U.S. election news overshadowed an extraordinary announcement by China last week: Its holdings of foreign currencies passed $1 trillion.
Much of the hoard consists of U.S. dollars, most of which are lent back to the U.S. government. This unprecedented development reveals how domestic political pressures can combine with weak leadership to create unsustainable outcomes — both in poor, non-democratic China and in the wealthy, democratic United States.
A trillion dollars is a lot of money. The value of everything China produces in a year only comes to $2.5 trillion. U.S. annual output is about $13 trillion. If we held proportional amounts of foreign money, the Federal Reserve would have more than $5 trillion in euros, pounds, yen and so forth. We don’t do this because there is no good reason to do so.
A developing country like China, however, needs reserves of other currencies to pay for imports and service debts if economic conditions turn adverse. In 1997, Thailand, Korea, Indonesia and Hong Kong ran into trouble because they lacked adequate reserves. China prudently should hold some dollars, yen and euros.
Most of China’s foreign holdings were purchased simply to keep the value of its own currency low. As foreign money pours into China to buy Chinese exports or to invest in its economy, the natural market reaction would be for the yuan to rise in value. That would make Chinese exports more expensive, and reduce output and employment in Chinese manufacturing. So China prints money to buy up excess dollars to keep the yuan from rising in value.
Printing money stokes an overheating economy and fosters inflation. But the Chinese government will not let the yuan appreciate and thus slow exports.
The United States has complained that the undervalued yuan gives unfair advantage to Chinese manufacturers.
Nonetheless, we are glad there is enough demand for our Treasury bonds that we can run large budget deficits without driving up interest rates.
As of June, U.S. national debt “held by the public” was $4.4 trillion. Foreigners — largely Asian central banks — held $2.1 trillion, or 48 percent. When George W. Bush was inaugurated as president, foreign holdings of U.S. Treasury bonds were about half of what they are now. When I started teaching economics two decades ago, the foreign-owned proportion was under 15 percent.
U.S. policy is paralyzed by domestic politics — just like China’s is. There is no agreement on spending cuts and tax increases. So we keep on borrowing, largely abroad, to finance spending.
We cannot sustain U.S. fiscal policies indefinitely without harming our economy. The Chinese cannot keep a lid on the value of the yuan without harming its economy. Something has to give in each nation, but it is not clear how or when it will.
© 2006 Edward Lotterman
Chanarambie Consulting, Inc.