Why China Will Continue to Buy U.S. Treasuries

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by: Rick Newman

Think American workers have it bad? It's worse in China.

You may not know that by scanning the headlines. Late last year the Chinese government passed its own stimulus package of about $600 billion, to meet its target of 8 percent GDP growth. That's right, 8 percent. That would be outlandish growth here, where the economy is now shrinking, not expanding.

But in China, that's barely enough to keep a restless workforce employed. And the government might not be able to make its 8 percent target. Unemployment is soaring, and there's even a possibility that economic woes could lead to angry public protests like those that preceded the 1989 Tiananmen Square massacre.

Since Tiananmen, America and China have become deeply linked to each other. Americans, obviously, buy a huge amount of imported Chinese goods—about $340 billion worth in 2008. Much of the cash that flows back to China gets invested in U.S. government securities, which helps keep U.S. interest rates low. China even invests directly in American firms. In 2005, Chinese computer maker Lenovo (OTCPK:LNVGY) bought IBM's PC division for $1.75 billion. In 2007, the Chinese government bought a $3 billion stake in the Blackstone Group, the American private equity firm. Historian Niall Ferguson, author of The Ascent of Money, even conflates the two nations as one: Chimerica.

Since the two countries are so closely linked, I asked Wei Li, a business professor at the University of Virginia's Darden School of Business who also teaches at the Cheung Kong Graduate School of Business in Beijing, for an update on the Chinese economy, and how changes there are likely to affect the United States. Excerpts:

How is the global recession affecting China? The outlook for China is very grim. Much more grim than for the United States. There are two main drivers: Housing and exports.

Ten years ago there was a housing shortage in the cities. But now there's a housing glut. The market boomed, and now there's a huge bubble. Price of housing in Beijing and Shanghai is sometimes higher than Hong Kong or Tokyo. One reason is there's very little opportunity to invest elsewhere. That led to lots of speculation. It's mostly urban. In rural areas, you still build your own house.

Is the housing bust in China worse than in the United States? Housing in China is a much bigger deal than in the United States because people just started buying. For many Chinese they were first-time homeowners. Prices haven't really fallen yet, but they have to. If they don't let prices fall, something else has to adjust. Either the price falls or quantity adjusts. If the quantity goes to zero, nobody buys refrigerators or tiles, or hires electricians or architects. The bust has been going on about one year now, and accelerated since the last quarter of 2008.

What about exports. There's been a double digit decline. For every 1 percent rise or drop in U.S. consumption, Chinese exports go up or down by 10 percent. The effect is 10 to 1.

So with consumption down in the U.S. by about 2 or 3 percent, you mean that exports in China have fallen 20 or 30 percent? That's right.

The unemployment rate in the United States is 8.1 percent right now. Is it higher in China? According to Chinese Academy of Social Sciences (CASS), the unemployment rate in urban areas in the end of 2008 was 9.4 percent, significantly higher than official jobless rate of 4.0 percent. It's probably higher now, since the Chinese economy experienced a marked slowdown since the last quarter of 2008. In addition, in 2009, 6.1 million college graduates are looking for jobs. These figures all underestimate the severity of unemployment in China. The unemployment stats count only jobless rate in urban areas. When rural migrants cannot find jobs, they often return home and subsist on their land.

Those are big changes. What are the implications? In the United States, the savings rate will go up. Up till now, why save if asset prices are going up? But now, with so much wealth destroyed, people have to rethink that. So consumption will go down as a percentage of GDP. So demand for Chinese exports will be somewhat less. The export engine in China will keep running, but demand will be much less.

That means the U.S. trade deficit will be smaller, right? Yes, the U.S. trade deficit will have to be smaller. As these bubbles burst, a lot of countries will re-look at their competitive advantages. The United States will be okay because it's a much bigger market. It won't break the social fabric of the United States.

But in China, it could be different. A lot of people in China are like people who just got a job and haven't yet accumulated a lot of wealth. They won't be able to maintain their lifestyle. China has a very nice veneer in the big cities, and great infrastructure, but there's not always a lot beneath the veneer. Unemployment is going up faster in China.

Can't the Chinese government pull the old levers of a command economy, crank up spending, and keep people employed? That's what people may think, but the Chinese economy is so much bigger than the government can control. If you think U.S. consumers are scared, Chinese consumers are equally scared, if not more. Stocks in China are down 60 percent. The new middle class who owns multiple apartments is living on a lot of borrowed money. They're in very bad shape.

Some people worry about the fact that the Chinese government owns several trillion dollars worth of U.S. government securities. You know the argument: If the Chinese sold their holdings the U.S. economy would collapse. China could conduct economic warfare against America. People worry about China buying Treasuries, but for China, they don't have a choice. There's really no place else they can put their money. To say that China is somehow controlling the U.S. economy is laughable.

So with China in tough shape, will Chinese influence fade? I think Chinese influence will still grow, but it has to be different. The Chinese approach used to be, speak softly and make a lot of money. That's not working any more. The system is flawed. If China wants to continue to benefit from globalization, China needs a voice.

What's the risk of some kind of serious instability inside China? Could there be another event like Tiananmen Square in 1989? A lot of people are unemployed. Not just rural labor. We're talking about highly educated college grads. When enough of them can't find jobs, they'll look for something to do. The events in 1989, that was described in romantic terms in the press in the United States and in the west. Democracy taking root, that kind of thing. But that happened because of high inflation, a lack of jobs after students graduated. A tighter money supply made it harder for companies to hire workers.

So could that happen again? It's already developing. Many grads from 2008 still don't have jobs. More students will graduate this June without jobs. We're talking about millions of people. But I don't think another incident like Tiananmen Square is likely because everybody got smarter after that. Many students will be happy to work for free as long as they can learn some skills. Today, more families have savings.

What's the thing to watch for, to tell how serious conditions get inside China? When people are literally starving. It could happen. Social insurance is much less than in the United States.

Disclosure: no positions