A HERETIC I AM's Journal
I hope i can answer the basic question you are looking for. If what i have written below does not do that, please let me know and i will try and expand later. If any economists read anything that i get wrong, please correct me. The following is, I admit, a very simplistic explanation but i think it is accurate.
From what i gather reading the two articles linked, China is simply trying to diversify it's debt holdings and it's cash reserves. These are two different things but i want to concentrate on the question of the 1.5 Trillion Yuan denominated Bond issuance;
Consider this scenario:
You own a company and on your books in the assets column are millions in Swiss Francs (SF). Why would you have SF's? Your company makes things that are highly valued by the Swiss watch and cheese making industries and by the people of Switzerland in general. When they buy your products, they pay you in their currency, either by sending you a check drawn on their bank or by literally sending you a shoe box full of SF's. Since you are American, you can't really buy anything at your local store or from your suppliers with SF's and you need to switch them to dollars. But if you sold something worth ten dollars and on tuesday you received 10 dollars worth of SF's, by Wednesday the value of the SF's could have gone down. You want, need and deserve the $10 so you wait until the currency exchange rate comes back up. On Thursday it does, so you go to the bank with your SF's and ask for US$. All is well.
What happens if business is so good that you are sending entire container ships of your products to Switzerland every week? Now you have so many SF's that even the slightest change in the value of an SF - even on the scale of 100th's of a percentage point - could mean millions of dollars difference. One way to alleviate this problem would be to spread out those exchanges over time so that if you exchanged some at a lower rate and some at a higher rate, it would all even out and you would still get your moneys worth. But that idea has drawbacks because you are sitting on a large chunk of money that is not doing anything for you. Here's an idea; Loan the money back to the Government of Switzerland so they can buy new uniforms for the Swiss Guards that look after Vatican City. Oh...and a new section of Railway. And a State owned tourist attraction needs a new coat of paint (You get the idea). The Swiss government takes your money and promises to pay it back over the course of a decade or two PLUS INTEREST. You just purchased Swiss Government Treasury Bonds. Now, not only is your money working to make more money, the stream of payments are guaranteed by the Oh-so honest Swiss! You can make the exchanges over time and average them out so you get closer to the real value of the goods you sold in the first place.
2 years go by. The Swiss have been making regular interest payments to you, you have been converting the payment into dollars and everyone is happy. But your company is wildly successful and you are sending 5 container loads of stuff to them every week. You have taken all those SF's and bought even more Swiss Treasury Bonds. You are up to HERE with Swiss bonds now. What happens if Switzerland has 5 warm winters in a row and no one goes there to ski? Or all of the talented watchmakers and cheese makers retire? Or the Vatican decides the Italians can guard them just fine and there are no more new uniforms to purchase?
You realize you are holding too many Swiss bonds and you need to diversify. So you decide to turn the stream of payments you are receiving from the Swiss into a bond issue of your own. Except now you are going to denominate your bonds in US $ and demand that they be bought from you in US $.
Here's the problem: You don't actually have the SF's in the bank anymore (or in the shoe box). What you have is a stack of papers printed with nice gilded edges that say the Swiss Government is going to pay you back over time with interest. Now everyone around you agrees the Swiss are great people, they're honest and hardworking and they make a great cheese. No one doubts you are going to get your money from them. But by issuing this bond offering, what you really want is your money NOW. How do you get it?
Bankers from NY, London, Berlin, Hong Kong, Singapore and other major financial centers realize that they can give you the money (underwrite your bond issue), sell the bonds on the open market and begin receiving payments FROM YOU. The money you are going to pay is money you are getting from the Swiss every day. But now, instead of having either a shoe box full of SF's or a locker full of papers with gilded edges, you have a HUGE PILE OF US DOLLARS!
That is in effect what the Chinese are trying to do. They want to convert the stream of payments they are getting from the US Treasury into Yuans.
The problem is that the Yuan has been artificially propped up by the Chinese government for years and is not traded on the international currency exchanges with the reliability that other major currencies trade. Any bond issue by them must be underwritten by banks, be they central banks of countries or the major commercial and merchant banks of the world. Those banks will want and are entitled to an expectation that the Chinese are reliable. That they will do what they say they will do and that they will pay the interest on time and in full. That is in essence, the "Risk" part of all this. What is the likelihood the Chinese will default? What if they don't make regular payments? No one can go knock on the door of the Chinese Parliament and demand their money back. The Chinese have an ARMY for cryin out loud! There is a way the banks can diversify all that risk by using derivatives. (That's another essay! See link below) The articles mention that the bond issue will have to be drawn out over 3 years or so in order to make sure the underwriting banks don't have to go and borrow themselves in order to buy and issue the bonds. That is the "liquidity" problem. How much actual cash do these underwriters have on hand? Quite frankly, $200 Billion is a drop in the bucket of international finance but it is still a huge chunk of change.
I hope this was of some use. The concept of "derivatives" is an interesting one and i found this web page that explains the concept for you; http://www.investinginbonds.com/learnmore....
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