Chinese Central Bank Buying Treasuries

Let's review everything we've
done in the last few videos

and then take it a few
steps from there.

So let's say we have a reality
that right now-- and this

isn't the actual exchange rate,
but I'm just using these

numbers because they're nice
simple numbers-- the current

exchange rate is 10
yuan per U.S. $1.

And now we're in a reality where
the Chinese Government,

the Chinese Central Bank,
wants to keep this

[? PEG'd, ?]

so it wants to lock this.

It wants to lock this exchange
rate right over here.

But the reality is, more is
being sold to the U.S., more

is being exported from China
to the U.S. than

the other way around.

And so that leads to this
weird dynamic that we've

studied in the last
few videos.

So this is China right here, and
then you have the United

States right over here.

And let's say at this exchange
rate right over here, you have

goods coming from China to the
U.S. Actually, let me do it in

that same magenta color.

So these are Chinese goods,
and then we are paying for

those Chinese goods in dollars
and those dollars are being

sent to China.

So let's say we pay in
this time period.

Let's say it's a year.

Let's say that $100 sent to
China for the goods, and this

is really just a summary
of what we saw in

the last few videos.

And let's say, on the other side
of this equation, some

goods are sent from
the U.S. to China.

Some are exported, so U.S. goods
are exported to China,

and then we sell them in China
and then we get some yuan in

return that go back to
the United States.

And, of course, the reality is
that the money seldom is

actually sitting on a ship
going across the Pacific.

It's all in these bank accounts
that can be wired

back and forth.

The actual exchanges are
essentially happening on the

internet, not really in any
physical location, but this is

a good way to visualize it.

So the U.S. goods are being
sold in China and then the

U.S. producer is going
to get yuan.

And let's say for their goods,
they get 500 yuan.

So if all of these people were
just convert, and you actually

don't know what the equilibrium
price would be,

because the demand changes
depending on what the price is

in each of the countries, but
if you really wanted to

convert these $100 that the
Chinese producer gets into

yuan at 10:1, you would need--
so we're going to assume that

this PEG is what at least the
Chinese Government wants.

So you would need 1,000 yuan in
order to convert all of his

$100 at 10 yuan per dollar.

Now this producer, the U.S.
producer, only has-- let me do

it in a different color and I
should put the quotes around

needs, not around the yuan.

Now this U.S. producer only has
500 yuan to convert into

dollars, and we've seen
this multiple times.

But I really want to reinforce
it about how these currencies

would fluctuate.

The demand for yuan is much
higher than supply for yuan.

And we could do the exact same
argument for the dollar, that

the demand for dollars
is much lower than

the supply for dollars.

At this exchange rate, if we
assumed a PEG, this would only

be $50 that we need to convert
into, while there's $100 of

actual supply.

But let's just focus
on the yuan.

They need 1,000 yuan at
this exchange rate.

There's only 1,000 yuan that can
be converted into dollars.

And if we had a floating
exchange rate, that would

increase the demand for yuan,
and then this number would go

down, or another way to view
it, either that number goes

down or this number
over here goes up.

You could say the yuan would
become more expensive, which

means maybe it's 9 yuan per
dollar or 8 yuan per dollar,

or it could go the other way.

For 10 yuan, instead of $1,
you'd get $1.10 or $1.20 or

$1.30, either way.

Now, in order for this lock and
for this PEG to occur, we

saw in the last video that
the Chinese Central

Bank needs to intervene.

Remember, where are the
excess dollars?

They're over here.

Let me make it clear.

There's $100 over here
that need to be

converted into yuan.

We have 500 yuan over here that
needs to be converted

into dollars.

Now, the Chinese government
wants this $100 to be

converted into 1,000 yuan.

So what he does or what they
do is they say, OK, $50 of

this $100 dollars can be
essentially traded

for these 500 yuan.

Let me draw a two-way arrow
there. $50 goes to the

American producer and then the
500 yuan go to the Chinese

producer in exchange
for that $50.

Obviously, this isn't
coordinated.

It's not like matchmaking.

It's not like someone
said, hey, you give

this money to them.

But essentially, there will only
be $50 to convert into

the yuan and then the other
$50 will go to the Chinese

Central Bank.

