What to Do With $20 Billion a Month

China has a big problem. The country is taking in about $20 billion a month in foreign currencies, mostly in U.S. dollars. What to do with all that money?

The problem really is American. With over $1 trillion in foreign reserves right now, China can be classified as one of the world’s biggest investors. About two-thirds of that trillion is in U.S. dollars, with the balance mostly in euros.

Chinese companies have been very successful in exporting their goods to the world, and Chinese exporters bring in loads of U.S. dollars that China’s central bank then buys to keep the exchange rate between the yuan and dollar tight.

In effect, China is taking the U.S. dollars it accumulates from its trade with the world and buying U.S. T-bills and bonds. To me, this is the equivalent of China financing the debt of U.S. As U.S. dollars kept pouring into Chinese exports, China keeps buying U.S. debt securities. And “pouring” is the right word.

The U.S. trade gap widened in December for the first time in four months — the U.S. trade deficit for 2006 grew to a record of $763 billion with about $230 billion of that amount going to Chinese exporters.

Now, here’s where it gets really interesting.

Earlier this year, the Chinese Premier publicly stated that China would like to explore other avenues for investing its huge foreign currency reserves. Does this mean U.S. treasuries and bonds might not be the prime choice anymore for China to invest its foreign reserves in? Maybe. How would the U.S. finance its debt? Wouldn’t that mean the U.S. would have to raise interest rates to attract foreign investors to buy its treasuries and bonds? The definite answer is, “yes.”

China’s huge $1 trillion in foreign reserves might be a bigger problem for the U.S. than it is for China. And that foreign trade imbalance that many have said is not an issue for the U.S. could ultimately lead to the unexpected — higher U.S. interest rates… the nail in the coffin for the U.S. housing market and economy.

NEWSFLASH – One of the largest home builders in the U.S., KB Home, just reported a loss for the last fiscal quarter and expects the next two quarters to be “challenging” times because of a continued oversupply of homes on the market. The company said orders in its latest fiscal quarter dropped 38% from the same period one year earlier. But we shouldn’t fear a hard landing for housing. Good old Alan Greenspan, during a speech last week to a group in Toronto, said the worst is over for the housing market. I think not.