Foreign Trade and Debt
The Chinese have been manipulating the yuan/dollar exchange rate for many years. They held a "fixed" exchange rate that used to be 8.28 yuan to each dollar. Recently, they disingenuously pretended to let their currency "float" against the dollar, but the exchange rate can't seem to find anything much below 8.08 yuan to the dollar, even though by many estimates the price of a yuan in dollars in a free float would be higher, perhaps even as high as 1.84 yuan per dollar, which would imply that the yuan is currently artificially undervalued by a whopping 84 percent. The Chinese keep their currency super cheap against the dollar by printing tons of yuan and buying dollars with them. The over-supply of yuan makes them worth little, and the over-demand for dollars makes them strong. This, in turn, makes Chinese goods very cheap in the United States at the same time it makes American goods very expensive in China. We then buy those cheap Chinese imports, paying with our U.S. dollars, which then end up in the hands of the Chinese, who collect them by the billions because of the mind-boggling amount of cheap stuff we buy.
So the Chinese have a massive foreign reserve of greenbacks accumulated over the years they've been trading their cheap exports to the U.S. for muscular dollars that we export to them in return. This is the so-called "current account," which is the flow of "liquid" (readily convertible to and from cash-money) assets. The United States constantly runs huge current account deficits simply because American dollars flow to the Chinese in exchange for their cheap goods, which flow into the U.S.
Now, the only place the Chinese can spend all those greenbacks they gather is in the country of origin of the currencythe United States of America. This is where the mirror image of the current account deficit comes into play. The Chinese have to spend their cache of greenbacks here in the United States, and they do so by purchasing our tangible and intangible assetsthings like real estate and corporations. Notice that these are not liquid assets: they're long-term things, what we call "capital goods," and the account that recognizes these transactions is called the "capital account." The most important capital investment the Chinese (and other foreign interests) make here is their purchase of debt instruments, both public and private. In other words, once the dollars have been exchanged for cheap Chinese goods, causing the U.S. to run huge current account deficits, those greenbacks come right back here, where we sell the Chinese things like stocks, bonds, and real estate, thereby getting our dollars back. The level of this capital account, then, is almost identical, but of opposite sign, to the current account. If we run a $100 million current account deficit (what some call a "trade deficit"), we'll run almost exactly the same $100 million capital account surplus as we repatriate those dollars by selling long-term, capital goods to the Chinese.
When someone borrows money, what he or she is actually doing is selling (the technical term is "issuing") a security, usually called a "bill," a "note," or a "bond" (the exact term depends upon the length of time to maturity of the instrument under consideration). So when the United States government borrows money, it does so by selling (i.e., "issuing") so-called "Treasury" debt instruments. Our U.S. Treasury holds regular auctions where buyers from around the world have the opportunity to bid for these debt instruments. In other words, people, institutions, and countries come to these Treasury auctions bidding for the right to lend our government the money it can't raise through taxes to pay its bills.
Generally speaking, the Chinese are regular participants in these auctions. So are the Arabs and other nations that have dollar foreign reserves they need to use. Essentially, then, what these buyers are doing is trading greenbacks for a "close substitute," government debt instruments.
Think about it this way: a dollar is a "Federal Reserve Note," an intermediate-term debt instrument issued by the semi-autonomous Federal Reserve Bank. The United States of America, through its government, guarantees that loan paper with its full faith and credit. The Treasury instruments are loan paper, too, but they're directly issued by the United States government. Hence, the greenbacks and the Treasury paper are rather close substitutes to investors, since both are as safe as any investment could be: at their essence, both are backed by the full faith and credit of the sovereign republic of the United States of America, which can satisfy its debts (to the extent that it so chooses) through taxes on the productive output of the largest economy in the world. Therefore, the Chinese are buying Treasury instrumentsa claim on American assetswith the greenbacksagain, a claim on American assetsthey earn through trade. Hence, the Chinese end up having a claim on American assets through their legal claim on cash flows promised in loans taken out by the U.S. government.
Of course, the Chinese don't buy just government debt; they go for the quasi-private paper, too.
The secondary mortgage market is a great example of where private debt instruments backed by the U.S. government or agencies thereof are sold. In a simplified nutshell, here's how a secondary mortgage market works.
A person goes to a bank to secure a loan to buy a house, and the bank agrees. The bank has the home buyer sign a "promissory note" that represents the borrower's obligation to pay the loan back, usually in installments, with interest. The borrower also signs a "mortgage agreement" that backs the promise to pay with the obligation to surrender the home in the event of default on some or all of the promissory note covenants, the most important of which are the covenants having to do with timely payments (although other covenants can be violated by the mortgagee that would trigger a "call" on the note).
