Will China End Its Co-Dependent Relationship with the U.S.?

There is quite the co-dependent dynamic happening between the U.S. and China. They need our consumers to support their export business, and we need them to buy up our debt so we can consume over our head... which allows them to sustain their export business! Even when they hate what we are doing they must support us [Feb 13, 2009: Ft.com - China to US: "We Hate You Guys"]

While some have called out that China will eventually abandon buying U.S. debt (which would cause a potential collapse in the dollar, and our country - although the Federal Reserve would step in as a buyer - remember, the whole Banana Republic thing) the problem is timing. Many think it is imminent or "in a year or two". Nah. I agree that if the Chinese had any other choice they should (and would) be moving away. But guess what - it's a co-dependent relationship. We need their money but they need us to buy stuff. Lots of it. As they say, when a borrower owes a little money, the power is with the creditor but when a borrower owes a ton of money, the power is with the borrower <--- waddya gonna do? walk away from us now?? Here is the blurb...

China will continue to buy US Treasury bonds even though it knows the dollar will depreciate because such investments remain its “only option” in a perilous world, a senior Chinese banking regulator said on Wednesday.

Mr Luo, whose English tends toward the colloquial, added: “We hate you guys. Once you start issuing $1 trillion-$2 trillion [$1,000bn-$2,000bn] . . .we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.”

Now that is the definition of a Jerry Springer like co-dependent couple: I hate you! But you're momma's baby daddy so I am stuck with you in my life.

A little known fact is actually China derives more exports to Europe than America, but we are still a very large impact on their GDP. Now I suspect over the coming decade China will continue to build its own in house consumption and other markets will continue to grow (Indonesia, India, Brazil), and at some point letting the US fall on its own sword will be more practical. But we're not close to that point yet.

However, there are many small things going on that almost no one talks about as China tries to detach itself slowly but surely from its debt-addicted junkie - we're seeing bilateral currency agreements with multiple countries, we're seeing China "stockpiling" hard assets rather than just piling the money into more US debt, we're seeing them switch from longer term paper to short term; it will be a long process but China is very patient and very methodical. The government there actually looks out more than 1 election cycle.

It also was interesting how Hank Paulson last fall said everything was fine with Fannie, and Freddie (remember, he had his bazooka!) and then China said they wanted guarantees on their agency debt holdings, and lo and behold look who they made jump when they said "jump"! Mr Paulson quickly effectively nationalized the two within days of the Chinese comment... I am sure it was just "happenstance". So we can sit here smugly and say we're the power, but really the Fannie, Freddie episode shows me how desperate the junkie can become when the dealer raises a fuss.

Folks, we are not changing or improving our behavior - in fact we're getting worse. Our debt load grows, and we continue to ignore our long term issues. Entitlements, pensions, state budgets, bailing out the oligarchs - all of it is solved by looking the other way and kicking the can or creating more debt. For those of us who actually pay attention (a small minority in the country) we simply lurch from one emergency to another and what "solves" emergency A creates new historic problems B, C, and D 3-7 years down the road. That's now official policy response.

It will all end badly - just a matter of when and how it ends. If I were China and I wanted to take the mantle as sole superpower, I'd continue to give the US as much rope as it wants (to hang itself), and then in 12-15 years say "no mas" all at once. The fireworks would be spectacular. But for now they can't go cold turkey - but per this NYTimes piece they are getting more picky in their demands.

(click to enlarge)

• Leaders in both Washington and Beijing have been fretting openly about the mutual dependence — some would say codependence — created by China’s vast holdings of United States bonds. But beyond the talk, the relationship is already changing with surprising speed.
• China is growing more picky about which American debt it is willing to finance, and is changing laws to make it easier for Chinese companies to invest abroad the billions of dollars they take in each year by exporting to America. (we saw the announcement a few weeks ago to allow investment in Taiwan) For its part, the United States is becoming relatively less dependent on Chinese financing.
• China has actually bought Treasury bonds at an accelerating pace over the last year — notwithstanding Chinese officials’ complaints about American profligacy. But the borrowing needs of the United States government have grown even faster. So China represents a rapidly shrinking share of overall purchases of Treasury securities.
• Americans and investors elsewhere are buying Treasuries instead. They are saving more and have been shifting out of other investments — including equities until the past two months — and into Treasuries.

