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American-Chinese debt loop

How the Chinese buying of American debt leads to lower interest rates. Created by Sal Khan.

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  • blobby green style avatar for user Fadi Dagher
    What if the US just refuses to sell bonds to China?
    (14 votes)
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  • blobby green style avatar for user Daniel Lim
    Won't spending dollars to buy US treasuries increase dollar supply, which will cause the value of yuan against the dollar to normalize, therefore preventing a loop?
    (8 votes)
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  • piceratops ultimate style avatar for user Hushus/حسين
    I watched the video, but I don't get how the Chinese are profiting, because if the Chinese aren't profiting they wouldn't do it. Wouldn't it be better for the debt market be free-flowing so that Americans receive less money, so they will buy cheaper objects, hence they will buy Chinese objects? Also why does the Chinese Central Bank care if more Chinese objects are being bought, its suppose to be trying to profit?
    (4 votes)
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    • blobby green style avatar for user leo.e.walsh
      The Chinese are also profiting in less direct ways.
      1) Transfer of productive capacity away from the US and into China. The big "win" for them is the transfer of know-how that can only be gained by doing.
      2) China owns a larger percentage of our national debt. And, our trade imbalance grows. This is clearly beneficial for them since we are unwittingly transferring our savings to them. This could give them a huge leverage over our economy.

      All we get is cheaper IPad's.

      See the Concord Group (or the documentary "IOUSA") for an interesting take on the dangers faced by the US economy... Or the insightful "Why the West Rules--For Now At Least" by the Stanford university historian Ian Morris.
      (8 votes)
  • primosaur sapling style avatar for user David Mayrose
    What will happen when China all of a sudden decides to no longer finance US debt? What a potential "weapon" they have at their disposal!
    (5 votes)
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  • blobby green style avatar for user Justin Adcock
    Of all the tresuries out there, why would the chinese govt. buy just american tresuries? Why not German tresuries, russian etc...
    (3 votes)
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    • leaf green style avatar for user Ryan
      Well, they don't only buy US treasuries. They have holdings in many other assets. But there are two main reasons why they hold such a large amount of US treasuries.

      First of all, China ships billions of dollars worth of goods to the US every year. In exchange they receive US dollars. They don't want to have US cash, that doesn't earn any interest, just lying around. So, they purchase US treasuries to earn some interest. Treasuries are the largest market in the world and you can buy a great deal without moving the market too much. This matters when you're dealing with billions of dollars. China is free to purchase other assets (which they do), but every other market is less liquid than the treasury market. If for example China wanted to buy German bunds, they would have to convert their US dollars into Euros and then purchase German bunds. Two transactions are far more expensive than one when you're dealing with billions of dollars.

      The second reason is because they peg their currency to the US dollar. China needs to hold a great deal of US treasuries and US cash in order to maintain a constant and unchanging exchange rate with the US dollar. China pegs it's currency in order to maintain an export advantage over other Asian countries. If they didn't do this, their currency would go up in value, which would make their exports more expensive and less desirable, which would hurt their economy.
      (5 votes)
  • blobby green style avatar for user Cameron Scott Kingsbury
    Aren't all US dollars "financed by debt?" With fractional reserve banking isn't this what happens?
    (5 votes)
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  • old spice man green style avatar for user ophunt2000
    Why do the Chinese want the Yuan low?
    (1 vote)
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  • blobby green style avatar for user bjornlevi
    So, who own all the Yuans and once the $ crashes won't it be "easy" to pay off those IOU's or buy the $ with those Yuans?
    (2 votes)
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  • orange juice squid orange style avatar for user Ctrader621
    It appears to me that China is financing their infrastructure and manufacturing capacity with US debt. When they build up their markets to the point that internal demand and markets other than the United States will absorb their supply, is there any reason for them to continue to buy US government debt? What happens if/when they become a seller of US treasury bonds instead of a buyer?
    (2 votes)
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  • blobby green style avatar for user Vu Tran
    So after all of this, I have to ask -- why bother? Why does the Chinese government go through such an elaborate process to lower their own value of their currency? Whenever we hear that the USD drops in value, we view that as a bad thing, a terrible thing.

