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The Trade Deficit, Again

December 4, 2011

The Chinese central bank, like all central banks, can create money, in its own currency, at will.

Suppose the PBC creates a billion units of its own currency, and uses it to purchase US currency on the open market, at market rates.

When a country purchases fx, three things happen. One is that the country – China in this example – accumulates dollar denominated deposits at a US bank – in this case, the Fed. Another is that one or more foreigners – in this case, Americans – obtain yuan-denominated deposits in China.

The other thing that happens is that the value of yuan falls relative to the value of the dollar. (China’s purchases increase the demand for dollars while decreasing their supply; while simultaneously increasing the supply of yuan.)

The net result is that Americans hold a billion newly-created yuan. These Americans (or more likely, American companies) can do one of two things with the newly-created yuan. They can do nothing, or they can purchase things from China.

Assuming they choose to use the yuan, their purchases create a trade deficit, as the newly created yuan flows back to China, and Chinese goods flow to the US.

The trade deficit, if or when the American companies use all of the yuan, will exactly equal the billion yuan the Chinese central bank created in the first place.

The conventional wisdom is that America borrows dollars from China in order to finance a trade deficit.

But what if the truth is that China is financing a trade surplus, by printing Chinese money?

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