I tend to be a bit better at spotting risks than opportunities. I have long worried that China might conclude that it is no longer in its interest to continue to buy ever larger quantities of Treasuries, especially as it buys Treasuries terms that likely imply future losses for China’s taxpayers. But that doesn’t mean that I am among those who are worried that China necessarily needs to slow its Treasury purchases (let alone sell its existing holdings) to finance its fiscal stimulus.
Let me see if I can explain why.
The basic argument why China’s fiscal stimulus could put pressure on the Treasury market is fairly straightforward; just read the FT’s Alphaville.
The US has long financed its fiscal deficit by selling debt to China.
Indeed, the scale of China’s purchases over the last twelve months is hard to overstate. Some work that I am doing with the Council on Foreign Relations Arpana Pandey suggests that China’s monthly Treasury purchases over the last year (really the last 12 months of TIC data, so September 2007 to August 2008) have averaged about $15 billion or month – or just under a $1 billion a business day. And that total almost certainly understates China’s recent purchases of Treasuries. During the last year, Arpana Pandey and I estimate that China bought about $15 billion of Agencies in an average month. However over the last few months China has stopped buying Agencies – and increased its Treasury purchases. As a result, China’s recent purchases of Treasuries could easily have exceeded $15 billion a month.
Looking forward, though, the US fiscal deficit is poised to increase – almost certainly significantly. The Treasury also has to sell bonds to finance the revamped TARP. China by contrast plans to run a bigger fiscal deficit and spend (or so it seems) more at home. Combine those two trends and it seems to suggest that China will be providing a lot less financing to the US just when the US is going to be selling more Treasuries than ever before.
So why am I not worried? Because not everything else is equal.
China has proposed a significant (or so I hope, the amount of new money in the announcement still isn’t clear – and some reports suggest that new spending could be as little as ¼ of the $585 “headline” announcement) fiscal stimulus because domestic activity in China is slowing. If China’s firms are investing less and Chinese households are saving as much China’s government can run a larger fiscal deficit without cutting into its purchases of US Treasuries.
The fiscal stimulus, in effect, would offset a contraction of investment that otherwise would have tended to push China’s current account surplus up. It would absorb the surplus savings freed up by the fall in investment. Remember, a fall in the pace of import growth pushed China’s October trade surplus up to a record. That means China’s external surplus is currently growing – not shrinking. The stimulus may just keep it from growing more.
Similarly the rise in the US fiscal deficit is coming when private consumption is falling rapidly – and when it is likely that US firms will be scaling back their investment. That implies that the rise in the US deficit will come when Americans will have more money to lend the US government and the US will have a smaller need for financing from the rest of the world.
In broad terms, China’s fiscal stimulus will offset a fall in domestic investment more than it reduces China’s purchases of US debt. Chinese banks that previously were lending to China’s property developers will be lending to China’s government instead. And the rise in the US fiscal deficit will offset a fall in borrowing by American households and firms. As a result it won’t need to be financed as heavily by the rest of the world. China’s fiscal stimulus will do more to keep China’s current account surplus from rising than to bring China’s surplus down. The United States fiscal stimulus will slow the contraction of the US current account surplus from being too fast – not get in the way of a fall in the United States current account deficit. Under current circumstances, a rise in the budget deficit wouldn’t necessarily lead to a rise in the trade and current account deficit. Or to put it a bit differently, private investment around the world is likely to fall faster than private savings, freeing up funds for a global fiscal stimulus.
This story is a bit too neat; no doubt some things won’t perfectly offset. But it helps illustrate what I think are the dominant dynamics right now.
There is a second reason why I am not all that worried by China’s plans: I don’t see much evidence that China has scaled back its Treasury purchases.
Fiscal deficits are generally financed by selling bonds domestically, not by selling off reserves. They only produce a fall in reserves if the fiscal deficit pushes up domestic demand -- and thus demand for imports -- to the point where the country runs a current account deficit. Or if the fiscal deficit induces capital outflows. And for now, China is still running a large (in fact, based on the September and October data, a growing) trade surplus. In the near term, China’s import bill is likely to fall faster than its export receipts, so that surplus will remain. Absent huge hot money outflows that implies that China’s reserves will keep on growing. So long as China pegs tightly to the dollar, it almost certainly will keep on buying some kind of US assets. And so long as China finds Agency bonds too risky, it more or less has to buy Treasuries.
