China's Incentives For Abandoning The Dollar

MarketSkeptics.com:

Thursday, November 20, 2008

by Eric deCarbonnel

About a week ago, Peter Schiff wrote an article making a very good point about China's $600 billion economic stimulus package. He rightly suggests that China would be wise to fund such spending through the sale of US treasuries:

(emphasis mine)

China's Stimulus Spells Trouble for U.S.

This week, Asian markets were initially energized by China's announcement of a near $600 billion economic stimulus package for its own economy. Although I have never been a fan of government-fueled stimuli, the relative wisdom of the plan hinges on the source of funds the Chinese government decides to utilize. Their best choice would be the country's nearly $2 trillion in foreign reserves, the largest portion of which is held in U.S. Treasury and agency debt. This pile of dollars, which really amounts to no more than a subsidy for U.S. consumers, does nothing to benefit Chinese citizens.

If it does decide to employ this ocean of cash, China will become a net seller of U.S Treasuries just as the U.S. Government itself will be pushing up its issuance of new Treasury bonds into record territory. With two huge sellers and few major buyers (just about every major creditor nation having problems of their own), the Federal Reserve will become the only reliable customer. As a result, not only will the Fed monetize our own economic stimulus packages, but will be forced to provide the same service to the Chinese.

Most economists feel that China will maintain the status quo by borrowing or printing the funds for their own stimulus while continuing to hoard its trillions of existing U.S. dollars. Most also believe that the Chinese will substantially increase their dollar holdings in order to finance America's never-ending string of bailouts and its ballooning Federal deficit, which is soon to pass $1 trillion annually. These optimists are in for a rude awakening.

The Chinese cannot follow such a course without unleashing intolerable inflation at home. Selling down their vast reserves of U.S. debt and using the proceeds for domestic infrastructure projects (or anything else for that matter) is a vastly superior stimulus mechanism than "lending" to Americans so we keep "buying" their products. When Chinese authorities finally figure this out the United States will suffer the consequences.

My reaction: For China, selling U.S. Treasuries to finance domestic economic stimulus packages makes sense for three reasons:

1) As outlined by Peter Schiff, selling US treasuries would allow China to finance its spending at home without printing or borrowing money, thereby avoiding inflation.

2) If China sold its 2 trillion dollars in foreign reserves, the dollar would collapse, forcing the US to drastically scale back on its consumption of the world's resources, especially oil. Who knows? If the dollar's purchasing power drops enough, the US might become a net exporter of oil as abandoned SUVs litter the roads. China and other creditor nations would reap the rewards of cheaper oil and gas prices, boosting their domestic economies.

3) Increasingly, China's purchases of US debt aren't translating into new consumer spending. Instead, all the money China is pouring into the dollar is being funneled and absorbed into the black hole which banks call a balance sheet. China now faces the law of diminishing returns: it is take ever bigger purchases of US treasuries to prevent falling US consumer spending from collapsing entirely. It is only a matter of time before China accepts that funding the US trade and current account deficits is no longer worth it.

The Day China Starts Selling Treasuries

What should you do to prepare for the day China starts selling treasuries? For starters, buy some physical gold. Then ask yourself the questions: What would 10 dollar gas do to the US economy? Do I really want to be here when that happens?