Relevant and even prescient commentary on news, politics and the economy.

Why China may have slowed Treasury purchases

by Bruce Webb

There has been a scattering of stories about how China has slowed or stopped buying U.S. Treasuries. This story offers a possible explanation

LA Times: China’s investments in U.S. up sharply

Beijing is using its accumulation of billions of American dollars to step up its investments around the globe. In the last year, Chinese acquisitions in the U.S. have ranged from a relatively obscure theater in Branson, Mo., to stakes in such famous brands as Coca-Cola and Johnson & Johnson.

China’s huge stockpile of dollars stems in part from Americans’ enormous purchases of relatively inexpensive Chinese manufactured goods and the significantly smaller volume of U.S. exports to the Asian country.

By recycling much of its dollar trove over the years back to the United States with the purchase of U.S. government debt, China has in effect helped Washington finance its deficits.

Now, Beijing is branching out. The country’s direct investments overseas rose 6.5% in 2009 to $43.3 billion — despite a global slump in such investments — and could jump to $60 billion this year, Chinese state media reported last week.

Formal estimates of Chinese investments in the U.S. last year, excluding bond purchases, range from $3.9 billion — a figure put out by New York research firm Dealogic — to $6.4 billion, a number that comes from Derek Scissors, a Heritage Foundation research fellow who tracks China’s global transactions

I’ll let the econoBears explain the significance here, my flip summary would be “Why rent when you can own”. It certainly doesn’t indicate that the Chinese are expecting some terrific crash in the medium term.

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TIC tock; TIC tock; TIC tock

No, the US Treasury’s time is not running out. Where’s Brad Setser when you need him – and the media definitely needed him in reference to the December TIC report.

Okay, okay, we know: China dropped its share of Treasury holdings in December by $US 34.2 bn. China now holds just 20.9% of the total foreign-owned stock of Treasuries, second only to Japan (21.3%).

But China’s share is closer to its average, while Japan’s share is way off – there may be a reversion here, i.e., Japan will grow its stock of Treasuries relative to China (Please see my post yesterday). Except for the period of September 2008 through November 2009, Japan held a much larger share of Treasuries than did China for every month since 2000.

Is there a sinister plot developing? Is China selling off S-T T bills to retaliate against the Obama administration’s push on the renminbi? Or is China simply reallocating its portfolio toward risk?

Perhaps there is a (partial) retaliation scheme underway, as suggested by the 3-month accumulation of short-term US assets (mostly T bills agencies with a maturity of less than 1 year).

But isn’t it just slightly more plausible that the Chinese are – official + private – selling off zero-yielding (practically) Treasuries in exchange for longer-duration, higher-yielding, and riskier assets.

The first bit of the story is this: one should take care in not reading too much into the TIC report. It’s just one month’s worth of data; but more importantly, the data miss a critical component of the capital account, foreign direct investment.

The chart above illustrates China’s one-year rolling monthly flows of long-term, high quality asset purchases – Treasuries bonds/notes, agencies, stocks, and corporate bonds. The Chinese are accumulating stocks, primarily through private investors, but through official channels as well (see press release, lines 8 and 13). This suggests an increasing interest in equity, which could signal growing foreign direct investment flows (not shown in TIC).

Furthermore, the entire year’s shift in assets, long-term Treasury purchases, +$US 98.8 bn fully offsets the drop in short-term Treasuries, -$US 98.8. This suggests diversification.

Finally, everybody’s doing it, not just China – diversifying away from T bills, that is!

The chart above illustrates the 3-month rolling sum of all foreign net flows of ST US assets (mostly T bills). If you invest $US 1 million dollars today in a bill expiring in August 2010, you make about 900 bucks. Man, doesn’t that sound like a wonderful investment?

So the next question is: why do the Chinese care about return on their F/X holdings? Because they have a peg! Here is a great article for all of you who wanted to know about the costs of maintaining a peg. Accumulating FX reserves is a costly business, and T bills are unlikely to finance the type of sterilization that is needed by the PBoC.

Rebecca Wilder

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Marshall Auerback responds

Marshall Auerback responds to Rebecca’s “I have to side with China on this one”.

There’s another factor as well. There’s been an enormous increase in money and credit in the past year. In fact, it seems to be as great as 5 years’ growth in credit in the previous Chinese bubble. What happens is that the increase in money and credit is so great and so abrupt that you tend to get a high inflation quite quickly even if there are under utilised resources? Add to this the fact that you’ve got massive fiscal stimulus occurring today in China.

