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I’ve written numerous times about the widespread (nearly universal) misconception that China’s $3.2 trillion in foreign currency reserves are a pile of cash which the Chinese government “owns” and simply throw at any problem it sees fit (to bail out banks, for example, or provide domestic social benefits). An op-ed that appeared in Friday’s New York Times illustrates this error in a new and somewhat fantastic way. The author’s main argument is this:

[President Obama] should enter into closed-door negotiations with Chinese leaders to write off the $1.14 trillion of American debt currently held by China in exchange for a deal to end American military assistance and arms sales to Taiwan and terminate the current United States-Taiwan defense arrangement by 2015.

Mainland China reabsorbing Taiwan, the author argues, is inevitable and does not pose any fundamental strategic threat to the United States; the unsustainable growth of America’s public debt, however, poses a serious threat to the country’s future. By trading debt forgiveness for Taiwan, Beijing achieves its most critical geopolitical objective, and the U.S. wins back its financial independence. It’s a win-win exchange: a modern-day versions of the Louisiana Purchase.

Let’s set aside the question — sure to attract the most attention — about the merits or demerits of the U.S. putting its alliance commitments up for sale (how much could we get from the Russians for NATO, I wonder?). I want to focus purely on the practical financial aspect of the proposed transaction, which sounds so enticingly simple: we agree not to defend Taiwan, they give us back our Treasury bonds.

The vast majority of China’s foreign exchange reserves are owned by its central bank, the People’s Bank of China (PBOC). When Chinese exporters earned foreign currency, or foreign companies brought their home currency to invest in China, the PBOC bought that currency from their banks, and issued Renminbi in exchange (by crediting those banks’ reserve deposits with the PBOC). In effect, it exchanges a claim on foreign assets for a claim on the PBOC. Some of those claims end up circulating in the Chinese economy as interest-free cash, but the PBOC must pay interest on banks’ RMB reserve deposits, and on RMB bonds it issues to manage the money supply. The PBOC then invests the foreign currency it bought into U.S. Treasury bonds and similar interest-bearing securities, in order to cover this “carrying cost.”

The critical point is, the $3.2 trillion FX reserves held by the PBOC (in the form of Treasuries, etc.) represent money that is already in the Chinese economy, in the form of yuan. There are already domestic claims on those assets; they cannot be “given away” or spent by the PBOC without receiving other assets of equivalent value in return, or incurring a loss that would have to be plugged by Chinese government’s own fiscal resources (taxes or government borrowing).

A Chinese decision to ”forgive” the U.S. Treasuries it holds as part of its FX reserves, in exchange for the U.S. abandoning its defense commitments to Taiwan, would render the PBOC hopelessly bankrupt. The central bank would lose RMB 7.2 trillion worth of assets, against only RMB 22 billion in capital, leaving a massive hole in its balance sheet. That, in turn, would hopelessly bankrupt the entire Chinese banking system, wiping out nearly half of the RMB 16 trillion cash reserve deposits they hold at the central bank (which are essentially claims on its FX reserve assets), against just RMB 2.8 trillion in paid-in capital standing behind the entire system.

The only way to avoid such a cataclysm would be for the Chinese government to write a fiscal check for RMB 7.2 trillion (the entire $1.14 trillion price of the transaction) to make them all whole, which would have to be funded by tax revenue or government borrowing. (That, by the way, is exactly how the U.S. government paid for the Lousiana Purchase. The British investment bank Barings syndicated a loan to European investors). The total bill would be roughly equivalent to China’s entire government revenue and expenditure, central and local, in 2010 and would single-handedly boost the country’s debt-to-GDP ratio by nearly 20%.

But wait a minute, some would argue, China is getting something in return: Taiwan. Maybe the PBOC could put Taiwan on its balance sheet, and even come out ahead! But let’s remember, Taiwan — its land, its housing, and its factories and other productive assets, much less its people — doesn’t belong to the U.S. to give. The U.S. wouldn’t be giving China, or the PBOC, any tangible assets. It would be giving a promise not to interfere with China’s own efforts (the outcome of which would still be uncertain) to exert control over Taiwan. That promise might have intangible political value to China, but it’s hardly the kind of thing you can put on a bank’s balance sheet.

Perhaps a very creative accountant might record it as “goodwill,” a huge intangible asset offsetting the PBOC’s domestic liabilities. If so, it would take the concept of “fiat currency” to an entirely new level. Conventional fiat currencies, like the dollar, the euro, or the yen, may not be back by gold or silver, but they usually are backed by central bank holdings of sovereign bonds or other securities that represent a claim on tax or other revenues, and presumably therefore a claim on real goods and services in that economy. For the PBOC to fill the hole on its balance sheet with some kind of political permission slip to subjugate Taiwan — a far-fetched idea at best — would be equivalent to the Fed printing money backed by the U.N. resolution for a “no fly” zone over Libya. How, exactly, does one value or monetize such an ”asset”?

I’ve stretched this story to an implausible breaking point in order to make a point: there is no way that China could “forgive” its holdings of U.S. debt in exchange for an American policy commitment on Taiwan without bankrupting its entire financial system, unless it made good the loss by heavily taxing or borrowing from its own people. To put it mildly, such a transaction – while theoretically possible — would be in no way as “simple,” or as obviously beneficial, as its proponent implies.

The author readily acknowledges that such an unconventional idea will attract critics:

Critics will call this proposal impractical, even absurd. They will say it doesn’t have a prayer of passing Congress, and doesn’t acknowledge political realities. They might be right — today.

They’ll be right tomorrow, too. The real reason the proposal is absurd isn’t politics. It is because it fails to understand either what the Americans are potentially selling, or what the Chinese have to buy it with. China’s central bank can’t part with any sizeable part of its foreign currency reserves without receiving an asset of equal or greater value in return. The United States wouldn’t be offering China any assets, just a promise that has no clear meaning in any financial sense. The result — if anyone actually tried to execute such a deal — wouldn’t just be bad foreign policy for the U.S. (explicitly selling out a long-time security partner for cold hard cash?), it would spell financial and economic catastrophe for China.

Given the politically controversial nature of this particular proposal, it probably won’t go very far. Unfortunately, the muddled thinking about China’s foreign currency reserves, what they are and what they are good for, are almost certain to go on confusing policymakers on both sides of the US-China relationship.

Source: Should We Sell Taiwan In Exchange For China's Debt Forgiveness?