Why China is Forced to Purchase US Debt

It has become conventional wisdom among ordinary people to think that Chinese purchases of US Treasuries are the “generosity” of the Chinese who are willing to lend to Americans so that they can purchase Chinese imports. Nothing can be farther from the truth. China purchases US government bonds not to accommodate US needs; instead, Beijing does so to continue running the current account surplus to provide domestic employment and relative domestic stability. In order to understand why, we have to delve deeper into the basics of economics, so let me explain the dynamics of the balance of payments, which are key to examining the US-China economic ties. BALANCE OF PAYMENTS Here is how the balance of payments equation looks: Current account + Capital account = 0 Why does this equal to zero? We can derive the equation from several variables. Demand for the US dollar comes from

1. American exports (foreigners buy US goods and services, American companies then exchange earned foreign currency for dollars, driving up demand for the dollar)
2. Capital inflows (foreigners invest in the US economy, increasing demands for US assets and consequently dollars)

Supply of the US dollar comes from

1. Foreign imports (Americans, after purchasing foreign goods and services, gave their dollars to foreigners, and foreigners increase the supply of dollars because they want to exchange them for their country’s currency)
2. Capital outflows (Americans investing abroad sell their dollars to purchase foreign assets, increasing supply of dollars)

Demand = Supply, therefore Exports+ Capital inflows = Imports+ Capital outflows (Exports-Imports) + (Capital inflows-Capital outflows) = 0 Current account + Capital account = 0 The current account consists of visible trade (export and import of goods), invisible trade (export and import of services), unilateral transfers, and investment income (income from factors such as land or foreign shares). The credit and debit of foreign exchange from these transactions are also recorded in the balance of current account. The resulting balance of the current account is approximated as the sum total of balance of trade. The components of the capital account include foreign investment and loans, banking and other forms of capital, as well as monetary movements or changes in the foreign exchange reserve. The capital account flow reflects factors such as commercial borrowings, banking, investments, loans, and capital. Source: Investopedia. As can be inferred from above, because the sum of two accounts equals zero, an increase in one variable means a decrease in another - consequently, if a particular country runs a current account surplus, then, by definition, it must run the capital account. (current account surplus/deficit is essentially the same thing as trade surplus/deficit).

CHINA AND US DEBT

Because Current account + Capital account=0 and an increase in one variable means a decrease in another, if China has a trade surplus, it must run a capital account deficit! What is a capital account deficit? It is when capital flows from the homeland (that is, China) to foreign economies (in our case, the United States). Purchases of the US Treasuries are one of the forms of capital outflows. It follows then that China buys US debt to continue running a trade surplus with the US. When seen from a different perspective, by accumulating US Treasuries, China increases demand for dollars, thereby increasing its value and making its exports to the United States cheaper, while American imports to China - more expensive. As a result, trade imbalance emerges: China runs a trade surplus thanks to more competitive exports and has a capital account deficit. The reverse is true of the US economy: it has a trade deficit, but runs capital account surplus. Why does China want to run trade surplus? China remains an export-depended economy (even though it is currently trying to shift its economic model). Therefore, it needs to run a current account (or trade) surplus. If it does not, China will face either

• more unemployment, for reduced exports mean that the Chinese exporters are forced to lay off workers,
• or more debt, as Beijing, will encourage large fiscal transfers to the households (social security, unemployment benefits, food stamps, etc.) or the creation of new businesses to mitigate the consequences of unemployment. All this requires more money and, consequently, more debt.

This is why China purchases US Treasuries: to run trade surpluses and avoid higher debt/unemployment — not, as many think, to “help” American consumers so that they can purchase more Chinese imports.