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China Threatens to Liquidate US Debt Holdings
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Several subprime lenders have recently gone under. Many alternate A lenders are teetering (an alt-A loan is one made to a person with good credit, but who lacks other qualifications for prime lending, like proof of income over some threshold). The stock market has been given the shakes as a result. So this doesn’t come at the most opportune time:

The Chinese government has begun a concerted campaign of economic threats against the United States, hinting that it may liquidate its vast holding of US treasuries if Washington imposes trade sanctions to force a yuan revaluation.

Two officials at leading Communist Party bodies have given interviews in recent days warning – for the first time – that Beijing may use its $1.33 trillion (£658bn) of foreign reserves as a political weapon to counter pressure from the US Congress.

Those foreign reserves come to more than $4,400 per US resident. China is by far the largest holder of US government debt instruments, and the country continues to extend that lead on a daily basis.

There are those who see this as, rather than a cause of concern, something to celebrated. By tying their holdings so intimately with US debt, the PRC has a strong incentive to see the economic strength of the US maintained. In the extreme case, if the US were reduced to having to default on the obligations, China would see $1.33 trillion–more than one-fifth of annaul GDP–go down the drain.

The currency “nuclear option” is clearly hyperbole, like the more literal nuclear option discussed publicly by the Chinese military two years ago. But the PRC can begin selling, or less dramatically, simply stop buying, US treasures at any time. That would accentuate the international enfeeblement of the dollar, which hit a new record low against the Euro a couple of weeks ago, and has taken it in the chin against the yen, as Japan has accepted Iran’s request that it cease paying for Persian oil in US dollars.

If China acted upon this threat and began a concerted selloff of its US debt holdings, the yuan would of course suffer alongside the dollar. But how much does Beijing care if that occurs? Less than policymakers in the US do. Keep in mind, by pegging the yuan to the dollar for so long (and now to a basket of currencies influenced by the dollar), the Chinese government has chronically kept the yuan weak for decades.

Further, because China is an export-driven manufacturing country, a drop in the yuan’s value will only make it an even more favorable nation to buy goods from. Chinese workers will see their savings worth less in terms of what they can buy on the international market, but that will in turn increase what Chinese citizens buy from within China. As a poor country that is becoming less so with amazing alacrity, the average Chinaman is looking at a potential decline in the rate of his own enrichment, not an impoverishment.

Contrast this to the effects such Chinese action would have on the US. A drop in the dollar would reduce exports to the US. With an annual trade deficit of $764 billion and rising, that will be felt immediately in the form of increased prices for lots of different goods. In an economy that is growing by only a few percentage points, that means an abrupt drop in the average Joe’s standard of living. Much of what the US physically exports are raw materials that return to the US at latter stages of product development, so the relative drop in the price of American-made products will be intially dampened.

China is better prepared, both economically and socially, for the shock than the US is, were it to occur.

Still, I see the forces conspiring against the valuation of the dollar as a net positive. The US has become a debtor nation that consumes more than it produces, a trend that enriches countries like China, Venezuela, and the Gulf states, who in turn buy up US assets with the money. We have an almost nonexistent savings rate and the world’s third least-favorable per capita account balance. We bankroll corrupt and antagonistic entities like the UN, shoulder the cost of military alliances like NATO that provide little benefit to us, and dole out more in foreign aid than any other country. I fail to see how this can continue on in perpetuity. Inevitably, a readjustment will occur, and much of this will be forcibly put to a stop, out of necessity.

Indeed, there are some encouraging signs that it is already occuring. While the domestic marketshare of US car companies has dipped below 50% for the first time, car manufacturing is showing some signs of moving back into the US due to the dollar dip:

Volkswagen AG is signaling it may build a new factory in North America, the latest sign of how the weak dollar is forcing European car makers to mull moving roduction closer to their U.S. customers.

The world’s fourth-largest auto maker is also considering a major reorganization of its U.S. business to try to bring consumers and decision makers closer together, according to Stefan Jacoby, who this month was named chief executive of Volkswagen of America Inc.

We can accelerate a resurgence in domestic manufacturing by scrapping the federal income tax and replacing it with a national sales tax (also known as a consumption tax). This would make the US an ideal place to export from. It would also have the added benefit of making illegal immigration less lucrative, by axing payroll taxes of the legally employed, thereby reducing their costs to their employers relative to the costs of hiring illegal workers by about one-third.

(Republished from The Audacious Epigone by permission of author or representative)
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  1. If China acted upon this threat and began a concerted selloff of its US debt holdings, the yuan would of course suffer alongside the dollar.

    Are you sure about that? I think if the Chinese take money out of the US and put it back in China that this would strengthen the yuan, not weaken it. But, international economics always messes with me and I sometimes get it backwards. You can read my take on this threat here.

    I also think the terms "weak" and "strong" to describe the dollar are odd choices as there is a connotation that you always want a strong dollar. I prefer the terms "cheap" and "expensive". A cheap (or weak) dollar is good for workers that want to export. An expensive (or strong) dollar is good for consumers that want to buy from abroad. Since we are both consumers and workers, I would think that we want neither a cheap or expensive dollar, just one that is fairly priced (unless I am vacationing overseas, then bring on the expensive dollars).