Now

• China bought less than a sixth of the Treasuries issued in the 12 months through March.

Then

• Less than two years ago, by contrast, Chinese purchases of Treasuries, which included purchases in the secondary market as well as newly issued securities, briefly exceeded the entire borrowing needs of the United States.

What's happening under the surface?

• Financial statistics released by both countries in recent days show that China paradoxically stepped up its lending to the American government over the winter even as it virtually stopped putting fresh money into dollars.
• This combination is possible because China has been exchanging one dollar-denominated asset for another — selling the debt of government-sponsored enterprises like Fannie Mae and Freddie Mac in a hurry to buy Treasuries.

Why you may ask? Well the Federal Reserve is now buying about 80% of all issued Freddie and Fannie debt. So it's a big shell game. This is quantitative easing of another nature. Instead of directly buying US Treasuries (over and above the $300B the Fed has promised) we've shifted the Chinese into that role, and then the Federal Reserve picks up the slack by buying agency debt.

So this way we look less like a Banana Republic... because if the Chinese were buying their old levels of agency debt, the Fed would have to be buying huge swathes of Treasuries. Hey - lookee here, try to find the debt! It's not under this shell, or that one! Tricked ya - it was under shell #3. This method allows us to save face and pretend we are not basically buying from ourselves day and night.

• ... new data shows that China is also trading long-term Treasuries for short-term notes, highlighting Beijing’s concerns that inflation will erode the dollar’s value in the long run as America amasses record debt. It has done so in ways calculated to reduce its exposure to inflation or other problems in the United States. As recently as a year ago, China actively bought long-dated bonds, seeking the extra yield they could bring compared to Treasury securities with short maturities, of which China bought virtually none.
• But in each month since November, China has been buying more Treasury bills, with a maturity of a year or less, than Treasuries with longer maturities. This gives China the option of cashing out its positions in a hurry, by not rolling over its investments into new Treasury bills as they come due should inflation in the United States start rising and make Treasury securities less attractive.
• So China’s rising purchases of Treasuries do not represent the confident bet on America’s future that they might seem to be on the surface. For instance, China does not appear to be dumping euros or yen to buy Treasuries, economists said.
• That said, recent Chinese and American data suggest that an astounding 82 percent of China’s $2 trillion in foreign reserves is in dollars.
• “We have lent a huge amount of money to the U.S. Of course we are concerned about the safety of our assets. To be honest, I am definitely a little worried,” Mr. Wen said earlier this year.

There is no free lunch; stock market participants are simply gleeful that risk has been taken away from them and instead hoisted onto the back of the US taxpayer. Eventually that taxpayer will pay... and in spades; either through currency or inflation crisis. When the world returns to normal, US Treasuries won't be the place to park money - rates will need to go up to compete for capital inflows with other countries. [Nov 21, 2008: Bookkeeping: Initiating Ultrashort Lehman 20+ Year Treasury] But for now - let's keep kicking the can and whistling - sticking our head in the sand also helps provide glee (I also believe green shoots grow underground). Maybe we can do it for a decade more.

p.s. my prediction for the first ever $2 Trillion Annual Budget Deficit I made in latter 2008 is looking like a home run. (remember the worst ever before this year was last year's $400Billion-ish!) Meanwhile what were those "in the know" telling you at the beginning of the year? [Jan 7, 2009: CBO Projects $1.2 Trillion Deficit in 2009] One blogger with common sense could project better than an entire government department. But don't you worry - deficits don't matter (source: Dick Cheney)

[Mar 29, 2009: CNNMoney: Should USA Still be AAA?]

[Nov 12, 2008: CNBC Europe - USA May Lose its AAA Rating]

[Apr 15, 2008: Could the US Lost its AAA Rating?]

