Comments abound on the significance of the S&P downgrade of US debt. Some think it will affect the stock market open on Monday. I don't, but if it does, I suggest it will last at most a day.
In "On the S&P ratings move" Bruce Krasting said essentially the same thing on the lasting effect, however he expects "interesting market action come Sunday night as this news is digested."
Moreover, if there is "interesting action" Sunday evening, it may not have anything to do with the rating cut at all. Rather, I suspect it will be in relation to the ECB confirming it will buy Italian debt.
What got my attention in Krasting's article was a fallacious, yet widely repeated set of statements "I don’t expect to see some big headline that says, 'China to sell'. That’s not going to happen. The critical issue is, 'Will they buy more?' I doubt they will."
The first sentence is true. However, the idea China will stop buying US debt is complete silliness.
Trade Deficit Math
The rationale for my statement is a simple mathematical identity. There can be no dispute of it. Yet, people dispute it all the time. I have a brilliant writeup from Michael Pettis on this very issue that I received a few days ago via email.
The timing is perfect. Michael Pettis writes ....
Foreign capital, go home!
Is the PBoC going to stop buying USG bonds? Once again we are hearing worried noises from various sectors about the possibility of a reduction in Chinese purchases of USG bonds.
The threat of a looming US default seems to be driving this renewed concern, although I am not sure that the PBoC really is worried about not getting its money back. After all if the US defaults, it will be mainly a technical default that will certainly be made good one way or the other. Since the PBoC doesn’t have to worry about mark-to-market losses, unlike mutual funds, I think for China this is largely an economic non-event (not that there isn’t good mileage in pointing to the sheer silliness of the US political process). Still, for domestic political reasons it needs to be seen huffing and puffing over American irresponsibility.
Xia Bin, an adviser to the central bank, told reporters earlier this month that China should speed up reserve diversification away from dollars to hedge against risks of the US currency’s possible long-term decline.
Let’s leave aside the fact that every six months we have heard the same thing for the past several years, and nothing has happened, shouldn’t we nonetheless be worried? Won’t reduced PBoC purchases be disruptive to the US economy and to the US Treasury markets?
No, they won’t, and anyway they aren’t going to happen.
There is so much muddled thinking on the issue, even from economists who should know better, that I thought I would try to address what it would mean if the PBoC were actually serious and not simply making noises aimed at domestic political constituents.
First of all, remember that the PBoC does not purchase huge amounts of USG bonds because it has a lot of money lying around and doesn’t know what to do with it. Its purchase of USG bonds is simply a function of its trade policy.
You cannot run a current account surplus unless you are also a net exporter of capital, and since the rest of China is actually a net importer of capital (inward FDI and hot money inflows overwhelm capital flight and outward FDI), the PBoC must export huge amounts of capital in order to maintain China’s trade surplus. In order the keep the RMB from appreciating, in other words, the PBoC must be willing to purchase as many dollars as the market offers at the price it sets. It pays for those dollars in RMB.
What does the PBoC do with the dollars it purchases? Because it is such a large buyer of dollars, it must put them in a market that is large enough to absorb the money and – and this is the crucial point – whose economy is willing and able to run a large enough trade deficit.
This last point is what everyone seems to forget when discussing Chinese purchases of foreign bonds. Remember that when Country A exports huge amounts of money to Country B, Country A must run a current account surplus and Country B must run the corresponding current account deficit. In practice, only the US fulfills those two requirements – large and flexible financial markets, and the ability and willingness to run large trade deficits – which is why the PBoC owns huge amounts of USG bonds.
If the PBoC decides that it no longer wants to hold USG bonds, it must do something else. There are only four possible paths that the PBoC can follow if it decides to purchase fewer USG bonds.
- The PBoC can buy fewer USG bonds and purchase more other USD assets.
- The PBoC can buy fewer USG bonds and purchase more non-US dollar assets, most likely foreign government bonds.
- The PBoC can buy fewer USG bonds and purchase more hard commodities.
- The PBoC can buy fewer USG bonds by intervening less in the currency, in which case it does not need to buy anything else.
