Now don’t get too comfortable, the trail keeps going for a bit.
As we asked in the last post, why would the Chinese government want to deprive its citizens?
The Cowboy’s view is that to answer that question, one has to look at the political situation and the motivations of those in power. Unlike the situation in Zimbabwe, one can safely assume that the people who govern China are not crazy, nor do they want anything but the best possible outcome for their country and themselves as they see it. They likely want to:
- Preserve power, and
- Make their countrymen better off, in that order.
There are undoubtedly plenty of exceptions, but the generalization applies. Preserving power means maintaining the status quo of rule by the single Chinese Communist Party. If the Cowboy asked you to manage an organization of a billion souls, many of whom are young men, the first reaction you would have is fear. Ditto the Party. They have to be afraid of the biggest threat to the status quo – restless citizens. The best way to address that fear is to keep them busy making things. The more people who are busy, the less people there are to riot. And busy is better than wealthy at the level of the individual. Wealth can bring trouble as people agitate for troublesome things like freedom. A large export-oriented manufacturing economy is very good at keeping people busy.
Why export-driven? By exporting first, the country is able to jump-start manufacturing without having to create the internal wealth to buy things that are produced. You are able to grow faster than you would if you relied only on an internal market. Second, the government is able to exert more control more easily, the Cowboy would argue, by channeling much of its economy into inter-national trade rather than intra-national trade.
Once you have people busy (and there are plenty of Chinese who are still not busy), what else do you have to fear? External shocks. One of the lessons that many emerging market countries learned from the Latin American crises of the 1980s and the Asian crisis of the late 1990s is that one does not want to be too beholden to outsiders. The best defense against that is, you guessed it, maintenance of foreign currency reserves, or savings. This makes sense. How do you protect yourself from external unforeseen problems? You tuck some money away in savings for a rainy day. By boosting export-led growth, China has been available to keep lots of other currencies flowing into its central bank.
If a computer is sold to the Americans, the exporter receives dollars which are converted into yuan by the Chinese central bank. The exporter gets local currency to pay employees and suppliers, and the government keeps dollars to sell to a Chinese importer who needs those dollars to buy a Boeing jet. As we already established however, more is exported than imported, and the government (central bank) keeps the difference.
This is the government’s piggy bank. If things go south, the government has lots of money to buy things internationally, to prop up its currency, to pay off international debts, etc. What drives this need for this piggy bank to be as full as possible? Fear.
Now we have to move on to the next problem. You have this piggy bank, but you can’t just leave it under your mattress. Someone might steal it, there could be a fire, and you wouldn’t make any interest on it. You can’t just go to the bank because you are the bank. You can invest it in other, international banks. The amounts are quite large, however, and you are worried about the safety of those international banks. Well, the safest stash for your money in the post-World War II period has been one country. It is the largest, most stable economy in the world. And the safest place to invest money in that economy, is in the debt of its government. In fact, the debt instruments issued by that government are the benchmark by which all other risks in the international financial markets are measured. They’re not perfectly safe, of course, but they are as safe as you can get, and they earn interest too. As you have undoubtedly figured out, these are U.S. Treasury securities.
As it turns out, these are quite a handy place to invest your money. These securities are very liquid, that is to say they are easy to buy and sell as you need. The market is quite large, so it can accommodate your volume. There is little fraud because the regulatory environment is good. And there is a great deal of transparency in the market – it’s pretty easy to see that you’re getting a fair price in a trade.
Far from being part of some sinister plot, the debt of the U.S. is the “no-brainer” of investments for a Chinese central banker. Yes, you put some money into other currencies as well. But as for the lion’s share, is there another candidate? The Euro is the other big, stable, so-called “hard” currency. But it was just created in the 1990s. How well will that experiment work? Plus, it’s dependent on all of those argumentative Europeans who have killed each other for centuries. How stable is that? Japan? Can we really trust them to play fair with our money? It wasn’t very long ago that they invaded us, enslaved our men and raped our women. I don’t think so. Plus, its political system is much more opaque – who can even keep track of all of those LDP factions? And finally it’s not nearly as large. Gold? Well, yes, but look at gold prices over the last few decades. They’ve been all over the map. How stable is gold, really?
Of course, like any good investor, you try to diversify. You buy some gold, you put some money in other currencies, you even create sovereign wealth funds to invest in companies, like start-ups. The problem is that even as you try to diversify into corporate debt and equity, you get stuck. How can you invest in companies and avoid the U.S., home to the largest economy and most vibrant venture capital industry in the world? So really. If you are interested in capital preservation, it’s pretty darn tough to avoid investing in U.S. dollars.
Interestingly, all of this has had a nice little side effect. By funneling money into the U.S. capital markets, rather than into the hands of Chinese consumers, you make it easier for Americans to buy things. This is true for the other “hard” currency markets where you invest as well. In buying all of this U.S. paper (debt, equity, etc.), you are increasing demand for those investments, making the prices higher. When prices go up, the cost to the issuer goes down. So, interest rates drop, as does the cost of issuing equity. A lower cost of capital means people can get money more cheaply and easily in order to buy things. This boost’s the economy, allowing consumers to buy more. When they buy more, they buy more from China.
This adds to the Chinese policy-maker’s effectiveness by allowing him or her to save more (current account surplus) and produce more (jobs). Pretty cool, huh?
Does owning all of this debt (and equity) of the U.S. give you (the Chinese policy-maker) some power over them (the Americans)? Quite possibly. That’s cool too.
Diaghilev Cowboy 