Why China Needs U.S. Debt

The entire phenomenon can be thought of as the USA exporting inflation to China.

On a smaller scale, this is actually a good idea. It's known as building a foreign currency reserve. It serves as buffer against inflation. If the Renminbi were to spiral out of control, they could adjust the peg, give US dollars back to the people in exchange for large quantities of Renminbi, and just retire the money. People would keep their holdings denominated in the dollar until things settled down with Renminbi. Every country has foreign currency reserves. In fact, with a stable foreign currency, building a foreign currency reserve is the safest way to inject money into an economy.

Generally, it is thought that Chinese holdings of American debt are far larger than necessary for an effective foreign currency reserve.

Problem : the more people buy Chinese goods, the higher the Yuan is supposed to get. Therefore, they would lose their initial competitive advantage, because a higher Yuan would mean more expensive Chinese goods. It's the classic path for any prospering country, at some point it has to become a "normal" rich country, adapting to a lower growth.

Solution : China buys a lot of US debt so it can artificially deflates its own currency. Because they sell a lot of Yuans, their currency is deflated = chinese good cheaper to the world = strong demand = especially from the US because of the stronger $, Americans can buy more Chinese goods.

You see it's a complex situation, and we can even argue it's a kind of win-win situation because Americans can afford more goods as well. But this strategy is unsustainable in the long run and could damage both countries if the worst case scenario happened.

Basically, China has been holding the ball underwater with the consent of the Bush administration, because of the susmentioned "win-win" deal. A lot of economists have been very critical of the former administration because such large amounts of money could put America at risk. Now that the crisis has stroke, this threat is more pertinent than ever.

Anyway, the Chinese governement has absolutly NO lesson to give to the Americans in this case, it was entirely their initiative and no one forced them to buy US debt, it was their own strategy, and it didn't come with any sort of guaranty that the $ would remain strong. The American people could blame the Bush administration for letting this situation happen tho, but everybody enjoyed it trough an increase in buying power.

Some number of dollars flow into their country every year. Some number of dollars flow out. The difference effectively ends up in the hands of the government. They have to do something with it... because if they do nothing with it, they are effectively exchanging Chinese goods for nothing more than cheaply printed pieces of paper.

They government can't spend US dollars inside of China. The only thing they could do is buy American exports, and American assets.

If China were somehow to launch a stimulus plan that was fueled by American production, than that would have the effect you are suggesting. They could have Americans come over and build their roads and schools for them, with American materials. They would improve their infrastructure and we would get our money back. But this is impractical, and China gets the long-term benefits, not us. In fact, we get screwed in the long-term, because the return of all those dollars to America would cause inflation.

It doesn't sound like you're correct though. At least S & P suggested that the U.S. might lose it's AAA rating. (Note also the article is from 2006, while we were still in the boom.)

http://www.savings-bond-advisor.com/us-credit-rating-could-d...

If they hold that cash without lending it then the US government would need to create money to avoid deflation and the Chinese would lose out on the interest they would get by loaning the money. Effectively this is loaning the US money at zero interest while the the USD they hold is deflating.

They can use some of this money to buy raw materials or intangible assets, but if buy finished products then the cost of raw materials would increase and they can just pirate most movies / software without cost.

PS: US debt is one of the few places you can safely hide a frighting amount of money. People have been buying notes whose interest rate is well below inflation even as the US borrows insane amounts of money to deal with this mess just for the safety.