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Should We Sell Taiwan?

November 11, 2011

I’ve written numerous times about the widespread (nearly universal) misconception that China’s $3.2 trillion in foreign currency reserves are a pile of cash which the Chinese government “owns” and simply throw at any problem it sees fit (to bail out banks, for example, or provide domestic social benefits).  An op-ed that appeared in today’s New York Times illustrates this error in a new and somewhat fantastic way.  The author’s main argument is this:

[President Obama] should enter into closed-door negotiations with Chinese leaders to write off the $1.14 trillion of American debt currently held by China in exchange for a deal to end American military assistance and arms sales to Taiwan and terminate the current United States-Taiwan defense arrangement by 2015.

Mainland China reabsorbing Taiwan, the author argues, is inevitable and does not pose any fundamental strategic threat to the United States; the unsustainable growth of America’s public debt, however, poses a serious threat to the country’s future.  By trading debt forgiveness for Taiwan, Beijing achieves its most critical geopolitical objective, and the U.S. wins back its financial independence.  It’s a win-win exchange:  a modern-day versions of the Louisiana Purchase.

Let’s set aside the question — sure to attract the most attention — about the merits or demerits of the U.S. putting its alliance commitments up for sale (how much could get from the Russians for NATO, I wonder?).  I want to focus purely on the practical financial aspect of the proposed transaction, which sounds so enticingly simple:  we agree not to defend Taiwan, they give us back our Treasury bonds.

The vast majority of China’s foreign exchange reserves are owned by its central bank, the People’s Bank of China (PBOC).  When Chinese exporters earned foreign currency, or foreign companies brought their home currency to invest in China, the PBOC bought that currency from their banks, and issued Renminbi in exchange (by crediting those banks’ reserve deposits with the PBOC).  In effect, it exchanges a claim on foreign assets for a claim on the PBOC.  Some of those claims end up circulating in the Chinese economy as interest-free cash, but the PBOC must pay interest on banks’ RMB reserve deposits, and on RMB bonds it issues to manage the money supply.  The PBOC then invests the foreign currency it bought into U.S. Treasury bonds and similar interest-bearing securities, in order to cover this “carrying cost.”

The critical point is, the $3.2 trillion FX reserves held by the PBOC (in the form of Treasuries, etc.)  represent money that is already in the Chinese economy, in the form of yuan.  There are already domestic claims on those assets; they cannot be “given away” or spent by the PBOC without receiving other assets of equivalent value in return, or incurring a loss that would have to be plugged by Chinese government’s own fiscal resources (taxes or government borrowing).

A Chinese decision to “forgive” the U.S. Treasuries it holds as part of its FX reserves, in exchange for the U.S. abandoning its defense commitments to Taiwan, would render the PBOC hopelessly bankrupt.  The central bank would lose RMB 7.2 trillion worth of assets, against only RMB 22 billion in capital, leaving a massive hole in its balance sheet.  That, in turn, would hopelessly bankrupt the entire Chinese banking system, wiping out nearly half of the RMB 16 trillion cash reserve deposits they hold at the central bank (which are essentially claims on its FX reserve assets), against just RMB 2.8 trillion in paid-in capital standing behind the entire system. 

The only way to avoid such a cataclysm would be for the Chinese government to write a fiscal check for RMB 7.2 trillion (the entire $1.14 trillion price of the transaction) to make them all whole, which would have to be funded by tax revenue or government borrowing.  (That, by the way, is exactly how the U.S. government paid for the Lousiana Purchase.  The British investment bank Barings syndicated a loan to European investors).  The total bill would be roughly equivalent to China’s entire government revenue and expenditure, central and local, in 2010 and would single-handedly boost the country’s debt-to-GDP ratio by nearly 20%. 

