There's Only One Chinese Bubble: Currency Reserves

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Photo Credit: AP

While real estate prices and a surging stock market steal headlines, a vicious bubble in China is coming out of the woodwork.  It isn't energy, and real estate is semi-debatable, but this bubble is certain: China's money stocks are exploding.

A Mass of Cash

While governments in the West were busy spending themselves into oblivion, China's state owned banks and sovereign wealth funds have been happy to finance the West’s out-of-control spending habits.  Their vast lending efforts have won over both financial and political supremacy, and now China has the ability to buy off entire countries with the stroke of a pen and delivery of treasuries.

However, these growing money stocks aren't always positive economically.  China is now so heavily invested in US Treasuries that the country couldn't realistically sell without discounting the debt into the ground.

Bleeding Cash

However, holding large foreign currency reserves presents a problem: each time a purchase transaction is made, China floods the economy with its own currency.  This increases the risks that an over-heating economy will plague China's future economic prospects.

Generally, central banks and sovereign wealth funds look to sell bonds to soak up liquidity from the marketplace and cool economies, and they buy bonds to provide excess capital to the markets.  China's now facing a liquidity problem of its own kind: there's simply too much!

The Cash Bubble Will Pop

China's cash bubble will eventually pop.  As China accrues more and more foreign IOUs, it has to bid prices lower and lower, ultimately bidding down its own returns.  In many cases, the treasury auctions’ largest bidder is China, beating out many institutions and professional bond managers for the claim to a nation's debt.

Eventually, China will have to address its deflated currency prices and its inability to create any substantial profit on its foreign holdings.  Or even better, China may realize its best investment is in itself – in health care, real infrastructure development and educating a heavily uneducated populace.  When that time comes and China needs cash, few nations, institutions and central banks will be able to provide the liquidity.

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