China warns of ‘dollar trap’

March 30, 2011, 6:18 PM UTC

The dollar can’t catch a break lately.

A top Chinese economist warned that the world has fallen into a “dollar trap,” as U.S. trading partners lack an alternative to the greenback and can’t prevent the Federal Reserve from printing more money.

Not fast enough for some

The arrangement means big holders of dollars – such as China, which holds some $3 trillion of foreign exchange reserves, mostly in dollars – must sit idly by and watch as the value of their holdings erode. They can’t lightly diversify out of dollars at the risk of accelerating the erosion.

The setup “lacks both stability and fairness,” wrote Xu Hongcai, an economist at the China Center for International Economic Exchanges.

He made the remarks in a paper published ahead of Thursday’s meeting of G-20 finance ministers in Nanjing. They will discuss what might replace the current dollar-centric system – a subject that has vexed economists and policymakers for years and has grown more pressing with the rise of China.

The meeting comes at a time when the dollar index is near its recent lows, thanks to the stumbles of the U.S. economy and the expansive monetary policy of the Fed. The dollar is down over the past year against the yen in spite of a massive disaster in Japan, and has failed to appreciate against the euro even as the Continent stumbles toward another spring of costly, politically divisive bailouts.

Xu, for his part, suggests moving toward a system of multiple reserve currencies overseen in part by the likes of the International Monetary Fund. He says the IMF could issue alerts that would prompt countries to intervene to hold the value of their currencies steady. Reuters notes that the proposal isn’t likely to pass muster with Westerners who favor the free-floating system that has been in place for decades.

There is no easy answer to a problem that has built up over decades, of course. But a report in the Wall Street Journal says the session promises to be even less of a free-flowing exchange of ideas than usual. Chinese officials are so sensitive on the subject of the weakening dollar and their tight control of their own currency, the yuan, that they have urged participants not to discuss the exchange rate issue that has been so heatedly debated on both sides of the Pacific.

But as appealing as that may sound, giving this problem the silent treatment is not going to make it go away.

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