Since the early 1990s, China has relied on exporting to grow her economy, and the high speed economic growth in turn helps to maintain the stability of transitions of the Chinese political system. For the CCP to protect its power, the growth thus exporting is very important. On the supply side of the export, the Chinese producers are very close to perfect competition and some people think its over-competition. On the demand side, the buyers are close to monoposony who can press the price as much as possible. So, cheap Chinese product flooded the U.S. market, supporting the U.S. consumers' high living standards and the U.S. economy used the recourse surplus built two bubbles: the internet bubble at the end of 1990s and and the housing bubble in the middle of 2000s. The result of this economic relationship is that U.S. has accumulated a large amount of liability to the rest of the world denoted in the U.S. dollars. If the U.S. repay the debt gradually and orderly, it is possible there will be no disruption in the relative closing up of the living standard differential between China and the U.S. One example of the closing up can be the slowing down of U.S. living standard growth and the speeding up of the Chinese living standard growth.
The domestic political sentiment of the U.S. focused on the manufacturing job loss and the trade deficits to China, which a country viewed by the U.S. not as a friend. So, the U.S. politicians started to demand the Chinese currency, Yuan or RMB, to appreciate. There is domestic demand for the appreciation of Yuan in China as well. In more recent years, China's wealth has accumulated to a level that can feed its own bubble in the stock market and her domestic housing market. The Chinese officials hope the appreciation of Yuan can help to keep the wealth produced by the cheap domestic labor remain in the country and benefits Chinese people, and they also passed a labor law to protect workers' rights for the same purpose. This consensus between the Chinese and Americans led to the depreciation of US dollar. The devaluation on the US dollar denominated assets owned by the Chinese government make the Chinese realize the depreciation of dollar is actually a default on the liability owed by the U.S. to China thus the wealth flow from China to the U.S. is disrupted abruptly both intentionally by the underweighting of USD denominated assets holding by the Chinese government and unintentionally by the higher labor costs for the Chinses suppliers. It is generally thought that to shift production of the exporting goods out of China will take time and incur higher production costs. Ultimately, very soon the cost of living in the U.S. will be higher than had the Sino-US trade relationship not been broken abruptly.
The U.S. can repay its debt by transferring wealth through trade or selling its assets to the Chinese or the Arabs, which is a choice that neither the U.S. government nor business leaders would like to make. However, when there is no obvious way to repay the debt through international trade, the U.S. have to sell its assets one way another once the process of wealth transfer from China to the U.S. is disrupted. The U.S. authorities realized that cheap dollar lead to higher oil price and higher inflation eventually a deep recession so they decided to reverse the depreciation of dollar. Then the only way to sell US assets is the the prices of these assets to collapse, as seen in the stock market and the housing market in the U.S. Even so, the barrier for Chinese to purchase U.S. assets is still extremely high due to the Chinese capital flow restriction and the reluctance of the U.S. government to accept this choice. So the U.S. government step in and bailed out the U.S. assets by either have direct stakes in some U.S. firms or now, an entity to hold toxic MBS derivatives. The question remains, however, how the U.S. economy will repay the liability to the rest of the world in general and China or OPEC countries in particular.
In the short term, if the U.S. economy is stabilized through the above government actions, the depreciation of dollar is inevitable since the market still needs to enforce the repayment of the liability owed by the U.S.
Magnus: China Must Reform or Bust - China's debt markets are looking more and more like the West, circa 2007. And it's not clear the government can intervene as successfully.
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