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“Should America Kowtow to China?”

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By Marshall Auerback, a fund manager and investment strategist who writes for New Deal 2.0.
Another Presidential junket to Asia and another one of the usual lectures from China, decrying our “profligate ways”. Today’s Wall Street Journal reports:, “China’s top banking regulator issued a sharp critique of U.S. financial management only hours before President Barack Obama commenced his first visit to the Asian giant, highlighting economic and trade tensions that threaten to overshadow the trip.”

According to Liu Mingkang, chairman of the China Banking Regulatory Commission, a weak U.S. dollar and low U.S. interest rates had led to “massive speculation” that was inflating asset bubbles around the world. It has created “unavoidable risks for the recovery of the global economy, especially emerging economies,” Mr. Liu said. The situation is “seriously impacting global asset prices and encouraging speculation in stock and property markets.”

Well, “them’s fightin’ words”, as we say over here. And of course, the President and his advisors are supposed to accept this criticism mildly because in the words of the NY Times, the US has assumed “the role of profligate spender coming to pay his respects to his banker.”

The Times actually does believe this to be true. They refer to China’s role as America’s largest “creditor” as a “stark fact”. They do not seem to understand that simply because a country issuing debt which it creates, it does not depend on bond holders to “fund” anything. Bonds are simply a savings alternative to cash offered by the monetary authorities, as we shall seek to illustrate below.

It is less clear to us whether the Chinese actually believe this guff, or simply articulate it for public consumption. China has made a choice: for a variety of reasons, it has adopted an export-oriented growth strategy, and largely achieved this through closely managing its currency, the remnimbi, against the dollar.

One can query the choice, as many would argue that it is more economically and socially desirable for China to consume its own economic output. According to Professor Bill Mitchell, for example, “once the Chinese citizens rise up and demand more access to their own resources instead of flogging them off to the rest of the world…then the game will be up. They will stop accumulating financial assets in our currencies and we will find it harder to run [current account deficits] against them.”

But there have undoubtedly been certain benefits that have accrued to the Chinese as a consequence of this strategy. The export prices obtained by Chinese manufacturers are about 10 times as high as the prices obtained in the more competitive domestic markets, and the challenge of competing in global markets has forced Chinese manufacturers to adhere to higher quality standards. This, in turn, has improved the overall quality of Chinese products. In the words of James Galbraith:

Is there a way for the Chinese manufacturing firm to turn a profit? Yes: the alternative to selling on the domestic market is to export. And export prices, even those paid at wholesale, must be multiples of those obtained at home. But the export market, however vast, is not unlimited, and it demands standards of quality that are not easily obtained by neophyte producers and would not ordinarily be demanded by Chinese consumers. Only a small fraction of Chinese firms can actually meet the standards. These standards must be learned and acquired by practice. (”The Predator State, Ch. 6, “There is no such thing as free trade”, pg. 84).

What about the US government? What should it do? Should it actually respond to China’s complaints by trying to “defend the dollar”?

I hear this recommendation all of the time in the chatterplace of the financial markets, but seldom do those who fret about the dollar’s declining level actually suggest a concrete strategy to achieve the objective. In fact, it is unclear to me that there is any measure the Fed or Treasury could adopt which might support the dollar’s external value.

And why should they? Given the horrendous unemployment data, and 65% capacity utilization, it is hard to view imported inflationary pressures via a weaker dollar actually becoming a serious threat.
But wait? Don’t the Chinese (and other external creditors) “fund” our deficit? And won’t they demand a higher equilibrating interest rate in order to offset the declining value of their Treasury hoard?

Again, this displays a seriously lagging understanding of how much modern money has changed since Nixon changed finance forever by closing the Gold window in 1973. Now that we’re off the gold standard, the Chinese, and other Treasury buyers, do not “fund” anything, contrary to the completely false & misguided scare stories one reads almost daily in the press.

This claim is seldom challenged, but our friend, Warren Mosler, recently gave an excellent illustration of this fact in an interview with Mike Norman. Mosler provides a hypothetical example in which China decides to sell us a billion dollars’ worth of T-shirts. We buy a billion dollars’ worth of T-shirts from China:

And the way we pay them is somebody pays China. And the money goes into their checking account at the Federal Reserve. Now, it’s called a reserve account because it’s the Federal Reserve, and they give it a fancy name. But it’s a checking account. So we get the T-shirts, and China gets $1 billion in their checking account. And that’s just a data entry. That’s just a one and some zeroes.