But wait a minute, some would argue, China is getting something in return:  Taiwan.  Maybe the PBOC could put Taiwan on its balance sheet, and even come out ahead!  But let’s remember, Taiwan — its land, its housing, and its factories and other productive assets, much less its people — doesn’t belong to the U.S. to give.  The U.S. wouldn’t be giving China, or the PBOC, any tangible assets.  It would be giving a promise not to interfere with China’s own efforts (the outcome of which would still be uncertain) to exert control over Taiwan.  That promise might have intangible political value to China, but it’s hardly the kind of thing you can put on a bank’s balance sheet.  

Perhaps a very creative accountant might record it as “goodwill,” a huge intangible asset offsetting the PBOC’s domestic liabilities.  If so, it would take the concept of “fiat currency” to an entirely new level.  Conventional fiat currencies, like the dollar, the euro, or the yen, may not be back by gold or silver, but they usually are backed by central bank holdings of sovereign bonds or other securities that represent a claim on tax or other revenues, and presumably therefore a claim on real goods and services in that economy.  For the PBOC to fill the hole on its balance sheet with some kind of political permission slip to subjugate Taiwan — a far-fetched idea at best — would be equivalent to the Fed printing money backed by the U.N. resolution for a “no fly” zone over Libya.  How, exactly, does one value or monetize such an “asset”?

I’ve stretched this story to an implausible breaking point in order to make a point:  there is no way that China could “forgive” its holdings of U.S. debt in exchange for an American policy commitment on Taiwan without bankrupting its entire financial system, unless it made good the loss by heavily taxing or borrowing from its own people.  To put it mildly, such a transaction — while theoretically possible — would be in no way as “simple,” or as obviously beneficial, as its proponent implies.

The author readily acknowledges that such an unconventional idea will attract critics:

Critics will call this proposal impractical, even absurd. They will say it doesn’t have a prayer of passing Congress, and doesn’t acknowledge political realities. They might be right — today.

They’ll be right tomorrow, too.  The real reason the proposal is absurd isn’t politics.  It is because it fails to understand either what the Americans are potentially selling, or what the Chinese have to buy it with.  China’s central bank can’t part with any sizeable part of its foreign currency reserves without receiving an asset of equal or greater value in return.  The United States wouldn’t be offering China any assets, just a promise that has no clear meaning in any financial sense.  The result — if anyone actually tried to execute such a deal — wouldn’t just be bad foreign policy for the U.S. (explicitly selling out a long-time security partner for cold hard cash?), it would spell financial and economic catastrophe for China.

Given the politically controversial nature of this particular proposal, it probably won’t go very far.  Unfortunately, the muddled thinking about China’s foreign currency reserves, what they are and what they are good for, are almost certain to go on confusing policymakers on both sides of the US-China relationship.

38 Comments leave one →
  1. November 12, 2011 12:32 am


    Long-time reader and first time commenter….

    I agree this is an awful proposal, but just hypothetically speaking, given that the liabilities of the PBOC to China’s domestic banking sector are presumably denominated in RMB, why couldn’t the PBOC simply increase the money supply to paper over any gap, even a seven trillion RMB one?

    I am sure I must be missing something, but given that the RMB is already circulating in the economy I’m not sure how this move would be particularly inflationary.

    • prchovanec permalink*
      November 12, 2011 12:59 am

      Even if China’s central bank were insolvent, it would never be illiquid, because it could always meet its RMB bond or deposit obligations by issuing RMB notes. However, this would be horribly inflationary because that “high-powered” money would go from being locked up in the banking system (in the form of bond or reserve holdings) to circulating and multiplying (via bank lending) in the economy.

      Yes, it is true that a central bank can simply issue issue more fiat currency to cover its obligations. But as I noted, fiat currencies are backed the presumption that the bank holds legitimate assets (such as the country’s own sovereign debt) that ultimately represent claims on real goods and services. Once that presumption is called into question — as it would have to be here — your domestic currency enters very dangerous waters.

