not be able to afford all his expensive new programs.

For all this easy credit, China seeks something in return. It wants to slowly dethrone the almighty dollar as the currency of choice in most global trade deals.

During the 1990s, Japan and Europe tried to reduce the prominence of the dollar and to boost the use of their respective currencies. They largely failed. And at the recent Group of 8 summit, both China and France called for an end to the greenback as king of currencies.

But it is China – the world's manufacturing center and the third-largest economy – that is now giving it a serious try.

By 2020, it hopes to be the world's financial hub. And its leaders are feeling the sting of criticism from poor Chinese for loaning so much money to the US rather than recycling that wealth back into their own country.

Despite these incentives, China isn't too sure how to get out of the dollar trap.

Earlier this year, it proposed a new type of global currency tied to a basket of currencies. When that idea didn't fly, it beefed up efforts to promote its own currency. China has signed "swap" agreements with several countries to trade in its own currency, the yuan. It also wants to set up an Asian body to provide emergency financial relief in the region, with the yuan as a prominent player.

In April, it began to allow Chinese companies in the country's major export centers to use the yuan to settle international trades. Before then, they had to use US dollars. Then in July it allowed traders in Hong Kong to make the switch.

Despite all these steps, the yuan is a long way from replacing the dollar. China still has not crossed the big threshold of making its currency easily convertible. And China's banking and bond markets are still too tied to the interests of the ruling Communist Party.

Most of all, from a currency trader's point of view, China's political stability is risky. Protests by workers, minorities, and aggrieved peasants are rising. Until it embraces democracy and rule of law without political interference, China may not be the best place for multidecade investments.

Despite America's debt woes, the US dollar is still being used in the vast majority of international trade deals. Until China's leaders stop acting like emperors over their own people, the dollar will be the emperor of world currencies for some time to come.

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