Whoever bought them gets a debit. You know, it might have been Disneyland or something. So we debit Disney’s account and then we credit China’s account.

In this situation, we’ve increased our trade deficit by $1 billion. But it’s not an imbalance. China would rather have the money than the T-shirts, or they wouldn’t have sent them. It’s voluntary. We’d rather have the T-shirts than the money, or we wouldn’t have bought them. It’s voluntary. So, when you just look at the numbers and say there’s a trade deficit, and it’s an imbalance, that’s not correct. That’s imbalance. It’s markets. That’s where all market participants are happy. Markets are cleared at that price.

Okay, so now China has two choices with what they can do with the money in their checking account. They could spend it, in which case we wouldn’t have a trade deficit, or they can put it in another account at the Federal Reserve called a Treasury security, which is nothing more than a savings account. You give them money, you get it back with interest. If it’s a bank, you give them money, you get it back with interest. That’s what a savings account is.

The example here clearly illustrates that bonds are a savings alternative which we offer to the Chinese manufacturer, not something which actually “funds” our government’s spending choices. It demonstrates that rates are exogenously determined by our central bank, not endogenously determined by the Chinese manufacturer who chooses to park his dollars in treasuries (credit demand, by contrast, is endogenous).

Here is how the mechanics actually work: government spending and lending adds reserves to the banking system because when the government spends, it electronically credits bank accounts.

By contrast, government taxing and security sales (i.e. sales of bonds) drain (subtract) reserves from the banking system. So when the government realizes a budget deficit (as is the case today), there is a net reserve add to the banking system, WHICH BRINGS RATES LOWER (not higher). That is, government deficit spending results in net credits to member bank reserves accounts. If these net credits lead to excess reserve positions, overnight interest rates will be bid down by the member banks with excess reserves to the interest rate paid on reserves by the central bank (currently .25% in the case of the US since the Fed started to pay interest on these reserves). If the central bank has a positive target for the overnight lending rate, either the central bank must pay interest on reserves or otherwise provide an interest bearing alternative to non interest bearing reserve accounts. But this is a choice determined by our central bank, not an external creditor.

Yet we are constantly being told by the financial press that the dollar’s weakness was supposed be the factor that would “force” the Fed to raise rates, since the Chinese supposedly “fund” our deficits.
So far, that thesis hasn’t been borne out. And it won’t be, because this isn’t how things operate in a post gold-standard world.

And a second and equally salient point: what would those who fret about the dollar, have the Fed do? Should they raise rates to defend it? It is unclear that this would work. The relationship between a given level of interest rates offered by the central bank and the external value of a currency is tenuous. Consider Japan as Exhibit A. The BOJ has been offering virtually free money for 15 years and yet the yen today remains a strong currency (much to the chagrin of the likes of Toyota or Sony).

Of course, higher rates can have an offsetting beneficial income impact (what Bernanke calls the “fiscal channel”), but it does not follow that a decision to raise rates would actually elevate the value of the dollar (and the benefits of higher rates from an income perspective could just as easily be achieved via lower taxation).

The reality is that private market participants could well view the move as something akin to a panicked response by the Fed, and the decision could well trigger additional capital flight, which could weaken the value of the dollar.

So it is unclear to me what the Tsy or Fed should be doing about the dollar. My view is that this is a private portfolio preference shift and I don’t think central banks should be responding to every vicissitude of changing market preferences. The US government should simply ignore the market chatter and idle threats from the Chinese and do nothing.

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  1. sn

    “Okay, so now China has two choices with what they can do with the money in their checking account. They could spend it, in which case we wouldn’t have a trade deficit…”

    They can surely spend it. Spend it on gold, copper, oil, EUR, AUD and many other things which USA does not produce.

  2. Kevin de Bruxelles

    I’m not qualified to comment on the macoreconomic currency discussion (although I just ordered Wray’s “Understanding Modern Money” so maybe I will dare to do so in a month or two!). Basically your article argues a defensive position of ignoring the Chinese outbursts regarding strengthening the US dollar, because among other reasons, it’s probably outside the power of the US officials to do much about the dollar on the upside.

