China is a banker over a barrel

1. money can't flow freely in and out; and
2. China's central bank - the People's Bank - must buy dollars from whoever wants to sell.

Say the Chinese government gives 100 billion in dollars to the Ministry of Education to improve schools, and the Ministry sends that money out to the provinces. Schools can't use dollars to pay teachers or construction workers because those people use yuan to buy food, clothes, and so on. Individuals can't even, by law, send dollars to another country.

Whoever ends up with the dollars will want yuan. Who gives them the yuan? You got it: the People's Bank, which buys back the dollars it just gave away. The People's Bank must, by law, buy all dollars it is offered. So nearly all dollars end up right back where they started. Nobody seems to quite believe this, especially inside China. Poor Yi Gang, People's Bank deputy governor, has to repeat every month that reserves must "unavoidably" or "inevitably" be invested outside the PRC.

Now, "outside the PRC." still seems to leave Beijing a lot of investment options. Here's where the sheer amount of dollars comes in: it's very hard to find places to invest all that money. For example, China has already bought more oil than it can store and there's not enough gold available on the planet to buy with just a year's worth of China's trade surplus.

Chinese state firms are working hard to invest overseas, but this isn't nearly enough either. Excluding bonds, China's "outward" investment soared 64 per cent last year. But, that was still less than half of "inward" investment. Beijing just can't keep up. Countries including the US are keen for China's dollars, but only on very narrow terms: they seek very large sums for small stakes in troubled companies. But those same countries basically forbid the PRC from buying the colossal amounts of stock or property it could afford to buy.

The only market open to the PRC and big enough to absorb its dollars is our American bond market. That's why China has at least $1.1 trillion, and maybe as much as $1.7 trillion, already invested in American bonds. That's why China moved $200 billion into US Treasury bonds last year, even though the interest rate was dropping like a stone. Beijing knows it has no real choice, even if it's very useful to pretend it is America which has no choice.

One last thing: while the US has the stronger hand, we're using it to slap ourselves. China is about to get much less important as a buyer of our bonds. The amount they buy is tied tight to their trade surplus with us, which isn't going to soar this year and may drop. Meanwhile, the amount we are going to borrow (from everyone) is going to soar, so President Obama and Congress can have their $1.75 trillion deficit. While we're patting ourselves on the back that Chinese bond purchases don't mean much, we should remember that selling all these bonds to anyone is a sign the US is in trouble.