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Tuesday, September 22, 2009

China holds a lot of U.S. dollars. They essentially fund our continued deficit spending. We hear many reasons as to why they continue to hold and acquire more U.S. currency. We hear almost as many reasons why this is a dangerous situation. Unlike many of these supposed explanations, this analysis is not meant to scare you.

The reason China continues to acquire more and more U.S. dollar assets is because their economy has failed to evolve from the export-driven model that has raised them to where they are today. In order to sell goods in the United States, Chinese companies (or the government) must be willing to accept U.S. dollars as payment. Since China exports a greater monetary value of goods to America than it imports from the U.S., China is left holding excess quantities of dollars (and large quantities at that).

The U.S. government only sees that we import more than we export - and fools themselves into thinking this is a problem. The government has correctly identified one reason for this trade imbalance: China's fixed exchange rate. However, it is mistaken in its attempts to change this.

China manipulates its currency more than most countries. For years, the U.S. government has pressured China to relax its control over the currency (while increasing control over its own currency with each passing year). This is not a healthy solution to the "problem." Because China manipulates its currency, China essentially is forced to extend the United States an unlimited line of credit. China's strictly controlled exchange rate only hurts China.

As for what China does with their dollar reserves - they invest it - and often in (or with) American enterprises at that! In 2008, Chinese state-owned enterprises invested $35.7 billion overseas, including the $14 billion purchase with U.S.-based Alcoa of a 12 percent stake in Anglo-Australian miner Rio Tinto Ltd.

If the U.S. government doesn't shoot itself in the foot by either pressuring China or prevent Chinese companies from investing in the U.S. (which almost always strikes me as absurd), we'll find that China's dollar reserves will eventually make their way back.

Of course, lowering our tax rates will do a great deal toward expediting this process (and have the pleasant effect of decreasing the use of overseas tax havens).

Posted by Eleutherian

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