    But what interested me was this statement:

    “Given the horrendous unemployment data, and 65% capacity utilization, it is hard to view imported inflationary pressures via a weaker dollar actually becoming a serious threat.”

    Two questions: Can US policy makers manipulate the dollar on the downside? And would a weaker dollar start to address the unemployment and under-utilization concerns you expressed above?

  3. RWC

    All would be well if the money was “Parked” in treasuries problem being the money gets spent by Uncle Sam.Just like Social Security is supposed to be in a lockbox.What happens when we have a run on the US Government?Wheres the FDIC that will cover their deposits?

  4. carol

    Marshall, thanks for reducing the very complex global financial crisis mess to no problem at all.

    Just some remarks:

    Marshall: ¨So when the government realizes a budget deficit (as is the case today), there is a net reserve add to the banking system, WHICH BRINGS RATES LOWER (not higher).¨

    You seem to forget the role of the FED.
    The ZIRP of the FED reduces the rates, assuming the same spreads pre- as post-crisis. On top of that, the FED has massively intervened in the market: buying $ 300 billion treasuries and $ 1.3 trillion (!) MBS brings down interest rates as well. Without the FED intervening so massively, rates would NOT have been lower.

    Marshall: ¨it is hard to view imported inflationary pressures via a weaker dollar actually becoming a serious threat.”

    Indeed Marshall, as the gov´s statistics nicely define away those inflationary pressures, in the so-called core inflation. From a real person´s perspective however, ´non-core´ inflations take away from said person´s ability to spend on non-essential items. F.Y.I. there are those who argue that the tipping point for the onset of the current crisis was the ´non-core´ inflation, especially the impact of the oil price.

    Marshall: ¨My view is that this is a private portfolio preference shift and I don’t think central banks should be responding to every vicissitude of changing market preferences.¨

    My view is that the ´US central bank´ has become part of the manipulated markets.

  5. But What do I Know?

    So I’ve said it before and I’ll say it again–why do I have to pay taxes? Is it merely a relic of a gold-based monetary system? I finally get your point about the government actually draining money out of the system by issuing bonds (sort of a carbon-capture program to keep the financial world from overheating), and I guess that as long as the Chinese, Japanese, Saudis, et al. are willing to send us stuff for computer entries we should keep taking it, but it sure doesn’t give me a lot of faith in the future.

    And for God’s sake stop telling people the government just creates the money as a data entry–the whole thing will fall apart if too many people know about it, and I like having people bring me stuff.

    As some English duchess is reported to have said when informed of Darwin’s theory of human descent from the apes: “Let us hope it is not true, but if it is true, let us hope it does not become generally known.”

  6. Bruce Krasting

    You are correct that bondholders of US securities do not have many rights. The only one they have is to vote with their feet. So what would happen if China woke up one day and said they were buying gold silver copper and other stuff with their tbills? They could do that very easily. Press of a button so to speak.

    That is a lights out situation for the US. We would die if china sold 20% of their reserves for commodities.

    So yes we kowtow, because we have to.

    1. pebird

      So China uses those US reserves to buy commodities and other businesses. So what? The money is cycled to another country, China has less reserves, the other country has more. The other country wasn’t forced to exchange for Treasuries. Keep the cycle going and eventually someone will decide to buy some goods/services/assets in the US and the trade “imbalance” goes away.

      But the Chinese don’t do that, because they lose the peg that way – instead since money is cheap they use the Treasuries as collateral for their own lending. Since they don’t publish the data – you have to guess as to whose debt they hold. If you think Hugo Chavez’ promises are more reliable than the US Treasury, so be it.

      The Chinese have received value from the Treasuries already – it was the mechanism that allowed them to reach their goal to be the manufacturing center of the world – they could not have done this with a floating rate.

    2. Yves Smith Post author


      China has kept its peg with the dollar all through the crisis, with the result that they have maintained their large surpluses while trade volumes have plunged. China operating to the detriment of every other exporting nation.

      They clearly, despite all the protestations to the contrary, cannot lose the exports, hence cannot do much save allow some modest appreciation of the RMB. Your scenario is mutual assured destruction.

