Wednesday, November 10, 2010

The China trashes Treasuries meme

Karen Maley has a long piece today largely paroting a Dagong Credit Agency Report on US credit worthiness. It's an interesting article that channels the argument that:
Tensions between the United States and China are set to escalate after one of China’s top ratings agencies downgraded the rating of US sovereign debt, and launched a blistering attack on US economic policy.

The report by Dagong Global Credit Rating Company is scathing of the US central bank’s policy of printing money, which it says will cause the US dollar to drop, and result in hefty losses for foreign investors in US government bonds. It warns that unless the US stops depending so heavily on loose monetary policy, the country could face “unpredictable risk in solvency in the coming one to two years".

The report is likely to fan fears that China is intending to scale back its purchases of US government bonds, which could put upward pressure on long-term US interest rates, and snuff out the fragile US economic recovery.

Official US data shows that China is the largest investor in US government bonds, holding $US868.4 billion of US treasuries at the end of August, ahead of Japan which held $US836.6 billion.

The question of whether or not China will shift away from US government bonds is an important one. However, the framework through which it is being viewed here is wrong, this blogger reckons.

First, for a year, both Maley and stablemate Robert Gottliebsen have intermittently fanned fears that China is already dumping treasuries, which is factually incorrect. As Brad Setser illustrated over one year ago, China also buys treasuries through the UK. Econompic has highlighted this too.

In fact, as Zero Hedge recently reported, the latest data suggests that China is ramping up its Treasury program.

More importantly, however, is the simple fact that the Chinese surplus is mushrooming again. According to John Garnaut this week:
Last year China's net exports detracted from its GDP growth, but in the recent September quarter net exports had returned to more than a third of GDP growth (3.7 out of 9.6 percentage points).

China's share of goods and services exports grew from 7.9 per cent in 2008 to 8.4 per cent last year. This year the World Bank forecasts that will shoot to 9.4 per cent. At this rate, China will supply 100 per cent of the world's imports by the end of the century.

The last time this blogger looked, the yuan was still pegged to the dollar as well.

So long as both of these conditions continue, China will need to put its surplus dollars somewhere. And the only place big enough is the US Treasury market.

But to really get to the bottom of China's intentions vis-a-vis Treasuries, perhaps we should apply some wisdom from strategic analysis.

There is almost always a gap between declared strategic/foreign policy and actual policy. The gap is a staple of international relations. In a simple example, sabre rattling is usually a way for nations to communicate their interests in emphatic terms rather than a prelude to war. The rattling sometimes also serves useful domestic purposes.

We should look to the emerging market's interests to gauge whether the rhetoric is for real (this blog does not mean to imply Dugang is an arm of the Chinese state!).

It would certainly make sense in the short to medium term for China to keep buying. The last thing it wants to see is the US recovery dissipate owing to rising long bond rates. Its own export industries would suffer further. This would make the transition to domestic demand tumultuous.

This blog suspects that the Chinese would fear this outcome far more than they would taking a bath on their Treasury holdings.

Only two things, it seems to this blogger, can change this. One is a trade war. At that point, the calculus of China's interests may shift because their trade exposed sector is screwed anyway. Even then, it is not a certainty. They may just raise the value of the yuan enough to shut the US up and keep buying.

The other reason is a certainty. It may happen because domestic inflation fuels internal demand and imports dramatically increase. In that event, the surplus just evaporates, like dew off grass.

Which doesn't make a great headline.

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