Ah, when it rains, it pours, We Americans get news that the US federal deficits are over the trillion mark even before Obama and Congress pull out the checkbook in an effort to buy some prosperity, when we also are told, via the New York Times, that China, our biggest creditor provider, is likely to be far less generous as far as buying our paper is concerned.
The Times does not make clear how sudden a reversal of conventional wisdom this is. Even though we have been of the school that the contraction in China will be worse than generally expected, most commentators, including experts we respect, have been swayed by reports from international agencies that frankly, are not willing to annoy the Chinese by saying their growth forecasts were delusional.
For instance, Brad Setser, who we particularly like because he is rigorous and digs into data, was nevertheless taken, in both senses of the word, by the World Bank’s latest World Bank report on China (issued late November):
Make sure it is the latest World Bank China Quarterly.
David Dollar, Louis Kuijs and their colleagues have outdone themselves – and in the process provided a clear assessment of the sources of China’s current slowdown and the risks that lie ahead. I won’t try to summarize the entire report. Read it. The whole thing. No summary can do it justice….
6. The last thing anyone needs to worry about is fall in Chinese demand for US treasuries.
The Treasury market obviously isn’t worried – not it 10 year Treasury yields are under 3%. And there is little reason for the bond market to be worried if current trends continue.
The World Bank forecasts that China’s current account surplus will RISE not fall in 2009, going from an estimated $385 billion to $425 billion. How is that possible if real imports are forecast to grow faster than real exports? Easy – the terms of trade moved in China’s favor. The price of the raw materials China imports will fall faster than the value of China’s exports. China’s oil and iron bill will fall dramatically.
In macroeconomic terms, China’s fiscal stimulus will offset a fall in domestic investment leaving China’s current account (i.e. savings) surplus unchanged. The 2009 surplus is expected to be roughly the same share of China’s GDP (9%) as the 2008 surplus.
In dollar terms, the World Bank forecasts that China will add almost as much to its reserves in 2009 than in 2008. That is a bit misleading: the 2008 reserve growth number leaves out the funds shifted to the CIC (ballpark, $100b in 08) and the rise in the foreign exchange reserve requirement of the state banks (ballpark, another $100b). But it captures a basic truth. Even if a fall in hot money inflows means that China will be adding $500b rather than $700b to its foreign assets, its foreign assets will still be growing incredibly rapidly. China already has – counting its hidden reserves – well over a $2 trillion. It is now rapidly heading for $3 trillion.
Yves here. When I read the Setser’s summary (I did skim the report, and it did not make a strong impression on me), I simply did not buy it. I also worried that I was being a reflexive skeptic and refusing to consider fresh data. Nevertheless, the idea that China would keep showing massive FX growth, on the same level as an eye-popping 2008, when world trade was falling off a cliff and hot money certainly no longer coming in on its face seemed ridiculous.
And a mere month later (and remember, the slowdown in China only started to get serious headway in September) a senior Chinese official, Cai Qiusheng, said that China’s FX reserves has ALREADY fallen by an undisclosed amount. So much for the race to three trillion. Oh, and he said reserves are below $1.9 trillion.
Separate and apart from China’s changing fortunes, the continued purchase of US debt was becoming controversial in bureaucratic and popular circles. The tone increasingly was that China had been snookered into buying lousy US paper. And since the regime had depended on continued growth to maintain legitimacy and social cohesion, the officialdom will need to find scapegoats for the downturn. Regardless of where one thinks the truth really lies, it’s a no-brainer that the US will become a leading culprit.
One remarkable omission in the piece is the failure to mention that the massive FX reserves resulted from China running first a hard, and then a dirty peg against the dollar. And correspondingly, there is no consideration of why China no longer needs to be as active to keep the yuan (which now appears to be back to a hard peg) where China wants it to be. A presumably smaller current account surplus and a capital exodus would seem to be prime suspects.
From the New York Times:
China has bought more than $1 trillion of American debt, but as the global downturn has intensified, Beijing is starting to keep more of its money at home, a move that could have painful effects for American borrowers.
The declining Chinese appetite for United States debt, apparent in a series of hints from Chinese policy makers over the last two weeks, with official statistics due for release in the next few days, comes at an inconvenient time…
Beijing is seeking to pay for its own $600 billion stimulus — just as tax revenue is falling sharply as the Chinese economy slows. Regulators have ordered banks to lend more money to small and medium-size enterprises, many of which are struggling with lower exports, and to local governments to build new roads and other projects.
“All the key drivers of China’s Treasury purchases are disappearing — there’s a waning appetite for dollars and a waning appetite for Treasuries, and that complicates the outlook for interest rates,” said Ben Simpfendorfer, an economist in the Hong Kong office of the Royal Bank of Scotland.
Fitch Ratings, the credit rating agency, forecasts that China’s foreign reserves will increase by $177 billion this year — a large number, but down sharply from an estimated $415 billion last year…
The long-term effects of China’s using its money to increase its people’s standard of living, and the United States’ becoming less dependent on one lender, could even be positive. But that rebalancing must happen gradually to not hurt the value of American bonds or of China’s huge holdings.