      • Pierce Inverarity permalink
        November 12, 2011 2:53 am

        Mr. Chovanec,

        I mean no disrespect, but both Mr. Kane and you are operating under flawed assumptions about, and understandings of, monetary operations.

        The central bank of any country that is the sovereign issuer of its own currency does not act, or function, like the private banks or businesses that are currency *users*. Balance sheets, claims on assets, capital restrictions, etc. simply do not mean the same thing to a currency issuer that they do in private markets or to those countries that have decided on on the ill-fated course of accumulating foreign-denominated, or convertible, obligations.

        A currency issuer is never operationally required to tax, or borrow, in order to spend. Taxation and bond issuance are not fiscal operations, they are monetary ones.

        Mr. Kane grossly misunderstands what China’s Treasury holdings mean to the U.S. government and people. Our government could, today, swap out the Treasuries China owns for USD and there would be no net financial asset creation. This means *no* inflationary impact. The U.S. government would simply hold the Treasuries on its books as a debt obligation…to itself. Which it would, or could, promptly retire. This, of course, simply highlights the absurdity of all the media’s jeremiads about the U.S.’s “debt crisis”. The U.S. government could, at any moment, buy ALL outstanding debt with USD and retire it immediately with no net financial asset creation.

        Now, you may argue that this would flood the system with dollars to be lent out and be wildly inflationary But, that’s not how it works. Swapping out Treasuries for USD is akin to moving your savings balance to your checking balance. It doesn’t impact your propensity to spend. QE2’s utter failure to generate new loan creation in the U.S. illustrates this perfectly: it was operationally identical with what I outlined above. The reason for this–as has been explained ad nauseum by Scott Fullwiler, Warren Mosler, Stephanie Kelton and James Galbraith–is that banks do not lend reserves. Banks are capital constrained, not reserve constrained. Swapping out bank Treasury holdings for reserves does not mean they will lend more. Banks lend when they find a creditworthy borrower. If there are no attractive borrowers, banks will not lend. It’s as simple as that.

        Thanks for your time,

      • November 13, 2011 4:27 pm

        Hey Pierce,

        You missed the currency revulsion that would accompany some of your ‘swaps’, if executed. Fiat currencies have value only as much as people believe in their value. Loss of belief would mean a lower value for the currency and hence higher inflation. For an extreme case, refer to Zimbabwe. (Practically speaking, it doesn’t really matter if the loss of belief is rational or not.)

      • Michael permalink
        November 14, 2011 3:44 am

        Pierce, the end of your argument basically says that just because base money increases doesn’t mean money supply will increase, so inflation won’t necessary happen – just what happened with the QE’s. While I agree with that, this does not at all damage (or is even relevant) to Patrick’s core message, which is that FX reserve is not unencumbered asset available for spending, and that FX reserve needs to be exchanged for real assets, not some phantom goodwill.

        Aside from all that, jacking up the monetary base increases the POTENTIAL for inflation. Just because banks aren’t lending now (and for a variety of reasons: lack of business demand, worries about their own capital hole..etc), doesn’t mean there’s not going to be lending down the road. Once that happens inflation can get out of control fast – and inflation expectation would increase even before that.

      • November 14, 2011 12:01 pm

        Michael, Pierce and Patrick,

        Just to follow-up, is there a good explanation for why fiat currency would be more dangerous than FX holdings in the Chinese case? Pierce’s answer makes sense to me, while Patrick’s warning about “dangerous waters” seems vague. There are plenty of sovereign currencies which are not backed by specie.

        More practically — even if this accounting change caused a marginal shift in people’s willingness to hold RMB — it seems reasonable to expect Chinese currency controls to prevent mass capital flight and Chinese monetary policy to handle consequent volatility in the money supply.

        Anyway, I stress the point only because I’ve read Patrick make it a number of times and it has always confused me. On the other hand, his comments on what is happening on-the-ground seem to be dead on with what I’m seeing myself. So I’m trying to tease out what assumptions he is making about where the destabilizing forces are when it comes to the Chinese banking system.

