Sino-US relations are becoming ever more important and for investors, it is critical to understand the political factors that drive China as well as basic economic fundamentals.
While I will provide a review of Chinese foreign exchange holdings and past trade patterns, I have to emphasize that for as long as the Taiwan issue remains unresolved, both countries could find themselves in a conflict situation within days. Next to providing a stable environment for economic growth future, reunification with Taiwan is one of the two main pillars of regime legitimacy.
"Now many countries are saying that China is good and hope that China will emerge, but honestly we are still a developing country. Don't over estimate the fact that we have almost 2 trillion dollar in our foreign exchange reserve. If you take that amount and divide it by 1.3 billion people, how much per head is that? Therefore, we truly need to conduct our own affairs well." (Hu Jintao in 2009)
As a result of large current-account surpluses, some nations have been able to build up impressive foreign exchange reserves with China having surpassed Japan sometime in 2008. Brad Setser, who works on the Council on Foreign Relations (CFR), has provided a fine analysis of China’s foreign asset holdings on his blog. In of his more recent entries, he sees China approaching a staggering 2.5 trillion in foreign-asset holdings.
When looking at this graph, we have take into account the enormous rise after 2003 when foreign exchange holdings were at US$ 500 billion.
They have increased five-fold since then. This means that China has domestic wealth-creation facilities and the ability, should e.g. US-debt be defaulted on, to quickly make up any losses.
Setser came to US$ 2.5 trillion by adding $1.946 trillion in formal reserves, $252 billion in portfolio debt and a further roughly $250 billion for bank’s dollar holdings and the assets of the China Investment Corporation (CIC).
How has China managed to build up such a large amount of foreign-asset-holdings? That issue is of much debate, leading to many heated sessions in the US Congress with some people accusing China of being a ‘currency manipulator’.
China is not the only goods-exporting nation that is running up a substantial surplus. Germany, which is part of the Eurozone, boasts a similar current- account surplus and can hardly be accused of being a currency manipulator.
A paper by the Congressional Research Service (CRS) summed up the accusations that China intentionally holds down the value of her currency, thus making American exports to China more expensive leading to a loss in manufacturing jobs and a substantial trade deficit. From 1994 to 2005, China pegged the yuan to the US$ at an exchange rate of 8.28. It was considered to be close to market value at the time.
However in 2005 policy switched and it was decided to let the yuan float against a basket of currencies. Ever since the exchange rate has moved to 6.83. Government is still intervening though and the shift is happening at a lesser pace than market forces would suggest. Despite that appreciation, some still argue that the yuan is undervalued by about 15-40%.
A recent study by Yin-Wong Cheung, Menzie Chinn and Eiji Fujii arrived at the conclusion that the exchange had been undervalued by 10 % in 2006. Considering the yuan moved up by 18% since December 2007 alone, we may conclude that as of now the yuan is close to where it should be were it fully under market forces.
China is not the only country to massively increase dollar-holdings; other East Asian nations followed suit. Why were they doing this? After all, it is ironic that some of the world’s poorest nations (by GDP/capita) were pouring trillions of money into one of the richest countries, the United States of America. Typically one would assume that those nations would be using their savings and CA surpluses within their domestic economy given the needs for infrastructure and basic social welfare.
Following the Asian crisis in 1997, many countries found their currencies under speculative attack and were only able to receive IMF credit lines by following austerity measures the US itself would not have imposed upon itself. The lesson those countries and an enraged public took from it was to build up foreign exchange reserves in order to be able to weather the next storm without IMF help (e.g. the IMF forced the countries to increase interest rates, that choke off economic growth).
As a result, the IMF’s reputation has suffered a lot of damage in East Asia with most governments very hesitant to approach it in times of crisis.
It was only in the 1970s that the Western World moved to floating exchange rates. Economic policy in China is driven by the desire to achieve both high growth rates but also stability. The Communist Party could politically not afford a serious downturn and is thus following a very cautious line.