  7. Ismail

    I do not quite agree with this analyses. It does make a difference whether you buy a T-shirt produced domestically or in another country. In the first case the money stays within the US, in the latter it leaves the US and causes a current account deficit. Now, the Chinese have chosen to reinvest their money in dollar assets with the intention to protect the dollar-yuan peg (the T-Shirt maker exchanges the earned dollars with the Chinese central bank for yuans and thereby increases the FX reserves). However, as one commentator said above, they are not forced to do so. What if they would give up the peg and decide that they will accept a higher yuan (causing them huge losses on their dollar holdings)? They could instead decide to go for other assets such as minerals and oil, or even other dollar denominated government bonds (eg Turkish bonds that yield a nice 5% versus a measly return for US bonds). Just look at China buying up tangible assets in Africa (mines, agricultural land), they pay for these assets in dollars (and thereby offloading the currency risk to Africans).

    If the Chinese would continue doing so and shunning US assets, then obviously interest rates would go up in America as all the surplus money is invested in Africa or other financial exchanges (Germany also offers dollar bonds, though not many).

  8. JeffC

    Time to take issue with some of the Chartalist arguments, to attempt to trigger some clarification discussion. Let’s begin here:

    “government deficit spending results in net credits to member bank reserves accounts.”

    No. To deficit spend without Fed involvement, Uncle first takes bank reserves out of the system and increases the supply of Treasury securities – that much constitutes a Treasury auction – and then spends those reserves back into the system – the deficit spending. There is zero net effect on bank reserves. The only net change is the increase in Treasury securities. In effect Uncle prints Treasuries to pay for its purchases. If the Fed is inclined, it can transform these into reserves through monetization at the risk of significant adverse psychological effects on markets, but that’s the Fed’s choice.

    The Treasury and Fed considered together can certainly create new “money” apportioned between new reserves and new Treasuries in any way they wish, but the cumulative promises to pay interest on the Treasuries can’t just be ignored. It is nominally a government promise like any other, but were it ignored like others routinely are, the psychological effects on credit and currency markets would be severe, just as would the effects of an outright monetization. Whether these effects are due to some mistaken understanding of post-gold monetary theory on the part of market participants is completely immaterial.

    Further, market participants’ anticipated need to pay taxes is a small fraction of their total demand for reserves. A far larger part of reserve balances is held in order to engage in trade. Yes, theoretically the value of reserves created by requiring taxes be paid with them serves as an anchor on a fiat currency’s value, providing a floor, just as the commodity uses of gold provided a floor to currency values in a gold-standard world. In monetary systems created as fiat or gold-based from the outset, these anchors initialize the Austrian money recursion that Mises laid out in his circa-1910 Theory of Money and Credit. But these tax/commodity values only start the recursion. As Mises argued, most of today’s value of money is a result of yesterday’s value, with psychology providing the mathematical continuity needed to get from one instant the next. The Austrians have missed the boat on many things, but on this they are certainly correct.

    In fact most of the value of fiat money today is due to its use in trade, and most of the value of gold today traces its value back to its history as a currency. Gold today still has a substantial amount of what in a theoretical sense is certainly monetary value: it is held for trade. To argue that the value of gold today is due to its commodity uses is nonsense, as value would remain if all commodity uses were superceded by a new discovery this afternoon. And it is similarly nonsense to argue that the value of fiat currencies today is due to their utility for paying taxes.

    1. Graphite

      Thanks for clearing up a lot of the misconceptions in Auerback’s post.

      [The promise to pay interest] is nominally a government promise like any other, but were it ignored like others routinely are, the psychological effects on credit and currency markets would be severe, just as would the effects of an outright monetization. Whether these effects are due to some mistaken understanding of post-gold monetary theory on the part of market participants is completely immaterial.

      IMO one of the strangest phenomena in modern economics is how befuddled the fiat money partisans are by the insistence of market participants that money & credit be backed by something — whether it’s a historically-valuable commodity (i.e. gold), or at least some sense of reasonable restraint on the part of the currency issuer.

      That investors should react unpredictably and badly to the absence of one of these forms of backing seems self-evident and obvious to me, but is apparently a source of great consternation to many a fiat money system builder.

      1. Gary J

        Graphite – points well made. The key phrase you made was clearly “reasonable restraint”. As you are probably aware the Chartalist central belief is that reasonable restraint is defined as “whatever it takes to achieve full employment” (however full employment is agreed upon).