    If the Chinese yuan is under valued, doesn't that mean the Chinese people lose out? The money in their pockets is worth way less on a global scale than an American dollar. What gives? Why does China do this?
    (2 votes)
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Video transcript

Where we left off in the last series of videos, we had the Chinese Central Bank that was trying to make sure that the yuan does not appreciate too much. So the way they did that is that they bought up all of the excess dollars using yuan that they printed. So what they do is, they print yuan-- I'll do the yuan in this blue color-- so they print yuan, and then they use that printed yuan to buy dollars in the open market. And what that does is it props up the demand for dollars and keeps the price of yuan down, so then they get dollars. So they print yuan and they buy dollars. And as we saw, they have to keep doing this in order to keep the yuan deflated, or in order to keep the dollar inflated. And this is so that they can maintain a favorable balance of trade. But as they do this, they're just building the stockpile of dollar reserves. And as we mentioned in the last video, they're not just keeping a big vault of dollar bills there. They're going to use it to buy assets, and they're going to buy liquid and safe assets. And the main asset they're going to buy is U.S. Treasury bills. So then they take these dollars and they buy U.S. Treasury bills. And let me draw some of the other actors here, because they can buy it from two separate people. There is the United States government. So there is the U.S. Treasury. They are going to issue Treasury bills, when they essentially just need to borrow money. And then there's other people that have already bought Treasury bills. So let me draw them over here. So then there are other people who own Treasury bills. So this is someone who owns a Treasury bill right over here, wearing a hat, maybe with a little bit of hair and a moustache. So this is someone who owns a Treasury bill. So just to give a review, when the U.S. government wants to borrow money, people hand the U.S. government money-- I'll draw it as a dollar bill, right over there-- they hand the U.S. Treasury money, and then the U.S. Treasury gives them an IOU. This IOU is what a Treasury bill is, and what it entitles the holder of this piece of paper to, it allows them to get interest from the Treasury, depending on what type of Treasury bill or bond it will be. It'll be over a certain period of time. I have a whole video on this, especially the ones where I talk about the yield curve. And then at some future date, the U.S. Treasury is going to pay them a larger amount of money than they put back in. So this right here is a Treasury bond or bill. T-bill if it's a shorter duration, Treasury bond if it's a longer duration. This is a Treasury bond. It is a loan to the U.S. Treasury. Now, the Chinese Central Bank, they have all these excess dollars. They can buy treasuries from either two sources. When the U.S. Treasury itself needs to raise funds, it will essentially put these IOUs for auction. It will sell them to whoever is willing to take them for the least interest. So let me put it this way, so what they can do is they can give the money directly to the U.S. Treasury, when the U.S. Treasury puts Treasury bills or Treasury bonds up for auction. So it can give the money directly to the U.S. Treasury, and then the U.S. Treasury will give them one of these IOUs, or it could buy it from someone already has it out in the open market. This is a very deep, very, very liquid open market. Or they can give these people right over here money, and then they would transfer the IOU over to this Central Bank. So what is happening at the Central Bank? What is essentially happening here? What's essentially happening is the Chinese Central Bank printing money to buy dollars that it will then essentially lend to the U.S. Treasury. So it looks kind of convoluted, but the essence of what is happening here is that the Chinese government, you have the Chinese Central Bank lending to the U.S. government. And it might be buying other assets, but the Treasury bonds and bills are really the main form of liquid asset they might be buying. So how does this affect the United States, other than the fact that instead of owing other investors these IOUs, it now owes it to the Chinese? But what is the net effect of having this player out here, having this very significant player out there, that is fairly aggressively willing to pay for U.S. government IOUs, U.S. treasuries? What is the effect of that? Well, we saw in the yield curve video that the more people willing to give you a loan, the lower the interest rates are going to be. And I can show you a very simple example of that. If I'm looking to borrow-- and I'm no longer talking about nations, I'm just talking about Sal now-- let's say that I'm over here, and I'm looking to borrow $10. And I say, hey, who's willing to give me the best deal on $10, and I'm going to pay you back next week. So you might come along and say, I'll lend it to you for 10% interest over a week. So you can pay me $11 next week. So this would essentially be 10% interest over the week. You give me $10 now, and if I agree to you, then I'll give you $11 in a week. That would be 10% interest. But then let's say Mary comes along. And she says, oh, I can do better than Mr. Orange Guy over there. This is Mary. I'll lend you $10, and you can pay me $10.50 next week. So notice what happened. Both of these people have $10 to lend. They're looking to get some return on their $10. If he was the only player here, I'd have to go to him and say, OK I'm going to pay you 10% interest. Then she says, no, no, no, I also have $10 and, gee, I'd be happy with just a 5% return. $0.50 off of my $10 in one week, that's a good return. So right now, look at this person. But the more money that's available to borrow, the more competitive this side of the equation is going to be, and the lower the interest rate I can get. You can imagine even a third person says, no, no, no, wait! I've got $10. Let me draw this third person, who says, I have $10, and you know what? It's going to just be sitting in my bank account doing