Jayden Why do some foreign governments invest in US Treasuries on such a large scale? One reason is that these countries that hold US Treasuries can reduce the value of their own currencies, such as China.
For these economies, lowering the value of their currencies makes it easier to export goods and services to the US. This is like a “buy one get one free” sale in a supermarket. Under normal circumstances, there are many things on the market that you might not buy, because they are too expensive. But when you come across these items buy one get one free, it’s easy to make a buying decision, because you only have to pay half the usual price for them.
The same is true when you choose imported or domestically produced goods. Most Americans prefer to buy goods that are made in the USA. But when goods from Asia or whatever are only 1/2, 1/3, or even 1/4 the price of goods made in the USA, then it is usually our wallets that end up making the buying decision.
One reason why Asian goods are so cheap is that there is a large amount of cheap labour available in many Asian countries. Another reason is that many Asian governments have artificially depressed the value of their currencies in order to promote the export of Asian products. If you can get 20 yuan for a dollar, you will be able to buy more Chinese products than if you could only get 10 yuan for a dollar.
One of the means these governments can artificially depress the value of their currencies is through the purchase of U.S. Treasuries. This goes back to the subject of supply and demand. When a foreign government wants to buy US Treasuries, it must first convert its own currency into US dollars, because to buy US Treasuries it must use US dollars. This act increases the supply of domestic currency while also increasing the demand for dollars.
When the supply of the national currency increases, it depreciates, while when the demand for dollars increases, the dollar appreciates. With the value of both currencies changing, one depreciating and one appreciating, these foreign governments are able to keep the value of their currency low.
While many governments do or have done this, it is difficult to maintain over the long term, especially when they are operating in a rapidly changing global market like the forex market. Back then Soros with other speculators attacked the pound, causing it to depreciate significantly, which is a very good example.
Foreign governments also hold large reserves of US dollars, as many of the world’s commodities are denominated and traded in US dollars. The most important of these commodities are crude oil. Crude oil is all priced and sold in US dollars. This means that any country that does not have the US dollar as its currency and wants to buy crude oil must convert its own currency into US dollars. When the dollar is devalued, it is a boon for these countries.
However, when the dollar appreciates, these countries will have to pay more than usual to buy the same amount of crude oil. The assumption is that 1 euro is equal to 1.20 dollars and the price of crude oil is 60 dollars per barrel. This means that it costs 50 euros to buy a barrel of crude oil.
60 USD/barrel ÷ 1.20 USD/euro = 50 EUR/barrel
Now assume that the dollar strengthens and that 1 euro can only be exchanged for 1 dollar, while the price of oil remains the same at 60 dollars per barrel. If you do a little math you will see that although crude oil is still worth that many dollars, it is worth more euros. To buy a barrel of crude oil costs 60 euros instead of 50 euros now.
60 USD/barrel ÷ 1.00 USD/€ = 60 EUR/barrel
So while the price of crude oil stays the same, any country using the Euro will have to pay 20% more than usual to buy the same amount of crude oil. This really counts as a spike, and it could easily happen.
In the forex market, it is very easy for a change of this magnitude to occur. So to avoid encountering this risk, these countries hold large amounts of dollar assets as foreign exchange reserves, a large part of which are US Treasuries. No matter how much the dollar appreciates or depreciates, the dollar-denominated foreign exchange reserves held by foreign investors remain constant relative to the value of the dollar.
Risks of holding U.S. Treasury securities by foreign governments
Foreign governments hold U.S. Treasuries for many reasons. As long as these reasons continue to exist, these governments will continue to buy US Treasuries and the US government will be able to continue its practice of financing itself with debt. But if circumstances change and foreign governments no longer need to hold such large reserves of dollar-denominated assets, the US government could face credit crunch pressures.
Suppose that one day these countries, intent on devaluing their currencies, decided to change their monetary policies and allow their currencies to float freely. While this would be beneficial to US producers, it would mean that foreign governments would no longer need to buy so many US Treasuries. But it is a big blow to the US government.
If the government cannot sell government bonds to any individual or institution, there is no way to finance government projects unless tax rates are raised, which is never a good solution. But attracting more investors in US Treasuries by raising interest rates is likewise not a good solution.
All investors want to take the least amount of risk for the greatest amount of return. Therefore, we examine each investment opportunity on a case-by-case basis to determine which one will give us the highest return. No one will buy a new issue of US Treasuries if they are not as attractive as other investments.
To solve this problem and make US Treasuries more attractive to foreign governments and other investors, the US government raises the interest rate on Treasuries, thereby increasing the return to investors. While this is an effective way to attract new investors, raising interest rates also slows down economic growth because it is more expensive to finance. We all like earning interest and we all hate paying it.
