China’s dollar conundrum

China is holding a lot of dollars, and dollar debt.  The Chinese government doesn’t want to take a big loss on its dollar holdings; which would happen if the Chinese government dropped the yuan peg to the dollar.  At the same time China wants to reduce its dollar holdings without suffering a drop in exports.  If China drops the dollar peg, the yuan will rise and Chinese exports will drop as they become more expensive.  They are trapped.  Brad Setser puts it nicely:  “China’s current exchange rate regime compels China to buy dollars when private Chinese investors don’t want them.*** The result: a strange world where China’s government ends up buying an asset that China’s people currently do not want …”

A couple of other pieces on this same subject:

When China Buys U.S. Bonds It Is Manipulating Its Currency
China and the liquidity trap

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