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Why China has to buy US debt

Dalrock
July 27, 2011

Captain Capitalism linked to an article on CNBC the other day titled US Image in China Already Tarnished by Debt Fight.  The basic premise of this article and countless others like it is that China might suddenly decide it didn’t want to lend the US any more money.  While this is something they could of course decide, there is some very important context missing around why China finds itself lending the US so much money in the first place.  This is very basic stuff, but I’ve never seen it discussed anywhere in the media.

As almost everyone knows China has been running a trade surplus with the US since at least the 1980s.  Every year they sell us more goods and services than we sell back to them.  This isn’t by accident or due to them discovering some economic principle the west hasn’t yet stumbled upon.  The Chinese government has deliberately managed their economy so that this will be the case.  The thing is, under normal circumstances the currency markets will eventually adjust so that trade is balanced.  Whenever Americans buy goods from China someone is taking dollars, converting them to yuan (or if you prefer renminbi), and then paying the factory which produced the goods.  The currency exchange assumes someone else wanted to sell yuan for dollars in order to buy goods and services from the US.  But the currency market can’t clear without intervention because as we already know Americans are buying more goods and services from China than the other way around.  If left alone (and without one country investing in the other), the currency market would adjust the relative values of the yuan and dollar until the total value of imports equals exports.  This hasn’t happened because China has been soaking up those excess dollars on the US/China currency market, supplying yuan in exchange.  They have to do this, or they will suffer the unimaginable fate of having balanced trade.

Since China has been buying up excess dollars on the currency exchange market for several decades now, they have amassed a lot of the things.  This creates a problem;  what should they do with all of them?  They could bundle $100 bills onto forklift manageable pallets and store them in a massive warehouse, but the darn things create a fire hazard, not to mention a security risk.  If Chinese thieves were to break in and steal some of these dollars, someone in China would end up turning them back in to the US for goods and services.  That’s right!  Now China is all of a sudden moving back towards an unimaginable state of balanced trade.  China isn’t about to let that happen, so they have decided to buy things with these dollars other than our goods and services.  In practice this has been US Treasury bonds, but they could buy and hold any financial asset which is denominated in dollars.

To understand how unnatural this situation is, remember that China is (or was) a poor country continuously lending huge sums of money to a rich country (or at least we were).  Or to put it another way, they are an undeveloped country investing capital in a fully developed country.  This shouldn’t be happening.  It is the international finance equivalent of water running uphill;  someone must be pumping it.

So when you read articles in CNBC and elsewhere like the one referenced above and they say things like:

“The high-stakes political posturing is a shock to these countries,” said Jina Ventures’ Ron Shah, who said he’s heard the same thing from contacts in India and the United Arab Emirates. “The point for them is not about whether or not a deal will be reached. The chance that the U.S. will leave this issue lingering is creating material damage to the safety of the U.S. dollar and Treasuries amongst the emerging powers in Asia.”

And then follow with another statement like:

“The damage is done,” said Brian Kelly, head of Brian Kelly Capital and a ‘Fast Money’ trader. “Look at Aussie and Kiwi dollar today, that is where the buyers are.”

They aren’t telling the whole story.  It is true that the US could take a hit regarding its credit rating and the dollar could be weakened in the process.  However if China and other Asian countries want to maintain a trade surplus with the US, they will have to continue investing in the US.  If they stop buying new dollar denominated assets, or even worse start selling the ones they have, they will necessarily switch from having a trade surplus with the US to a trade deficit.  Since even balanced trade is something which has terrified them for 25 years, I’m guessing they will be very reluctant to do this.

I’m not saying the current model is a good idea for either country, I’m just pointing out the basic mechanics of how it works.  What strikes me is that no one else seems to want to talk about this.  On the left, the Keynesians don’t seem to mind one bit that China and other countries are distorting our economy to lessen demand for US goods, trampling the average US worker and environmental protections they profess undying love for in the process.  If I didn’t know any better, I’d think that all they really cared about was a supply of cheap credit to continuously expand the US federal government just for the sake of having a bigger government.   On the right, the Ricardians don’t seem to mind that instead of creating a mutually beneficial exchange based on comparative advantage, our so called free trade partner has been rigging the game for decades and the end result is massive federal debt and a larger government.  If I didn’t know better, I would think they didn’t really care about comparative advantage and instead were merely interested in supplying business with cheap labor and a way to avoid first world labor and environmental regulations.

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Post Information
Title Why China has to buy US debt
Author Dalrock
Date July 27, 2011 10:03 PM UTC (12 years ago)
Blog Dalrock
Archive Link https://theredarchive.com/blog/Dalrock/why-china-has-to-buy-usdebt.12249
https://theredarchive.com/blog/12249
Original Link https://dalrock.wordpress.com/2011/07/27/why-china-has-to-buy-us-debt/
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