In this episode you’ll learn:
- What it means to have your investment capital treated well.
- Why the U.S. dollar is stronger than the Canadian dollar.
- What drives currency exchange rates.
- What are the negative consequences of a weak currency.
- What are foreign currency reserves and how do countries acquire them.
- Why China owns U.S. Treasury securities and why it is selling them.
- What is the monetary trilemma, also known as the impossible trinity.
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Will China Keep Selling Its U.S. Debt?
There has been a lot of coverage in the financial press lately about the Chinese government “dumping” some of its holdings of U.S. Treasury securities.
China owns upwards of $1.5 trillion in U.S. government bonds and bills. These comprise over 40% of China’s $3.5 trillion of foreign currency reserves.
Why is China selling its Treasury holdings, and how did it end up owning so much U.S. government debt? Will these sales not cause U.S. interest rates to skyrocket? And what exactly are foreign currency reserves?
What Drives Currency Exchange Rates
Most countries allow their currencies to float in value relative to other currencies. In the case of China, the yuan is allowed to float in value within a specific range relative to the U.S. dollar.
The value of a nation’s currency is determined by supply and demand as businesses and investors sell and buy various currencies in the foreign exchange markets.
Much currency exchange is transacted in order to facilitate trade between private businesses.
Other participants in the foreign exchange markets include speculators who attempt to profit from anticipated changes in exchange rates as well as investors who want to invest in the stock, bond or real estate markets outside their home country.
Governments like to have reserves of foreign currencies so they can intervene in the currency exchange markets if they believe their currency is weakening too much and getting undervalued relative to currencies of other nations.
The Downside To A Weak Currency
A weak currency that is falling in value can be harmful to the government, households and private businesses if they owe debt denominated in a foreign currency as it causes their principal and interest payments to increase in local currency terms.
A weak currency can also spark inflation due to rising import prices.
Finally, a weakening currency can attract the attention of speculators who attempt to sell massive amounts of the currency in order to profit from its continued weakening.
The one advantage of a weak currency is it makes a nation’s exports to other countries more attractively priced.
If a government’s central bank believes the nation’s currency has weakened too much, it can intervene in the currency exchange market by buying some of its own currency while selling some of its foreign currency reserves.
How Governments Get Foreign Currency Reserves
A government accumulates foreign currency reserves during periods when it feels its currency is too strong so it attempts to weaken it by selling (or exchanging) some of its own currency and buying the currency of a foreign nation.
Mostly, though, countries with sizable foreign currency reserves accumulate them by running large trade surpluses.
For example, in 2014 China exported $343 billion more in goods to the U.S. than it imported.
That means Chinese businesses had $343 billion dollars in 2014 that they needed to do something with, and another $202 billion year-to-date through July.
They could invest those dollars in the U.S. by purchasing real estate, stocks or U.S. government bonds. Or they could sell those dollars to the Chinese government in exchange for newly created yuan. In the latter case, that leads to an increase in China’s foreign currency reserves.
The Chinese government in turn invests much of those dollars in U.S. government debt.
In other words, China’s U.S. government debt balances are directly linked to U.S. household and business demand for Chinese made goods.
Why Capital Is Leaving China
Recently, there has been an increased demand by local Chinese and foreign investors to move money out of China.
This is mostly due to China’s slowing economy as investors including wealthy Chinese seek more attractive or safer investments elsewhere.
To move money out requires exchanging yuan for U.S. dollars, euros or other currencies. This puts downward pressure on the Chinese yuan while causing foreign currencies to strengthen.
The Chinese government has allowed its currency to weaken in response to this capital flight from China.
At the same time, it doesn’t want its currency to weaken too much so it intervened in the foreign exchange market in order to try to stabilize the yuan to dollar exchange rate. It did this by trading some of its U.S. dollars for the exiting yuan.
A Circular Path Back Into Treasuries
Where did China get the U.S. dollars? It liquidated some of its U.S. Treasury holdings.
In August, China reduced its foreign currency reserves by $94 billion, its biggest monthly drop on record.
The question is what did the investors who exchanged yuan for dollars do with those dollars.
It’s likely many of those dollars went into the safety of U.S. Treasury securities. Or perhaps the investors bought other U.S. assets, such as stocks and real estate and the sellers of those assets took the proceeds and invested them in U.S. Treasury bonds.
If China sold U.S. Treasuries in order to exchange dollars for yuan and the investors on the other side of the trade (or even several trades down the line) took those same dollars and invested them in U.S. Treasuries then the net effect is overall holdings U.S. Treasuries stayed the same.
That means there would be no impact on U.S. interest rates related to China reducing its foreign currency reserves.
In fact, since the news came out that China was “dumping” its U.S. Treasury holdings, yields on U.S. government bonds and notes have barely budged.
If China really wants to decrease its holdings of U.S. Treasuries, it first has to stop running a trade surplus with the U.S.
Otherwise, the Chinese will continue to have hundreds of billions of additional dollars each year that can be invested in U.S. dollar assets including in U.S. Treasury securities.