Why China has to buy US debt

Captain Capitalism linked to an article on CNBC the other day titled US Image in China Already Tarnished by Debt Fight.  The basic premise of this article and countless others like it is that China might suddenly decide it didn’t want to lend the US any more money.  While this is something they could of course decide, there is some very important context missing around why China finds itself lending the US so much money in the first place.  This is very basic stuff, but I’ve never seen it discussed anywhere in the media.

As almost everyone knows China has been running a trade surplus with the US since at least the 1980s.  Every year they sell us more goods and services than we sell back to them.  This isn’t by accident or due to them discovering some economic principle the west hasn’t yet stumbled upon.  The Chinese government has deliberately managed their economy so that this will be the case.  The thing is, under normal circumstances the currency markets will eventually adjust so that trade is balanced.  Whenever Americans buy goods from China someone is taking dollars, converting them to yuan (or if you prefer renminbi), and then paying the factory which produced the goods.  The currency exchange assumes someone else wanted to sell yuan for dollars in order to buy goods and services from the US.  But the currency market can’t clear without intervention because as we already know Americans are buying more goods and services from China than the other way around.  If left alone (and without one country investing in the other), the currency market would adjust the relative values of the yuan and dollar until the total value of imports equals exports.  This hasn’t happened because China has been soaking up those excess dollars on the US/China currency market, supplying yuan in exchange.  They have to do this, or they will suffer the unimaginable fate of having balanced trade.

Since China has been buying up excess dollars on the currency exchange market for several decades now, they have amassed a lot of the things.  This creates a problem;  what should they do with all of them?  They could bundle $100 bills onto forklift manageable pallets and store them in a massive warehouse, but the darn things create a fire hazard, not to mention a security risk.  If Chinese thieves were to break in and steal some of these dollars, someone in China would end up turning them back in to the US for goods and services.  That’s right!  Now China is all of a sudden moving back towards an unimaginable state of balanced trade.  China isn’t about to let that happen, so they have decided to buy things with these dollars other than our goods and services.  In practice this has been US Treasury bonds, but they could buy and hold any financial asset which is denominated in dollars.

To understand how unnatural this situation is, remember that China is (or was) a poor country continuously lending huge sums of money to a rich country (or at least we were).  Or to put it another way, they are an undeveloped country investing capital in a fully developed country.  This shouldn’t be happening.  It is the international finance equivalent of water running uphill;  someone must be pumping it.

So when you read articles in CNBC and elsewhere like the one referenced above and they say things like:

“The high-stakes political posturing is a shock to these countries,” said Jina Ventures’ Ron Shah, who said he’s heard the same thing from contacts in India and the United Arab Emirates. “The point for them is not about whether or not a deal will be reached. The chance that the U.S. will leave this issue lingering is creating material damage to the safety of the U.S. dollar and Treasuries amongst the emerging powers in Asia.”

And then follow with another statement like:

“The damage is done,” said Brian Kelly, head of Brian Kelly Capital and a ‘Fast Money’ trader. “Look at Aussie and Kiwi dollar today, that is where the buyers are.”

They aren’t telling the whole story.  It is true that the US could take a hit regarding its credit rating and the dollar could be weakened in the process.  However if China and other Asian countries want to maintain a trade surplus with the US, they will have to continue investing in the US.  If they stop buying new dollar denominated assets, or even worse start selling the ones they have, they will necessarily switch from having a trade surplus with the US to a trade deficit.  Since even balanced trade is something which has terrified them for 25 years, I’m guessing they will be very reluctant to do this.

I’m not saying the current model is a good idea for either country, I’m just pointing out the basic mechanics of how it works.  What strikes me is that no one else seems to want to talk about this.  On the left, the Keynesians don’t seem to mind one bit that China and other countries are distorting our economy to lessen demand for US goods, trampling the average US worker and environmental protections they profess undying love for in the process.  If I didn’t know any better, I’d think that all they really cared about was a supply of cheap credit to continuously expand the US federal government just for the sake of having a bigger government.   On the right, the Ricardians don’t seem to mind that instead of creating a mutually beneficial exchange based on comparative advantage, our so called free trade partner has been rigging the game for decades and the end result is massive federal debt and a larger government.  If I didn’t know better, I would think they didn’t really care about comparative advantage and instead were merely interested in supplying business with cheap labor and a way to avoid first world labor and environmental regulations.

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20 Responses to Why China has to buy US debt

  1. Alte says:

    They are very reluctant to do that, but they know they have to, so they’ve been going on a dollar spending-spree and buying up everything they can, all around the globe. Farms in Africa, mines in Australia, oil in the ME, etc. Anything at all, as long as they take dollars.

