from Follow the Money

One thing not to worry about ...

May 22, 2008

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

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Calculated Risk is worried that China -- and other countries with lots of reserves -- may start to spend more domestically, leaving less to park in US Treasuries. This concern is sometimes tied more specifically to last week’s tragic earthquake. Funds that China spends rebuilding won’t be available to lend to the US. It would be hard to float a new bond to investment the CIC’s investment in US banks when there are very clear pressing needs in China. Calculated Risk writes:

"What happens if these countries use these accumulated surpluses to stimulate their domestic economies to offset weaker exports to the U.S.? Wouldn’t they have to sell U.S. assets? And wouldn’t that push up interest rates in the U.S. - further weakening the U.S. economy - and further weakening exports for these same countries?"

I worry about a lot of things, but I would put the risk that China will spend too much domestically far down on my list of concerns.

The most likely impact of more domestic spending in China isn’t the sale of US assets. It is a somewhat reduced amount of new buying. And if China’s foreign assets rose by something like $200 billion (counting funds shifted to the CIC and the rise in the foreign assets of the state banks) in the first quarter, China has a lot of scope to reduce its purchases without selling anything.

And the way is oil is rising right now, any fall off in Chinese purchases will be offset by rising demand for US financial assets from cash rich oil exporters. There is an enormous difference between a world where oil trades at $70 a barrel (and the oil-exporters can cover their budgets and pay for their imports with $50 a barrel oil) and a world where oil trades at $130 a barrel (and the oil-exporters can cover their budgets and pay for their imports with $55 a barrel oil). Spending would have to go WAY up before the Gulf would need to start selling off some its foreign assets right now.

Official portfolios are set to increase by well over a trillion dollars this year. There is lots of scope to buy less without selling anything.

Moreover, a rise in domestic spending that reduces the surpluses of the big surplus economies will intrinsically be a gradual process. It won’t happen overnight. It won’t produce any sharp, sudden adjustments. Over time, it should mean less new demand for US assets, and slightly higher US rates. But that is in some deep sense inevitable: the US cannot realistically expect to finance deficits for ever by selling bonds that pay interest rates too low to provide foreign investors a real return. It is also part of the process that will bring the US economy into better balance. Higher rates will make it more costly to borrow, and increase the return on savings -- leading Americans over time to borrow less and save more.

As long as that adjustment happens gradually, the US economy should be able to adapt -- just as it adapted to a surge in imports and lower interest rates in the late 1990s and the first six years of this decade. Manufacturing was hurt; interest-sensitive sectors did well. That process will have to run in reverse for a while.

The scenarios that worry me are those where there is a sharp discontinuity in the world’s willingness to finance the US that forces sudden and immediate adjustment, not a gradual adjustment. Something analogous the Asia’s 1997 crisis -- or the sudden collapse in demand for risky US debt in the summer of 1998.

The other scenario that worries me is the possibility that China won’t change. If the big surplus countries continue to maintain policies that rely on external rather than domestic demand and in process finance ever bigger deficits. Over time, that to me implies bigger not smaller risks.

If the slowdown in sales to the US -- and China’s very visible domestic needs -- lead China to issue bonds to finance infrastructure investment in China rather than the purchase of US bonds and banks, the US should applaud. That would be the kind of rebalancing of China’s economy toward domestic demand that the US and others have long argued is needed to reduce China’s surplus.

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