    • vokoyo permalink
      November 22, 2011 8:11 pm




      (一)因發現、命名、使用而取得的「原始權利」 (Inchoate Title)。

      (二)根據「大陸架公約」第二條規定: 「海岸國有行使發掘大陸架與利用其天然資源之主權權利 (Sovereign Rights)」 而取得的「主權權利」。


      第一步,收回原始權利 (Inchoate Title)。 釣魚台最早是由中國人發現、命名和使用的。據史籍記載,自從一四0三年至一九六九年這五百年間,中國人自由來往釣魚台,視為家常便飯,並且留下大量文字紀錄。近三十多年來,日本政府突然宣佈釣魚台為其治下領土,不許中國人自由往來釣魚台,剝奪了中國人五百年來自由來往釣魚台的權利,這不但違反國際法理,而且違背人類公理。


      第二步,積極行使主權權利 (Sovereign Rights)。美國總統杜魯門於一九四五年九月二十八日發表的有關大陸架的一項聲明指出:「美國政府認為大陸架之底土及海床所有天然資源,由土地連接國家行使管轄權,是合理及公正的。」根據該項聲明精神,聯合國於一九五八年簽訂了《大陸架公約》(Continental Shelf),其中第二條規定:「海岸國有行使發掘大陸架、與利用其天然資源之主權權利。」


      • JudyJudyJudyCARYgRANt permalink
        November 23, 2011 11:38 pm

        Very Glad to see Chinese characters, as they should be written, published on this site, for a change. I will go to my death wishing that the freaks in Red China never simplified the written language of China, for no real good purpose, nor valid benefit.

  2. Anthony Vespa permalink
    November 12, 2011 12:43 am

    Let’s see, sell Taiwan to China, which we do not own, and that China believes belongs to them, is that right? Do you really believe the US will go to war over Taiwan with our military stretched as far as it is, with the public as war weary as it is, and with our economy as fragile as it is?. And, do you really believe this is a concern of China.
    Over time, Taiwan will be eventually go to China by the continuing successful integration of their economies and with the approval of the Taiwanese people. Hong Kong has prospered after 1997; Taiwan.will also continue to prosper.

    • November 12, 2011 6:46 pm

      HK and Taiwan have two entirely different make up, Hong Kong did not prosper after 1997, it was already well ahead of their China counterpart, and still today, act as a different governing sector to mainland China. Taiwan is a de facto independent country, any integration with the “willingness” of the Taiwanese people is highly unlikely in the near future. or at least decades.

    • November 14, 2011 5:10 pm

      The vast majority of Taiwanese also do not want to join the mainland. I don’t understand why this is continually ignored by the many fans of “Da Zhong Hua”

  3. Siggyboss permalink
    November 12, 2011 12:59 am

    I disagree. Option contacts (ie promises) are traded on public exchanges. Also, fiat money historically represented a claim on an asset. Today, none the world’s fiat monies represent claims. Any assets held are residual from past practices or the byproduct of monetary inflation. Lastly, any accounting shortfall at central banks aren’t real because all liabilities can be satisfied by merely creating more fiat money. They can never experience a traditional bankruptcy.

    • prchovanec permalink*
      November 12, 2011 7:13 pm

      What financial value would you assign to this promise, based on discounted projected cash flows or some other generally accepted valuation method? More importantly, what transferable value would it have to a holder who was not the Chinese government?

      I agree that a central bank in control of the currency with which it values its obligations can never go bankrupt in the sense that regular banks or businesses can. But in liquidating its obligations by printing cash, it can effectively bankrupt its currency, with much the same result.

