This piece originally appeared in Forbes
Have you read about tens of billions of U.S. dollars — sometimes over $100 billion — “flowing out of China” every month? Makes one wonder where, how and when China got the plates, paper and special ink to start printing American currency. Of course, it is all electronic money, but press reports still leave readers wondering where the Chinese businesses and households get the U.S. dollars they are investing in the U.S. and other places around the world.
In one way, the answer is simple, the Chinese government is selling dollar assets while the Chinese people are acquiring dollar assets — consolidated, “China” has the same amount of dollars as before. The people have more dollars, the government (including the central bank) have less.
What is going on can best be understood by rewinding the past couple of decades and looking at how the Chinese government came to have about $4 trillion as of a year or so ago. The Chinese economy has had a persistent trade surplus with the U.S. and the rest of the world for about a quarter century; that means they sold more stuff to the rest of the world than they bought. The excess cash that was earned from selling stuff abroad — but not buying a like amount of foreign goods — wound up in the hands of the government (central bank intervention in the currency market to keep the Chinese currency from appreciating against the dollar and other foreign currencies).
The Chinese government didn’t actually have a big vault full of U.S. and other foreign currencies — they “invested” all that cash in the U.S. Treasury and other government securities. This huge cookie jar is called “foreign reserves.” Sometimes there were press reports that the Chinese were “financing the U.S. government deficits,” which was partially accurate. U.S. consumers bought goods made by Chinese workers and the Chinese government bought bonds issued by the U.S. government.
Sometime in 2015, Chinese businesses and households began to want to “diversify” their asset holdings with less Chinese yuan and more U.S. dollars and other foreign currency-denominated assets. In a free-floating exchange rate system, the value of the yuan would fall relative to the dollar, euro, yen, British pound, et. al. However, the Chinese government chose to meet the increased demand for foreign currencies (decreased demand for Chinese yuan) by selling assets they held — such as U.S. Treasury bonds — and turning the proceeds over to households and businesses that wanted to exchange excess yuan for dollars, etc.
Now, more than a year later, the Chinese government has over $1 trillion less foreign currency assets and the Chinese people have over $1 trillion more foreign currency assets. So what?
Reports in the press and “investment advisory letters” go something like this: “more than a trillion dollars worth of Chinese currency has been converted into dollars and moved offshore in the last few years, finding a new home in real estate, stock markets and other investments.” Often the analysis suggests that asset prices in western countries are being “driven up” by Chinese private investors. That may be true, but the stories would be more balanced if it were also reported that the source of all those dollars was the Chinese government selling other dollar assets such as Treasury bonds. Net, China does not own any more or less dollar assets. In fact, if the preference of private Chinese investors was to acquire exactly the same assets being sold by the Chinese government, there would be no story at all.
As far as anyone knows, the Chinese government (again, including the central bank) still has around $3 trillion of assets denominated in foreign currencies — they are far from broke. Nevertheless, if the Chinese people continue to want to convert on the order of $100 billion worth of yuan into dollars every month at the prevailing exchange rate, there will soon come a point when the government faces a tough policy choice: either sharply increase interest rates on yuan savings/investments so the people want to hold them (maybe very bad for a struggling economy); or let the yuan/dollar exchange rate decline significantly (making foreign goods more expensive and Chinese goods cheaper for foreigners) which would no doubt trigger an adverse political response from trading partners such as the U.S.