China has a $1 trillion trade war weapon. Will it ever use it?

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      Creigh Gordon

      That’s the August 7 headline from CNN (

      The gist of the story is that “Beijing could trigger a panic in bond markets by dumping some of the $1.1 trillion in US Treasuries that it owns.” In CNN’s mind, if the People’s Bank of China sold all its Treasuries the price of Treasuries would collapse and interest rates would rise, imposing large borrowing costs on the US Government. Once again, the mainstream financial press completely misunderstands how fiat money works.

      What would actually happen is that the Federal Reserve Bank of the United States would simply accommodate China’s sale by buying the Treasuries and crediting the Bank of China’s reserve account with $1.1 trillion dollars and nothing would happen to interest rates.

      You’ll remember that in 2009 and 2010 the Fed bought $4 trillion in assets, mostly Treasury securities, as part of Quantitative Easing (QE). Mainstream economists predictied interest rate rises and inflation would result. Needless to say, they were wrong then too.

      Another interesting question is why the Bank of China holds a trillion of US Treasury securities in the first place. The answer is currency manipulation. When China exports to the US, they are paid in dollars. But China’s exporters, in order to pay their workers and suppliers have to exchange those dollars for yuan. This oversupply of dollars would normally cause the yuan to rise against the dollar. That in turn would cause Chinese exports to the US to fall.

      The Chinese government doesn’t want that to happen. So the Bank of China prints yuan and uses them to buy dollars, holding the value of the yuan down and the dollar up. The BoC then uses those dollars to buy Treasuries, presumably because Treasuries earn interest.

      So again, China simply selling its Treasuries and holding reserve dollars instead would have no effect on dollar interest rates or US bond prices. If China sold all its dollars it would have to hold some other currency instead, either a foreign currency like the Euro or its own currency. What would ultimately happen is that the yuan exchange rate would rise and China’s exports would fall. I don’t see China allowing that to happen to any great extent in the near future.

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