“The U.S. government has to come to terms with the painful fact that the good old days when it could just borrow its way out of messes of its own making are finally gone…” — China’s state-owned Xinhua News Agency.
It’s been quite a few days of chest thumping for our friends in the Chinese government. The ruling Party’s propagandists in Beijing have been working overtime, huffily putting out statements bashing the United States for its fiscal profligacy and economic sloth. China, you see, is the new economic super power. Its days of lending to the United States out of the goodness of its beneficent heart are just about over. Or so Beijing would have you believe.
Coming from Washington’s largest creditor, the noises out of Beijing now sure sound threatening don’t they? The Chinese, afraid that their massive three trillion dollars portfolio of foreign reserves — 70% of which is in Treasury debt — is going to be devalued, are just going to take their hard-earned money and go home. Screw you, Uncle Sam.
There’s this one little thing, though. There is no chance — none — that this will happen.
The amount of misinformation, the number of overwrought headlines and the fundamental economic illiteracy that surrounds the subject of China’s purchase of U.S. Treasury debt continues to be astounding. There are a couple of key points to remember whenever some hysterical radio talk show host or uniformed politician starts ranting about how China “owns us.” First, as Michael Pettis, a professor of finance at Peking University’s Guanghua School of Management and perhaps the most lucid voice on this subject amidst a global cacophony of dunces, wrote recently in his China Financial Markets newsletter: “Remember that the People’s Bank of China does not purchase huge amounts of U.S. government bonds because it has a lot of money lying around and doesn’t know what to do with it. Its purchase of U.S. government bonds is simply a function of its trade policy.”
Second, as Pettis again reminds us, “you cannot run a current account surplus unless you are also a net exporter of capital.” And China, lest anyone forget, is still running huge current account surpluses. Not, it is true, as massive a surplus as a share of its overall economy as it had a couple of years ago, when the current account surplus reached 10% of GDP, but huge nonetheless. It was $28.2 billion in the first quarter of this year, and exports continue to be a key driver of China’s overall economic growth. (Exports of goods and services constituted about 40% of China’s GDP growth in the first quarter.)
China could, of course, repatriate all the dollars its exporters earn by selling stuff to the U.S. But bringing that money home means converting the dollars into its own currency, the Renminbi (RMB), which means the value would rise—sharply against the dollar. This, of course, is how text-book trade and currency markets are supposed to function. If you run persistent trade surpluses, eventually your currency appreciates to the point that your goods become less competitive and the trade accounts adjust accordingly. Precisely because exports are such a significant part of China’s growth story, however, Beijing has purposefully slowed the adjustment process. The RMB over the last half-decade has gone from 8.2 to the dollar to about 6.5 now. It has appreciated somewhat, in other words, but as fast as it might have if the government hadn’t purposefully intervened to slow the process. The PBOC buys as many dollars as the market offers at the price it sets, and it pays for those dollars in RMB. (As Pettis writes, it does so by borrowing RMB in the domestic market, or by forcing Chinese banks to place reserves on deposit at the central bank.)
Beijing, it’s true, has tried to slow down its rapid accumulation of foreign exchange reserves over the last couple of years. But as Yu Yongding, an economist and advisor to the PBOC said in a piece last week, “these policies failed because they did not address the real cause of the rapid increase in foreign exchange: namely, state intervention aimed at controlling the pace of Renminbi appreciation.”
The value of Beijing’s dollar based foreign exchange reserves are eroding for China, as the RMB, slowly but surely, has crept against the dollar. Which is why Yu, to his credit, wrote in the FT that “the People’s Bank of China must stop buying US dollars and allow the Renminbi exchange rate to be decided by market forces as soon as possible.”
That’s exactly correct. The thing of it is, there’s about as much chance of that happening as there is of me replacing Yao Ming as the Houston Rocket’s center. There is no way Beijing is going to go cold turkey on exchange rates. Its exporters, already under pressure thanks to rising wages and some currency appreciation, would scream bloody murder. And remember, China is all about stability. Sudden, dramatic economic policy shocks are to be avoided if at all possible.
China does have a few options, of course. It could, instead of U.S. Treasuries, buy other foreign government bonds. You know what the second and third largest, most liquid domestic bond markets are in the world? Japan and Italy. Let’s have a show of hands of you folks at SAFE (the State Administration of Foreign Exchange, which manages Beijing’s foreign exchange reserves). How many of you want to significantly increase your exposure to Japan and Italy , particularly today with the ECB stepping in as a buyer of last resort for Italian debt?
On the margins, Beijing may well increase its reserves held in Yen, as well as in gold. And it will no doubt continue to increase its investment in hard assets, in the U.S. and elsewhere. Indeed, that would be good for everyone else. (The Obama administration should be issuing free visas to any Chinese citizen willing to pay $100,000 or more to buy a house in the United States.) But remember that China, in the first quarter of this year alone, acquired an additional $138 billion in new foreign exchange reserves. That money needs to go somewhere. It can either come home, or it needs to be reinvested. And the only market in the world that has the size and depth to handle that kind of money is, for better or worse, the U.S. government debt market.
As Pettis says, “every six months for the past several years we’ve heard the same thing:” China’s going to take its money elsewhere. Now, Beijing is making that threat in ever more strident terms, particularly following the controversial S&P downgrade. It earns cheap political points, both at home and abroad, for doing so. But the truth is, as Pettis says, “it isn’t going to happen.”