China reduced buying US Bonds, raising its own currency

China has sent the clearest signal yet that it may be about to scale back lending to the United States. On Wednesday, the Chinese Central Bank indicated that it would consider allowing the dollar to fall against the yuan. The change in policy—at a time when America is running the largest deficits in world history—could have major ramifications for the U.S.


The People’s Bank of China’s most recent policy report contained some interesting new language. Instead of repeating the typical rhetoric about keeping the yuan “basically stable at a reasonable and balanced level,” it hinted at a move away from the dollar peg (the mechanism by which it keeps the exchange rate of the yuan stable to the dollar).

The new policy language said that the bank will “improve the yuan exchange-rate formation mechanism,” based upon principles of “initiative, controllability and gradualism.” Analysts are interpreting this to mean that China may be about to allow the dollar to fall against the yuan.

“I think the wording change … shows that it is an irresistible trend for China to resume yuan appreciation,” said Xing Ziqiang, an economist at Beijing-based China International Capital Corp.

One of the ways China intervenes to keep the yuan pegged to the U.S. dollar is by purchasing dollar assets—like U.S. treasuries—in international currency markets. This increased demand for dollar assets, along with the subsequent increased supply of yuan, helps prop up the value of the dollar against the Chinese currency. However, if this relationship is about to change, and China is going to allow the dollar to fall in relation to the yuan, it means that China’s central bank will probably have to reduce its purchases of dollar assets.

If China curtails its treasury purchases, America may find itself in a pickle. China is America’s most important creditor. Over the past decade, China has willingly lent money to the U.S. government (by purchasing treasuries), so that the yuan would be artificially pegged at a low rate to the dollar. China did this to give an advantage to its exporters and encourage U.S. businesses to relocate to China. The advantage for America was that both the government and consumers had an easy source of borrowed money, and interest rates were kept low. This allowed both the public and private sectors of the U.S. economy over the past few years to embark on what was probably the biggest spending binge in history.

However, the downside to this arrangement may now be about to be felt. American society is addicted to debt. China’s announcement that it will let the dollar fall against the yuan is a warning that Chinese money might not be quite so easy to get. For the U.S. government, it means that it may need to find an additional source of foreign lenders—not an easy task when you are already the world’s largest borrower and you are running world-record deficits.

The U.S. is auctioning off another $81 billion in treasuries this week. This total is lower than other recent auctions, but it is still gargantuan compared to pre-economic-crisis days. This auction may not fail, but the probability that one will fail someday soon just got a whole lot more likely.

And if an auction were to fail? Interest rates could soar. For an economy addicted to debt at all levels—federal, state, municipal, corporate, personal—higher interest rates could be a killer.