This blog from time to time has commented on deteriorating economic conditions in China, and expressed the view that the slowdown is likely to be worse than most mainstream forecasters have anticipated (although the projections are now being revised downward). That sort of post has often lead to reader comments that a lower level of Chinese exports means a sharp falloff in the purchase of Treasuries, perhaps even a reversal, and therefore the Treasury bond market is set for a nasty reversal soon.
We don’t give investment advice, and note the Treasury market could go into a downdraft for a host of reasons. However, an economic unwind in China is unlikely to be the cause. Brad Setser explains why in, “Worry about a fall in China’s demand for the world’s goods, not a fall in China’s demand for Treasuries.”
Earlier this month, the Wall Street Journal reported that even though China’s exports in December fell sharply, imports fell much further. Now as import prices stabilize (commodities will bottom at some point), imports will cease dropping so quickly, but a general point holds: China is very likely to continue to run trade surpluses even with global trade at depressed levels.
That means China (which is still running monster surpluses) will, absent other factors, continue to buy foreign assets. Now they could shift the mix away from dollars, but the weakening trade market alone is not sufficient reason to expect the Chinese to quit buying Treasuries. (I am of the Herb Stein school, which is that that which is unsustainable will not be sustained, but have seen way too many times things that looked like they ought to collapse under their own weight, like the dot-com bubble, go much longer than any skeptic would have imagined. And if, contrary to conventional economic wisdom, the Fed fails to whip deflation, those Treasury yields would not be crazy).
There are reasons to be skeptical of Treasury bonds, namely the big increase in the fiscal deficit and the number of contingent liabilities the US government has assumed. But the slowdown in China is having a much greater impact on commodities than it has on Treasuries, and that pattern appears likely to persist.
There is another way to look at Setser’s reading. Keynes had taken note of the role of persistent trade imbalances as a cause of financial instability. He further noted there was no disincentive for the trade surplus nation to continue to rack up disruptive surpluses. Keynes did come up with a remedy which was never implemented, and the current vogue for Keynes appears to have left out this important part of his prescription. If Keynes is correct, we may go from emergency to emergency until a better fix is put into place.
From Brad Setser:
Suppose China’s economy slows sharply — a not-impossible development given the rather starling fall in the OECD’s leading indicators for China. How would that impact China’s balance of payments?
The first impact is rather obvious. China would import less. It would buy less. And since the rise in Chinese demand helped push the price of various commodities up, it stands to reason that a fall in Chinese demand would push prices down. It probably already has. That implies a big fall in China’s import bill, and a larger trade surplus. A slowing global economy would hurt China’s exports, but in this scenario China would slow more than the world. That means China’s imports would fall more than its exports. China’s trade surplus would rise.
But, you might say, the current account surplus is determined by the gap between savings and investment. Why would that change in a slowdown? Simple. China’s slowdown reflects a fall in investment (especially in new buildings and the like). Less investment and the same level of savings means a bigger current account surplus. In practice, though, savings would also likely fall a bit — as a slowdown would cut into business profits and thus business savings. It possible that China’s households would reduce their saving rate to keep consumption up as their income fell. But it is also possible that Chinese households might worry more about the future and save more. My best guess though is that the fall in investment would exceed the fall in savings, freeing up more of China’s savings to lend to the world. That surplus savings has gone into Treasuries and Agencies in the past….
Setser then turns to the complicating factor of a recent, large exodus of hot money:
Since reserve growth is a function of both the current account balance and capital outflows, it is possible that the rise in capital outflows could overwhelm the rise in the current account surplus. That seems to be what happened in q4.
In the absence of such outflows, though, the rise in China’s current account surplus would imply that China almost certainly would continue to add to its Treasury holdings. And even if there are large outflows — so large that the outflows exceed China’s current account surplus and China’s government has to dip into its reserves to meet the surge in Chinese demand for dollars — China would still be financing the rest of the world. The accumulation of foreign assets by private Chinese savers would substitute for the accumulation of foreign assets by the central bank, but money would still be flowing out of China. And some of that outflow likely would still make its way into Treasuries.
The full post, which has considerably more detail, can be found here.