You might be inclined to think that countries with big trade surplusses do not have problems. They’re just sitting there, amassing assets from the rest of the world. Think again. And the worst part, these problems matter for the rest of the world economy, they matter a good deal..

Here is what happened to Japan a couple of decades ago:

• They had an enormous trade surplus
• the dollars you gain by maintaining the currency from appreciating too much as a result are reinvested
• but the currency rises nevertheless, making those investments, well, worth a good deal less..
• These kind of problems had ramifications for the global economy then, we have new players, but the same problem, and the same ramifications.

It’s an awkward problem, sort off. Trade balances have a natural tendency to make imbalances smaller over time, as the surplus country will see it’s currency appreciate in value. People need that currency to buy all that stuff from the surplus country in the first place, and since they buy more there than the surplus country buys with them, the currency of the surplus country has a tendency to appreciate.

Unless the surplus country doesn’t want that. What can it do to prevent it (and some implications)?

1. capital transactions are drastic, but probably most effective (although it depends on the internationalization of your banking system, amongst other things, in how effective they are). It’s what China has done, and this has another advantage, interest rate freedom (see 2)
2. Lower interest rates to diminish the attraction of the currency and lessen capital inflows. Lowering interest rates would boost demand in the country (including demand or imports), and increase inflation, making the country more expensive , so this would be another self-correcting mechanism for the trade imbalance. However, if you have made capital inflows difficult through 1, you can keep most of your interest rate policy for domestic purposes.
3. Intervene in the currency markets, selling your own currency (which is in high demand because of the trade surplus) will keep it from rising. The counterpart is twofold:
4. You buy foreign currency, and to get some return on these you have to invest them in some assets. The asset of choice is usually Treasury bills, which is why China sits on an enormous mountain of these
5. Selling your own currency brings more of these into circulation, basically, it increases the money supply. If you don’t want the possibly inflationary consequences of that (“too much money chasing too few goods”), you can ‘sterilize‘ it, that is, selling Chinese bonds to mop up the excess liquidity
6. You’ll see now how the Chinese central bank ends up with ever more US Treasury bills, and ever less Chinese equivalent. This has been happening for some time, and since the currency is still appreciating, these US Treasury bills are worth less and less, creating problems for Chinese central bank.

Having explained the mechanisms, you’ll be able to appreciate the following article a bit more, we hope:

China Suddenly Can’t Afford U.S. Debt

• Friday, September 5, 2008 12:06 PM.  China’s central bank has been on a buying spree for the last seven years, taking home $1 trillion worth of U.S. Treasury bonds and mortgage-backed debt issued by Fannie Mae and Freddie Mac. Now the bills are coming due, and the bank doesn’t have enough money to pay them.
• That’s because the bank’s U.S. investments, which comprise most of China’s foreign securities, are worth a lot less when converted from weak U.S. dollars to stronger yuan, reports The New York Times.
• Last year, China spent more than one-eighth of its entire economic output on foreign bonds and has bought even more this year. If it stops buying dollar-denominated securities now, the dollar would tank, and U.S. interest rates would skyrocket.
• The situation is so serious that the People’s Bank of China, which earlier ignored warnings from the International Monetary Fund that its $3.2 billion capital base is too small, has asked the country’s Finance Ministry to help it get more capital.
• The move may signal a shift in power from the bank to the Finance Ministry, which has long advocated slowing the yuan’s appreciation to increase the global competitiveness of Chinese goods.
• The U.S., however, wants a stronger yuan, which would reduce Chinese competitiveness and the U.S. trade deficit as well. The yuan has risen 21 percent against the dollar since mid-2005, when China quit pegging its currency to the dollar.
• U.S. Treasury Secretary Henry Paulson, long an advocate of a strong yuan, warned in a recent issue of Foreign Affairs that the Chinese juggernaut is headed for the wall, a serious risk for the rest of the world’s economies.
• “Americans who worry that China might overtake the United States are worrying about the wrong thing,” Paulson wrote.

Some awkward choices:

1. The obvious solution, keeping the yuan from rising altogether would work for a while, but the bill would be that much bigger. You can’t keep a currency of a country with 10% growth (and three times the productivity growth)  and very high saving rates stable against the currency of a country with much lower growth and savings (in fact, it’s in a spot of bother right now) for too long.
2. Keeping the yuan from rising at all would trigger the wrath of the Americans
3. The efforts of keeping the currency low would need further Chinese buying of US assets, and either a balooning domestic money supply as a result, or a continued sell-off domestic assets to fight off the balooning of the domestic money supply, worsening the books of the Chinese central bank ever more when the final revaluation of the yuan will come.
4. But if they stop buying US assets, the dollar would plunge immediately..

An awkward dilemma. It matters a good deal how the Chinese will solve it. If they stop buying US assets, the dollar could really plunge