      I think there’s an important distinction between a central bank that is technically insolvent on the margin, in which there is always the presumption that its backing government can and will make it whole sooner or later, and one that is insolvent many times over. A central bank may not be able to go bankrupt in the conventional sense, but it does have to maintain some semblance of credibility in order to perform its functions. This may not be obvious in developed economies, but it is certainly evident in underdeveloped or developing economies where presumptions of continued confidence are not quite so strong and supporting resources are understood to be limited.

  4. Lu Yan permalink
    November 12, 2011 6:16 am

    Prof. Chovanec,

    Thanks for this post and previous ones, which have really cleared up my understanding of foreign exchange reserves. Many say that countries such as Taiwan were able to endure the 1997 Asian financial crisis better than others b/c it had huge FX reserves that it could use to inject into the economy. Following your explanation of FX reserves, does this mean that this line of argument is also flawed? Or, could we say that the FX reserves at least allow for temporary relief while imposing costs in the longer term?

    Secondly, even though FX reserves are accounted as a liability in a country’s domestic currency, are more FX reserves still better than less, b/c it provides a short-term monetary tool?

    Thanks for your answer.

  5. Harry Lo permalink
    November 12, 2011 3:10 pm

    As a Taiwanese, I agree to sell Taiwan for this money so that we could bankrupt China and Taiwan will then be safe forever.

    Also, We need to pass a law that any person who wants to write any article about Foreign Currency Reserve needs to join a basic economics class taught by Mr. Chavonec.

    What kind of person will write an article to sell off Taiwan in return for writing off Foreign Debt?

  6. funnypost permalink
    November 13, 2011 11:06 am

    So Kane is suggesting that America’s continuing peace and prosperity and our children’s future (and their Christmas shopping fund) lie in selling out an island that we do not own?

    Why hasn’t Bernanke thought about this?

  7. November 14, 2011 5:17 pm

    I thought this was pretty ridiculous too when I first read it. Maybe that’s why NY Times turned off the comment feature for that editorial? Makes me a little nervous to see the author is a scholar at Kennedy School of Government, generally regarded as a top producer of US political elite. Scary stuff.

    It also seems to be widely misunderstood on the China side as well. I remember reading something in Global Times a while ago about how China should use it’s “financial weapon” to attack the US for one reason or another.

    Do you think we could also sell the Philippines while we’re at it?

  8. Hua Qiao permalink
    November 15, 2011 10:01 am

    With a fiat currency, what do you do with it? If you take it to the central bank and the bank has no assets backing that liability, then you must exchange it for other currencies from other countries or other assets, real or financial. None of the sellers of those currencies or assets would be too interested in your currency. If you got them to do an exchange, it would have to be at a very steep price to you.

    A key part of a fiat currency is that domestic sellers and buyers of goods must accept this currency by law. Of course, if they are worried about its future efficacy, they will raise the price of their goods and you will begin to have black market and bartering going on. This credibility problem puts even greater inflationary pressure on the currency.

  9. Mike Tian permalink
    November 16, 2011 2:46 am

    Prof Chovanec,

    Perhaps you can clear something up for me.

    Let’s say you have a really simple Central Bank. The liability side of the balance sheet is $1 trillion of paper notes floating around the economy. The asset side of the balance sheet is $1 trillion of bonds.

    One day, the bank writes off the bonds down to zero, leaving a $1 trillion capital hole. The central bank is now hopelessly bankrupt.

    What exactly is the mechanism that will cause the Central Bank to print trillions upon trillions of $ of bank notes (especially since this doesn’t affect its capital ratio at all)? I don’t see why anyone would figuratively line up at the Central Bank teller counter and say: give me my deposit of $xyz.

    Of course, to the extent that the bankruptcy of the Central Bank changes people’s “faith” in the paper currency, there would be some effect in the real economy. Everyone would theoretically rush to spend their currency, causing the velocity of money to increase dramatically and thereby causing inflation. Ironically, in the short-medium run, this should boost the economy! But that’s not what we are talking about here.

