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Who would have thunk it two years ago? China’s massive trade surplus melted into a deficit during the first quarter, mainly due to unexpectedly high domestic demand. That is perhaps the best piece of news the world economy has had in a long time: It means that China has shifted from dependence on exports to sustain a 50% savings rate, to a more balanced model sustained by the internal market. We don’t yet have data, but China’s saving rate must have shrunk, and China’s relatively poor interior must be absorbing more of its output. All this is for the good.

Also remarkable is that the United States is managing to import capital at a trillion-dollar annual rate despite the fact that China no longer has a trade surplus to invest in U.S. Treasury securities. Who is buying U.S. Treasuries? The answer is: Everyone. As the table below makes clear, a third of the total came through the United Kingdom, which means banks and hedge funds, and a sixth of the total came through the Caribbean, which also means banks and hedge funds. Brazil accounted for $35 billion.

That contains good news as well as bad news. The good news is that a great deal of the world’s new wealth is coming back to the U.S. Treasury market. Despite the frightening size of the U.S. deficit, the U.S. Treasury market in some ways is the leper with the most fingers. Japan’s debt ratios are the worst in the world, and the European Union is held back by the PIIGS. New wealth diversifies out of risk, and some of this comes back to the U.S.

The bad news is that some of this reflects the weakening of the U.S. dollar and foreign exchange intervention by central banks, including Brazil, whose reserves have grown by almost $29 billion this year. The Fed prints money and foreign central banks print their own currency to slow the rate of appreciation of their own parity.

Net Foreign Purchases of U.S. Securities, November 2010 through January 2011:

All Countries

242567

United Kingdom

84399

Memo: European Union

72883

Total Europe

66872

Total Asia

60544

Total Caribbean

45624

Total Latin America

37939

Brazil

35505

Cayman Islands

32723

Canada

30791

Japan

25061

Bahamas

9605

China, Mainland

8276

Taiwan

7664

Thailand

6000

Luxembourg

3940

Hong Kong

3477

Philippines

3432

This suggests that if the Fed were to end quantitative easing, U.S. rates would have to adjust upwards to draw in real money — perhaps by a percentage point or so. The Fed’s own securities purchases through the quantitative easing program are supplemented by the purchases of central banks (such as Brazil) whose currencies are appreciating. Of the $242.5 billion in net purchases of U.S. securities by foreigners during the last three reporting months, though, only $160 billion was in Treasuries. The rest were in stocks, corporate bonds, and mortgage-backed securities.

It is a difficult calculation, because an end to QE would have a direct impact on inflation expectations. With European and Japanese interest rates at extremely low absolute levels, even a 25 bps or 50 bps increase in the fed funds rate probably would give a big lift to the dollar exchange rate.

[Click to enlarge]

A rise in the funds rate would boost the dollar (which would tend to depress bond yields) as well as reduce inflation expectations, somewhat mitigating the upward pressure on yields. The U.S. savings rate would rise in response to higher yields and consumption would fall.

Source: China's Trade Deficit Good for the World - But Not for U.S. Bonds