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Is the U.S. outmaneuvering China?

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I came across an interesting article on how the recent Federal Reserve plan to inject trillions into circulation has diluted China’s portfolio of American debt:

China’s U.S. Debt Quandary

They know that their government is now America’s largest creditor, with more than half of its $2 trillion in foreign exchange reserves invested in Treasury securities and other U.S. government bonds. Some of these critics suspect that the Federal Reserve essentially prints more money not just to stimulate the economy, but also to devalue China’s U.S. dollar portfolio, undermining a rival power.

It may be a paranoid theory, but it is a popular one. One of China’s bestselling books in the past 18 months is Currency Wars, a conspiratorial screed that suggests that Western financial interests, including the Federal Reserve, seek to destroy the Chinese economy. The book has sold more than 1 million copies officially, and probably several million more pirated copies, and remains a bestseller now as economic conditions deteriorate. 

This may have been the Fed’s follow-up to a January claim by Treasury Sec.  Geithner that China is manipulating its currency.  Still it’s hard to blame China for being risk-adverse at a time when global stocks have been tumbling.  Buying up Treasurys may be a safe investment, but it runs the risk of the Fed diluting the value of its holdings.

Conversely, conservatives critics are worried that rampant government spending might leave the US vulnerable to a sudden fall in demand of Treasury’s:

Fiscal Stimulus, Fiscal Inflation, or Fiscal Fallacies?

It matters tremendously which path we choose.  At some point the crisis will pass, and demand for Treasury debt and money will revert to normal levels. Sooner or later, investors and banks will decide they’re sick of holding $850 billion of reserves and 2% treasuries when high-rated corporate bonds are going for 9% and tax-free municipal debt is going for 6%.  Sooner or later banks will figure out that borrowing deposits at 4% and holding reserves that pay 0.75% is not a good long-term business model. If the resources are not there to unwind our current operations, to quickly retire at least two trillion dollars of newly created debt, a large inflation will result as people dump government debt. If history is any guide, this outcome will unleash economic dislocations on a scale to make our current troubles look like a pleasant memory.

Emphasis added.

So I would say it’s a smart move that the Fed has executed, if that was its intention. (Of course there’s the risk that the giant increase in money supply might have some adverse effects on its economy in future, but still…)  At some point China will have to choose between maintaining an artificially low yuan exchange rate with the US dollar, or risk losing the value of its Treasurys.  Perhaps China would eventually follow Japan’s decision to lower its holdings of  Treasurys.  Who knows?

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Written by defennder

March 22, 2009 at 8:36 PM

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