We’ve all been hearing a lot about how China is fast becoming a dominant economy and may soon take over as the world’s largest economy. I’m not going to make any predictions, but I would like to share with you this explanation of how the creditor-debtor relationship between China and the U.S. came to be.
First of all, let me explain why countries that export products want to keep the value of their currency low (debase their currency) relative to other currencies. If a country’s currency is low relative to other currencies, then it is more affordable for people from other countries to buy their exports. As an example, let’s say the exchange rate is 6 Chinese Yuan per US dollar. And let’s say that a shirt made in China costs 12 Yuan to manufacture. That means in US dollars, it costs $2 to manufacture. The Chinese manufacturer sells it to a US retailer for $8, giving them a profit of $6 USD per shirt.
Let’s say they allowed their currency to appreciate so that it was closer in value to the US dollar. We’ll use an exchange rate of 4 Chinese Yuan per US dollar. It still costs them 12 Yuan (now equivalent to $3 USD) to manufacture the shirt and they still sell the shirt to the US retailer for $8, but now they only have a profit of $5 USD per shirt.
You have probably heard that the US dollar is the world’s reserve currency. You may not know what that means. It means that whenever countries conduct business between each other, they use US dollars as the unit of measure of value exchanged. This means the product or service is priced in US dollars and the purchaser actually converts their currency into US dollars to buy the product or service from the party in the other country. This monetary policy was put in place by a meeting of the 44 Allied nations in Bretton Woods, NH in 1944. Hence, it is referred to as the Bretton Woods agreement.
Note that the USD is not always used to pay for the exchange of goods and services between countries, but it is the most common currency used for that type of exchange. There has been more talk lately about coming up with a different unit of exchange to use as the world’s reserve currency because the USD is no longer backed by gold and is being debased by all of the Fed’s money printing.
Now we’ll go into what happens to the US dollars received by the manufacturers in China from selling their goods. Because of the Bretton Woods agreement, the Chinese manufacturers receive US dollars in exchange for their products. What if they were to convert all of these profits that were received in US dollars into Chinese Yuan? The same thing that happens whenever there is a lot of demand for any fixed number of things. The price goes up. If the Chinese manufacturers converted all of their US dollars to Chinese Yuan…the price of Yuan would go up, thereby hurting the Chinese exporters’ profits.
As was discussed earlier, the Chinese want to keep the value of the Yuan down so the manufacturers’ profits are higher. But their profits are in US dollars and they can’t convert them to Yuan or they’ll drive up the value of the Yuan, hurting future profits. So what they do with these dollars is they don’t convert them to any other currency. Instead, they buy US Treasuries with them. That is why China is the largest US creditor that has ever existed.
In case you don’t fully understand what Treasuries are, all you need to know is that they are a form of debt used to finance the US government.
Fortunately for China, the US is borrowing money at an unprecedented rate because of the budget deficit so there are plenty of Treasuries to buy. This situation is also fortunate for the US government; it brings the money that US consumers are spending on products made in China back to the US. The only problem is that it is debt. Debt is supposed to be repaid, eventually. If the US government is spending more than it is bringing in through its profit center (ie. taxes), then how can it possibly repay this debt? Is China concerned about that? Are you concerned about that? I sure am. I don’t have a solution for this, but it is something you should be aware of. When an individual spends more than they earn and they have already burned through all their savings, what happens?
If China stops buying the US debt, what will they do with their profits that are in US dollars? I don’t know. If China stops buying the US debt, how will the US government fund all of their programs and make interest payments to their creditors? I don’t know. One thing the US government can do and has done on a large scale (quantitative easing) in the last few years is to “print” more dollars. I wish I could do that! Just think if you got into financial difficulties and could print money to pay everybody off! But I digress.
Although keeping the value of a currency low is good for exporters who operate with that currency, it is not good for investors who invest in that currency. It means that their investment is losing value. You can imagine that the Chinese and other US creditors do not like it when the Federal Reserve prints more money because it means their investment is losing buying power.
One other point I want to make is what it means to the general population of a country when its government keeps the value of their currency low. It means that it takes more of that currency to buy products from other countries. It causes the population of that country to be poorer than they would be if the currency floated freely relative to the US dollar (as the world’s reserve currency) and was not artificially pegged at a lower exchange rate.
This brings up the idea of spending money in countries or buy products from countries whose currencies have been going down in value relative to your country’s currency. If you buy products and services from these countries, you’ll be getting more value for your money. Switzerland recently pegged their currency (the Swiss Franc) to the Euro. The Franc was doing so well (appreciating in value) that people from other countries could not afford to buy anything from them and it was very expensive to visit Switzerland because of the difference in their home currency vs. the Swiss Franc.
So there you have a simplified explanation of the convoluted relationship between the US and China. It should help you to understand that the US is not completely in control of what happens to our economy and how our quality of life has benefited from globalization (we can afford products from China that we might not have been able to afford if they were made in the U.S.).