        Fiat money for the people by the people. Inflation be damned it is a mere unintended consequence of their definition of reasonable restraint/ full employment.

        Inflation in their view of the world, probably quite rightly, merely affects the wealthy, as the lower income population affected by higher inflation would merely get greater government support or higher wages under a full employment scenario.

  9. Mickey in Akron

    Another piece of “yellow journalism”… Now it’s the dragon instead of the bear. Why should China kowtow to the United States? And where does this end?

    Deficits don’t matter. CHENEYSIAN Economics!

    In theory then, with the flip of an electronic switch the FED could debit my account a million or two. In fact, why not do this for all Americans. Then we could pay off the house, the cars, and the imported toys from Walmart.

    Please Ben make it so. Why won’t he do it for me and my fellow Americans?

    1. Chris

      You seem to be satisfied with the market working perfectly in this scenario, but aren’t you ignoring the massive manipulation of the RMB by the Chinese (not to mention whatever the Feds doing)? If the market were working correctly, after you bought all those T-shirts the RMB would rise against the dollar and theoretically the Chinese would be more inclined to buy some US stuff, and THEN you’d have a balance.

      But if China continuously pushes the value of the RMB down AGAINST market pressures, how can you be satisfied with the result as simply markets working as they should? The US will constantly import more and more T-shirts without an economic incentive to stop (tariffs), and the Chinese consumer certainly has no wealth to return the purchases and bring everything into balance.

      You’re right that we shouldn’t kowtow, though. The problem all lies with RMB manipulation, and if China stops that I have confidence the markets will balance MOST things out.

  10. Binhai Maven

    Should we reestablish a profitable relationship just because they want us to clean up our books and pay our debts? Perish the thought! If we kowtow to them now, next we’ll be kowtowing to them in Hawaii,and finally right on the streets of Peoria.

  11. dave

    It sure is fun to buy goods from someone else in exchange for computer entries. More for us and less for them.

    But what happens when we have to sell our land/resources/goods/capital to get balance out those computer entries. Sounds like less for us and more for them.

    Personally, I prefer being the owner rather then the worker. I don’t think people are going to enjoy working and selling off their assets to pay debts as much they enjoyed getting “free” stuff by going into debt. American consumers will not like having to pay higher prices because they are being outbid by Chinese consumers.

    Or to put it in a way you free lunch New Deal 2.0 people can figure out:

    Consuming = Fun
    Working & Foregoing Consumption = Not Fun

  12. HigherLearner

    A revalued Yuan does not necessarily solve the US trade deficit problem. While the US may buy less from China but at a higher price in US$. Who can be sure that this will result in improved trade deficit for US? Further, Americans could buy more from other cheaper sources if they buy less from China. To me, the only sensible solution is for Americans to consume less imported products.

  13. MyLessThanPrimeBeef

    China does not sell $1 billion worth of T-shirts.

    Great Wall T-Shirt Plant #1 does.

    Great Wall T-Shirt Plant does not park its money in the Fed Reserve account nor Treasury securities. The Chinese central bank does. But Great Wall T-Shirt Plant doesn’t care about that. Great Wall T-shirt Plant #1 wants its’ $1 billion so it can buy an equal amount of Chanel #5 from Paris because apparently, the owner’s wife has very expensive tastes. So, it gets that $1 billion in RMB from the Chinese central bank and then exchanges that into the Euro before wiring it to France. The Chinese central bank is very gratefully for that purchase of Chanel #5 because it doens’t have to mop up or sterilize or whatever they call for removing that excess RMB liquidity.

    Imagine that multiplied a 100,000 times. So, Paris now has $100 trillion worth of dollars. The French, being French, with a convertible currency, will sell their dollar holding to buy the Euro, on the open market, driving down the dollar, perhaps crashing it.

    That’s how I see it. I dunno. Is that correct?

    1. Gary J

      No its not correct – you have fundamentally missed the currency control regime in China. Their policy is Mercantilist not Consumerist. To purchase the Euro to buy US$1bn in Chanel No5 – T-Shirt Co would need approval, i.e. state its case to SAFE. With the mercantilst policy the stockpiling of perfume would NOT pass the smell test (no apologies for the pun). Transaction denied.

