Sunday, May 13, 2012

What If China Shorts Dollars?

I've been pondering Chinese forex policy lately.  News that China will allow its banks to short U.S. dollars is more than just a safety valve in the event of a run on the dollar.  It allows banks to hedge any long positions they have in U.S. Treasuries.  Placing limits on short positions is smart but basing those limits on annual turnover is not.  Safe limits would be based on the net notional value of currency positions marked to market daily, complying with Basel rules on capital.  Western banks are pretty good at getting around capital adequacy rules, so perhaps China is just taking a less subtle approach.

Don't expect to see a whole bunch of Chinese banks piling into dollar shorts all at once.  Greece's potential exit from the euro makes that currency look increasingly weak and the dollar look relatively strong.  That means the U.S. federal government can continue to finance its ginormous budget deficits cheaply and Chinese banks can breathe easier about the value of their Treasuries.  Wait a few months after the euro breaks apart.  The British pound and the dollar will then be in the spotlight.  

Full disclosure:  No short positions in the U.S. dollar or long positions in other currencies at this time.