China is the largest holder of US debt. It bought almost $500 Billion in the last quarter of 2008 alone. What are the prospects that China will continue to finance the US consumption of goods? Let's check the macro situation.
From undervalued currency to the need to buy up US dollars, a lesson in how it works:
China’s undervalued currency adversely affected the US in two ways. First, it damaged the US manufacturing industry, as it couldn’t compete with cheap Chinese products. Second, the resulting trade imbalance has enabled China to accumulate vast amounts of dollar reserves.
Beijing has invested a substantial part of those reserves to buy US treasury notes and other assets. This has given it a potential role in influencing US policies by being its major creditor and a lender at a time when Washington needs dollops of money to fund its stimulus packages.
Why does China Continue to buy US Treasuries? One view is that otherwise China's currency would rise against the dollar, and US manufacturing would become more price competetive:
The simple reason is that is has to, because of its exchange rate policy. In order to keep the value of the Chinese Yuan from appreciating versus the dollar, China’s central bank must buy U.S. dollars in massive quantities. And rather than just sitting on the physical currency - which pays zero interest - it buys foreign securities.
In a signal of at least increased diplomatic spatting, the Yuan manipulation was noted on Obama's second day in office by Geitner's written statement to Congress during his confirmation hearings that is sure to piss China off.
"President Obama — backed by the conclusions of a broad range of economists — believes that China is manipulating its currency," Mr. Geithner wrote. He stopped short of charging that China is manipulating its currency intentionally to gain an unfair trade advantage, as the 1988 law requires for an official citation of currency "manipulation."
Central bank manipulation is inferred when the Yuan rises so much less in the long term than other currencies:
The yuan has risen 0.6% against the dollar since July, compared with a 3.4% jump in Korea’s won and 4.8% advance in Thailand’s baht.
In response, denials from China, but also a report suggesting a guided move to 6.93 yuan to the dollar (up from 6.84), a small move that is not likely to satisfy critics. The irony of relatively poor countries financing relatively wealthy US debt is not lost on macro level economists:
Creating a more financially balanced global economy will be difficult so long as China’s government continues to peg tightly to the dollar and add large sums to its foreign assets. And so long as China’s macroeconomic policy mix produces large surpluses, there will be large deficits elsewhere in the global economy –whether in the United States or somewhere else. Rebalancing will be complicated if the United States and other larger deficit countries provide more macroeconomic stimulus in the downturn than the larger surplus countries. It should be possible to find a more stable basis for global growth, one that doesn’t require a still-poor country to provide financing to far wealthier countries indefinitely.
The New world order has hollowed out the US manufacturing base. Instability is assured until there can be a more balanced approach to trade and the elimination of the gianormous surplus. While the Port of LA's largest export is recycled cardboard headed to China to make boxes to be filled with Chinese electronic gear, a sustainable balance seems a long way off. Should China slow its purchase of US debt, interest rates would have to increase to attract other buyers and the costs of borrowing would be greater for the US Taxpayer, if there are any left.