The story of US & China: How China is locked in the vicious circle of currency and debt!

                  We have already established the fact that China holds large amounts of US$. This is infact due to the need to peg its currency low and absorb US$ to print Yuan. Now,since it holds such large amounts of US$, it has to invest them in the safest possible assets. US Treasury offers the safest investments and in-turn borrows from around the world to fund its debt. Hence, in the last post we learnt about this entire circle.

What if China decides not to invest in US$ and fund US debt? What if China decides not to print any more Yuan and stop absorbing excess US$? Is this decision entirely in the hands of the Chinese? Well not entirely!

Let us analyze what happens if China decides not to fund US debt -

1)Slowdown in Chinese exports if buying US Treasury stops: Cheap funding for US vanishes. Due to this when US goes to borrow for its debt, the cost of loan (interest rate) will go higher as a major lender is no more willing to lend. This will increase the cost of loans within US, between banks and between banks and individuals. The flow of "credit" will get tighter. US corporations and individuals will have lesser access to cheap money which they had earlier. Hence, their capacity to buy cheap chinese goods will reduce. And ultimately, Chinese exports will slow down. This is a situation China does not want!

2)Appreciation in Yuan, Depreciation in US$:  We know that inorder to peg its currency at artificial low levels, China sucks the excess US$ from its trade surplus and prints Yuan. This keeps US$ in demand. If China decides to reduce this activity or perhaps stop it eventually, the repercussions would be tremendous.

Clearly, as China stops buying US$ in huge quantities (in the order of its trade surplus, which runs into hundreds of billions of dollars) the overall global demand for US$ drops. Simultaneously, since the supply of excess Yuan is stopped simultaneously, the demand for Yuan equally rises. Hence, the US$ depreciates due to failing demand Yuan rises on high demand.

            Now, on the whole it might look good for China as its currency appreciates. But a closer look will reveal that China is losing doubly due to this. Firstly, as Yuan appreciates, one dollar yields lesser amount of Yuan and hence, the same amount of US$ earned by China yields lesser domestic currency back home.Hence, export income reduces and domestic costs increase.

            Secondly, we know (as of now) China holds around $800 billion - 1000 billion in US treasury alone, leaving aside other US investments. Since US$ would depreciate due to the above action, the value of its US treasury and other investments would directly diminish. Even if there is a 5% decline in US$, it could result in $40-50 billion dollar loss.

Analyzing an even worse but quite realistic scenario, if US loses its biggest lender, it would find difficult to raise big amount for its debt. Due to this the cost of loans would increase for US. This could make it difficult to repay older loans. This is because, US has taken trillions of dollars of loans from the world and the interest payments of those loans alone runs into billions.This year 2011, US paid around  $450-500 Billion as interest on its loans. 

So US takes more loans to repay interest and principle of older loans. This is the vicious cycle and once started it becomes extremely difficult to get out of it. Imagine an individual having a $1000 loan from a bank. Should he be allowed to take another loan of $1000 to service his first loan to the bank? Ofcourse not and in most cases he isn't allowed to take another loan. But governments are allowed to take such loans because they are deemed to be responsible and more credible.

Now, if China stops buying US debt, US could no longer easily take more loans to repay its previous loans. In that case US could default! However unrealistic this might sound, it is quite possible in the foreseeable future!!!

Hence the policy change has the potential of reaching two very negative states.

If US defaults it would trigger an armageddon globally which will be as catastrophic as the word armageddon! Both these actions are detrimental to China and hence it is not viable to change its policy drastically.

It has to slowly and carefully unwind this vicious circle and make sure it does not reach to any of these extremities.

How it plans to unwind this circle will be discussed in the next post ! Your comments are welcome.

China goes shopping : How China invests its massive reserves!

               We now know from previous discussions that, China has built a massive war chest of foreign currency reserves in order to keep its currency pegged at an artificial low rate. For this, China absorbs the excess dollars in the system and prints Yuan to match that amount. So it keeps on accumulating dollars and over a decade China has accumulated the biggest dollar reserve equal to over $3 trillion and about 1/3 the total dollar reserves in the world! This is just staggering!!

                 Idle cash yields nothing! Its better invested. But this is no individual's money. This belongs to China and hence has to be invested in the safest asset available in the world. Until lately, US government bonds (Treasury bills, notes and bonds) were perceived to be the safest assets in the world. This is because it is believed that the US will always be able to repay any kind of loan it takes. This is called debt (http://en.wikipedia.org/wiki/Government_debt. Along with US, debt of countries like Germany, Japan, UK, France etc which are developed and have a sound economy are considered to be safer as well. Hence, China invested a major chunk of its reserves in US debt and a smaller part in these other countries.

