U.S. Financial Crisis: Why China Has Much to Fear

Evelyn Black wrote a great blog on September 26 explaining the financial inter-connectedness of the U.S. and China. To sum it up, she says that the U.S. imports more from China than it exports to China. This difference, the trade deficit, is made up by the Chinese government’s investment in U.S. government debt. In other words, China trades the U.S. real goods in exchange for paper promises. Now, as the assets backing those paper promises (housing prices in the case of mortgage-backed securities, “full faith and credit” otherwise) are depreciating in value, China’s government is in a pickle. If it dumps its U.S. dollars and dollar-denominated debt instruments on the open market, the value of those assets will fall further and faster. But holding them as they depreciate isn’t an attractive option, either.

I’d like to expand on Evelyn’s article and answer these questions: Why the heck would China put itself in this predicament? Why trade real goods for paper promises? Why put so much faith in the value of the Federal Reserve Note (FRN) and in the ability of the United States’ central bank to maintain the value of dollar-denominated assets?

As a developing (nearly developed) country transitioning from socialist central planning to a market economy, China has relied on the U.S. dollar as a means of stabilizing its own domestic currency, the yuan. For a long time, the yuan was pegged directly to the dollar so that its value went up or down with the FRN. But the U.S. Congress viewed this as “currency manipulation” and threatened high tariffs against Chinese imports if the yuan weren’t revalued. In other words, Congress demanded that China make the U.S. dollar weaker vs. the yuan, which would diminish the trade deficit – at least on paper.

Ever since the end of World War II, when the international gold standard was abandoned, the U.S. dollar has served as the world’s reserve currency. It has been the most stable and widely accepted of the world’s fiat money. But years of monetary expansion have eroded the FRN’s value, and the policies of aggressive debasement of Alan Greenspan and Ben Bernanke have led us to the place we find ourselves today: with the dollar rapidly losing its status to the euro.

What prevents China from switching out of the dollar and into the euro? Again, it holds too many dollars and dollar-denominated assets to make the trade without severely throwing the relationship between the dollar and the euro out of whack. Many other governments are in a similar quandary. And the U.S.’s military dominance still holds sway, particularly over petroleum-exporting countries who are literally forbidden from accepting anything other than the U.S. dollar in exchange for barrels of oil. Just ask Saddam Hussein.

Evelyn said it best when she called the U.S. financial system “Orwellian, bizarre, and unbalanced.” Another word she could have used is “unsustainable.” How and when the system will come crashing down remains to be seen, but my bet is that it happens sooner than most of us are are expecting.

4 comments to U.S. Financial Crisis: Why China Has Much to Fear

  • It’s funny to think what is responsible for such relationship, the Chinese government is the single largest holder of the US dollar, of Gold, and of US Treasuries. I had immagined that given the current downturn, they would have offloaded some of their current positions, but such an act would have anhilated the US economy.
    Gives so much insight to the reason why there must have been so much visits by Paulson to China just before the Financial crisis kicked into its fourth gear.

    Good analysis!

  • Raymond

    By bailing out Fannie and Freddie the American taxpayer did in fact bail out the Chinese government since they were big holders of that funny, er, Fannie paper.

    I now wonder if the Chinese government is even remotely considering unloading the rest of their unwanted American “assets” trough the newly passed bail out package?

    Nah, that would be too obvious, Paulson is too subtle an operator :)

  • J.D. Seagraves

    China has every right to unload those assets if they choose. They are not to blame — we are. There would be no “assets” (debt) to buy if we did not run deficits. China isn’t making us do that. All China has done is allow us to live beyond our means.

    If China did decide to dump all of their U.S. debt and dollars, it would be a murder-suicide. They are such large holders that by the time they were half-done, the dollar would be destroyed. No, the Chinese government is with us… For now. It can’t last forever, though.

  • Joanna Speer

    that’s incredible.

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