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Video transcript
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.