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China has three main goals it weighs when considering where to invest its vast sums of money. Those goals are “safety, liquidity, and profitability - in that order.” For many years, the result of this strategy has been to invest heavily in U.S. Treasury notes. As the Middle Kingdom’s coffers began to fill with dollar-denominated debt, the financial well-being of the entire nation began to be increasingly tied to the strength of the U.S. dollar. So it should not come as a surprise that declines in dollar value that have occurred in recent years have been met with consternation by the Chinese.
This brings us to the repeated calls from China in recent weeks to have a new global reserve currency. Yet for all of the commotion being raised there lacks the real possibility that such a change would take place in the foreseeable future. Curious why? Well for starters, a change in the global reserve currency would actually cause considerable harm to China’s financial well-being.
In a slightly ironic twist of fate, if China were to abruptly cease purchasing the very product causing the nation’s overexposure to the dollar, they would ultimately end up significantly devaluing the investments they are currently holding. It sounds counterintuitive, but under the posited scenario the U.S. government would need to scramble to find alternative buyers. It is unlikely that enough buyers could be found to fill China’s massive shoes, and the U.S. government might be forced to simply print more money to bridge its budget deficit. This would in turn lead to inflation, a weakening of the dollar, and a decline in the value of China’s $800 billion investment in treasuries. So it seems China will continue gobbling up U.S. debt, while it formulates a strategy to further diversify its investments in the future.
So basically, the United States needs China to keep buying debt to finance its budget deficits, but it also knows this path is not sustainable. China needs to diversify its investments, but doing so too soon would cause a shock to its economy and investments in the short term. This whole situation is kind of like a house of cards being built on a tight rope. Both parties want to build a real foundation for sustainable growth together in the years to come, but it’s tricky to do that without knocking down the house right now. And frequent political rifts between the two countries can shake the tightrope they are balancing on to fix the economical house of cards. Of course there are other goals the two nations must work together on, but one wrong move could cause the whole house to come crashing down.
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