The Chinese Liquidity Mechanism

In terms of how much liquidity a foreign country injects into the world financial system, countries can be classified using two characteristics: their current account balance and the level to which they manipulate their currency. In trade, a country may either be a net exporter or a net importer. Most countries fall into the exporter category. None more so than China, which maintains a growing trade surplus with the US. As for currency, a more continuous scale can be used: active manipulators on one end and completely unregulated currencies on the other with shades of gray in between. China falls at the extreme end of the manipulation spectrum; they actively manipulate their currency to remain cheap against other currencies like the dollar. China's intention is to remain competitive in export markets by keeping export prices low in terms of dollars. That way more of you will go to target or wal-mart and send your levered cash to chinese exporting firms.

The american consumer sends a constant and growing flow of dollars to firms in china. when the dollars reach the chinese banking system, the domestic banks sell their dollars deposited by the exporters in exchange for yuan on the open market. If unchecked, this exerts a marginal downward pressure on the value of the dollar and a corresponding upward pressure on the value of the yuan. This increases the export price of chinese goods in dollars and makes them more expensive for you to buy at retailers state-side.

The chinese central government wants to avoid such an outcome. They counteract the effect of the domestic banks' currency conversions by entering offsetting positions in the market: printing new yuan and selling them for dollars on the open market. This exerts a marginal upward pressure on the dollar, making both the yuan cheaper and chinese export goods to america. This keeps americans buying cheap chinese shit.

This amounts to money creation on a massive scale. Chinese export firms are awash in yuan that they converted from the dollar profits on exports. Chinese banks get yuan deposits and make domestic loans to chinese firms in yuan. The government prints yuan in order to sell them for dollars. This has the effect of injecting yuan into the world markets, but since the majority of yuan are employed in china, the printing presses increase domestic chinese liquidity even further. The dollars that the central government acquires are then reinvested in dollar denominated assets like US government debt, US corporate debt, US agency debt, oil, gold, corn, soybeans... you get the idea.

Since china actively manipulates its currency, it injects far more liquidity into the world system than a country that allows their currency to appreciate as the result of a prolonged trade surplus. This liquidity has decreased worldwide interest rates, increased the ability of banks to lend in the form of mortgages, car loans, credit card loans and so forth and contributed to the preceding boom we had from 2003-2007.