Together, the promissory note and the mortgage agreement represent not just a contract, but a special security: what has happened is that the borrower has actually issued a standardized, if somewhat complicated, "bond" (a long-term debt instrument), which the lender has pre-arranged to purchase under the terms of the lending agreement.
From a financial perspective, that's what has happened, and the bank is now the "holder" of the bond; but it has no intention whatsoever of being for very long in that kind of relationship with the issuer (the homebuyer/borrower) of the bond. The bank is going to unload that bond very quickly, and it does so by bundling that bond with a bunch of others it has recently purchased (a number of other mortgage loans it has made) and selling them to one of several secondary mortgage market companies, which are for the most part nothing more than wholly-owned entities within agencies of the U.S. government. The one to which the bundle is sold depends upon the particulars of the mortgages in the bundle, as in what agency of the government underwrote or backed the original loan: "Ginnie Mae" is the Government National Mortgage Association; "Fannie Mae" is the Federal National Mortgage Association; "Freddie Mac" is the Federal Home Loan Mortgage Corporation; and so on. Even a student loan, another type of fairly long-term loan backed by the federal government, has a secondary market: it's called "Sallie Mae."
Once one of these government quasi-corporationsGinnie Mae, Fannie Mae, Freddie Machas purchased enough bonds from banks, it puts them all together into a single re-issue, a massive bond that is then sold to private investors at very attractive terms. The terms are attractive for several reasons, one of which is that there are tax advantages to owning and receiving cash flow from these secondary mortgage market instruments; another big attraction is that the cash flow from these instruments, which ultimately arises from people making their mortgage payments, is effectively backed by the full faith and credit of the United States of America, as well as almost always being guaranteed by private mortgage insurance, the insurance premiums for which are paid for by that hapless homeowner/mortgagee as part of the total monthly payments. In other words, by the time the original mortgagesall mashed together and sometimes even chopped up into various cash flow componentsget to the secondary mortgage market investors, they are so safe you could bet your favorite grandmother's virtue on them.
The Chinese, using the huge piles of dollars they've earned by selling their cheap goods in the U.S., are big on these giant secondary mortgage market bonds. So, too, are other countries with lots of dollars to invest. So, too, are huge institutional investors like insurance companies, which favor safe securities that return cash flow over a nice, long period of time.
But that's not the end of the story with secondary mortgage markets: those secondary mortgage market governmental quasi-corporations are selling these Ginnie Maes and the like, so they're receiving money in exchange, and some of that money is lent right back to the mortgage-originating banks so they can make more mortgage loans, which are then bundled, sold to the secondary mortgage market corporations, which then package them and sell them into the secondary mortgage markets, where they are again bought byyou guessed itamong others, the Chinese, the Arabs, and all the other countries with foreign reserves of dollars they've earned because we run trade deficits with them. And as long as everyone plays nice in this game, that circular flow of money from current account deficits to capital account surpluses keeps rolling right along, which ultimately means that credit is easy to obtain here in these United States of America.
So it's not just the federal government that's been slurping at the foreign reserves teat of the Chinese, who have all those billions and billions of dollars because they sell us cheap stuff; it's everyone who takes out mortgages, even the folks who take out second ("home equity") loans on their houses.
The United States governmentrunning staggering, near-record deficits under the Republican Administration in the White House and the Republican majority in both Houses of Congresshas every reason to be very nice to the Chinese because it's the folks in Beijing (and Riyadh and other places, of course) who are funding our public profligacy. However, anyone who wants a nice home with a tolerable mortgage interest rate also has to be nice to these foreigners because it's those same Chinese (and Arabs and others, of course) who are also providing the liquidity to keep American households happy piling on debt up to their eyeballs.
Finally, and in conclusion, guess what happens if the dollar becomes so worthless that the Chinese, the Arabs, and all the other countries with piles and piles of greenbacks in foreign reserves decide it's not worth holding them anymore. Far worse, what happens if the declining dollar and unrelenting, skyrocketing government demands on global capital flows come together to create a credit squeeze, driving the economy downward, pushing mortgage default rates upward, and thereby exposing all the highly leveraged, mortgage-collateralized financial paper for the vapor it really is?
If you guessed something along the lines of "Oh, God," you get an "A" for this lesson in Pulp Economics.
The Dark Wraith bids readers a pleasant journey on the narrowing road over the canyon of economic catastrophe.