To understand why China purchases US debt one has to look at the manufacturing and distribution model. A totally vertically integrated company, or for that matter, a country would manufacture and sell its products directly to the consumer.
Each stage of the process would have a cost and would require a profit. A farmer would raise his own eggs and sell (trade) his surplus to his neighbor. That was how commerce began. There was no such thing as outsourcing. All costs and profits, or losses were born by the farmer. Modern society is far different.
The manufacturing and distribution process has evolved into specialists who manufacture, distribute or sell products. When China decided to get into the game of world commerce, she assessed her structural weaknesses and strengths. The US was a powerhouse of distribution and sales. It simply was not possible for China to set up a retail or wholesale distribution in the US which represented almost a third of global consumption.
Chinese strength rested in low cost manufacturing. Low cost manufacturing can be dependent on well chosen capital or intensive use of low cost labor. China used low cost labor to build capital.
The huge US market was open to China and welcomed low cost Chinese produced goods. US branding of products could easily allow retailers to sell American named goods produced in China.
A $90 Black and Decker appliance, made in China, could be sold for $80 to a consumer with a greater profit to the retailer than a US produced unit. China made the product and gleefully took the dollars. The Question was what to do with them?
The Chinese had little need for US products but a huge need for the dollars. The currency generated could be redeployed globally through banking, distribution, construction or for internal financing of capital or infrastructure. China bought US securities with the trade dollars because there was nothing better or smarter for them to buy. They bought a lot of securities because they had the excess cash from export.
Today China will buy US securities based upon its trade with the US. If the US slows in buying Chinese goods, China will buy fewer US securities because it has fewer dollars. If China needs more money for internal consumption, it may have to sell US securities to raise cash.
China will not be selling or refusing to buy US securities because they are mad at us. If China wants to sell in the US, it must take dollars and either spend them or invest them. There is no other way.
U.S. Rates to Stay Low as China Cuts Debt Purchases
By Kevin Hamlin and Judy Chen
Jan. 8 (Bloomberg) -- U.S. Treasury yields are unlikely to climb significantly should a decline in China’s foreign-exchange reserves force the nation to scale back purchases of the securities, according to Fitch Ratings Ltd.
The New York Times reported yesterday that China is losing its appetite for debt from the U.S. and said this could have “painful effects for American borrowers.” Demand for Treasuries remains robust with investors shifting out of riskier assets, and yields on 10-year bills are close to historical lows, said James McCormack, the Hong Kong-based head of Asian sovereign ratings at Fitch.
“China is going to buy less Treasuries but only because foreign exchange accumulation is not going to be so large,” he said. “It’s not as though they are shying away from Treasuries and buying something else.”
China’s currency reserves, the world’s largest at about $1.9 trillion, recently fell for the first time in five years, Cai Qiusheng, who works for the State Administration of Foreign Exchange, said last month. With less dollars flowing into the country, China’s need to buy U.S. debt is reduced.
The total amount of U.S. government debt outstanding rose to $10.7 trillion in November, from $9.15 trillion a year earlier, as the government bailed out financial companies. President-elect Barack Obama, who takes office on Jan. 20, is pressing Congress to approve an economic stimulus plan of about $775 billion over two years.
“The likely scale of China’s reduced purchases will not be enough to overwhelm other global factors that are pushing down rates,” said Brad Setser, a fellow at the Council on Foreign Relations in Washington.
The yield on the benchmark 10-year Treasury note was recently at 2.50 percent, compared with an average 3.64 percent last year. It reached a record low of 2.0352 percent on Dec. 18 as recessions in the U.S., Europe and Japan boosted demand for the safest assets.
U.S. Deputy Secretary of State John Negroponte downplayed questions about potential conflict over how China handles its holdings of Treasuries while visiting Beijing today.
“My Chinese interlocutors pointed out that they have been very responsible in dealing with the question of the American debt that they do hold, and they want to be viewed as a reliable partner in that regard,” he told reporters at a press conference today in Beijing.
Zhu Guangyao, the Chinese Assistant Finance Minister, said on Dec. 5. that China may continue to buy U.S. Treasuries to help stabilize the American financial system as the global financial crisis deepens.
The latest data shows China continues to have a strong appetite for U.S. debt. In September it passed Japan to become the largest overseas holder of Treasuries. China’s holdings of the securities increased $67.5 billion in October to $652.9 billion, according to Treasury Department data.
That level of purchases is probably unsustainable because China’s reserves growth has slowed, said Setser. Data on China’s foreign-exchange reserves at the end of December are scheduled for release next week.
The reserves may have declined due to “changes in valuations of assets, especially in euro-denominated assets,” Chinese central bank adviser Fan Gang said Jan. 6.
The euro has fallen 18 percent against the U.S. dollar from its record high of 1.6038, touched on July 15.
China’s reserves may decline in the first half of 2009 as a pause in the yuan’s appreciation prompts speculators to pull money out of the country, Moody’s Economy.com said on Dec. 30.
Other factors that may slow growth in the reserves this year include a possible narrowing of the trade surplus and less foreign direct investment.
China’s trade surplus may have dropped to $34 billion in December, from a record of $40.09 billion in the previous month, according to the median estimate in a Bloomberg survey of 17 economists.
China should diversify its currency holdings away from Treasury bills because credit default swaps show they are “a relatively big risk,” former central bank adviser Yu Yongding said Dec. 12.
Such diversification is not easily executed, said Stephen Green, head of China research at Standard Chartered Bank Plc in Shanghai.
“We still have the same old problem,” he said. “There are not many other places to invest the money.”