from Follow the Money

Did the Fed bail out China by buying Treasuries?

March 20, 2009

Blog Post
Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

More on:

Monetary Policy


No. Not really. At least not in the sense that is usually argued. China has no need to sell foreign assets like Treasuries to finance its domestic fiscal stimulus so long as it is running a large external surplus.

But China could use a large buyer for some of its Agencies. Now it has one. Though here the Fed isn’t so much bailing China out as substituting for the falloff in Chinese and other central band demand.

And I would be curious to know if China is worried by the latest bout of dollar weakness or relieved that a weaker dollar is pulling the RMB back down. China’s biggest financial exposure isn’t to the equity market, it is to the dollar. It thus benefits financially from dollar strength. But a strong dollar also doesn’t exactly help China’s exporters. And exporters have long driven China’s policy choices.

Let’s start with the first point. Does China -- as Felix’s correspondent implies -- need to sell Treasuries to finance its fiscal stimulus?

The simple answer is no, it doesn’t.

Foreign exchange reserves can finance a current account deficit or a capital outflow. Foreign assets aren’t needed to finance a fiscal stimulus. The US is a case in point; it has financed a large fiscal deficit by selling dollar-denominated bonds -- not by selling off its reserves. China would only need to draw on its foreign exchange reserves to cover its fiscal deficit if its fiscal deficit led to a trade and current account deficit.

And China no need to worry there. It isn’t Russia -- a country that looks set to run both a fiscal and a current account deficit this year, and thus will need to draw on its reserves to meet the balance of payments needs associated with its fiscal deficit.*

Don’t take my word. Read the World Bank’s latest China Quarterly. Thanks to David Dollar, Louis Kuijs and the rest of the staff of the Beijing office, it remains the best single source for analysis of macroeconomic trends in China.

The World Bank forecasts that China’s fiscal deficit will expand by about 2.8 percentage points in 2009, with the fiscal deficit rising from 0.4% of China’s GDP to 3.2% of GDP (table 4)

The World Bank also forecasts that China will run a $425 billion current account surplus in 2008. That means Chinese investors -- whether private investors or the central bank -- will be net buyers of the world’s financial assets, not net sellers. China, like the Fed, will be buying Treasuries.

How can the fiscal balance deteriorate by 2.8% of GDP while the current account deficit deteriorates by only -- according to the World Bank’s forecasts -- 0.8% of GDP? Shouldn’t the fiscal deficit suck up some of the funds that China would otherwise lend to the world?

There is an easy answer here too: the rise in the fiscal deficit will offset a sharp fall in private investment, a fall that otherwise would have pushed the current account surplus up.

But aren’t China’s reserves falling because of China’s new spending plans? It is certainly rumored that China’s reserves fell by $30 billion in January. But the euro fell sharply against the dollar in January (after rising in December). Currency moves alone likely subtracted $40-50 billion from China’s reserves. If China’s reserves only fell by $30 billion, China was still buying foreign exchange in the market to keep its currency from rising.

Consequently, it is more accurate to say that China’s reserves are still growing, just at a much slower pace than before. More importantly, the currency slowdown in reserve growth isn’t due to a spending spree that brought China’s current account surplus down. Not at all.

Real imports -- according to the World Bank (see Table 1) -- fell by more than real exports in November, December and January. February will prove to be a bit different, but it is a month that is heavily shaped by seasonal factors. Nonetheless, China’s q1 current account surplus is on track to exceed its current account surplus in q1 2009, even with China’s fiscal stimulus.

On a rolling 12m basis, China’s trade surplus is at or near a record high, even including the February data. That may change if the global slump -- now a quite severe global slump -- continues to cut into China’s export and the stimulus reverses the slide in China’s (real) imports. But for now, China’s surplus is getting bigger not smaller.

So why has reserve growth slowed? Simple: private capital is leaving China. And that has nothing to do with the fiscal stimulus. It is tied to the dollar’s rise -- and expectations that China might allow its currency to slide against the dollar to help its export sector.

For the year, the World Bank forecasts that China’s $425 billion current account surplus will lead to $425 billion in reserve growth, as "hot" outflows subside. That means that China will still be buying foreign assets, and unless something changes, it will still be buying Treasuries. Perhaps not quite at the same rate as before. But there is a difference between not buying as much and selling.

So what has China been selling? Simple: Agencies. That isn’t because China needs the money to finance its fiscal deficit, or (more realistically) to finance large capital outflows. It is simply because China seems to have lost confidence in the implicit guarantee that backs the Agency market.

What is the Fed buying: Agencies.

That helps China. If SAFE wants to lighten up its Agency portfolio -- and it has a lot of Agency MBS -- it can now sell to the Fed. That facilitates its exit from its large position in the Agency market. I suspect that China alone accounts for about half of all central bank Agency holdings -- it is a huge player. The Fed, in effect, is making it easier for China to sell long-term Agency bonds and shift into short-term Treasury bills -- or whatever other asset China wants to buy.

That help though isn’t free.

The Fed’s move has pushed the dollar down v the euro. And helped push oil up. Neither helps China financially. If China wants to shift from say Agencies to bunds, it is now easier for it to trade its Agencies for dollars, but each dollar buys fewer euros.

The dollar’s share of China’s reserve portfolio exceeds the United States’ share of China’s imports. The more the dollar falls over time, the fewer of the world’s goods China can buy with all the dollars it has salted away. And the more the dollar falls, the more likely that the RMB will eventually resume its rise against the dollar.

That also doesn’t help China financially. China’s government has borrowed in RMB to buy dollars and to a lesser degree euros, effectively opting to hold more reserves than it needs to support its export sector. The ultimate cost of that policy hinges on the dollar’s ultimate fall v the RMB.

SAFE thus should want a strong dollar, as it is fundamentally long dollars. Relative to other reserve currencies. And relative to China’s own currency.

Then again China’s policy of building up far more reserves than it needs never made much financial sense. China wasn’t all that happy with a strong dollar, even if that was in its financial interest.

The RMB has appreciated far more in real terms over the last nine months -- when it has been tightly pegged to the dollar -- than it ever did back when the RMB was appreciating against a depreciating dollar. My guess is that Europe is far more worried by the dollar’s recent slide than China. China -- or least its exporters -- weren’t happy with the RMB’s recent strength.

The Fed thus, in some sense, bailed out China’s exporters far more than it bailed out China’s reserve managers.

Actually, it makes more sense to think of the Fed as substituting for China in the market for Agencies -- and other central banks -- than to think of the Fed as bailing out China and other central banks. The end of the foreign central bank bid, as global reserve growth slowed and central banks shifte dto Treasuries -- has had a big impact on the Agency market. That wasn’t helping the US housing market.

Nor is the Fed just stepping in to buy the Agency bonds central banks now want to sell. It is also trying to substitute for the collapse in private financial intermediation here in the US. Private banks have gone from lending huge sums for almost nothing to not lending even when spreads are much higher for the same risk.

Put it this way: foreign central banks never bought anything close to a trillion dollars of Treasuries and Agencies in a single year. A half trillion or so of annual purchases was more than enough to have an impact ..

* Russia is effectively using its reserves to make up for the fall in the government’s export revenues. Absent a buffer of reserves, that short-fall would have required that Russia reduce both government spending and its import bill.

More on:

Monetary Policy