I keeping seeing articles and headlines in various places about how China is revolting against US paper in various ways. These headlines either say that China is selling off US T-bond holdings or on the verge of rejecting US dollars. This makes for great headlines and generates lots of page views for those who think China is about to “dump” their Treasury Bond holdings on the world and crash the US bond market, but it is outright misleading and infuriating for anyone who actually understands how the monetary system works.
First of all, let’s go back to basics. Why does China buy t-bonds in the first place? Well, China runs a trade surplus with the USA. So, China sends us pieces of plastic and other cheap goods and services and we send them pieces of paper (or electronic credits if you prefer). These pieces of paper ultimately end up at the Chinese Central Bank when they are converted from USD to RMB. So, this all starts because China likes obtaining US Dollars. Why is this? Because China generates a huge amount of domestic employment and domestic investment thanks to this continual business coming from the USA. The USA, in return, gets cheaper goods and services. It seems like a fair trade for all involved (although the real debate here is whether that’s actually true in the long-run).
So, China wants USDs in the first place. In fact, China needs USD’s because their economy remains one that is largely built on export growth (thought that’s changing to some degree as time goes on). So these USDs ultimately end up at the Chinese central bank. So what can they do with them? Well, they can either use them to buy something of relative value denominated in USD (like t-bonds or other assets) or they can use the dollars to defend the exchange rate (which China does by pegging the RMB to the USD).
So, long story short – China’s trade strategy directly contradicts anyone who says China is rejecting the USD. No, they want USDs. They need USDs. They enjoy many benefits from obtaining USDs. And they use many of these USDs to manipulate their exchange rate to keep MORE USDs flowing in. If China doesn’t want to buy t-bonds then who cares? If they want to let those pieces of paper sit around collecting dust then great. That’s less interest we need to pay them! Also, anyone who understands how a US Treasury auction works knows that indirect bidders are marginal buyers and that the Primary Dealers can ALWAYS take down the entire auction. So, ignore all this fear mongering about China rejecting the USD. It’s not happening. And due to China’s growth strategy, it would be against China’s best interest for it to happen.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.