The answer involves three definitions: the current account, the capital account, and the balance of payments. The
for a nation is just net exports minus net imports for all goods and services. This means manufactured goods, raw materials, as well as services such as "receipts from tourism, transportation (like the levy that must be paid in Egypt when a ship passes through the Suez Canal), engineering, business service fees (from lawyers or management consulting, for example), and royalties from patents and copyrights."
The capital account
refers to ownership of assets--things that aren't good or services but which form the basis of the production of goods and services. These include not only hard assets like land, but also stuff like government bonds. The current account is then added to the capital account, and the resulting number is called the
balance of payments
The current account--goods and services--and the capital account--ownership of assets--theoretically add up to zero. This is a bit puzzling at first, but it kind of makes sense: If there is a flow of in products from one country to another, as measured in currency, there must be a flow of money into the other. That is to say, simply, if a country imports goods that have a money value higher than the goods its exports, then it must export that same amount of money to its trading partners,
in its currency
. And since it must also purchase assets that are denominated in this currency, this results in a net purchase of assets in the country with a current account deficit because that money has to go somewhere (and not just under the mattress...) By definition it can't go into purchasing goods and services, or else this would erase the trade deficit. Thus--it must go into things classified as assets.
Micheal Pettis writes:
"First of all, remember that the PBoC does not purchase huge amounts of USG bonds because it has a lot of money lying around and doesn’t know what to do with it. Its purchase of USG bonds is simply a function of its trade policy. You cannot run a current account surplus unless you are also a net exporter of capital, and since the rest of China is actually a net importer of capital, the PBoC must export huge amounts of capital in order to maintain China’s trade surplus. In order the keep the RMB from appreciating, the PBoC must be willing to purchase as many dollars as the market offers at the price it sets. It pays for those dollars in RMB.
It is able to do so by borrowing RMB in the domestic markets, or by forcing banks to put up minimum reserves on deposit. What does the PBoC do with the dollars it purchases? Because it is such a large buyer of dollars, it must put them in a market that is large enough to absorb the money and – and this is the crucial point – whose economy is willing and able to run a large enough trade deficit.
Remember that when Country A exports huge amounts of money to Country B, Country A must run a current account surplus and Country B must run the corresponding current account deficit. In practice, only the US fulfills those two requirements – large financial markets, and the ability and willingness to run large trade deficits – which is why the PBoC owns huge amounts of USG bonds."
So, as Pettis suggests, China is able to maintain a current account surplus over an extended period by keeping its currency artificially low in relation to the dollar--the infamous peg. Normally, when a trade deficit occurs, there will be increased demand for the foreign (rather than domestic) currency which will push up the price of the foreign currency in terms of the domestic currency. That in turn makes the price of foreign goods less attractive to the domestic market and thus pushes down the trade deficit. Under fixed exchange rates, this automatic re-balancing does not occur. Pegging a currency to another currency really is just like pegging it to anything else: just like if your currency is on a "gold standard" you need to keep a supply of gold and money, and trade that gold or money to maintain a certain balance of in the price of gold vis-a-vis your currency, likewise china needs to maintain dollar denominated assets and actively maintain a certain balance between the Renminbi and the dollar.
By using the Chinese central bank to manipulate the flow of dollar in the chines economy and reinvest them in treasuries, the Chinese government ensures that the trade relationship between the Chinese and the Americans never reaches equilibrium, as would supposedly happen otherwise. The Chinese government artificially increases demand for dollars, and floods the market with Renminbi.
But it goes further: the entire system is propped up by the American government, its armed intervention and network of power that spans the globe. The entire system of international trade. And by continuing its support of the us government in particular by trading in bonds, it ensures that not only the trade imbalance stays in place, but also the system that makes such relations possible in the first place. As Pettis suggests in other articles, however, this inevitably comes at the expense of Chinese households, and is reflected in the historically low ratio of consumer spending to GDP (and,conversely, our historically high ratio.) The Chinese government maintains a number of practices that systematically transfer wealth from households to capital intensive, export-driven businesses, while garnering a lot of money from them and redirecting it back over to the US in a variety of ways.