[Jan 8, 2009: New York Times - China Losing Taste for US Debt]

[Dec 26, 2008: Japan Should Just Begin Writing off US Debt]

Comments

[JohnAl:]

Thought provoking article, thanks.

Americans underestimate the Chinese. We've been on top so long, and we ignore history. The west hasn't always ruled but not one in one hundred Americans appreciates this. If we don't change our profligate ways soon, we WILL come to appreciate this.

As you point out, there is solid evidence that the Chinese are decoupling. Americans need to understand this.... It is they, not us, who hold the cards in this game. They produce. We consume.

May 21 07:22 PM

[traden4alpha:]

Great article, TraderMark. Two thoughts:

First, global trade has fallen much more than has GDP of countries. Some of this is only a clearing of inventory in transit, but some if it represents a more long-term loss of global trade to consumer frugality and "buy local" trends. If so, then Chinese exports might not recover to pre-crash levels and the Chinese might realize that we've stopped holding up our end of the we-buy-they-lend codependency. That may cause the Chinese to see less need to protect trade relations.

Second, what about Chinese activity in the derivative markets? I'd imagine that the Chinese could hedge some of their dollar and T-bill risks with fx and interest rate swaps. A methodical and carefully distributed program of these contracts might build a fully hedged position for the Chinese without the market being aware that the Chinese had effectively "sold" most of their USD assets. Given all the "flight to quality" movement into "safe" US assets, would anyone notice if the USD or UST prices were less than as high as they could be? Of course, this strategy assumes the counterparties can handle the risk.

P.S. I too see much higher US govt deficits in the future. The progressive nature of the US tax code means that tax receipts generally fall faster than GDP or aggregate household income. Revenues will be light.

May 21 08:46 PM

[PastTense:]

I don't understand why China isn't buying more U.S. companies--I would think natural resources, technology, and distribution channels (Walmart...).

May 21 08:54 PM

[nun:]

Gosh I'm sick of hearing China complain.

They chose to intentionally deflate their currency beyond belief and restrict currency exchange. They chose to put 80+% into one bucket. They chose their reserve currency. If they wanted guarantees on their agency debt holdings, they should have bought treasuries with a smaller return. China has done all of this intentionally and then wants to portray a "poor China" image.

Last year my company started a fund to support earthquake victims in China. WHAT??! China is loaded with reserves. Why are we donating money?

May 21 09:12 PM

[Tony Petroski:]

Mr. Mark, you wrote "...it will be a long process but China is very patient and very methodical. The government there actually looks out more than 1 election cycle."

Huh? What election cycle? The one in which the correct communists get 99.8% of the vote and the losing candidates are shot?

May 21 09:28 PM

[Mark Bern:]

Trader Mark - Your article was insightful and very thought-provoking! Enjoyed the read.

The Chinese can and do have a much longer view of things. They are in control to a greater degree than our government and can round up any strays that get out of line without lawyers. They don't worry about elections every four years. As long as things appear to be heading in the right direction the leaders lead for as long as they breath. But they are accumlating considerable problems of which they would rather we weren't aware.

Some months ago a Chinese government agency had reported the loss of 20 million manufacturing jobs due to lower export demand, especially in heavy industries like steel. They projected that the total number of lost jobs could get as high as 50 million before the recession was over. That was the last we have heard from that official or his department.

China cannot hide the deterioration in their exports. Their counterparties and transporters have the numbers and, thus far, are reporting that exports from China in the 1st quarter of 2009 are off by 25%. That's huge! Even if, as it has been widely reported by the Chinese government, only 20% of GDP is derived from exports then the impact on GDP is still a negative 5%.

Since the Chairman says they will have growth in 2009 of at least 6% (and more recently reported that it would be 8%) the other 80% of the economy (the domestic portion) will have to grow much faster than in the past. Just to get to 6% overall GDP growth it would require the domestic economy to grow at a 14% rate over the full year. If things were slack in the first quarter before they could ramp up, it may take more like 16-18% domestic growth to reach the 6% GDP growth overall.

