Over the last five years, China has become the number one buyer of American Treasury obligations. Spending close to 15% of their GDP on American Treasuries, China passed Japan in September of last year to become the largest overseas holder of America’s sovereign debt. This was not by chance. The Bush Administration had earlier made a deal with China. We would allow Chinese hard products unfettered access to American markets, if they would buy our debt. Both countries got what they wanted: China got a huge market for the products of its new factories, and America got its huge budget deficit financed on the cheap.
The deal allowed us to continue the enormous trade deficit we ran with China without taking any corrective actions. And the Chinese continued suppressing the price of the yuan to allow for its trade surplus to continue.
The size of the deficit grew so large, however, that Congress saw the implications of mortgaging America’s future production to the Chinese. A few influential Senators began a campaign for China to revalue the yuan to a more realistic level. This would help us reduce our trade deficit, thus reducing our need to continue financing it with Treasury bonds. Even the U.S. Secretary of the Treasury joined the chorus: the Chinese responded with a slight increase in the price of the yuan, as can be seen in the chart below.
This chart shows the fall in the number of yuans required to buy one dollar over the last year. Although the decline in the dollar/yuan currency pair looks dramatic, it is only about 5-6%. This bone was thrown our way to mollify the Bush Administration, but it was far short of being enough (estimated at 20-30%) to put us at trade parity. China continued supporting our long Treasury auctions; our interest rates were kept low. Washington couldn’t complain too loudly, because it got the support it needed to keep our house of cards standing just a little longer.
Recently, however, China has encountered a few bumps of its own. The serious recession that has Western Europe and American economies in a tailspin, has also reduced American and European purchases of Chinese goods. This, in turn, has forced China to close factories in the coastal regions where most of their export production is domiciled. Political unrest among the workers who had abandoned their rural life to work in these new cities is a cause for great concern for the Chinese government.
The fall in exports also had a serious impact on the Chinese government’s revenue. During 2007 the government’s tax revenue rose 32% over 2006. But, by November of 2008 the year over year tax revenue fell 3%.
China must now turn its financial attention to funding its own stimulus package in order to keep its economy growing. They recently announced a $600 billion package on infrastructure spending. But, some of this increased spending is coming from their vaunted $2 trillion in foreign currency reserves, which have fallen recently.
Their financing problems can be summarized by three trends, all pointing in the wrong direction:
- Direct foreign investment is falling. Foreign firms, such as General Motors and IBM, aren’t going to be building any new factories in China for a while.
- Chinese assets are declining in value. The Chinese stock market is down over 50% the last year, which has driven foreign investment money out of China. Also, the Chinese housing market was in a bubble, and that has contributed to more capital flight.
- The trade surplus is falling. Prices of commodities that China must import have been rising, while the prices of the products they sell are falling. This scissors effect is estimated to cut the trade surplus from $40 billion a month to closer to $20 billion.
This is not good news for American Treasury obligations. The effects of a reduced participation by China in our bond auctions will be felt here as lower bond prices and higher yields. In other words, the low interest rates we enjoy on our long-dated obligations will give way to higher rates as China adjusts to its new realities.
For the U.S., this is not a good time to have long term interest rates go up. We need low interest rates on the long end in order to help sell the millions of unsold homes that clutter the housing market. Higher interest rates will force some prospective buyers out of the real estate market. This, in turn, will probably prolong our housing crisis.
The prospects for rising long-term interest rates come at a point where yields on 30-year Treasuries have fallen to about 2.8%. The failure of so many banks around the world contributed to a massive capital outflow of international monies from emerging markets and an abandonment of commercial bonds. Even investment-grade debt suffered in the flight to quality that has characterized fixed income markets since September of last year.
But, the near panic that these events set off will eventually play itself out, and we should see something of a recovery of both the corporate bond market and emerging market debt. Actually, the chart below shows that the steep fall in share price of the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA:LQD) has already improved. The chart clearly shows that corporate debt was hit hard in mid September. It also shows how prices for intermediate term Treasuries (NYSEARCA:IEI) have risen while corporate debt was falling. The green line represents EMB, iShares Emerging Markets Debt ETF.
Much of the devastation has already been repaired, however, and my guess is that the price appreciation of this class of debt will continue improving. The flight to quality scare that sent Treasury yields falling will reverse itself and find its way back into higher yielding instruments of good quality.
Emerging market debt has also come off the lows of October/November, but its recovery has not been as robust as American corporate debt. As the chart above shows, there has been substantial improvement from the lows in late October.
Taken together, then, there are three factors that will contribute to a rising yield (and lower prices) for Treasury obligations as this year matures:
- Less demand from China for long Treasuries.
- Recovering confidence in corporate sector debt.
- Recovery of confidence in emerging market debt.
I look for a continuing improvement in investment-grade corporate debt before emerging markets debt recovers. The economies of the world have a long way to go before employment levels recover and consumer spending gets back to a healthy level. Once these things come about, the appetite for riskier assets like emerging markets debt will follow.
Treasuries, on the other hand, will be experiencing the opposite reaction. As the appetite for risk returns, corporate bonds will see new inflows. But their inflow will be an outflow from Treasuries. Couple this with China’s reduced presence in the bond auctions and you get a clear picture of Treasury yields rising.
The last implication of this complex series of actions and reactions is the effect on America’s ability to finance about a trillion dollars of new debt for each of the next few years. With a reduced demand from China and recovering commercial debt, we will probably be paying a significantly higher price for deficit financing than we have in the past. This, in essence, is the price we must pay for allowing ourselves to become too dependent on China as our financier of last resort.
Classical economic theory shows how trade imbalances will correct themselves when the relative currency prices are allowed to adjust in a free exchange market. But, with China “managing” the price of the yuan, and with America “managing” their trade deficit, the correcting mechanisms of a free market were annulled. We are seeing today what the long-term effects are when this correcting mechanism is overridden. There are times when a short-sighted policy of expediency leads to long-term pain; we’re going to have plenty of it for the next few years.