Why We Have to Keep China Happy

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Includes: CDCAQ, IEF, SHY, TLT
by: Greg Feirman

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

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. While this has been clear for months, 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.

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.

- “China Grows More Picky About Debt”, The New York Times, B1, May 21

A couple of other interesting excerpts from the article:

China now earns more than $50 billion a year in interest from the United States, [Brad] Setser at the Council on Foreign Relations calculated

This spring China has also been stepping up its purchases of commodities, which are usually bought in dollars. Iron ore has been piling up on Chinese docks, government stockpiles of crude oil and grain are being expanded and stockpiles are being started for products like gasoline, diesel and sugar.

After six years of silence, China unexpectedly disclosed last month that it had been gradually buying gold from domestic producers. The country’s reserves had climbed from 600 tons in 2003 to 1,054 tons, worth $31.8 billion at prices late Wednesday.

The disclosure, which produced a frisson of excitement in gold markets, may have been aimed at reassuring a domestic audience that the Chinese government was not putting all the nation’s savings into American dollars. But the actual investment was tiny compared with China’s foreign exchange reserves — and showed that China was accumulating gold at a much slower rate than foreign currency.

A person in periodic contact with China’s central bank, who insisted on anonymity to preserve his access, said that a Chinese central banker complained to him last year that “we have so much money and there’s so little gold, we can’t buy much without driving up the price.”

I recently wrote about this subject in a Client Note:

We have lent a huge amount of money to the U.S., so of course we are concerned about the safety of our assets. Frankly speaking, I do have some worries.

- Chinese Premier Wen Jiabao.

We hate you guys. Once you start issuing $1 trillion to $2 trillion…. We know the dollar is going to depreciate.”

- A Chinese official in an interview with the Financial Times last month.

The other big story that caught my attention last week: Some strong words out of China about its massive US dollar, agency and treasury holdings. For those of you who don’t know, massive imbalances have grown in the global economy over the last decade. Many of the goods we buy here in the United States are made in China and Asia. On the other hand, we don’t sell nearly as much to Asia as we buy from them. That results in massive current account deficits here and surpluses over there.

Ultimately, that means they have a huge excess of dollars that they must either hold or re-invest in US assets. This has been going on for many years and as a result China and the rest of Asia have accumulated massive holdings of US assets, mostly treasuries. For example, according to the US Treasury, China held $727.4 billion in US treasuries as of December and Japan only slightly less.

As Fed Chairman Ben Bernanke told 60 Minutes this evening, in response to the financial crisis the Federal Reserve has essentially been printing money (”Ben Bernanke’s Greatest Challenge", 60 Minutes, Sunday March 15, 2009: This dilutes the value of the dollar in foreign exchange markets and destroys the value of foreign investors’ dollar denominated holdings. China is none too happy about this and Premier Jiabao’s comments were a shot across the bow.

There is real risk here because China and the rest of Asia’s massive US holdings give them a measure of power over our economy. Were China to start to unload its dollar and treasury holdings, that would send the dollar down in foreign exchange markets and the fall in treasury prices would result in an increase in interest rates. The falling dollar would make imported goods more expensive meaning higher prices for U.S. consumers. Rising interest rates would hurt all borrowers and increase the strain on our debt-laden economy.

This is a serious, big picture, geopolitical issue. I know it’s hard to get your mind around a big, abstract issue like this, but this is something every investor should be aware of. We must keep China and the rest of Asia happy because of the economic power they now hold over us due to their enormous lending to the US government.

Richard Duncan has written a superb book on the subject: The Dollar Crisis: Causes, Consequences, Cures (Updated June 2005) for anyone who is interested. In fact, it was my good friend bringing this fascinating issue to my attention towards the end of 2004 that catalyzed my interest in the economy and financial markets and ultimately resulted in my leaving the Phd Philosophy program at UC Davis and starting Top Gun.

- “Top Gun FP Client Note: You’ll Never Catch The Bottom”, March 15

Also see: “Is This A Dollar Crisis?”, Top Gun FP, November 7, 2007