China’s Nuclear Option To Sell US Treasurys

Lest the above be taken as vindication for Trump’s tariffs “at least they’re hurting China more than America,” let us be clear. We are damning the whole regime of irredeemable currency, with the dollar as the world’s reserve currency. To do so with maximum impact, we must describe the mechanics of the system accurately.

The Addicts’ Need for Dollar Injections

Every country in the world (except a few pariahs) needs a steady flow of newly-created dollars. They must have dollar revenues to service their debts. And, like everyone else, they are trapped by the feature, not bug, irredeemable currency. Debt cannot be extinguished, only serviced. Someone must borrow more—many someones—to keep the scheme going.

We see here, in this discussion of Chinese capital outflows, a little bit of the meaning of the reserve currency. It does not mean: oil is priced in dollars (though oil is priced in dollars). It does not mean that transactions are settled in dollars (though they are settled in dollars). It means that a great deal of borrowing is done in dollars.

The growing group of Chinese manufacturers that are getting caught in the trade war’s net still must service their debts. If they cannot, then they are in default and their lenders will seize their assets. And, it should be noted, the lenders want the monthly cash flow, not the defunct manufacturers’ assets because they themselves borrowed in order to lend. They must service their debts, or else face their own liquidations.

Not only is the dollar on the liability side of every major balance sheet in the world. It is also on the asset side. Including most especially the People’s Bank of China (PBoC). Like other central banks, it issues the local currency as its liability. And it holds dollars as its asset. That is, it borrows in its local currency to fund its portfolio of dollar assets. This is why we say that the other currencies are all dollar-derivatives.

Inside its local currency, the same mechanics of irredeemable currency are in effect. Debts cannot be extinguished, so there must be a steady flow of new borrowing sufficient for even the marginal debtor to service its debts. It is counter to this absolute requirement, for the PBoC to buy yuan and sell dollars. For a central bank to buy its own currency and sell assets, is to affect a monetary contraction. That is anathema to any irredeemable currency scheme.

Out of Frying Pan, Into Fire

At this point, someone might say that China need not sell dollars and buy yuan. It could trade its dollars for another currency. Aside from the question of whether another currency could support the enormous flows that China would create, and the fact that the other currencies are all dollar derivatives, there is a problem. The game for any central bank is to earn a profit on the spread between its liabilities and its assets. Let us explain.

The Fed is in the relatively simple position of borrowing short to lend long, with both liabilities and assets in the same currency. The Fed relies on the interest rate differential between its borrowings in the overnight market and its long-term assets. This is normally positive (though there is now an inversion).

To this duration mismatch, other central banks add currency mismatch. They care both about the interest rate differential and the exchange rate. Ideally, for them, their local currency would decline. Everyone loves a falling liability, indeed this is the point of inflationism. However, they must temper their desire. Their domestic corporations borrow in dollars. A falling local currency—in which they earn their revenues—feels to them like a rising dollar. They service their debts in dollars, which means they eat up more and more of their revenues to service the debt.

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