With exports putting them in the hole 5% one might assume that the domestic economy needs grow only at 11% to make up for the minus 5%. Not so! If 80% of the economy grows at 11% it only increases total GDP by 8.8%. Now subtract the negative 5% for lost exports and you're only at 3.8% overall. Bummer, Dude! But with 14% growth of the 80% domestic economy, you get to 11.2%. Now, when you subtract the 5% drag for diminished exports, you still have overall GDP growth of 6.2%

But using the same math, a domestic economy growth rate of nearly 16% is required to achieve a net of 8% GDP annual growth. He must be talking about achieving an annualized rate of 8% growth during the last quarter of the year. That point hasn't come out in any of his comments or any Q&As. Even that will be daunting.

My point for all this is that the interdependency relationship that China has with the West (not just the U.S.) is reeking havoc with their planning in the short and intermediate term. How much, we'll never know for sure. But don't believe the "official" communications coming out of Bejing. They are feeling the pain. They aren't in denial internally (internally to their public, yes) as they understand all too well what is going on. But when you control all forms of communication (including the Internet) you can say whatever you want others to believe.

I also liked the comments by traden4alpha. Yes, I wouldn't be surprised if the Chinese have already taking such moves. They are patient and will go to great lengths to hide their real activities and intentions. But the truth is out: They hate us guys! It isn't hard to guess what their intentions are. They're just waiting for the right moment. Are we really safe for as long as we want to think? If they get themselves properly hedged, why would they wait?

May 21 10:05 PM

[thiazole:]

The only way I can think of to solve this problem is to make a new WTO rule that limits the discrepancy in trade between two trade partners. If one nation exports $50 billion to another, they need to import within a certain percentage of that same number. If they don't, then they can't export. It isn't a perfect solution, but it is the only way I can think of to force China, Japan, and oil producing nations to stop hoarding currency - they can either play be fair rules or not play at all. They are the cause of the global recession. Consumption is not the cause, but lack of consumption. It is like having a trading partner that only accepts IOUs and won't take any of your goods. Then once they've built up so many IOUs that you couldn't possibly barter them away in a short period of time, they extort you with them.

May 22 12:39 AM

[beijingpaddy:]

Lots of useful data here. Very helpful. But I don’t think the Chinese are deliberately trying to do the US dirty via some type of currency wars. Rather it is a case of smart business practices. No one ever accused the Chinese of being poor in business. The world has changed and guess what? The entire international community is now stuck in a co-dependency syndrome. Can’t live with them, can’t live without them. Things are only going to get more complex (dysfunctional?) going forward.

China needs to reduce their current over-dependence on USD dollar holdings to whatever degree possible from their standpoint. Some reformulated foreign exchange strategies are already beginning to emerge. We are getting hints of where they would like to go if they could have everything their own way. But they can not as they suffer from many trade constraints (suffer is not the correct word unless you equate making hordes of money with pain). If you have studied anything about the history of China, you will know that they are extremely pragmatic when allowed to be. Don’t expect any sudden shocks. Any changes in their foreign exchange policy will be gradual giving everyone lots of time to adjust. They are not interested in killing the goose that lays the golden eggs.

The real question that will need to be answered is how Americans will respond to policies from our global peers that change the status quo. I think this is the more uncertain part of the equation for the future, more than worrying about the Chinese. For good or bad, the Chinese are more predictable.

May 22 01:52 AM

[Hot Richard:]

Will China End Its Co-Dependent Relationship with the U.S.?

YES!

There's still trouble looming for China as they look to replace US consumption, absorb the bad US debt (made bad thru $$$ printing presses), and having to look for other places to stack their cash.

That last problem is the easiest. It is actually not a heavy burden, regardless what Washington DC might think, to spend less than you take in. China can invest internally for decades just with the Honey-do list of infrastructure projects they have right now.

The other two are also pretty easy, but take time. The rest of the world will benefit from a flood of cheap Chinese production capacity with mutually beneficial trade lifting a lot of global boats. And, that whole bad debt thing will most likely be taken care of China-style with a few high ranking officials taken behind the barn and shot. Not a good idea to lose billions of the people's money in China (you have to be in America to be rewarded for that!).

May 22 09:49 AM