  2. AmStrat says:

    Hmmm, very interesting. You’re the first one I’ve read that is saying anything remotely like this. This is good for you, bad for the financial sources I read. I’ve always subscribed to Henry Hazlitt’s idea about international trade deficits. Paraphrasing “Okay, so we buy more from them than they from us, this means they have a lot of US dollars… Where else in the world are these going to be spent? Of course, the USA. Either they eventually have to use those dollars to buy from us, or find someone who will and trade the dollars to them”.

    I’m thinking that in the end this whole thing will just blow up in their faces…

    [D: Thanks. It didn't end well for Japan in the early 90s. But as Keynes said, markets can remain irrational a lot longer than you and I can remain solvent. Who knows how long this will go before it can't go any further.]

  3. Gorbachev says:

    Kaching. Nice observations.

    Problem: This is a shell game, a death-spiral where both partners are circling a drain.

  4. Doug1 says:

    Martin Feldstein, head of the council of economic advisors or some such for Reagan, has talked about this for years. The vastly higher savings rates of the Chinese (almost 50%!!) compared to the US 3%, are another factor as well, facilitating their doing this.

    The Chinese wishing to run a mighty trade surplus isn’t some quirk of fancy. It’s a concerted strategy. The Chinese are playing a mercantilist game, though instead of wishing to accumulate more and more gold, which was the reserve currency until in effect the 19th century (when the pound sterling became it, until the 20th), they are accumulating the current reserve currency, plus the Euro for good measure. The theory of mercantilism focused on reserves accumulation, but the effect was to shelter infant industry and grow industrial knowledge, capacity, and efficiency behind protectionist walls and captive colonial markets, walled off from other industrial countries, i.e. Britain.

    Britain was the first capitalist country to depart from wanting mercantilism but to rather push for free trade, it said due to economic theory, but it must be noted that it was also the first industrial nation and thus for some time the most efficient and low cost producer, due to accumulation of know how, capital and the largest markets due to its colonies and also until the end of the Napoleonic wars also to a good extent the semi protected market in the recent ex-colony known as America (see the War of 1812).

    All other industrializing nations to greater and lesser extents held on to far less than free trade leaning policies such as high tarrifs and quotas, and wishing to protect their own colonial markets through the 19th century. This very much includes the United States, which had high tariffs throughout the 19th century. In fact they were about the only major source of income for the federal government then.

    China has evidently paid more attention to economic history than current Anglosphere economic theory. Basically the idea is that you starve current middle and working class consumers of a lot of what would be their free trade, free floating currency, share of the growing wealth of China as a whole, in order to extremely rapidly build up Chinese industrial knowledge, capital and markets. It gives China an artificial competitive advantage, to the benefit of current elites, and the future benefit of all levels of Chinese society. It’s an imposed form of national savings, on top of the voluntary one at the individual level.

  5. Doug1 says:

    They shouldn’t tolerate it by threatening and then enacting punitive tariffs for currency manipulation.

    This isn’t something the US can do these days due to the our debt problems. Greatly raising US Treasury interest rates due to dumping of Chinese held bonds (dumping=less demand=lower bond prices=higher bond interest rates) would sink our deficit and total government debt even more. Damn democrats. As an independent.

  6. Dan in Philly says:

    What’s the difference between 100 weathermen and 100 economists? You can usually get the weathermen to agree on what the weather was like yesterday.

    The problem with the modern financial system is it is far too complicated for anyone to understand, and economics does not offer many good tools to answer the issues the modern world faces. There are many different ideas about what’s going on, and many different predictions about what will happen, but there is no rational model which can accurately predict anything, nor is there any rational model which can with any degree of certainty tell you why anything which has happened did.

    The guys at the Fed are pretty smart, and know far more than I ever will about what makes the world go around, and have access to almost unlimited computing power, but they apparently had no idea that letting Bear Sterns go under would lead to what happened. If they can’t predict the future, how can we be expected to?

    All this to say that China is borrowing a lot of money from us may be a good thing, it may be a bad thing, but it’s extremely likely that we’ll never know for sure, even 100 years from now if there’s an “official” explination for it (narratives have a way of being shaped in favor of those doing the explaining, and history is no exception). Even if we knew for sure China lending us money is a terrible thing, there’s pretty much nothing we can do about it, so we might as well make do the best we can, which is what we’re doing anyway.

  7. Dalrock says:


    they’ve been going on a dollar spending-spree and buying up everything they can, all around the globe. Farms in Africa, mines in Australia, oil in the ME, etc. Anything at all, as long as they take dollars.

    I suspect part of this is them managing the same issue they have with the US that they have with other trading partners. They need to dispose of Euros and British Pounds, etc too.

    I imagine this is no small task given the numbers involved. The US monthly trade deficit with China is over $20 billion. That is a lot of money to invest on a monthly basis. I imagine part of the reason they have ended up with so many treasuries is they need a financial asset with a big enough market to not be overly distorted by their purchases. Otherwise their entry into an asset class would excessively drive up the price they end up paying, and of course if they ever sell they get hit in the opposite direction. Since the US is borrowing $200 billion a month, treasuries are probably one of the better choices available.

