Comment by kornhole
2 years ago
Thank you for the thought out explanation to a complex topic important for us to understand.
You recognize impact to exchange rates when one currency is in more demand than another. If this causes an increase in exports sold in the devalued currency, rates could eventually stabilize, but that depends on many things. Those exports could be gold in our treasury, US land, and factories. Those assets that are fixed in place are only valuable to a foreigner if they can be assured they will not be confiscated.
I know this is simplistic, but let's walk through this flow. I print up a $100 bill and give it to China for a washing machine. China will take it because they need it to buy a barrel of oil from Saudi Arabia. That $100 floats around in the world perhaps never returning as long as others accept and use it. If Saudis start accepting Yuan in payment for oil, China does not need that $100 bill as much. They start reducing their dollar reserves and US bonds. They use those dollars to buy the gold, US land, and factories. The US then has a lot of dollars but not as many assets. The dollars become less valuable because we have so many of them but not as much demand for them. If they are afraid of US sanctions, China will be less inclined to buy assets that could be seized and so the currency is less useful to them.
Admittedly there are many other factors. We will need to see how it plays out.
So let's do it realistically. You take out a loan for 100 USD, it gets printed by some bank, let's say Chase. You buy a washing machine from China, they put it in their central bank. (And they don't but bonds, let's assume.)
What if they want to buy oil, which happens to be sold by the Saudis, who want 100 USD for it. They can do it, or they can print more yuan, and use that to buy more USD on some exchange. (And they did it a lot, to keep the yuan artificially low. That's basically half of how they ended up with this huge reserve.)
And since their inflation was around 2 percent since 2010, and currently even negative unfortunately, they can print a lot.
And this is how economic development and exchange rates connect. One man's trade deficit is another's reserve basically. As long as there's some slack in economies (mostly some unemployment metric is used as a proxy for this) it makes sense to spend. (Otherwise it'll just push up prices more, ie. lead to inflation. Hence the very technical sounding name of NAIRU, Non-Accelerating Inflation Rate of Unemployment, I think hands down the worst name for any concept over many fields.)
If China starts using its reserves to buy US assets, that leads to a lot of USD getting back into the US economy, it's like a stimulus. It would push up prices of course, the Fed would increase interest rates, maybe it would even start fiddling with some other knobs (it could increase the fractional reserve ratio, it could increase interest paid on reserves, or interest paid on excess reserves).
> If they are afraid of US sanctions, China will be less inclined to buy assets that could be seized and so the currency is less useful to them.
Yes, and one read of the belt and road initiative is basically this, instead of giving it to citizens to spend, they tried to use it for geopolitical/colonialist/mercantilist projects.
All in all, my understanding is that using their huge reserve to cause some crisis would be a zero-trick pony (because after 2008 and the recent bank crisis, and the Russian sanctions implementations the West seems capable of handling speedbumps), and a slow decoupling would be good anyway. (As it would help the non-finance sectors of the US.)