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Why China Still Buy US Debt August 9, 2011

Posted by tkcollier in Economy & Business, Geopolitics.
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The People’s Bank of China (PBoC) accumulated its forex reserves by borrowing yuan from the Chinese people. The U.S. dollar assets and yuan liabilities are roughly balanced on the central bank’s balance sheet. If the U.S. government is addicted to debt, so is China’s.

The purpose of that precarious balance sheet is to subsidize exports by keeping the yuan’s value low and deferring inflation. An economy like China’s that is enjoying rapid productivity growth would normally see rising real wages and hence benign inflation that would increase the cost of its exports. Because that process has been stopped, China’s exporters remain competitive across a range of labor-intensive products such as shoes and garments in which the country no longer has a true comparative advantage.

Were the PBoC to stop buying U.S. Treasurys and other dollar assets, the result would be an immediate increase in the yuan’s value. The losses on U.S. investments as the yuan slowly appreciates are one part of the cost for the export-subsidy policy.

In the short term Chinese threats to stop buying U.S. debt are empty, since there are no other asset markets deep and liquid enough to absorb the purchases needed to keep the yuan stable. Were China to buy euros or yen in sufficiently large quantities, it would soon run into a protectionist backlash in Europe and Japan as those nations ran trade deficits. The U.S. willingness to run a persistent trade deficit is key to the dollar’s status as a reserve currency.

via Review & Outlook: China’s Debt Addiction – WSJ.com.

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