You have the makings of a very messy situation: if China seeks to sustain demand via fiscal policy, then you could get a big inflation problem, which could severely erode the tradeables sector. And you have all of these Chinese students all steeped in Chicago School monetary theory, coming home and taking over. So they might do a Paul Volcker to stop inflation.

But, what if the they don’t? Inflation can take off and thereby begin to ERODE the competitiveness of Chinese exports. This might be the real reason why China is so reticent to revalue its currency. The Americans might go crazy if the Chinese devalue, but if the inflation is high enough, they might have to do it, as it will severely erode their terms of trade and cause their tradeables sector to collapse.

Or you get the hard-line monetarists triumphing by fighting inflation and you get riots as unemployment increases.

It could get very ugly.

This could be happening now in China. Everybody says no. The consensus is that inflation is a couple per cent and it is all pork prices because there was a lousy corn harvest.

However, economists such as those at Lombard Street in the UK, Jim Walker, Simon Hunt and the like try to figure out the changes quarter to quarter in Chinese nominal GDP which is reported only year on year. And they come up with giant double digit growth rates for the second half of last year.

Now this is complicated by the fact that the Chinese have revised up their GDP numbers and they throw the revisions all into the final quarter of the year. But when these guys try to adjust for that statistical screw up they still come up with giant nominal GDP increases. Lombard Street thinks it was twenty five per cent or so in the second half of last year. They think it was twenty per cent real and five per cent inflation.

Economies never grow at a twenty per cent real rate. And Simon Hunt says if you look at proxies like power output and rail traffic you don’t get those kinds of numbers for real growth, which suggests that inflation must be higher than four or five per cent. Indeed, it could already be double digit. It is hard to say. But if it is double digit then the resultant inflation will cause a real revaluation of the trade weighted exchange rate.

And more so if the dollar rallies. That could well crush the volume of exports and the profitability of the industrial tradeables sector. Exports are the only area where China makes any kind of money because they can sell these products for about 10 times what they obtain for a comparable product in the domestic economy (where profits are virtually nil). The export sector is a big contributor to overall super excessive fixed investment in China. FDI will go to zero net.

There will be strong forces for a reduction in fixed investment in this large sector. Hence, there is a good chance that even without monetary tightening by the Chinese authorities, the overall fixed investment boom in China will turn down.

Nobody is thinking about this but it is a real possibility. And with fixed investment now at fifty per cent of gdp (which is unprecedented in any economy) and exports at more than thirty, we’re looking at ratios that have never been reached before on a combined basis turning these two down could create a severe recession in China. China has gone too far this time. I think they are in a box that they and others don’t recognize. The “Black Swan” event this year could well be a devaluation of the RMB.

by Marshall Auerback, posted by Rebecca Newsneconomics

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Industrial policy is not just green technology or an electric car…

The New Yorker gives us a small look into policy in china other than the currency peg:

The Problem Statement

U.S. manufacturing’s competitive status is increasingly challenged by other economies. Established industrialized nations such as Japan, Germany, Korea and Taiwan are developing state-of-the-art technologies, which range across all areas of manufacturing from electronics to discrete parts. Products based on technologies that originated in the U.S. economy, such as semiconductors and robotics, are increasingly both developed and produced elsewhere.

Emerging economies, such as China, are acquiring manufacturing capability through modest R&D intensities, tax and other incentives for foreign direct investment, and intellectual property theft. This second group then competes through low-cost labor and the use of exchange rate manipulation along with tariff and non-tariff barriers.

However, emerging technology-based economies have the long-term goal of attaining world-class status as innovators, which means they are not content to operate at the low-technology, labor-intensive portion of manufacturing. China already is producing 30,000 patents annually and its patent application rate trails only the United States and Japan.1 Finally, event the huge U.S. lead in biopharmaceuticals is now under attack, as an increasing number of economies invest in supporting science and technology infrastructures and provide financial incentives for foreign direct investment in this rapidly expanding technology.

The combined long-term impact on the U.S. economy of investments by both established and newly industrialized economies has been the offshoring of substantial portions of U.S. manufacturing supply chains—first the labor-intensive industries but now the high-tech ones, as well.

In the years that followed, the government pumped billions of dollars into labs and universities and enterprises, on projects ranging from cloning to underwater robots. Then, in 2001, Chinese officials abruptly expanded one program in particular: energy technology. The reasons were clear. Once the largest oil exporter in East Asia, China was now adding more than two thousand cars a day and importing millions of barrels; its energy security hinged on a flotilla of tankers stretched across distant seas. Meanwhile, China was getting nearly eighty per cent of its electricity from coal, which was rendering the air in much of the country unbreathable and hastening climate changes that could undermine China’s future stability. Rising sea levels were on pace to create more refugees in China than in any other country, even Bangladesh.