      The problem most miss is the hermetically sealed nature of Chinese capital markets. In a free markets Chinese T-Sirt maker would have recycled his US$ by buying out French fashion houses and creating a global conglomerate. Just as many US companies did when the US was a creditor country.

      China cannot do this, as in most jurisdictions foreign governments will not allow China state owned or largely state owned enterprises from acquiring domestic assets or companies.

      In other words the outlets for China to recycle its US$ holdings are very limited in the short to medium term. That is until they become a real consumerist or free capital market society. This will not happen in 5 years.

      So how does this play out…

      1. Gary J

        Also – to prove my point. China’s stockpiling of Australian Iron Ore is a classic example. Aussie miner digs big hole, extracts ore, processes, transports to China who then drop it in a huge pile to use later. Seems very inefficient to me. Leave it in the ground, that is also stockpiling!

        Surely the rational thing to do would have been to just buy heaps of Aussie miners with proven but extracted reserves…they tried. But there state owned policy in effect kicked them in the teeth. Try Africa they will do anything for hard currency.

        The outlets for China just aren’t there given their currency regime and corporate ownership model.

        1. Skippy

          One phone call from the States killed a done deal.

          Wonder how Obama’s talks would be framed to day if it had gone

          Skippy..from the land of free markets ha!

      2. MyLessThanPrimeBeef

        Gary J, I was exaggerating with the Chanel #5 stuff, but it’s hard to believe you can’t buy things with that much money. I am sure they can buy lots of missles and bombers from the Russians. How about set up their own ‘charity foundations,’ cultural programs, etc. to befriend, persuade or influence others? I think there are a lot of things and gratitute they can buy with that. If you have money, you don’t worry you can’t afford a Louisiana or Alaska, or land-lease Hong Kong, Botswana, Jersey Island or Puerto Rico for 99 years. In fact, you can buy a few elections around the globe.

        1. Gary J

          I understand your point of exaggeration, but trying to deploy US$2.3 trillion is just not easy, with currency controls and no real “private” national champions.

          Throwing a few hundred billion here and there just ain’t going to make any difference, the Fed swallows this in a couple of months via QE.

          This death spiral will sooner or later collapse. My view we are in for some deflation until trade wars commence between Europe+Emerging Markets versus China…then all hands on deck for the mother of inflation break-outs.

          Thats why in my opinion you don’t need to be in either the inflation or deflation camp…be in both its just a matter of timing.

  14. Lord

    The best measure of the strength of a currency is whether it supports a negative current account balance in which case it is strong or a positive one in which case it is weak. The dollar is strong and will remain strong under most any conceivable circumstance. The yuan is weak and will remain so as well.

  15. Chris

    Are you arguing that Kang is wrong and that the US has not become the source for a new international carry trade (borrow here cheap, lend elsewhere, make more on the round trip off currency movements?

    It would be interesting I think for you to publish some thoughts about the recent contributions from Soros and Roubini on the question of the speculative nature of this carry trade and what they think its consequences might be. Perhaps you could supplement this with some thoughts on how Kang’s remarks differ from the contributions Soros and Roubini have made on the subject. There are probably others, but those will do.

    I for one will look forward to reading it.

  16. Stelios Theoharidis

    If the Chinese float their currency, or raise the RMB’s value then they lose quite a bit of value in their US treasury holdings as it appreciates. If they try to dump a significant portion of their US treasury holdings, given the size of their holdings, then there will likely be a run on the dollar and they may lose more that way.

    If the US raises interest rates to stop the dollar carry trade it will slow emerging speculative bubbles abroad and in our own equities markets, but it will also likely put a massive amount of private debt that is near default past the brink. Exacerbating the default issue with alternative home loans (Alt-A, Option-Arm), CMBS, ect in the US will likely put us into a double dip. Not to say that it won’t happen otherwise.

    There is likely to be a very slow change or none at all. I could only see them agreeing if they can set a mutual timetable for China to slowly appreciate their currency in exchange for a guaranteed US repurchase of Treasuries and a set timetable for interest rate hikes. I’m sure that others on here know much better than I do, any errors in my logic?

