Chimerica-How is China being affected by what’s happening in the US?

The term Chimerica, describing the relationship between the now 2 largest world economies was made popular by the economist Niall Ferguson, with a chapter in his 2008 book The Ascent of Money

 With the current debt uncertainty in the US and devaluation of the dollar, the economic growth of China may not be such a dead cert.

Here are the two main ways China is exposed to the falling $

Foreign Exchange Reserves

It starts with the Chinese government, which has had for a long time a policy of keeping the currency, the Yuan undervalued in an attempt to boost exports.

It has done this by directly pegging it’s currency to the dollar and due to a ‘managed floating’ regime it has bought up masses of US dollars in the foreign exchange markets.

That is just over $3 trillion, yes with a ‘t’, half of China’s economy!

 

Of course, these holdings are not just cash, which makes up a minimal holding (there is nothing like $3trn in cash even circulating, let alone what 1 country can get it’s hands on) but a variety of US assets…

Mainly Treasuries

The main characteristic of the Chimerica relation is simply, China lends the US money and the US buys it’s goods. This has made China the joint highest holder of US government securities with the Fed.

It is a very large holder in US equities, corporate and agency bonds

Though put in the Wealth of Nations that sovereign wealth funds is a main source of funding public works, this was much more common in the 18th century under Mercantalist colonies. Today it is unique in China..

The Export Market

China is a lead exporter in manufactures, particularly gadgets and communications equipment as well as textiles and non precious metals. Who is the main buyer?

As said before, the US, buying over $280bn of China’s stuff in 2010

Now a drop in the $ makes Chinese products less affordable, causing it to lose this export income unless:

  1. The price elasticity of demand of China-US exports is inelastic: Unlikely (but not impossible).
  2. China devalues the Yuan to move it with the $: Exposing it to bigger losses on $ denominated assets.

China’s high rates of growth in the last 10 years have been largely due to their exports, and it would hurt them to see a fall in demand from their biggest customer which is almost certain given the exceptions above.

One-Year Chart for DOLLAR INDEX SPOT (DXY:IND)

US Dollar Index has plunged against a basket of currencies. Taken from Bloomberg

You can compare the US and China to a company which lends it’s customers money to buy it’s goods, as it is in simplicity the same model. When it’s going good, it’s a fine strategy, but when something unexpected happens, the company is hurt twofold; by write downs of its debt assets and falling sales.

The stories of such companies reveal the risks of this approach. Notably MFI and Lucent Technologies

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