Friday, October 14, 2005

Someone asked me the random question of "if USA forbids China from buying treasury bonds, would China lose the ability to maintain the current (relatively) fixed exchange rate?" This actually got me on an interesting intellectual exercise. The answer of course is no, but the effect of such a policy would not be trivial.

On the exchange rate issue, forbidding China from buying bonds would not force the RMB to revaluate, but might help to ease the trade deficit. Chinese trade surplus essentially translates into a large foreign exchange reserve for China. What makes the "low" RMB exchange rate is not purchasing of US bond, which is just another form of keeping US currency in the reserve. China can well keep cash, bond, or stock; they just imply different risk levels and rates of return for the foreign exchange reserve. The fixed exchange rate is kept by a process called sterilization. It is sterilization that makes the fixed exchange rate possible. Basically, with rising trade surplus, China is getting lots of US dollars into the economy. To maintain the fixed exchange rate, the PBOC has to give 8 RMB to every new dollar that enters China, or the price of the RMB will start to go up (increase of dollars relative to RMB in the economy). But this means that billions of RMB is being pumped into the economy, causing inflation. In fact, this did happen a bit in 2003-2004. Fortunately, the PBOC has been "sterilizing" this new supply of RMB by issuing PBOC bonds, which soaks up the new supply of RMB in the economy.

But, your friend is sort of right. If the US forbids China from buying US treasuries, a large part of the demand for US treasuries would be eliminated, which means the US would have to drastically increase interest rates on the treasuries, which will increase general interest rates (usually treasury rates is closely tied to general mortgage rates..etc.) So, this would slow down the flow of hot money into China as global investors invest in high-yield US treasuries. This would also slow down US consumer purchasing drastically since they have to pay much higher interest on their debt. Although their purchasing power would increase from the rise of the US dollar, given that this is a debtor country, consumer demand would slow down, which would likely decrease the trade deficit between the US and China.

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