              Today, China is the largest investor in US debt. This means that China is funding US state expenditures, war expenses, medicare, social security for which US borrows money. Let us analyze the chain reaction now.

(Read "->" as leading to)

                  China pegs currency artificially low -> China exports cheap goods -> China gets excess dollars->Prints yuan and absorbs excess dollars to maintain the currency peg -> Keeps accumulating US dollars in huge amounts (equivalent to trade surplus) -> Invests in US debt and lends money to US in huge amounts -> Large amount of cheap loan made available to US -> Borrowing cost for US remains very low-> Interest rate in US remains extremely low for an entire decade -> Cheap money causes US corporations and individuals to borrow more and buy more cheap Chinese goods -> AND THE CYCLE CONTINUES

The flow in the picture summarized the explanation above.

      Thus by selling more and more cheap goods China is actually encouraging the US to buy even more goods. The results have been extremely negative for US. Firstly, the direct effect was that the manufacturing base in US is almost eroded and it has caused lower GDP growth, unemployment etc. The indirect effect it that the Americans having access to cheap money have been borrowing more money than ever funded by China. Its a classics case of spending more than earning. 

     By putting some into play, we will get a direct idea of the consequences. The US debt has risen like an exponential graph and is nearing 100% of its GDP. 

(Although not all of this rise can be attributed to this topic. US being involved in a decade long war in Afghanistan, Iraq along with 2008 crisis have significantly contributed to this rise in debt)

           At the same time the Chinese foreign reserves have increase in somewhat similar fashion. Can we relate the two graphs? One is where one party is going into huge debt and the other is building a huge reserve at the same time!! 

          Along with a huge store for shopping, US has found in China a banker who lends enormous amounts and makes borrowing cheaper for US. US is now addicted to this double cushion China is providing. Cheap    goods and easy money to buy them. US is getting extremely indebted and China is gaining doubly. 

  Imagine if China gets hesitant to lend money to US, who else is big enough to fund the US????

Check out this link http://www.defeatthedebt.com/

How China built its massive foreign reserve!

            Till now, we have established that with a very weak currency (artificially kept weak) the export industry of a country gets boost. China, in order to make itself an exports hub, artificially pegged the Yuan to US$ and maintained it for more than a decade. The manufacturing base started picking up steam and soon China started exporting billions of dollars worth of goods worldwide.

                Consider the following example. 

1. 10 Yuan = 1US$ is the official peg that China wants to maintain.(for example).
2. China produces and exports goods worth $10 Billion to US. Hence, China receives $10 Billion which it need to convert into Yuan ( $10 Billion = 100 Billion Yuan).
3. US produces and exports goods and services worth $5 Billion to China. Hence, China pays 50 Billion Yuan which is converted into $5 Billion and paid to US.

                 

        China : Pays 50 Billion Yuan

                    Receives 10 Billion US$ (equivalent to 100 Billion Yuan)

            US: Pays 10 Billion US$

                   Receives 50 Billion Yuan ( equivalent to 5 Billion US$)

            Here, China need to convert 10 Billion US$ to 100 Billion Yuan to have domestic use. But it has 50 Billion Yuan only to pay to US. Thus there is only 50 Billon Yuan in the system but there is a demand for more 50 Billion Yuan to match the excess 5 billion US$ received. Hence, Yuan is in demand here as more US$ is available and it needs to be converted into Yuan. Ideally, Yuan should appreciate as it is more sought after.

           But the Chinese government has to maintain the peg constant and hence it needs to supply more Yuan without letting it appreciate. Hence, it simply prints more Yuan in exchange of US$. Hence, in this way, to supply Yuan, China prints 50 Billion Yuan and sucks up the additions US$ 5 Billion. The Yuan stays at the same peg due to this printing and remains artificially low, further assisting export industry in China.

           The Chinese reserve bank now has US$ 5 Billion as its reserve against which it simply printed 50 Billion Yuan. As the trade keeps increasing and Chinese exports keep growing, China prints more Yuan to match the excess US$ received. It sucks the US$ and prints Yuan and keeps accumulating foreign currency reserve base. 

           Currently China has the biggest and most massive foreign currency reserve to the tune of $ 3197 Billion as of June 2011. It must be remembered that, had China not adopted a fixed currency regime by pegging theYuan to USD, the trade imbalance in its favor would have helped Yuan to appreciate and hence there would have been no need to absorb US$ to print Yuan and hence there would never have been such a massive foreign currency reserve base. 

           What China does with its massive foreign reserve will be discussed in the next post.