Factoring in various problems, such as the instability of market forces (maybe even distrust of market forces within the CCP), the relatively short time floating exchange rates have been in existence and how quick ‘hot-money’ in-and-outflows can cause destabilization, it is understandable that China only gradually eases restrictions on capital movement and yuan convertibility.
However, as noted above, on a per-capita basis, China’s foreign exchange reserves aren’t that impressive and there is a focus to concentrate on solving the vast array of problems at home.
Nonetheless, China is engaging in the world at a rising speed and has found its influence already increased.
A large part of China’s foreign exchange reserves is invested in US Treasuries and US agency debt. A noticeable shift towards short-term Treasury bills has been happening most recently and China has been aggressively snapping up deals to secure natural resource supply.
As China holds such an enormous pile of foreign exchange reserves, it has given rise to speculation that China might use them in order to gain influence by giving out ‘soft-loans’ or helping out in other ways.
It came as no small surprise when Pakistan’s president Asif Ali Zardaria approached Beijing in 2008 for some hundreds of millions in emergency aid. Geopolitically that move makes sense as India, feeling threatened by China’s string of pearls policy, and America have been moving ever closer. It has been reported that America and India are in negotiations to develop an Indian missile shield.
China is already strengthening ties in the region with Burma’s regime and is still well regarded in Thailand for its help after the Asian crisis. Not to mention the fear and anger stoked by China’s involvement in Sri Lanka by building a port in the country's southeast at Hambantota; after the United States dropped aid because of human rights issues, China became the biggest donor and equips Sri Lanka with military hardware.
China is further engaging in the Mekong region, building ties through the Greater Mekong Subregion Programme for Economic Cooperation.
From personal experience in the region, Chinese influence, especially in Cambodia and Vietnam to a smaller degree, became evident after seeing how ethnic Chinese dominated business.
The Bond Market
While China’s been quickly adding to its holdings of Treasuries, Japan has been keeping them about constant, which means that it did not engage in buying Treasuries in a meaningful way in the past few years and looks set to continue in that role. The oil exporters hold fewer than might be thought given that they receive billions daily for their resources (US$ 200bn). The UK has holdings in the range of about US$ 130bn. Holdings of China, Taiwan, Hong Kong and Singapore put together were close to one trillion (US$ 962bn)
It is important to note that whilst the other players aren’t involved with similar stakes, there are more than a dozen nations, most of them geopolitically important, also involved in the Treasury market. Any quick move out of Treasuries by China would lead to massive losses for all the parties concerned, which is why despite the talk of China using the ‘nuclear option’ of selling large amounts of those bonds, it would be political harakiri leading to worse relations with key players such as the oil exporting nations Brazil, Singapore and Turkey.
Foreign Assets & Trade
The US share of China’s portfolio has remained just about constant since 2000, dipping slightly higher over time.
The majority of China’s US holdings is invested in Treasury bonds, the second largest group being agency bonds. However, China has been leaving the agency bond market (mostly Fannie and Freddie) over uncertainty about their financial soundness. China further holds $100bn each in corporate bonds and equities.
Chinese assets have grown steadily over time, reserve growth skyrocketed in 2007 and 2008 at the height of the consumption bubble. After a sharp downfall in trade reserve growth, it is currently at the level of 2005.
Chinese purchases of Treasuries and agencies have provided about half of the financing the United States stemming from central banks.
While the black line shows the American trade deficit, the green line depicts the purchases of central banks, with red representing Chinese purchases. Japan hardly increased its purchases, as can be seen by the dark blue line which hardly moved above the zero line.
Trade stands now at more than US$ 400bn, quadrupling in size over less than a decade. The trade deficit was at a staggering 266.3bn in 2008. Chinese exports have for years increased at over 20%.
US exports had similar growth rates but started at a much lower basis.
China’s electrical machinery and equipment exports to the United States were larger than all American exports to China put together ($80.3 bn against $71.5. bn).