  8. greyghost says:

    i once heard something to the effect that if you lend enough the borrower will own you.

  9. John says:

    This aspect of the subject has been discussed on several occasions in “The Asia Times”, with one other caveat added, that being that the entire world is so overly invested in U.S. debt that they cannot afford not to keep on doing the normally unthinkable – loaning money to a deadbeat.

    The lugs nuts are loosened and a drunk is behind the wheel. Wheeee!

  10. Mannerheim says:

    You allude several times to China’s fear of letting their currency rise so trade with the US will balance; this is because they’ve designed their economy entirely around low-wage manufactured exports to the West and therefore need to keep their currency artificially weak to keep their products cheap for Americans. If the yuan rose against the dollar Americans would switch to buying goods manufactured in Southeast Asia or Mexico, and millions of Chinese would lose their jobs and have a serious bone to pick with their ruling elites (off topic, but these are the same frustrated young men who will never find wives due to the one-child policy and the penchant for aborting daughters). I often see the figure cited that China’s leadership feels it must grow its economy by 8% annually just to maintain social stability (and even so riots are not uncommon in major Chinese cities), so a sharp revaluation of the yuan could very possibly lead to economic collapse and all-out insurrection.

    Short version: it’s a mistake to claim China holds some kind of upper hand over America. While they could wreck our economy by ceasing to buy Treasuries and selling their current holdings, doing so would utterly annihilate their export sector, i.e. their whole economy.

  11. Ano says:

    “On the left, the Keynesians don’t seem to mind one bit that China and other countries are distorting our economy to lessen demand for US goods, trampling the average US worker and environmental protections they profess undying love for in the process.”

    Which Keynesians say this?
    That’s not what Krugman says here, here, and here.
    Dean Baker has the same opinion here, here, here, and here.

    Keynesians understand national income accounting far better than Republicans and most Democrats do.

    [D: Pretty much all Democrats are rabid Keynesians when the issue of government spending is brought up. See the stimulus bill, and Obama's famous lecture; what do you think stimulus is?]

  12. Pingback: China’s ghost cities | Dalrock

  13. very very good write up

  14. Brock Arthun says:

    China does not purposely hold its trade surpluses in order to continue its trade surplus with the United States. China has, and will have a trade large trade surpluses for two reasons. First, china is well endowed with low skilled workers and will export low skilled created products to the United States. Second, the Peoples Bank of China deliberately undervalues the Yuan to artificially make there products cheaper then any other country can compete with. There is no possible way that the United states has enough products that China needs to equalize the trade. Its just silly to think that!

  15. KTH says:

    A bit late. but a very interesting article. Where do Petrol Dollars fit in with China buying oil with USD?

  16. James says:

    THERE ARE SEVERAL FAR FETCHED SOLUTIONS TO THIS. Im not so stupid to think solutions are easy but the United States has been importing a surplus of uneducated minorities for quite some time now and it s hysterical that the politically correct of this world dont seem to want to point out why American math and science score are below other countries when its obvious it is high minority population.
    This counrty needs innovation. Yet minorities are electing our president. He has 40% white support. So we have the people with the lowest intelligence, pay the least or zero taxes, deciding out of selfishness, from a pandering group of socialists who preach business is evil, running the free world.
    The exact opposite message needs to be preached. We need a revolutionary innovation that everyone in the world needs. If we concentrated on that –not only would the debt we wiped out but this country would be on top again. While the countries europe turn into governmental socialist states which squash innovation–we need to be the inventors again.

    The other solution–very far fetched–is to couple with Mexico. If we partnered with Mexico to replace what China provides we could still have our walmart prices. yes, the workers would have to make more than savage Chinese government permits but the cost of shipping would be greatly reduced and it could weaken the stress illegals put on our economy is they are turned in a manufacturing state.
    Look, if people would realize how destructive a child like Obama and his godless panderers are for growth–and White men would show up at the polls we could squash this decent into a minorities controlled mindset. How about instead of telling minorities they are gonna get free stuff from the innovators of the country while they pay zero taxes…you make things fair and light a fire under their arses to become innovators and successful themselves.

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  18. Cole says:

    This may be too late and my comment is a bit scary I feel,
    My wife is Chinese and she came over to American for nursing. What she has continually told me is that China doesn’t want the US to pay back the debt for 1 reason. And that is so that they can infiltrate us and mostly beginning with international students. When the Chinese are very young they are given an American name and told that they will eventually take over America. Really, and ive spent time in China and they will tell you otherwise. They are reserved and nice people but sly and great at saving face. 95% of all international students stay in America after graduation and most of them find jobs. Anyway for what it’s worth my two cents.

  19. james says:

    The fast red fox jumped over the lazy dog

  20. Johnny Cage says:

    James you’re a fucking idiot. We need to go back to the pay as you go model.

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