Yves here. I hate to say this, but if China were to be rational about their Treasuries, they are a sunk cost. Will China realistically ever see 100 cents per dollar invested? The answer is certain to be no. The US is out to create inflation (as a matter of policy, to avoid deflation taking hold). In addition, the massive federal deficits in the pipeline, plus the high odds of a somehow cosmeticized bailout of the Fed down the road (it has been hoovering up crappy assets certain to be worth less than their reported value) will necessitate a default via inflation. And since China has run double digits inflation, they really can’t complain if we go that course. And that’s before we consider that the powers that be, like just about every economy in the world, presumably want their currency to be weaker (a weaker dollar would also erode the value of US government paper). How that race tot the bottom plays out is anyone’s guess.
Very few seem to be looking at the gives and gets in a hard-nosed fashion. China has to know the Treasuries it holds will, under NO plausible scenario, be in economic terms worth face value. In fact, were there any realistic way for them to dump them now, that would probably be the value-maximizing course of action. Pull out a calculator and start playing with, say, 12% inflation over 6 years. It is remarkably destructive.
Now the powers that be would no doubt deem 12% inflation to be barmy, but given the level of deficits in the pipeline, one could argue that we need inflation of that order to avoid explicit default.
That does not mean China will dump Treasuries, but merely that any cold-blooded analysis needs to start from how bad likely scenarios would be for the Chinese, what actions are open to them, and how they affect risks and outcomes. I don’t see much evidence that anyone has put together a decision tree from the Chinese perspective.
Back to the story:
Another danger is that investors will demand higher returns for holding Treasury securities, which will put pressure on the United States government to increase the interest rates those securities pay. As those interest rates increase, they will put pressure on the interest rates that other borrowers pay….
Yves here. Why did the Times not mention that prices (and hence yields) are set via auction? It makes it sound as if the Treasury has more control than it does (it could shorten average maturities and/or try new structures, but the yield the market wants at a given maturity is the yield it wants for a given volume on offer). Back to the story:
The strength of the dollar against the euro in the fourth quarter of last year contributed to slower growth in China’s foreign reserves, said Fan Gang, an academic adviser to China’s central bank, at a conference in Beijing on Tuesday…
Yves here. No mention, zero, zip, nada, that the reason that China had to sop up so many Treasuries was to keep the RMB from appreciating too much versus the dollar, and that the strength of the dollar relieved China of the need to intervene. Back again to the piece:
China manages its reserves with considerable secrecy. But economists believe about 70 percent is denominated in dollars and most of the rest in euros.
China has bankrolled its huge reserves by effectively requiring the country’s entire banking sector, which is state-controlled, to take nearly one-fifth of its deposits and hand them to the central bank. The central bank, in turn, has used the money to buy foreign bonds.
Now the central bank is rapidly reducing this requirement and pushing banks to lend more money in China instead.
At the same time, three new trends mean that fewer dollars are pouring into China — so the government has fewer dollars to buy American bonds.
The first, little-noticed trend is that the monthly pace of foreign direct investment in China has fallen by more than a third since the summer. Multinationals are hoarding their cash and cutting back on construction of new factories.
Yves here. This is sufficiently incomplete as to be misleading. Michael Pettis has indicated that a lot of the hot money flows into China were disguised as FDI. Back to the story:
The second trend is that the combination of a housing bust and a two-thirds fall in the Chinese stock market over the last year has led many overseas investors — and even some Chinese — to begin quietly to move money out of the country, despite stringent currency controls.
So much Chinese money has poured into Hong Kong, which has its own internationally convertible currency, that the territory announced Wednesday that it had issued a record $16.6 billion worth of extra currency last month to meet demand.
A third trend that may further slow the flow of dollars into China is the reduction of its huge trade surpluses…
Two officials of the People’s Bank of China, the nation’s central bank, said in separate interviews that the government still had enough money available to buy dollars to prevent China’s currency, the yuan, from rising. A stronger yuan would make Chinese exports less competitive…
Treasury data from Washington also suggests the Chinese government might be allocating a higher proportion of its foreign currency reserves to the dollar in recent weeks and less to the euro. The Treasury data suggests China is buying more Treasuries and fewer bonds from Fannie Mae or Freddie Mac, with a sharp increase in Treasuries in October.
But specialists in international money flows caution against relying too heavily on these statistics. The statistics mostly count bonds that the Chinese government has bought directly, and exclude purchases made through banks in London and Hong Kong; with the financial crisis weakening many banks, the Chinese government has a strong incentive to buy more of its bonds directly than in the past.
The overall pace of foreign reserve accumulation in China seems to have slowed so much that even if all the remaining purchases were Treasuries, the Chinese government’s overall purchases of dollar-denominated assets will have fallen, economists said.
Update 3:40 AM: Brad Setser begs to differ: “China hasn’t (yet) lost its appetite for US Treasuries …“