    Thank you,
    Mike T

  10. susian permalink
    November 16, 2011 3:16 pm

    Germany, France, the ECB and other creditors have successfully forced leadership changes in Ireland, Spain, Greece and Italy, once it became clear that markets refused to continue financing these latter 4 countries. Germany is a big exporter – an important supplier of industrial and infrastructure goods to Greece among others – and the status of its FX reserves haven’t come into question in any significant way throughout this process (although there is a lot of scrutiny of its banks’ holdings of Greek paper).

    Why would China’s position be different if the US ever gets into a position where markets refuse to continue buying its paper ?

  11. John Klok permalink
    November 17, 2011 4:16 am

    The high ranked chinese officials are all technocrats en will follow tao and sun tzu. So they will just wait(if the situation is entangled don’t move)and when the dollar starts to devaluate – and it will – they will buy the best companies and idea’s. They know it’s just a matter of time before Bernanke will start to print dollars again to keep the top 5 banks in the US from defaulting. China also has an internal problem, their huge housing bubble, they will need their dollar reserve if it implodes.

  12. permalink
    November 19, 2011 10:57 pm

    i have a better idea. why not trade a commitment of not invading tibet or imposing NFZ over china for 50 years, or even better, not bombing beijing, for that trillion dollars?

  13. Chen Zak permalink
    November 24, 2011 8:50 am

    Professor –

    You don’t seem to have considered the New York Time’s Op-Ed was not meant to be taken literally or as a black or white policy position assessment.

    It seems THE ATLANTIC magazine did an interview with the author and found Swiftian satire was also baked into the piece. Here is the post explaining the author’s intent:

    You are not the professor he mentions in his comments are you? Thank you. – Chen

  14. November 24, 2011 2:14 pm

    Perfectly shocking to see in electrons how over-leveraged the China Central Bank really is. It is hard to imagine how PBOC could effectively respond to a decline in asset values in their client’s accounts, a decline in real estate bubble prices.

    Their large euro reserves have to be troubling them, too, w/ EU defaults and runs completely out of their control.

  15. November 24, 2011 11:10 pm

    Hi professor, I understand that the Chinese government will not write off the U.S. debt for Taiwan, but I do not agree that the problem lies in “ownership”, which leads to the unbalanced sheet because of an “asset” missing.

    How about considering “selling Taiwan” as a service? Suppose the U.S. provide such a service that it cultivates a ruling government in Taiwan who are submissive to Beijing, and the U.S. charges China for such a service. Such an approach can be well explained in terms of business- money is spent and “benefit” comes in, like what happens in reality that we do buy services in addition to tangible assets.

    There may be absurdity in the selling Taiwan article, yet I wonder whether “ownership” is the point.

  16. Dale Worley permalink
    December 5, 2011 9:53 am

    When you ask “How, exactly, does one value or monetize such an ”asset”?”, the answer that comes to mind is “looting”. But the Taiwan economy is less than $1T/yr, so it probably can’t be looted or taxed for anywhere near the needed amount.

  17. Staatsbankrott permalink
    February 22, 2012 2:23 am

    I found something on a forex chart.

    Instruments search for USD/TWD

    In the weekly chart you can see many huge candle sticks for the whole past year and somehow it looks like the TWD is going to devalue against the USD in a short time. To me, it looks like the USD is ready to jump up like a rocket against this la la currency. If US wanna get rid of Taiwan now would be the best time for it. The economy is going down here and the real estate bubble is huuuuuge. – In this place is no money to make anymore. Possibly the US take out money of foreign countries and QE printing is just a lie.


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  5. Ridiculous New York Times op-ed – 四海为家
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  8. ‘To Save America’s Economy, Ditch Taiwan’ … Or Not. | China Digital Times (CDT)
  9. ‘To Save America’s Economy, Ditch Taiwan’ … Or Not. | China News Center
  10. Selling Taiwan to Mainland China: the Author Explains His ‘Swiftian’ Intent | B.log
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