China increased exports to the world by a factor of seven within a decade; imports haven’t risen at the same pace, however, and thus China’s been able to record a surplus of almost $300bn in 2008. Trade has been highest with the United States followed by the East Asian neighbours and Germany.
Trade with other nations has been far more balanced, The United States is the biggest export destination but only ranks fourth in terms of imports, behind Taiwan. Germany has a fairly balanced trade relationship, Japan and South Korea even hold surpluses against China.
The United States thus remains one of the most important countries for China, about one fourth of its exports make its way to the ports of America. As the yuan dollar exchange rate is on a ‘managed float’, China needs to buy those dollars generated by the trade surplus in order to keep the exchange rate stable.
To gain interest on these dollars, China invests them back in the United States.
The American Budget
“Be nice to the countries that lend you money.” (Gao Xiqing)
The forecast by the Congressional Budget Office (CBO) projects record fiscal deficits all the way through 2020. Most of the deficit is structural, one-off programmes like the stimulus package and TARP don’t make up for the huge gap.
Before heading to the current bond market, remember the problems that continental Europe faces. Milton Friedman predicted that the Eurozone would not survive its first economic crisis. The problems confronting Britain: this year alone at least 12% of a budget deficit, not to mention the insane growth in credit and asset price inflation.
Many people will be asking themselves if being able to vote every couple of years is worth the political shenanigans; what's the point in voting if your mortgage payments go through the roof because of policy-induced price hikes?
Now compare the relative macroeconomic stability China enjoys amidst all that data coming from the Western Word. A side effect of political turmoil in the West would be a strengthening of regime legitimacy in China, which would hurt the democratic movement for decades to come. The Communist Party will thus do its utmost to prevent any severe downturn, which is why we shouldn't expect monetary tightening anytime soon.
Considering China’s vast population, GDP/capita will remain low for decades. However, wealth is unequally distributed within China. What is often forgotten is that a flight to Albania or Sweden is about equally long from Frankfurt; Europe itself does have pockets of poor people.
China’s huge population makes it impossible for hundreds of millions to find work in productive jobs (some companies ‘dumb down’ processes as Chinese labour is cheaper than machines in some cases), thus their wages are low , thus they ‘drag down’ per capita figures.
Still, hundreds of millions will find decent work that enables them to be just as productive as a Westerner; the only thing that is keeping their pay low is the currency they are being paid in.
And that moves us to the bond market.
Deflation or Inflation?
One of the most critical debates in today’s world is whether we're going to face deflation or inflation. Both sides have powerful arguments on their side setting multi-billion bets each way.
Inflationistas point out to the large increase in money supply and quantitative easing, deflationistas to the huge wealth and credit destruction as well as excess deposit reserves (i.e. the printed money isn’t given out in loans).
Not only is there thus dollar-risk, there is also a risk of losing money on bonds as interest rates have to rise in order to get enough investors to part with their capital.
Within China there has been apprehension over the security of its bonds and there is increasing pressure on the US to assure China. “It will be helpful if Geithner can show us some arithmetic,” said Yu Yongding, former Chinese Central bank advisor, when Treasury Secretary Geithner came to China.
Furthermore, 17 of 23 Chinese economists having been asked prior to Geithner’s arrival in June 2009 considered holdings of Treasuries a “great risk” for the nation’s economy.
Most embarrassingly, when claiming that Chinese assets were very safe during a talk at Peking University, his answer drew laughter from the student audience.
The US needs to issue some 2 trillion in debt this year alone (the forecasts had been too optimistic again). Every second dollar that is spent is borrowed.
As is visible from the CBO's forecast, that situation will only slightly ease. However the question remains as to how the deficits are going to be financed. The Fed has been trying to absorb some of the debt and keep yields low by engaging in quantitative easing, basically monetizing the debt. The programme runs at 300 billion.
