Saturday, November 5, 2011

Similarity of China's USD peg with the Euro monetary union

Many people continue to hold the false notion that foreign creditors like China are keeping the USD (US currency) value afloat, and that when they stop buying US debt, the value of the USD (US currency) will fall. The reality is that China doesn't need to keep buying US bonds to keep the USD from falling. China buying US bonds is not what keeps USD value up. The Chinese are already locked into buying USD indefinitely, whether they buy its bonds or not, because that’s what they do every time they incur a trade surplus with the US denominated in USD. The dollar keeps strong only if, and this is important, China’s trade surplus is in USD.

Now, the Chinese agree to engage in trade with the US in USD denomination because this allows them to keep their peg with the USD, and no matter how big a surplus they incur with the US, all that influx of USD into their economy will not raise the value of their own currency for as long as the surplus is in USD. That means continuing demand for USD for as long as the peg is in place, and the Chinese wish to maintain their trade surplus. The irony is that, only when the US goes MMT, and prints dollars as needed to fund its trade deficits with China while keeping its own local employment up, will the Chinese see the error of their ways and abandon the peg.

For now, the Chinese continue to maintain the peg despite just getting what to them are useless not-to-be-spent USD in order to maintain their trade surplus, and to keep their own employment up, not out of benevolence to the US. It follows, ironically, that all it takes to arrest the unstoppable increase in US borrowings is for China to accept that the hoard it has accumulated all these years is essentially worthless (because the US can just print more of it to pay them), unless it decides to spend it all back in the US (which means they will start incurring net trade deficits with the US).

If China decides to spend their accumulated dollars domestically in China instead, then that ends their sterilization of the surplus, and effectively ends their peg, and the yuan will then rise vis-a-vis the US dollar. Ending the peg would result in US trade surpluses with China, so there will effectively be less Chinese demand for US treasuries. But the lost demand from China will just be a wash since there will be less need for US borrowings that are due to its deficits with China.

I think China’s main concern, rather than attaining a nice return on its US debt investments, should be that their accumulated dollars do not fall in value vs other currencies. I don’t think they’re too happy with the dollar’s recent fall, which is just as well. They should have spent that money back in the US long ago. That's the only real use for their large accumulation of foreign currency.

China's peg and the current monetary union in Europe are very similar in nature and intent (of those who propagate them). Continued monetary union has in effect pegged the core countries' (like Germany's) currency with that of the PIIGS, thereby giving the core the same perpetual trade advantages over the latter that China has with the US. And just like China’s peg to the US dollar, Germany’s currency peg to the PIIGS via the Euro is causing the extensive sovereign borrowings of the latter countries.

This is the reason Europe is now being dragged, German fear of inflation notwithstanding, into the same printing binge as the US dollar. Just look at how the EFSF is supposed to prop up the PIIGS. For how long will this continue before the Germans blink and stop the endless Euro printing? Both the ECB now (and the German banks previously) have continued to pledge buying Greek debt, in order to prop this system up, and to continue with the current status quo. They enjoy continuous trade surpluses with the PIIGS without altering their superior terms of trade, which eventually would happen if each had their own currency. All the Germans need to do to maintain their current terms of trade is to keep the Greeks in a common currency with them. German terms of trade keeps strong only if, and this is important, they keep the common currency with those that currently incur deficits with them. That means continuing Greek demand for the money that Germany ends up with a lot of. So Germany has to ensure that someone keeps buying Greek bonds, to keep their superior terms of trade vis-a-vis the Greeks.

Ironically, all it takes to arrest the unstoppable increase in Greek borrowings is for Germany to accept that the currency hoard it has accumulated all these years is essentially worthless (because the Greeks can't just print more of it to pay them, and will likely default sooner or later), unless Germany decides to spend more of it in Greek products. That's the only real use for their large accumulation of the common currency.

If Germany decides to spend its surplus Euro domestically in Germany instead, then that increases their domestic inflation and ends their superior terms of trade, while the Greek terms of trade rises vis-a-vis theirs. Germans have so far maintained the monetary union despite just getting what to them are useless Greek debt in order to maintain the surplus, and keep their own employment up, and not out of benevolence to the Greeks. The irony is that, only when the EU goes MMT, and prints the Euro as needed to fund trade deficits while keeping Greek employment up, will the Germans see the error of their ways and abandon the peg/common currency.


Rogue Economist said...

Just to add: To sterilize incoming dollars, China also prints yuans to buy every dollar its exporters earn that they want to use locally, at the pegged rate, resulting in a great amount of yuan circulating in China. That's why domestic inflation in China spirals out of control every time aggregate demand returns in the US, not to mention the asset bubbles fly out to outer space. So imagine what happens there if the US prints the dollar to compensate for its trade deficit and mitigate its resulting lost domestic employment.

The Arthurian said...

I have to read this one again. Good post.

Rogue Economist said...

Thanks, Arthurian.

CJF said...

Great piece! I sent a link-in over from Crackerjack Finance.

Rogue Economist said...

Thanks CJ!

Mario said...

mind-blowing stuff. love it.

I think the ace in the hole with all this is that China doesn't care about it's people unless they have to care for some political reason. The people have little power and the trajectory for a more democratic process in China appears to be VERY FAR OUT there. This means that they will happily continue this process with us. Plus if they don't have any other buyer to replace the US, they won't stop selling to us.

In a sick way in fact it appears that we've exported our slaves to China, I'm afraid to say!!! :( :( Are we really progressing or just re-arranging the furniture a tad?

Germany is in a tougher spot b/c politically they can't push on like China does and ignore the Greeks and the Italians and the Spanish, etc. Perhaps all of these issues is some weird karma being played out on Europe for their historical world wars and imperialism? It all definitely seems to have back-fired on them.

thanks for sharing!!!

Rogue Economist said...

Thanks Mario.

I think China's ace, which could also be considered its curse, is that it has a glut of people it has to provide employment for, or its society may break down. Hence its policies.

I think US's ace, which could also be considered its curse, is that it has a glut of capital it has to provide a return for, or its society may break down. Hence its policies.

Mario said...

hmmm that's interesting. And funnily enough it appears it was that very rapacious need for returns which caused such huge bubbles and subsequent crash which we are still living in. The US also is growing more of a UE population that it too needs to provide for now. :(

I was also thinking that with China if like you say they really don't want our bills anymore and see no value in holding US notes...then they won't want to sell to us anymore either b/c they get nothing for it if they don't want our bills...and perhaps they might sell to themselves for a change....this would probably be years down the road and could coincide with a social movement in China. I hate to think that we are using China for such consumptive and materialistic ends here in the US but I fear it is quite the case. :( :( sometimes the reality of these economies just downright sucks. Hey Director!! Producer!! Writer!! When do we get a new script for this movie again?!?!?!!