In 2006, Chinese leaders redoubled their commitment to new energy technology; they boosted funding for research and set targets for installing wind turbines, solar panels, hydroelectric dams, and other renewable sources of energy that were higher than goals in the United States. China doubled its wind-power capacity that year, then doubled it again the next year, and the year after. The country had virtually no solar industry in 2003; five years later, it was manufacturing more solar cells than any other country, winning customers from foreign companies that had invented the technology in the first place. As President Hu Jintao, a political heir of Deng Xiaoping, put it in October of this year, China must “seize preëmptive opportunities in the new round of the global energy revolution.”

A China born again green can be hard to imagine, especially for people who live here. After four years in Beijing, I’ve learned how to gauge the pollution before I open the curtains; by dawn on the smoggiest days, the lungs ache.

David Sandalow, the U.S. Assistant Secretary of Energy for Policy and International Affairs, has been to China five times in five months. He told me, “China’s investment in clean energy is extraordinary.” For America, he added, the implication is clear: “Unless the U.S. makes investments, we are not competitive in the clean-tech sector in the years and decades to come.”

China is already buying and installing the world’s most efficient transmission lines—“an area where China has actually moved ahead of the U.S.,” according to Deborah Seligsohn, a senior fellow at the World Resources Institute. In the next decade, China plans to install wind-power equipment capable of generating nearly five times the power of the Three Gorges Dam, the world’s largest producer.

The prospect of a future powered by the sun and the wind is so appealing that it obscures a less charming fact: coal is going nowhere soon. Even the most optimistic forecasts agree that China and the United States, for the foreseeable future, will remain ravenous consumers. (China burns more coal than America, Europe, and Japan combined.) As Julio Friedmann, an energy expert at the Lawrence Livermore National Laboratory, near San Francisco, told me, “The decisions that China and the U.S. make in the next five years in the coal sector will determine the future of this century.”

When Albert Lin, an American energy entrepreneur on the board of Future Fuels, a Texas-based power-plant developer, set out to find a gasifier for a pioneering new plant that is designed to spew less greenhouse gas, he figured that he would buy one from G.E. or Shell. Then his engineers tested the Xi’an version. It was “the absolute best we’ve seen,” Lin told me. (Lin said that the “secret sauce” in the Chinese design is a clever bit of engineering that recycles the heat created by the gasifier to convert yet more coal into gas.) His company licensed the Chinese design, marking one of the first instances of Chinese coal technology’s coming to America. “Fifteen or twenty years ago, anyone you asked would have said that Western technologies in coal gasification were superior to anything in China,” Lin said. “Now, I think, that claim is not true.”

The Obama Administration is busy repairing the energy legacy of its predecessor. The stimulus package passed in February put more than thirty-eight billion dollars into the Department of Energy for renewable-energy projects—including four hundred million for ARPA-E, the agency that Bush opposed. (It also allocated a billion dollars toward reviving FutureGen, though a final decision is pending.)

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I side with China on this one

by Rebecca Wilder

Yes, the renminbi (RMB) is closer to fair value. Chinese Foreign Ministry spokesman Ma Zhaoxu states:

“Our currency, the RMB, has appreciated more than 20 percent against the U.S. dollar since July 2005, when China moved to a floating exchange rate regime,” Ma said. Before 2005, the RMB was pegged to the U.S. dollar at a fixed rate.

“The RMB exchange rate has drawn close to a reasonable and balanced level, given the international balance of payments and the market supply and demand for foreign exchange,” Ma said.

The New York Times asserts that China’s currency is undervalued by 25%-40%. The NY Times, like many politicians and media channels, is entirely too obsessed with China’s exchange rate; they fail to understand that economic fundamentals are changing.

Contrary to popular belief, the level of the renminbi has become rather inconsequential to Chinese trade flows. Why? Because despite the fact that the renminbi has been pegged against the dollar since July of 2008, imports are surging.

The chart above illustrates the 3-month annualized growth rate in exports and imports and the renminbi valued against the US dollar. I use the 3-month annualized rate, rather than the year/year rate, to remove the strong base effects from the drop-off in trade last year.

The first thing to notice is that while export growth is indeed strong, “business as usual” in China, import growth is surely breaking trend. The 3-month annualized growth rate of imports – a good proxy for domestic demand – averaged 117% annualized growth per month from April (when it turned positive) to December 2009. Compared to this period in 2006, annualized import growth is up almost 80 percentage-points, while that for exports is up just 5 percentage-points (76.2% average 3-month annualized growth in exports May-December 2009 vs. 71.7% in 2006).

