The economic situation between China and the U.S. is the financial version of mutually assured destruction – that cold war doctrine of nuclear deterrence. If you destroy me, I will destroy you.
Let me explain. I’ll start with the facts. China is indeed America’s biggest foreign lender – it owns about 1.2 trillion dollars of debt – more than Japan, the UK and Brazil.
A little-known fact is that most of America’s debt – 14.3 trillion and counting – is owned by Americans in Social Security trusts, pension funds, and by the Federal Reserve.
But it is the marginal buyer that matters, so China is important. Imagine that China were to sell off those 1.2 trillion dollars of U.S. Treasury bonds. This is a huge hypothetical – but let’s play out the disastrous chain of events that would happen if China began to divest.
It would trigger panic selling of the dollar. That would in turn hurt the U.S. economy, which is China’s number one export market (not a good idea if you are the Beijing government trying to keep workers occupied in factories across China).
China is addicted to a strategy of export-led growth, which requires that it keep its goods cheap. This means keeping its currency undervalued. That’s why it buys dollars.