As noted above, low yields are absolutely necessary as the 30-year mortgage rate and thus housing prices are linked to the 10-year bond. With falling house prices, banks will not be able to repair their balance sheets and many people find themselves ‘underwater’ on their mortgage.
However, there is a conundrum in that government deficits to the tune of two trillion US$ inevitably pushes yields higher. The Fed cannot keep on monetizing the debt as this is stoking inflationary fear among investors and would cause them to sell their bonds.
Further quantitative easing causes investors to sell their bonds to the Fed (high bid-to-cover ratios) as the Fed must overpay in order to keep rates low.
This is harming the long-end of the curve as we can already witness a steep-yield curve. Many flee towards the short-end. In fact, quantitative easing can cause mistrust since the market is not allowed to work on its own and there’s deliberate manipulation.
Recently a shift from long-term bonds to short-term bills has been visible. China is moving towards the shorter end for now and possibly trying to unwind as much long-term Treasuries as possible; due to being such a substantial holder of Treasuries, any rash sell-off would lead to massive losses (remember also all the other players with Treasury holdings) on the remaining bonds.
Thus China has to gradually ease out of the bond market. They are still earning money from their trade surplus and may decide to invest it in natural resources or keep it simply in cash; in such times, many investors value return of money higher than return on money.
The announcement of QE initially moved rates lower however they’ve been creeping back up again to prior levels.
There is nothing the Fed can do about rising rates as the market is too huge to be controlled (300bn US$ of QE against trillions in debt issuance). Any increase of QE would spark fears of inflation. Investors would be leaving the market as they’d assume debt would be monetized, with fewer investors rates would increase. As a result, QE would be self-defeating. China could help get rates lower by showing signs of trust and making commitments in the market.
Commodities & Other Alternatives
China is making moves into the commodities market and has been been buying farmland in Cambodia and Africa to secure food supply and combat rising world market prices.
China owns surprisingly little gold. Its reserves have more than doubled over the past five years but China is still only the fifth biggest holder with 1,054 tons. The US is the biggest one with 8,133 tons followed by Germany (3,412 tons), France (2,508 tons) and Italy (2,451 tons).
To put those numbers into perspective, the International Monetary Fund (IMF) holds 3,217 tons of gold, which were valued at US$ 94.8 billion as of March 31, 2009.
From that we can calculate that America’s gold reserves only cover a fraction of Chinese Treasury holdings. In comparison to other nations, China’s gold holdings only account for 1.6 percent of its reserves.
Even though the IMF will be selling some if its gold holdings, the gold market is not big enough to serve as the sole source of diversification for China.
After the collapse of commodity prices, China went on a shopping spree and built up large inventories in items such as iron ore, aluminum, copper, nickel, tin, zinc and soybeans. That increase in prices helped natural resource exporting nations such as Australia. Nonetheless, a deal between Chinalco (ACH) and Rio Tinto (RTP) fell through amidst speculation that the decision to walk away from the $19.5 billion deal was politically motivated.
Ironically, it was exactly the increase in Chinese spending on commodities that led to dissatisfaction among Rio Tinto shareholders, since prices recovered from their low at the time of the offer.
China is such a big participant that any move it makes immediately changes the market price. No single market is big enough for China to significantly diversify into unless it doesn’t mind paying over the odds.
One option that hasn’t been looked into is to stay in cash, as during a deflation the real value of cash rises. That way they would forgo any interest payment but would have the safety of not having to unwind an asset at a possible loss.
In summary, whether we like it or not, economic policy in the Western World is directly playing into the CCP's hands. China has been handing out credit as if it were going out of fashion for both political and economic reasons, and state banks will surely incur losses on them, but domestic stability trumps economic viability.
- Brad Setser, "China’s $1.5 Trillion Bet". Council on Foreign Relations (2009)
- CGS Working Paper (pdf warning)
- US-China Trade Statistics and China's World Trade Statistics
- Perot Charts: CBO’s Estimate of the President’s Budget
Disclosure: No positions