There is a bit of evidence that suggests that China’s reserve growth – counting the growth of China’s hidden reserves – has slowed a bit in the third quarter of 2008. But the slowdown reflects a fall in “hot inflows” – not a fall in China’s trade surplus. The underlying dynamic is one where China’s government is still adding substantial sums to its external portfolio. $150 billion of reserve growth in a quarter is only seems small in comparison to the $200 billion or so in the spring.
I of course do not know for sure who is adding to their Treasury holdings at the New York Fed. But the pattern of past purchases suggests that Asian central banks tend to make more use of the Fed’s custodial facilities than the oil exporters. And I do know that right now China is the only major emerging economy adding significantly to its reserves. Consequently I would assume that the evolution of the Fed’s custodial holdings offers some insight into how China is investing its reserves. It consequently seems like SAFE is reducing its Agency holdings and adding to its Treasury holdings. That certainly is what the TIC data suggest China did in August.
Finally, I worry far more about a sudden fall in China’s willingness to buy US assets than a gradual reduction – particularly a gradual reduction that is tied to a large fiscal stimulus that increases China’s demand for US (and European) goods even as it reduces Chinese demand for US (and European) debt. The US can adapt to a gradual fall in China’s current account surplus that leads to a gradual fall in China’s demand for US Treasuries. Yes, that would put upward pressure on US interest rates. But if Chinese demand for US goods is growing (as its trade surplus falls), the US could scale down its fiscal stimulus without producing a big slowdown in the US. That is something that the US should want, not fear.
The more troublesome scenario is one where China suddenly stops buying US Treasuries – and where it stops buying Treasuries without increasing its purchases of US goods. The fairly sudden end of central bank demand had a big impact on the Agency market; a similar sudden end to Chinese demand for Treasuries could have a comparable impact. But for that to happen China’s current account surplus would need to fall sharply – or China would need to suddenly stop buying dollars and starting buying other currencies. Both are potential risks. Neither seems particularly likely right now.
So what do I worry about?
The risk that China’s surplus will prove far smaller than announced – and that the fiscal stimulus won’t be strong enough to offset China’s domestic slowdown. China’s current account surplus could rise even as China’s exports start to fall if China’s imports start to fall even faster.
I agree with Martin Wolf: China should, ideally, be doing more to stimulate its economy than the US, as that would help to facilitate global adjustment. Wolf writes:
If the US external correction is to be consistent with global growth, demand must expand vigorously elsewhere, particularly in chronic surplus countries. The new administration should lead the world towards an understanding of a point that concerned John Maynard Keynes: it is hard to accommodate countries with massive and persistent current account surpluses. The counterpart deficits, if prolonged, almost always lead to financial crises. The way out is for most surplus countries to spend more at home. The expansion programme announced by the Chinese government early this week is just a beginning. Instead of toying with protection, the Obama administration needs to focus on global imbalances. The immediate way to deal with this challenge is to demand a global fiscal stimulus, with surplus countries implementing the biggest packages.
I also worry about the risk that once current pressure on say Korea’s exchange rate diminishes, Korea will conclude that a depreciated won is in its own interest - -and resume intervening in the foreign exchange market both to rebuild its reserves and to support its export sector. Ragu Rajan of Chicago outlines this scenario in his contribution to VoxEU’s G-20 spectacular.* He writes:
“If we do nothing to address this issue (the absence of sufficiently large multilateral pools of foreign exchange reserves) we will set up serious problems for the future. We will emerge from the crisis with many countries attempting to build reserves through export-led strategies and managed exchange rates, aggravating the demand imbalances at the heart of the current crisis.”
A sustained effort to maintain undervalued exchange rates would tend to increase demand for US Treasuries. But it would slow needed adjustments in the global economy. I am still among those who thinks that a shortfall in foreign demand for US goods is a bigger worry than a shortfall in foreign demand for US Treasuries.
*Dani Rodrik’s G-20 communique is also worth reading; alas, the odds that the actual communiqué will be as substantive are rather slim.