The real economic structure determines why China must accumulate U.S. Treasuries. Chinese government adopted policies to attract foreign investments which bring capital, technology and management skills to China in 80s. To achieve this, the government tried to create the best business environment for foreign investors. Two major financial policies are fixed exchange rate policy and capital control.
Fixed exchange rate policy removes the interest rate risk for both Chinese and multinational firms to do business internationally. Chinese yuan (RMB) was pegged to the US dollar till 2005. After 2005, China adopted managed floating system. Still the People’s Bank of China remains exchange rate target to the US dollar while allowing some flexibility around it.
Capital control is highly desirable in the early stage of industrial development. Capital flight is less possible and hot money has less chance to interfere with the normal productive activities of business. During the Asia financial crisis beginning in 1993, most Asia countries had suffered significant capital flight and huge deterioration of living standards for people in these countries. However, China has hardly felt the pain of the crisis because of its tight capital control.
The two policies complement each other and create the best possible business environment for both domestic and foreign companies in China. Since 2005, the globalization went on full speed. With educated workforce, excellent infrastructure and favorable policies to foreign companies, China started to attract direct investment of high technology industries from all over the world and quickly moved up to the value chain. Today, the majority of famous brand products are made by multinational companies in China. Indigenous companies also started to gain importance in many fields.
The US dollar as the most stable, reputable and reliable international currency in the world naturally became the role of lubricant in facilitating international trade and investment in China. The amount of US dollar in Chinese banks started to grow like a snowball, bigger and bigger. Holding a large amount of US treasuries seems to be more reasonable than ever for several reasons.
First, the US dollar is one of the dominant international trading currencies. It is fully convertible and provide sound rate of return for the last few decades. The U.S. economy is the number one in the world. No one seems to doubt that there would be any risk for US treasuries.
Second, China and the U.S. had formed strategic relationship with each other starting 80s. The U.S. is the largest importer of Chinese goods. On the surface, the U.S. had done a great favour in consuming Chinese goods for companies in China. The top leaders usually view the U.S. as a partner instead of a competitor.
Why did China keep increasing US treasuries after the financial crisis in 2008? First, I think that the Chinese government thought this recession was only one of the normal economic cycles that the U.S. had gone through many times in the last few decades. Helping friends out is the main objective for increasing treasury holdings. US treasuries were viewed as the safest investment option in the world. However, the Chinese government significantly shortened the duration of bonds and purchased more short-term bonds than long-term bonds. After US’s continuous quantitative easing in 2010, it did put the Chinese government in a very uncomfortable position. Inflation is the main consequence China suffered from the quantitative easing in the U.S.
There are many dilemmas on what to do with these US treasuries. First, the reserve money is not the real wealth held by Chinese banks. The Chinese banks issues Chinese yuan (RMB) loans against the reserve money. The devaluation of dollar is equal to the increase of Chinese yuan debt. Second, if the Chinese sell US treasuries, it will set the vicious cycle of devaluing the US dollar which in turn will hurt China. Third, by replacing long-term bonds with short-term bonds, China only postponed the problem to a later date.
What are the long term solutions for this problem? One solution is to internationalize Chinese yuan (RMB) and make it used in international trade and investment. Through this way, China doesn’t have to accumulate a large position of the US dollar assets. This would call for the reform of world financial system. It needs significant cooperation among major currency players in the world such as the U.S., European Union and Japan. It’s questionable whether any agreement could be reached for all parties in the end. Fortunately, China can still reach bilateral agreements with many trading partners in the world to alleviate its dependence on the U.S.
Internally, China also needs to reform its financial system and allow free flow of capital and free floating of its exchange rate. Whether China will achieve this or not, it depends on whether the domestic industries in China are capable of weathering the storm of violent international financial market.