It’s hard to argue that the Chinese currency is so “undervalued” if the import response is this strong.

Another myth is that China is running large current account surpluses. Given the chart above, it won’t surprise you to know that China’s current account has dropped markedly since late 2008.

The thing is: since prices in developed economies have dropped relative to those in key emerging markets (i.e., China), real exchange rates are coming back in-line with a s0-called equilibrium. Therefore, the renminbi, by definition, is closer to whatever an equilibrium would be, despite the fact that it is fixed. Thus, like Ma Zhaoxu says, it’s at a “reasonable” value.

Rebecca Wilder

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Inflation in China is not necessarily a bad thing

Yesterday, the release of key economic indicators in China produced headlines like this: China Targets Inflation as Economy Runs Hot. The table below lists the full release, including the consensus expectations (Bloomberg’s survey) for each statistic. (Here is the link for the actual data release.)

As you can see, the survey undershot the actual results across many of the releases, including that for GDP and inflation (CPI). The surge in the CPI, 1.9% y/y in December versus 1.4% y/y expected, attracted a lot of attention. According to the Economist, Helen Qiao and Yu Song at Goldman Sachs points out that prices may be on an (increasingly) upward trajectory:

The recent rise in inflation was caused mainly by higher food prices as a result of severe winter weather in northern China. In many cities, fresh-vegetable prices have more than doubled in the past two months. But Helen Qiao and Yu Song at Goldman Sachs argue that it is not just food prices that risk pushing up inflation: the economy is starting to exceed its speed limit. If, as China bears contend, the economy had massive overcapacity, there would be little to worry about: excess supply would hold down prices. But bottlenecks are already appearing. Some provinces report electricity shortages, and stocks of coal are low. The labour market is also tightening, forcing firms to pay higher wages.

The final sentence is very important – a tight labor market will lead to higher wages (the data on wages is 4 months old, so I will not plot it out). This suggests, completely by inference on my part, that prices pressures will be the wage-price spiral type – this can quickly get out of hand.

To be sure, the inflation surge was driven primarily by food prices, up 5.3% over the year; but with retail sales growing at a rate of 17.5% over the year and broad money growing at a 27.7% pace in 2009, prices hikes are bound to spread. We already saw inflation pressures building in the trade balance. Now I get to my chosen post-point: why is inflation in China necessarily a bad thing?

The inflation pop sparked a lot of market angst yesterday. Of course, this is just a single data point; but if inflation does build, and the government insists on maintaining its tight peg against the $US, then inflation will do what US consumers and Asian savers have not: reverse trade flows.

Specifically, and holding all else equal, sizable inflation in China would drive up the value of its real-exchange rate (REER), where the REER is the nominal exchange rate adjusted for relative prices in China versus its trading partners – faced by the Chinese.

As illustrated in the chart above, the REER has been on a downward trajectory throughout 2008, but remains elevated compared to its 2006 levels. The real exchange rate is the single-most important factor in determining trade flows. An inflation-driven growth in the real value of the Chinese yuan (REER) would effectively, and eventually, drop China’s export share with key trading partners.

Rebecca Wilder

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Is the government actually forecasting a narrowing of the U.S. current account deficit?

This is a follow up to an article I wrote earlier this week, Older workers working longer; labor-force participation falling. In response to the article, which highlights the BLS employment and labor-force participation projections for 2008-2018, 2slugbaits (a loyal AB commenter) presented the following point:

The 2 industry sectors expected to have the largest employment growth are professional and business services (4.2 million) and health care and social assistance (4.0 million).

Put another way, employment growth will be in nontradeable goods sectors, which suggests we might have to sell a lot of assets in order to pay for imports.

Is the government actually forecasting that Japan an China will finance the U.S. trade deficit for the next ten years? I assumed (silly of me) that any government (BLS) projection would be based on such international pledges as the U.S.-China Strategic and Economic Dialogue:

To this end, both countries [U.S. and China] will enhance communication and the exchange of information regarding macro-economic policy, and will work together to pursue policies of adjusting domestic demand and relative prices to lead to more sustainable and balanced trade and growth.

…and more specifically…

The United States will take measures to increase national saving as a share of GDP. The U.S. household saving rate has already risen sharply as a result of the crisis, contributing to a significant decline in the U.S. current account deficit, and the United States will adopt policies that will continue to encourage household saving.

The U.S. commitment: grow national saving as a share of GDP and significantly reduce the current account deficit. According to the BLS long-term forecast, the U.S. will make good on just one the these two pledges.

The table below extracts national saving and the current account from the BLS 2018 economic assumptions for the employment projections (Table 4.3).

