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China and Germany: The Perils of Vendor Financing

by John Rubino on February 26, 2010

In response to Why Would Anyone Buy a Spanish Bond?, reader RAID 3000 pointed out that the U.S. has far more serious problems than Europe (no argument there!) and included a link to LEAP2020, a European site doing great work on this subject. One of its articles contained the following chart:

This got me to wondering if it would be possible to construct a similar chart for China and its main trading partners. (The U.S. would dominate that one.) From there it occurred to me that China and Germany are in more or less the same boat due to their practice of vendor financing. They’ve gone about it differently but the effect has been the same. Consider:

China lends money directly to the U.S. by using the dollars it receives from us to buy Treasury paper. This lowers U.S. interest rates and supports the dollar, which allows us to continue to buy Chinese stuff.

Germany, on the other hand, has lent its credit rating to the whole Euro Zone, allowing countries like Greece and Spain to borrow more and at lower rates than they could have otherwise. The borrowers use some of this money to buy cars, pharmaceuticals, and solar panels from Germany.

Now both China and Germany have discovered that their surpluses were based in part on bad loans to weak borrowers, and that some of the assets they thought they owned are 1) not really theirs or 2) worth way less than face value.

China has a lot of dollars, but can’t unload them without destroying the value of the dollars it retains. It’s trying to move out slowly, scaling back its purchases of U.S. debt and buying gold and oil resources, but it has to walk a fine line because spooking the markets would defeat its purpose. So it’s stuck with big dollar balances for the foreseeable future, while the U.S. is actively destroying the currency’s value.

Germany doesn’t own a lot of Spanish or Greek assets, but is now on the hook for what might end up being hundreds of billions of euros of PIIGS country debt. Which is to say it has to eat some of the loans it made during its vendor financing days.

Either way, those surpluses — and the balance sheets built on them — have turned out to be, in part, illusory.

Tagged as: Dollar, euro

{ 15 comments… read them below or add one }

Jim February 26, 2010 at 2:14 pm: Are you saying that the Chinese or German manufacturers buy US and Euro country debt with their profits? Is that what the phrase “the Chinese have bought a lot of US Treasury bonds” means?
John Rubino February 26, 2010 at 3:15 pm: Jim

Almost. When a Chinese company sells, say, a computer to an American customer, its receives dollars. It can’t spend dollars in China, so it goes to the government or a bank and exchanges the dollars for yuan, which it uses to pay its suppliers and workers. The government ends up with the dollars, and invests them in U.S. Treasuries, in effect lending the money back to us. Put another way, China finances our deficit with the money we print to buy their stuff.
Doug February 26, 2010 at 11:23 pm: It seems like creditor nations should be headed for a deflationary bust as their debtors stop buying stuff from them. At the same time, debtor nations will be cranking up the printing presses and suffering through high inflation. I wonder what will happen in Europe where the euro will force debtors and creditors to have the same currency fate.
Jim February 27, 2010 at 5:55 am: John Rubino,

Thanks for your answer. But, how does the Chinese government “end up with the dollars”? Wouldn’t a Chinese manufacturer have a bank account in the US that receives the American purchasing dollars, and wouldn’t that bank convert some of that money to Yuan so the company can pay its expenses? Are you saying what’s left over would be used to buy Treasuries as an investment for the company? If so, I don’t see how or why the Chinese government would be involved.
John Rubino February 27, 2010 at 8:02 am: Jim,

A US bank still has to get yuan from China in order to exchange them for dollars. So eventually the dollars we spend on Chinese stuff find their way back to China.
khl February 27, 2010 at 10:34 am: There’s one key step that is missing from the process of the China-US trade/currency exchange scheme. And I use the word scheme because that is exactly what it is. When a Chinese company sells stuff to the US, they get dollars back. Some of these dollars wind up in secret accounts wherever, so that the Chinese vendor has an insurance policy, so if there’s a shtf moment in the People’s Paradise, they can make a hasty exit and live happily ever after. However, the bulk of these dollars are exchanged for yuan at local banks. The local banks give the vendor yuan from their existing stockpile. The bank then takes those dollars and exchanges them for yuan at the Central Bank of China. But the CBOC doesn’t take existing yuan from its existing stockpile. Rather, they print up fresh new yuan and in this manner they maintain the value of the yuan vis-a-vis the dollar. Previously, when the bank got its newly minted yuan, they were required to buy Chinese Government Bonds with the proceeds. This is the process known as sterilization, whereby the newly minted yuan don’t find their way into the Chinese money supply. Its also a form of de facto competitive devaluation because if existing yuan were used for the exchange, and the supply wasn’t inflated, the yuan would rapidly strengthen against the dollar and the sale of goods to the US would eventually diminish, due to the rising price of Chinese goods.

However, about one year ago, the Chicom government stopped mandating sterilization of newly minted yuan. The banks were then free to invest the formerly sterilized yuan. This led to a rapid expansion of loans which we now see the Chicom government attempting to stop. This will lead to hyper-inflation in China.

The question is what will the Chinese government do stop it? Raising rates to cut down inflation will result in a rapidly appreciating yuan which will lead to exports decreasing even more. This will lead to immense pressure being put on the Chinese to float the yuan and make it fully convertible. What happens next is anyone’s guess, but one thing for certain, it won’t be pretty.
Bill Jones February 27, 2010 at 12:26 pm: It’s interesting to see the difference between the priorities of the Chinese and U.S. governments.
China is using the excess dollars it has to buy the natural resources it needs and will need material goods.
The US is borrowing from China to spend dollars it doesn’t have to bail out the bankers who produce nothing.
T-Dog February 27, 2010 at 3:38 pm: Please comment on what DOUG has written. I agree with him and would like to know your opinion.
Brad Thrasher February 27, 2010 at 4:05 pm: Hey Kids,

Quit getting your panties in a knot about the imminent collapse of the USA. Are we in a major depression? Yes, absolutely. Will it get worse before it gets better? Again, of this there should be no doubt.