    1. john c. halasz


      Just to add some wrinkles on China’s sterilization policy, it works to the extent that it does, because China is still a highly authoritarian regime and its banking system is largely state-owned, so sterilization bonds can be forced on the system at very low interest rates. (Never underestimate that vague phrase “administrative measures” in considering reports on how China implements economic policies and controls). But China is not just concerned with maintaining exports with its FX peg, but also controlling domestic inflation, and, more generally, with maintaining domestic control over economic policies, monetary, fiscal and other, via capital controls. (Though those capital controls, while generally effective, are leaky, resulting in further pressure on the RMB from foreign speculative finance, beyond just the trade surplus). (High inflation was one of the contributors to the popular unrest leading to Tienamen Square). But if China were to run high domestic inflation with a fixed peg, it would mean a de facto real appreciation of its currency in FX terms.

      I caught out paine making an elementary mistake on the matter at Thoma’s site. I’ll just paste the explanation here:

      “Oops! paine, I think you’ve got this backwards. With a fixed exchange rate, higher domestic inflation than RoW is a de facto real appreciation of the domestic currency. Say 1$ = 7RMB = 1 bag of rice. After 2 years, 1$ is still worth a bag of rice, but a bag of rice goes for 9RMB. So one can buy 1$ for 7RMB, buy a bag of rice with it, and still have 2RMB to buy some soy sauce. So the apparent domestic depreciation in the buying-power of the RMB through inflation is de facto an increase in its buying-power expressed in $ terms. Of course, this all is complicated by the fact that the US$ floats against other major currencies, so the RMB might de facto appreciate against the $, while depreciating still against the Euro.

      But then what has been remarkable is the extent to which the Chinese authorities have managed to contain their domestic inflation, at least of the CPI sort, through massive sterilization. But then that has resulted in a massive accumulation of $ reserves by PBoC and SAFE, which amounts to a policy of forced savings on households, and only contains inflation at the cost of large future capital losses on those excess reserves. China too is in a pickle, because their hoarding of excess reserves reduces the global demand upon which their development, export-led or not, depends. When they move away from the $ peg depends on how soon the growing costs of the policy outweigh the benefits, and when they actually come to feel/perceive those costs. But maybe it’s something like a paradigm shift. The old policy will be abandoned only when they’ve figured out a new policy to replace it.”

  17. gordon

    “Okay, so now China has two choices with what they can do with the money in their checking account. They could spend it, in which case we wouldn’t have a trade deficit, or they can put it in another account at the Federal Reserve called a Treasury security, which is nothing more than a savings account”

    I suggested exactly this mechanism in a comment under the post “China Lambastes Dollar “Carry Trade,” Diverting Attention from Its Currency Manipulation” (16 Nov.) and was politely corrected by both Yves Smith and John C. Halasz. They explained that the Chinese Govt. has to “sterilise” a mountain of Yuan called into being by (so far as I understand, which may not be far at all) the repatriation of the trade surplus. It does this by issuing “sterilisation bonds”, in other words immediately borrowing the Yuan so that all that new money doesn’t flood Chinese domestic markets and cause inflation.

    So if Yves Smith and John C. Halasz are right, is Marshall Auerback wrong? Or is he just simplifying the story for dunderheads like me?

  18. RebelEconomist

    This post is dangerously misleading. If China was not content with the interest rate available on dollar savings accounts (ie treasuries), it would seek to buy something else with the dollars, such as copper. And if, not surprisingly, sellers of copper were also unhappy with the interest rate on dollars, they would need to be paid more dollars to persuade them to part with their copper. In short, China’s attempt to avoid receiving low interest rates would generate inflation. Now, part of the Fed’s mandate is to keep inflation low, so unless it raises the interest rate on offer, inflation will breach that mandate.

    Of course, the Fed can renege on its mandate and allow inflation to rise, and effectively cheat China – not to mention every other holder of dollar denominated assets. But thereafter, unless the US can avoid any further borrowing, it will pay more to borrow – more than the extra interest rate that might initially have been required to avoid inflation – as an insurance premium required by any lender to cover it against the possibility of future cheating. And whether the Fed has a formal inflation mandate does not matter; cheating is judged by the creditors. In short, there is no such thing as a free lunch – Argentina has been trying this for years.

    1. Yves Smith Post author


      You are 100% wrong on this. The dollar holdings come about via China BUYING DOLLARS to maintain its peg.

