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China is a major manufacturer of merchandise. They are the world’s second largest economy, following the United States. China is the world’s biggest exporter of goods and have the largest trade surplus. That trade surplus results in vast currency reserves.

This positive balance of trade for China has continued to keep the level of the Yuan (Chinese currency) at an increased level as the economy has been growing, until recently. Since 2014, China’s foreign reserves have been steadily declining after peaking at over $4 trillion:

Chinese Foreign Currency Reserves

Chinese Foreign Currency Reserves

In early 2014, the reserves peaked at their highest level at $4 trillion. In January of 2017, China reported that their reserves have dropped to their lowest level since February of 2011, a decline of 25% from the peak.

Economy of China

China accumulated these reserves as a function of world wide economic growth, which has contributed to economic growth in China. However, economic growth in the past few years, as measured by GDP, while still stronger than in other countries, has been slower than in prior years:

China's GDP Growth

China’s economy has slowed considerably over the years. With the slowing of the economy, this has forced capital to flee China in increasing numbers, which feeds into the cycle and reduces the available capital for investment in China, which further slows the economy. The continued slow growth has forced China to place capital controls on capital exiting the country.

These factors have forced the Yuan to decline in value relative to the US Dollar:

Chinese Yuan

As the Yuan declines in value, as a function of slowing economic growth and less investment capital demand for the Chinese Yuan (as explained above), this has forced the Chinese central bank (People’s Bank of China) to spend its US Dollar reserves on purchasing the Chinese currency, the Yuan, in the open market. This creates artificial demand for the Yuan, therefore, allowing China to “manage” the price of the Yuan relative to other currencies, particularly the US Dollar.

From the perspective of the Chinese government, if they allow for the Yuan to naturally deteriorate in value, without artificially supporting the value of the Yuan with the use of its reserves, then according to some estimates, the value of the Yuan would need to drop significantly. Kyle Bass, founder of Hayman Capital has stated that the Chinese currency could fall by as much as 30% against the dollar. If this were to happen quickly, while it would save China’s foreign currency reserves, it could be a one-time shock to China’s economy that could cause unwanted ripple effects throughout China.

Despite having one of the largest foreign currency reserves, China’s growth of the past decades has not been natural. In fact, it has been anything but that. China’s growth has been a function of debt, and the problem is substantial. If you are thinking how bad is it? It’s worse than the US subprime housing issue…

China’s National Debt

Here is a chart of China’s total Debt-to-GDP:

China Debt to GDP

If you think this is sustainable indefinitely, you’re mistaken.

Debt Cost Per GDP Percent

This chart depicts the costs of funding each percentage point of GDP growth. As you can see from the chart above, with more debt, the costs grow. As the costs grow, this reduces economic growth, in a self feeding negative cycle.

One way China has been funding it’s own economic growth all these years is by purchasing US debt, more specifically, U.S. Treasury bonds. With the funding of the US economy, China in a sense has ensured that there would be continued demand from the US for Chinese exports to the United States, creating a feedback loop.

US Treasury Bonds

However, since the election of President Trump, there has been increased uncertainty about policy moving forward which has resulted in this:

Chinese US Treasury Holdings

Whether the election of President Trump was the fundamental reason behind this drastic change or not is unclear. Part of the reason is to continue to support the Chinese Yuan, as detailed earlier. Despite there not being a definitive reason, what is clear is that the trend has changed, and that is negative for the US in the long-term.

As we have detailed earlier, the number one US export is debt. If the United States is unable to export debt, that creates significant problems for the US economy, which also creates problems for China as well.

What is more interesting is that not only has China begun to unload their US Treasury reserves, but others have as well:

Foreign Central Bank Holdings Of US Treasuries

Another primary reason behind a decline in foreign holdings of US debt is the continued threat from the federal reserve that yields will continue to increase as part of the Fed funds rate hike. As the Fed hikes rates, the prices of bonds decrease, which makes holding low yield fixed debt a losing investment in light of rising yields.

What To Expect Going Forward

A decline in global growth could continue to create significant headwinds on both the Federal Reserve to continue increasing rates as well as on China’s foreign reserves and the economy altogether. This creates a potential dynamic whereby nationalistic rhetoric increases from all sides, and trade wars ensue. This increases the costs of goods for consumers, which decreases demand for those goods. A decrease in demand for consumer goods slows economic growth and leads to a self feeding cycle. As such, while the Federal Reserve may continue raising rates, over time this may prove to be a policy error that forces them to once again resume quantitative easing, a way to artificially paper over economic reality with new debt. At the end of the day, not only is China depending on US economic growth to jump start its economy, the US relies on China to buy its debt. When one of those links break, this will have significant negative repercussions for the world.

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