Better and worse are terms of art, not science. Economics is an art, not a science.

For all your fears about money, you’re sweating the unreal or virtual. Money is a virtual and transitory representation of value. It shouldn’t be confused be anything that is real. Like oil.

So what if China divests itself of US debt instruments? Recently, our Fed raised an obscure interest rate half a point in response. Oil shot up 8 bucks or 11%.

Which of the major world economies are most dependent upon oil for their bread and butter? The manufacturing/exporting vendor financing nations or the service/importing near deadbeat nations?

Frankly the China fear consuming Americans must be incredibly insulting to the Chinese. Unless of course, they really are as stupid as most of you are making them out to be.

Yeah, yeah lets get a worry on because the Chinese are buying up the world’s raw materials, including and especially oil. So where are they shopping? Siberia and in the deep ocean off the coasts of Brazil and Cuba. In other words, the most expensive places in the world to shop for oil.

Take the blinders off kids and start looking at this for the asymmetrical geo-political chess game it truly is. And for all of you believing the USA is doomed, remember terms of art are relative.

Still not convinced? I offer you Winston Churchill, “You can always trust the Americans to do the right thing, after they’ve tried all the wrong things first.”
John Rubino February 27, 2010 at 4:24 pm: To Brad and T-Dog

Brad:
Sure, economics is an art not a science. But if you have wealth at risk you still have to try to figure out what’s most likely to happen and invest accordingly. And money isn’t an illusion. When it’s functioning correctly it’s a store of value, the place you park your (real) wealth until you’re ready to spend it. So a gold bar, which functions as money, is just as real as a barrel of oil, which functions as fuel. Both functions are crucial to a modern society.

Churchill was probably right, which means we have a lot of mistakes to look forward to, many of which will scare the hell out of traditional investors.

T-Dog:
Doug is right about the initial effects of the crisis, inflationary for us, deflationary for our trading partners. But further out it all kind of blurs together. The creditor nations have foreign currency reserves that they can spend to cushion the effects of lower sales to the U.S. And they have printing presses which they’ll crank up if their reserves don’t save them. So eventually you end up with a world where everybody who can inflate is inflating.

Because all the countries in the euro zone have to live with a single exchange rate the strong ones are okay and the weak ones can’t compete. Just like the U.S. where well-run states are in okay shape and badly-run states are a mess. In both cases the only (politically palatable) solution will be bail-outs and money printing.

But we’ve never been here before (where everyone has both massive debt and a printing press) so it’s not clear which force wins out in the end: the debt implosion or unlimited money printing. I’m betting on both by shorting stocks and Treasuries and going long gold. At least one of those should work out.
Brad Thrasher February 27, 2010 at 11:10 pm: “If you have wealth at risk” is certainly the operative phrase Mr. Rubino.

According to the CNBC show, High Net Worth, if your assets aren’t $30 million more than your liabilities, you aren’t rich. In other words, the vast majority of us have no business accepting any risk. First and foremost, risk begins the moment you trust anyone with your money.

But in answer to your caveat, no I don’t believe I am at risk now or in the foreseeable future. Not because I don’t have anything. The modest amount we do have is right where I put it 8 years ago, in 1 troy oz. Maple Leaf gold coins. Back when the USD bought $1.37 CDN and gold was $350.00 a troy ounce

But I’m not absent compassion for those who thought they were very smart and rich. I’m just a lowly law clerk with a passion for economic bias in the system.
Brad Thrasher February 27, 2010 at 11:24 pm: Sorry but forgot one thing, Mr. Rubino. I never posted “money is an illusion.” You infer what was never implied. I posted, “Money is a virtual and transitory representation of value. It shouldn’t be confused with anything that is real. [sic]”

Real it is not. Virtual and transitory it is. Huge difference.
real_econ February 28, 2010 at 11:57 am: John,
What’s your take on fofoa.blogspot.com’s latest article: Greece Is The World? Specificaly about half way through it when he talks about the ECB nuclear option. Personaly, I think he’s got it figured out;-)
John Rubino February 28, 2010 at 3:55 pm: real_econ

FOFOA is one of the best blogs out there. I usually have to read their longer posts a couple of times to fully understand the argument. This is one of those. The “nuclear option” in this case is Europe letting gold float according to physical (as opposed to paper) market demand, and then revaluing national reserves based on the new higher price.

Gold will probably be priced this way eventually, but I’m not sure I agree with FOFOA that it works to the advantage of the PIIGS countries long-term. If it allows them to avoid getting their public finances in order, it would just delay their bankruptcy. There’s no substitute for a balanced budget!
Brad Thrasher February 28, 2010 at 9:34 pm: real_econ, thank you so much for making reference to FOFOA. I just read Greece is the Word and all I can say, Wow, somebody else gets it and ‘splains it better than I do.”

Mr. Rubino, you are quite correct, “There’s no substitute for a balanced budget.” If I get FOFOA, I read it once, the move from paper sensitive debt instruments into freegold will force balanced budgets as savers/investors won’t look to debt instruments as a safe haven for our savings.

econ_real, thank you again. Mr. Rubino thank you for providing the venue.

Anyway I see there’s a lot more brain candy at FOFOA so will catch up with my fellow travellers here later. Thanks again.