Let me draw the Chinese Central
Bank, and they will

just print yuan and give
another 500 yuan.

And this is exactly what
happened in the last video.

I drew it a little
bit different.

All I'm showing is to make up
for the lack of supply of

yuan, they needed 1,000
yuan, there's

only 500 yuan to convert.

In order to make that up, the
Chinese Central Government

prints the extra Chinese
currency and buys

dollars with it.

So it's essentially sucking up
the excess dollars, right?

This was excess dollars right
over here so that the dollar

does not weaken.

It is sucking up extra dollars
so that the supply for dollars

isn't so high that it weakens
or so that the yuan

strengthens.

And so that's the way
the Chinese can

maintain the trade imbalance.

They could continue to
export more goods

than they are importing.

Now, what is the effect
of this, though?

And we saw this.

In order to maintain this
currency PEG while there is

this trade imbalance, the
Chinese Central Bank keeps

printing yuan and they keep
accumulating dollars.

And if they ever stop
accumulating dollars, so it's

not like they can just hold the
dollars they have and the

PEG will hold.

If they ever stop accumulating
dollars, then the PEG will

break down.

They have to do this
every time period.

They have to actively
participate in the market

printing yuan and
buying dollars.

They are doing it every day
to maintain the PEG.

Not every day, maybe sometimes
when it won't fluctuate on

their own, but if the yuan is
getting expensive, they

actually maintain a range, and
they will buy dollars.

So they're just accumulating
more and

more of these dollars.

And now this is where
it gets interesting.

What does the Chinese Central
Bank do with that cash?

Now, like anybody,
cash is useless.

You're not getting any
interest on it.

It's just paper.

It allows you to buy other
things that could give you

some income or could give
you some value.

So what the Chinese Central
Bank does, it doesn't hold

actual dollar bills.

It goes and tries to buy
the safest U.S.-

denominated asset it can.

And another thing, not only does
it care about safety-- so

it wants to go to
a safe asset.

It wants to go to the safe
dollar-denominated asset,

which means that you would buy
it in dollars, and if it

produces interest, the interest
would be in dollars.

And it's also doing this on a
massive, massive scale, in the

hundreds of billions of dollars,
and actually the

Reserve is in the trillions
of dollars, so it's

on a massive scale.

So they can't just go buy a
random company's stock, one

that won't be safe, but also
they would just drive the

price up to infinity if they
used this many dollars.

So it has to be a very liquid
asset, one that has a very

deep market where the people
trading in that market, it

really is in the tens
and hundreds

of billions of dollars.

And there's really only one
asset that meets those

requirements, and that's
U.S. Treasuries.

And this isn't the only thing
they will do, but this is the

great majority.

So what the Chinese Central Bank
does with all of these

excess dollars, it essentially
buys U.S. Treasuries.

So it gives the dollars away.

Well, not gives away, it sends
the dollars to the people who

are holding the U.S. Treasuries,
and then it gets

U.S. Treasuries in return.

Now, as a bit of review, and
I've done a few videos on

this, what are U.S.
Treasuries?

U.S. Treasury bills and bonds
are loans to the Federal

Government.

So that's maybe how you
should view it.

These are loans to the
Federal Government.

These bonds, these Treasury
bonds or these treasury bills

that they're getting, these
certificates, are

essentially-- in fact, they
are-- IOUs from the U.S.A, not

to get cheesy with the acronyms.
These are literally

IOUs from the U.S. Government,
and the U.S. Government will

pay interest. They are
essentially-- so just to make

it all clear of what's going
on, they're printing money.

They're accumulating dollars.

They're using those dollars to
go out into either the open

market or even directly from
the Treasury, from the U.S.

Treasury, and they are buying
U.S. Treasuries, which

essentially means that they are
lending this money to the

U.S. Government.

Now, I'll leave you there in
this video, and maybe you want

to think about it a little
bit before you even

watch the next one.

But in the next one, we'll talk
a little bit about what

that even means.

What happens if you have this
big holder of U.S. dollars,

this huge holder of U.S. dollars
going out there and

buying Treasuries and being
willing to lend money to the

U.S. Government?

Think about it.

And in particular, think about
what would happen to interest

rates and what those low
interest rates' impact would

have on the rest of
the U.S. economy

and on debt in general.