      What happens if it sells these dollars to buy copper? The dollar falls, which means the RMB rises in relative terms. This is contrary to the point of the entire exercise. If China weren’t controlling its currency, it wouldn’t be holding dollar assets in these amounts to begin with.

      1. MC

        “The dollar holdings come about via China BUYING DOLLARS to maintain its peg.”

        Where does this come from? The dollar Reserve in China’s central bank comes largely from Chinese exporters. China does not need to buy or sell dollars to mainitain its peg to US$. The Yuan is fixed rate and not floating.

  19. RebelEconomist


    The question of sterilisation arises because it is not actually the Chinese state that sells shirts – it is a Chinese firm, which typically requires renminbi to pay its workers. The firm sells its dollars for renminbi to the Chinese state at the fixed exchange rate (ie this fixed rate is held by intervention). The Chinese state could “print” the renminbi to pay the exporter for their dollars, but that would generate inflation in China, so instead they borrow renminbi from Chinese banks by issuing sterilisation bills.

  20. L. Randall Wray

    Nice post by Marshall and interesting comments; not surprisingly I am in agreement with Yves and Marshall.
    There are so many hydra heads to deal with I won’t try to deal with all posts. So I will provide a limited comment.

    It takes two to tango. China wants dollars (for a variety of reasons) and wants to prevent currency appreciation to maintain the flow. From the US “real” perspective that is great–we get net real benefits (imports greater than costs), however, we choose not to enjoy them (we let workers lose their jobs in the face of import competition). We could instead maintain full employment at home, allowing us to reap all the real benefits.

    From the Chinese “real” perspective, they face net costs (net exports, producing stuff they cannot enjoy). They are willing to bear these now as they develop domestic markets. It is perhaps a good strategy. We shall see–I expect they will develop domestic demand. They are also (apparently) scared to death of an Asian Tiger-like currency crisis; hence accumulate dollar assets. Again, perhaps a good strategy.

    Some day they will transition to a different course. Let us say they do decide to exercise their “right” to buy US output and other stuff denominated in dollars. US exports will rise; perhaps the trade balance will turn around (I will not hold my breath–there are plenty of other mercantilists out there). In “real” terms, that is bad for the US; in “job” terms it is good (since we refuse to hire the workers displaced by net imports); in nominal GDP terms it is “good” since net exports add to GDP. Now the demand for dollar rises; perhaps dollar appreciation results.

    The cost of a floating rate is that it floats. The benefit is that we can pursue domestic policy since we have policy space. Unfortunately, we choose (largely) not to do that. We accept unemployment as the cost of keeping inflation at bay; and to avoid “bankruptcy” of our sovereign govt. But both of these arguments are flawed. We can have a true full employment program (the Job Guarantee) while helping to stabilize prices; and our sovereign govt cannot go insolvent.

    I am often asked: “if it is so easy why don’t we do it?”. Well, we now know that wiping out the black death is actually easy. Don’t throw garbage into the streets, and kill the rats. We are, unfortunately, still at the cat killing stage. (hint: junk bonds are garbage, budget deficits are the cats, and you-know-who on Wall St. are the rats)

  21. gordon

    “We can have a true full employment program (the Job Guarantee) while helping to stabilize prices…”.

    Perhaps L.Randall Wray would like to enlarge on this a little, or provide a link. Sounds interesting.

    I am fully on board with the interpretation of unemployment being welcome to those who worry about inflation. The War On Labour appears to be one policy which genuinely has bipartisan support.

  22. gordon

    I’ve just found this piece on job guarantee (also called Employer of Last Resort, or ELR) here:

    Wikipedia has an article on Job Guarantee, and notes that in the US the Humphrey-Hawkins Full Employment Act of 1978 already provides legislative backing for such a move.

    The UK Govt. has experimented with the idea, but I’ve only found this old link so far.

  23. L. Randall Wray

    Whoops this will be clearer written this way: It takes two to tango. China wants dollars (for a variety of reasons) and wants to prevent currency appreciation to maintain the flow. From the US “real” perspective that is great–we get net real benefits (import BENEFITS ARE greater than EXPORT costs), however, we choose not to enjoy them (we let workers lose their jobs in the face of import competition).

    Yes there are many papers on the JG at our and websites.

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