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Suppose hypothetically... you're a country. Not just any country, but a country that has some serious clout these days. Perhaps, oh, I don't know, maybe your name is... um say, oh, how about China. This is totally and completely hypothetical, of course. Now, let's say, you've had a trade agreement with another country, and we'll just call that country the United States, and that trade agreement involved two key elements. First, there is a set currency rate. The second key element to the agreement is that you use any reserves to buy up trade partners' debt.

So, we have China who's agreed to a set currency rate way below market value, which pretty much guarantees that the United States will be buying just about everything that they make. In exchange for the cheap currency and the title of "America's personal manufacturers", you agree to take all the excess reserves and loan it right back to the United States.

Who wins, and who loses?

Nobody, really. The Chinese get a serious injection of demand for their products. Americans get to buy the cheapest stuff on the planet, thereby satiating their appetite for consumption of anything and everything at all times. No one loses.

Ahh, but what if you are China, and you've been dumped with so much currency that you no longer no what to do with it? You diversify. We heard that just a couple of weeks ago. But, the original agreement never had any clause for diversification. If China diversifies, doesn't that also mean that would have to revalue? If they just took said dollar accumulation, and turned right around and bought pound sterling, that goes against the agreement.

I wouldn't be surprised that if China goes ahead and starts to diversify as they have mentioned, there would be some serious backlash coming out of Washington. I'm not talking about the cheap lip service we've heard so far. I'm talking about serious consideration of trade barriers. That of course may prompt China to rethink its desire to break the original agreement.

Source: Will the U.S.-China Trade/Currency Deal Adjust?