Note: two identities are needed: (1) National Saving is Income minus Consumption minus Government Spending, and (2) the Current Account is National Saving minus Investment. The BLS projects GDP rather than GNP = GDP + net receipts from the rest of the world. In using GDP as the definition of “income”, net receipts from the rest of the world is zero, and the current account reduces to net-exports.

To be sure, the BLS does forecast that U.S. national saving rate will rise 67.5%, from 9.3% of GDP in 2008 to 10.2% in 2018. But domestic investment rises by more, +72.1%. Therefore, the current account deficit grows by 81.3%.

I’m not seeing any healthy reduction of the current account deficit by 2018. 2slugs is right: the BLS is essentially forecasting that China and Japan (among other perpetual savers) will finance a growing U.S. trade deficit. Oh man.

Rebecca Wilder

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US Flow of Funds: wealth recovery fully underway, China?

by Rebecca Wilder
(crossposted with Newsneconomics)

This week the Federal Reserve reported the Q3 2009 Flow of Funds accounts. The headline indicators show household net worth improving and private debt burden falling.

The private sector – households and firms – is dropping leverage.

Update: This chart has been modified slightly – the leverage level data (highlighted in blue, red, and green) has been updated.
Either by default or by growing saving, the private sector is de-leveraging. According to the D.1 table, households and nonfinancial businesses dropped debt a further 2.6% q/q annualized, while financial sector debt fell another 9.3%. However, total debt (of the domestic nonfinancial sector) grew 2.8%, as the federal and state and local governments grew debt 20.1% and 5.1%, respectively.

Household wealth grew $2.7 billion trillion for a cumulative gain of $4.9 billion trillion since wealth hit a cyclical low in Q1 2009. To put this gain in perspective, household net-worth dropped $17.5 billion trillion from Q3 2007 to Q1 2009, 3.5 x the recent gain. Wealth to disposable income, a statistically significant factor of the personal saving rate, rests right around it long-term (1952-1007) average, 4.9.

The chart illustrates the wealth-effect as the ratio of net-worth to disposable income. The direct and adverse impact of the wealth loss on consumption probably peaked last quarter; however, the lagged effects are ongoing.

Notice that the ratio shifted discretely in the 1990’s, not coincidentally when China’s current account surplus took off.

Most likely, the wealth to personal income ratio has mean-reverted, and will not rise back to its 5.7 1997-2007 average. A necessary condition is that global portfolio flows rebalance – i.e., China saves less and the US saves more. However, this will not happen tomorrow – de-leveraging is a process that takes years. The increase in international saving (i.e., falling current account deficits) will take some time, and by definition includes the general government eventually dropping its debt burden. Not to mention the political rhetoric and growing trade barriers suggest that a long-term economic shift is a ways off.

Rebecca Wilder

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Sit back and relax: the US and China, this is gonna take awhile

China exported its way to a $2 trillion dollar fortress of F/X reserves ($USD mostly), while the US borrowed its way into a hole deep enough to spark a vast global recession. Who’s to blame?

Given the symbiotic relationship in the chart above, it’s hard to blame any one individual, group, or even country. But blame we do. Martin Wolf, at the Financial Times, wrote an interesting article about the need for a “co-operative adjustment” of global current account deficits and surpluses. He argues the following:

China’s exchange rate regime and structural policies are, indeed, of concern to the world. So, too, are the policies of other significant powers. What would happen if the deficit countries did slash spending relative to incomes while their trading partners were determined to sustain their own excess of output over incomes and export the difference? Answer: a depression. What would happen if deficit countries sustained domestic demand with massive and open-ended fiscal deficits? Answer: a wave of fiscal crises.

It sounds so imminent: re-balance now, or else. Sure the tides of portfolio flows must change; structural current account imbalances are now proven to cause economic catastrophe, as illustrated by the 2-yr case study of late. But it’s not going to happen over night. It takes a long time for re-balancing of any kind to fully pass through. Just look at Japan in the 1990’s.

Data note: you can download Japan Flow of Funds data here, and US Flow of Funds data here.

The chart above illustrates the debt bubbles in the US financial crisis and in 1990’s Japan. In Japan, the households didn’t accumulate as much debt relative to the non-financial business sector; however, both sectors dropped leverage. And notice, that it took about a decade for households and firms to do so.

What’s overly obvious is that the Chinese will not be bullied into revaluing the yuan just because the US says so. And also evident is that there is a (very lengthy) de-leveraging process underway in key economies. By default, the debt-reducing developed world will force the Chinese to focus policy more inward (domestic demand) and less outward (export demand), as US consumers drop debt levels. But sit back and relax, it’s gonna be a while.

Rebecca Wilder

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