Currency Wars_ The Making of the Next Global Crisis - James Rickards [56]
Despite its economic miracle, China ran trade deficits with the world as late as 2004. This is not unusual in the early stages of a developing economy, when efforts at export success must be tempered by the need to import infrastructure components, industrial equipment, raw materials and technology with which to launch exports. China did run a bilateral trade surplus with the United States; however, this was not initially cause for concern. In 1997 the U.S. trade deficit with China was less than $50 billion. Then the deficit grew steadily, and in the space of three years, from 2003 to 2006, it exploded from $124 billion to $234 billion. This period, beginning in 2003, marks the intensification of concern about the U.S.-China bilateral trade relationship and the role of the dollar-yuan exchange rate in that relationship. In 2006, Senator Charles E. Schumer of New York called the U.S. trade deficit “a slow bleeding at the wrists for the U.S. economy” and pointed to China as a leading contributor.
China’s internal deflation is exported to the United States through the currency exchange rate and ends up threatening deflation in the United States. This begins with the Chinese policy decision to peg the exchange rate between the yuan and the dollar. The yuan does not trade freely on international currency markets in the same way that dollars, euros, sterling, yen and other convertible currencies do. The use of the yuan and its availability to settle transactions are tightly controlled by the People’s Bank of China, or PBOC, the country’s central bank.
When a Chinese exporter ships goods abroad and earns dollars or euros, it must hand over those currencies to the People’s Bank of China in exchange for yuan at a rate fixed by the bank. When an exporter needs some dollars or euros to buy foreign materials or other imports, it can get them, but the PBOC makes only enough dollars or euros available to pay for the imports and no more; the rest is kept by the bank.
The process of absorbing all the surplus dollars entering the Chinese economy, especially after 2002, produced a number of unintended consequences. The first problem was that the PBOC did not just take the surplus dollars, but rather purchased them with newly printed yuan. This meant that as the Fed printed dollars and those dollars ended up in China to purchase goods, the PBOC had to print yuan to soak up the surplus. In effect, China had outsourced its monetary policy to the Fed, and as the Fed printed more, the PBOC also printed more in order to maintain the pegged exchange rate.
The second problem was what to do with the newly acquired dollars. The PBOC needed to invest its reserves somewhere, and it needed to earn a reasonable rate of return. Central banks are traditionally ultraconservative in their investment policies, and the PBOC is no exception, preferring highly liquid government securities issued by the United States Treasury. As a result, the Chinese acquired massive quantities of U.S. Treasury obligations as their trade surplus with the United States persisted and grew. By early 2011, Reuters estimated that total Chinese foreign reserves in all currencies were approximately $2.85 trillion, with about $950 billion of that invested in U.S. government obligations of one kind or another. The United States and China were locked in a trillion-dollar financial embrace, essentially a monetary powder keg that could be detonated by either side if the currency wars spiraled out of control.
The United States desperately urged China to increase the value of the yuan in order to reduce the growing U.S. trade deficits with China and slow the massive accumulation of dollar-denominated assets by the PBOC. These pleas met with very limited success. From 2004 through mid-2005 the yuan remained pegged at about 8.28 yuan to one dollar,