nothing unless I lend it to you. You can pay me, I don't know, $10.25 next week. And then I'm going to go to this person. So the larger than the number of people willing to lend to me, the lower my interest rate will be. Or another way you could think of it, the larger the supply of money to be lent, that leads to lower-- you can view it different ways. You could view it as lower borrowing costs, which is another way of just saying lower interest. Or you can even view it as cheaper money. It costs less to borrow the money. The cost of borrowing money is the interest. Now, what does that do? What does having lower interest? So this is just a small example with me trying to borrow $10. The more people there are, the more competitive that is, the better interest rate I'll have. So you just take that same notion to kind of a macro level. The U.S. government is constantly borrowing money. The more people out there willing to give it money, willing to buy the U.S. government's IOUs, the lower the interest rate will be. So the net effect of having this major buyer of U.S. Treasuries is that having them out there accumulating all of these dollars, taking them all out of the foreign exchange markets and then using them to buy treasuries, it lowers the interest rate for treasuries. So the net effect is the U.S. Treasury has lower borrowing costs. So what does that mean? So let's make it very clear. So the Chinese buy treasuries, which are essentially loans to the U.S. government, then the U.S. has lower borrowing costs. The U.S. has lower interest or borrowing cost. And I'm talking about the government right now. And this has several interesting side effects. This means that it's easier for the government to finance deficits. They don't have to pay as much in interest to finance deficits. So that means that they can spend more. They can give out more payments to U.S. citizens, or they could lower taxes, either one. Both of those would lead to deficits. So it's easier so that the government can either spend more or they don't have to raise taxes. Or they could they could lower taxes, because they don't have to spend as much in interest. Now, the other interesting thing that the U.S. Treasury borrowing costs go down, that means that the interest rate on everything goes down. This is one of the benchmark interest rates. And you should watch the video on the yield curve if you want to understand more about it. And I know some of you are saying, wait, doesn't the Federal Reserve set interest rates? The Federal Reserve only sets overnight, very short-term. If you're going to borrow money overnight in your bank, that's what the Federal Reserve sets. If the U.S. government is borrowing money over 5 or 10 years or 20 years, that is that by the market. That is set by a market mechanism very similar to what I showed just over here. So this is dependant on more capital being there to be borrowed. So this is 10-year, and 15-year, and 20-year debt for the U.S. becomes cheaper. But this makes all debt in the U.S. cheaper. And there's two ways you can think about why this piece happens. One is, just on a very superficial level, people say, hey, you know, someone like General Electric is only a little bit more risky than the U.S. government. If the U.S. government only has to pay 3% on its on debt that it has to pay back in 10 years, maybe General Electric should only have to pay 0.3% more than that. So you use the U.S. government as a baseline, and then depending on people's risk, they pay a little higher spread. Another way to think about it is up here. The Chinese government is just pouring dollars either directly into the U.S. government, or into the actual U.S. Treasury market. So this guy right now, he has more dollars. He's not going to use the Treasury, because he thinks treasuries are too expensive, which means that their interest is too low. So he's going to take these dollars he got from the Chinese, and he's going to lend it to someone else. That dollar is still there. He'll lend it to General Electric, or maybe he's a credit card company and he'll lend it to the consumer. So in general, all debt in the U.S. gets cheaper. Now, what's the net effect of all of these points? What's the net effect of this, all debt in the U.S. Becomes cheaper? There's just more dollars for loan in the U.S., more dollars than people can borrow. The government is spending more, or the government will lower taxes. What is the net effect of all of this? Well, people will either have more money in their pockets, because they've gotten a government job or they've maybe gotten some type of entitlement payment. Or, they're going to have more money in their pockets, because they're paying lower taxes. Or they're going to have more money in their pockets, because it's easier for them to put more debt on their credit card, or to refinance their mortgage. So all of these lead to more cash in American pockets. Now, that's obviously not an unambiguously good thing, because this is all financed with debt. It's not just solid debt-free cash. So more cash in American pockets essentially financed with debt. And this debt, as you can see, it's either occurring at the credit card level, it could be occurring even at the corporate debt level, or it's occurring indirectly at the government level. But all of this is being enabled by the fact that China is willing to buy treasuries, which means that China is really just willing to lend to the U.S. So what's happening? China is artificially keeping its currency low, and it's doing that by buying dollars, taking those dollars and essentially lending them to the United States. And that eventually ends up in the hands of American people and companies, and even the government. And what are they going to do? Well, they're going to buy cheap Chinese products that are artificially cheap because the currency is lower. And obviously, you know, they do have lower labor costs and all of that, but it's even lower to the American than it would be if the currency were allowed to freely float. So the net effect of this entire scenario that I've been describing over the last few videos, is that the Chinese are essentially lending money to the Americans to then go ahead and buy more Chinese products.