How is China slowing the never-ending stream of $US? Part 1: Currency swaps

July 21st, 2009

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In our previous article, we showed you the circuitous route made by a US$ from America (as consumer spending) to China and then back to America as investment in US Treasury bonds. Once you understand this process, you can easily see (as one of our reader David saw) how the US export inflation to China (see How does the US export inflation?). Also, it is easy to see (as another one of our reader Steve Netwriter saw) a problem with such an arrangement. This is what is commonly called a “massive global imbalance.”

So, you can see the never-ending stream of US$ flowing from America to China (and then back to America) as some sort of air streaming via a hose into a balloon waiting to burst. Recently, China has tweaked the rules in order to let some air out of the hose. What are the tweaks?

First, let’s take a look at step 7 of the process in our previous article,

Trade between China and other countries are also settled in US$, which means even more US$ are piled up in the PBOC.

Usually, when China trades with many other countries, the accounts used for the trade is denominated in US$. For example, if China wants to buy palm oil from Malaysia or sell textiles to Europe, US$ are used for settlement. Therefore, the net US$ that flows into China does not come from America alone.

What is happening today is that China is quietly setting up currency swap systems with its trading partners one at a time. With a currency swap system in place, the currency used for trade can be denominated in the Chinese currency (RMB) instead of US$. As this news article reported back in March 2009,

The agreement marks Argentina as the fifth nation to sign currency swap agreements with China following similar agreements with South Korea, Malaysia, Belarus and Indonesia. China ranks as Argentina’s second-largest trade partner.

Some people are saying that this is China’s scheme to slowly supplant the US$ as the world reserve currency. This will happen if/when one day, China captures more of the world trade then the US.

In August this year, China will open up another avenue for the US$ to ‘leak out.’ Keep in tune!

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