    China values its workers more than its consumers and has a cheap yuan policy. To keep the value low, they invest a lot in the US. This has the odd implication of a poor country saving to allow a rich country to consume more. I don't get why they want to do this, but I will thank my poor peasant creditors anyway.

  2. John says: • Website

    China can't liquidate, or even stop buying and holding dollar reserves, without turning the growth of its export manufactures down faster than has ever occurred. They use forced savings to keep exports growing, but that method was used by other countries when America still had an export surplus. The Chinese are trying to build up their exports into a market which is not a paying one. The yuan would of course rise hugely against the dollar if they stopped doing dollar support.

  3. FK,

    Or you'll want a weak dollar if you're in the tourism industry!

    I use the terms because they're standard lingo in the work-a-day world I exist in, but I agree that they should be thought of as value-neutral. Or more accurately, as contingent upon who you're referring to. If you're a fat cat, a devalued dollar is bad news–all your assets and savings lose power. If you have nothing, it's good news, because the costs of doing business in just became cheaper, which means you'll be better able to find and maintain work.

    What makes you think the PRC won't simply move that investment money elsewhere?

    The yuan would rise moderately against the dollar if the Chinese government decided to continue to let it be influenced to some extent by other currencies. But it is still chiefly tied to the dollar, with a slight premium–that would not change. The dollar's value is the greatest driver of the yuan's value. Consequently, a plummeting of the dollar cannot mean anything but a drop in the international valuation of the yuan, even if it gains somewhat against the dollar.

    Other reasons the yuan will suffer:

    – China's economy, especially its banking industry, is not nearly as sound as the US'. So if the PRC doesn't retain its dollar peg (although I think it would in any case), it is going to become more volatile, and that volatility will come with some cost premium.

    – The US is China's leading export market. A weakening dollar will drastically cut into Chinese exports to the US, especially if that dollar drop is a result of this threatened nuclear option, in which case Congress will almost certainly react with major 'protectionist' measures directed at curbing Chinese exports. A Chinese slowdown will put downward pressure on the yuan.

    The PRC does what it does because its population, already gaining materially in an astounding way, doesn't demand it do more. The average Chinaman is becoming wealthier, yet at the same time he is managing to delay consumption now for more consumption in the future, thanks to the PRC's policies. It's a strategy long-term in oritentation–nationally, the Chinese are living under their means. Americans are living beyond theirs'.

  4. AE,

    Or you'll want a weak dollar if you're in the tourism industry!

    I see that you have caught on. 🙂

    But what makes you think the PRC won't simply move that investment money elsewhere?

    If they move it out of dollars and into another currency, this will have downward pressure on the dollar. All of the rest of the Chinese investments in the US denominated in dollars will be worth less. So, if they do pull out, they will lose lots of the money they have invested here.

    I could be wrong on this, but I believe that in order for the Chinese to support their peg to the dollar at an artificially low rate, they need to keep investing in the US/purchasing US dollars. As soon as they stop buying dollars, there will be upward pressure on the yuan. So, I don't believe they can both sell off their dollars and keep the peg.

    Other reasons the yuan will suffer

    It is probably just a terminology dispute, but I firmly believe that a currency can not suffer. Economies can suffer, but currencies just go up or down. I agree with you that the Chinese economy will suffer if they do this, and their exports to the US will go down as the yuan strengthens relative to the dollar.

    Interesting take on why the Chinese save more. I think that sounds plausible. I have also heard that because of a lack of a social safety net, the Chinese save more for health emergencies and retirement.

    Hey and did you see where Mankiw linked to your boy Nicholas Wade? See, I told you he's not so bad. 🙂

  5. FK,

    The Chinese government sets the yuan's value. For years it had been pegged at 8.28 yuan per dollar. A couple of years ago, the government shifted it to 8.11 yuan. There is no reason the CPC could not continue to do the same, even with a dollar collapse. Of course, doing so would also result in a yuan collapse. But the government is fine with a weakened, er, cheaper, yuan as is, which is why I wouldn't completely rule some slowdown out (although the 'nuclear' option seems implausible, especially in light of the painful jolt that has hit markets over the last couple of days).

    Regarding the lack of a social safety net: Sure. The less people have to save, the less they will. Okay to have no safety net. Better, perhaps, to have a safety net but not to let anyone know about it (or have the population think its collapse is near). Worst–promise a safety net and then not be able to deliver (that's us, unfortunately).

    Hehe, Wade is bigger than your man, Mankiw. And I have nothing against the latter, even if he sometimes doesn't do all the investigating that I'd like him too 🙂

  6. Ian,

    I'm with you and I have. I do well thanks to the incredibly burdensome, costly, and arcane IRC. Yet my conscious won't let me apologize for it. I'd like to see it scrapped. I'll go into cost accounting exclusively. The deadweight loss and warped incentives (for poor people to have lots of babies and the affluent to have few) are inane.

  7. Anonymous • Disclaimer says:

    China knows well itself and the adversaries. As long as China’s economy will increase, they will stay in the status quo, but when the china’s economy growth will level at 3 percent increase or so, then will be the time to be worried. Unfortunately this will happen one day, and they will have nothing to lose but to win ….
    Keep well in mind that, not long ago they were communists, and still remember the saying:
    The proletarians have nothing to lose but their chains. They have a world to win. …

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