China’s Currency Holdings

Chinese Yuan and U.S. DollarsChinese Yuan and U.S. Dollars

The Wall Street Journal reports that China is decreasing its holdings of  U.S. dollars

Fresh data suggest China is moderating its appetite for investing in U.S. securities, a trend that could mean lower flows of cheap capital from Beijing and a possible rise in borrowing costs across the American economy. An analysis of U.S. Treasury data suggests China, with $3.2 trillion in foreign-exchange reserves, has begun to rapidly diversify its currencies portfolio. “It clearly indicates China’s intention not to put all its eggs in one basket,” said Lu Feng, director of Peking University’s China Macroeconomic Research Center. China still remains a strong buyer of U.S. debt. China’s holdings of U.S. securities rose 7% to $1.73 trillion as of June 30, an increase of $115 billion from 12 months earlier, Treasury data show.

This is a good time, then, to review how our balance of payments work here in the U.S. and to explore China’s role in our economy.

Balance of Payments

With some detailed records and some good guessing our government estimates how much money is flowing in and out of the country each quarter. You can read these reports, from the Bureau of Economic Analysis here. The most widely publicized of these is the trade deficit which measures the inflow of funds (when we sell/export goods and services to overseas customers) versus the outflow of funds (when we pay to import goods and services.) Most everyone knows that the U.S. chronically runs a trade deficit. A somewhat broader definition is the current account balance, which includes the trade deficit but also adds in unilateral transfers (think of grants and foreign aid) and interest income on investments. The current account balance (inflows minus outflows) is also negative.

If we keep running these deficits, shouldn’t we be running out of money? That’s a good question but fortunately there is another flow of funds into the U.S. that largely offsets our current account deficit. These are capital funds (think of loans or purchases of real assets) that outside investors, including foreign countries make. When an investor in Switzerland, or an insurance company in Singapore, or the government of China buys a U.S. treasury bond, that represents a flow of funds into the United States. These bond purchases also put some upward pressure on the value of the U.S. dollar, since those purchases require dollars to be completed.

To put it simply and approximately, our appetite for imported goods and services is paid for by foreign investments in our country. In theory this can continue on for a long time.

China’s Actions

Instead of a trade deficit, China has a trade surplus – exporting more goods and services than it imports. Though this surplus has been shrinking in recent years, the accumulated surpluses generated added to the stock of funds held by China. It is prudent for China to hold those excess funds in different currencies – kind of like a stock portfolio. It has also been prudent for China to invest their funds in US bonds, which are still considered the safest investments in the global economy.

China also purchases assets denominated in dollars in order to influence the relative exchange value of their currency, the yuan (AKA renminbi) against the dollar. They have manipulated the value of their currency in order to keep the value of the yuan relatively low against the dollar. This preserves the low cost competitiveness of Chinese goods in the American market. When China buys dollar assets, like US bonds, that puts upward pressure on the dollar and downward pressure on the yuan. They have been criticized for this currency manipulation, which is relatively rare in a global climate of floating exchange rates.

When Things Begin to Change

This takes us back to the WSJ article. Though China’s holdings of US bonds continue to grow, some analysts see a new trend that will diversify China’s holdings away from the dollar. What might that mean for us?

If China and other foreign investors slowly begin to shift their investments away from the U.S. and towards other attractive economies, the capital inflow that pays for our trade deficit shrinks. The value of the U.S. dollar on currency exchanges might slide more than it is doing now. The impact of a weaker U.S. dollar is that our exports seem cheaper to foreign buyers and they will go up, while foreign goods will appear more expensive to American buyers and imports will go down. Those two forces will shrink our trade deficit. In addition, if capital flows into the U.S. slow down we will see upward pressure on interest rates – particularly on long term loans such as mortgages.

In many ways a slow, purposeful shift in capital funds might be healthy in the long run for the U.S. They can reduce the trade deficit and restore a sort of balance to our position in the global economy. If that shift happens suddenly, however, it would wreak havoc with our economy and almost certainly drive us into a deep recession.

Could China trigger a huge shift in capital flows? In theory. yes. A pragmatic policy on their part would argue against that kind of radical action. They, after all, have a lot of their “savings” in U.S. bonds and it is not in their interest to drive down the value of those bonds. And radical action would cause swift changes in the value of their own currency against the dollar, which in turn would decimate their sales of goods to the U.S. Still, a politically motivated action, similar to declaring war, could prompt them to harm the U.S. economy, even at a significant cost to their own domestic economy. I don’t pretend to have a good crystal ball in this arena, but it is tough to imagine the current leadership would take those radical actions.

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