Since these are the only ways that the PBoC can reduce its purchases of USG bonds, we can go through each of these scenarios to see what would happen and what the impact might be on China, the US, and the world. We will quickly see that none of them imply calamity. On the contrary, every outcome is neutral or positive for the US.
To make the explanation easier, let’s simply assume that the PBoC sells $100 of USG bonds. Since the balance of payments must balance, this immediately implies that there must be corresponding changes elsewhere in trade and capital flows.
1. The PBoC can sell $100 of USG bonds and purchase $100 of other USD assets.
In this case there has been no change in the balance of payments and basically nothing else would change. The pool of US dollar savings available to buy USG bonds would remain unchanged (the seller of USD assets to China would now have $100 which he would have to invest, directly or indirectly, in USG bonds), China’s trade surplus would remain unchanged, and the US trade deficit would remain unchanged. The only difference might be that the yields on USG bonds will be higher by a tiny amount while credit spreads on risky assets would be lower by the same amount.
2. The PBoC can sell $100 of USG bonds and purchase $100 of non-US dollar assets, most likely foreign government bonds.
Since in principle the only market big enough is Europe, let’s just assume that the only alternative is to buy $100 equivalent of euro bonds issued by European governments. The analysis doesn’t change if we include other smaller markets.
There are two ways the Europeans can respond to the Chinese switch from USG bonds to European bonds. On the one hand they can turn around and purchase $100 of USD assets. In this case there is no difference to the USG bond market, except that now Europeans instead of Chinese own the bonds. What’s more, the US trade deficit will remain unchanged and the Chinese trade surplus also unchanged.
But Europe might be unhappy with this strategy. Since there is no reason for Europeans to buy an additional $100 of US assets simply because China bought euro bonds, the purchase will probably occur through the ECB, in which case Europe will be forced to accept an unwanted $100 increase in its money supply (the ECB must create or borrow euros to buy the dollars).
On the other hand, and for this reason, the ECB might decide not to purchase $100 of US assets. In that case there must be an additional impact. The amount of capital the US is importing must go down by $100 and the net amount that Europe is importing must go up by that amount.
Will this reduction in US capital imports make it more difficult to fund the US deficit? Not at all. On the contrary – it might make it easier. If US capital imports drop by $100, by definition the US current account deficit will also drop by $100, almost certainly because of a $100 contraction in the trade deficit (the US dollar will decline against the euro, making US exports more competitive and European imports less competitive).
A contraction in the US trade deficit is of course expansionary for the US economy. Since the purpose of the US fiscal deficit is to create jobs, and a $100 contraction in the trade deficit will also create jobs, the US fiscal deficit will contract by $100 for the same level of job creation – perhaps even more if you believe, as most of us do, that increased trade is a more efficient creator of productive jobs than increased government spending.
In other words although there is $100 less demand for USG bonds, there is also $100 (or more) less supply of USG bonds, in which case there is no need for a price adjustment.
This is the key point. If foreigners buy fewer USD assets, the US trade deficit must decline. This is almost certainly good for the US economy and for US employment. When analysts worry that China might buy fewer USG bonds, they are actually worrying that the US trade deficit might contract. This is something the US should welcome, not deplore.
But the story doesn’t end there. What about Europe? Since China is still exporting the $100 by buying European government bonds instead of USG bonds, its trade surplus doesn’t change, but of course as the US trade deficit declines, the European trade surplus must decline, and even possibly go into deficit. This is because by selling dollars and buying euro, China is forcing the euro to appreciate against the dollar.
This deterioration in the trade account will force Europeans either into raising their fiscal deficits to counteract the impact of fewer exports or letting domestic unemployment rise. Under these conditions it is hard to imagine they would tolerate much Chinese purchase of European assets without responding eventually with anger and even trade protection.
3. The PBoC can sell $100 of USG bonds and purchase $100 of hard commodities.
This is no different than the above scenario except now that the exporters of those hard commodities must face the choice Europe faced above.
Stockpiling commodities, by the way, is a bad strategy for China but one that it seems nonetheless to be following to some extent. Commodity prices are very volatile, and unfortunately this volatility is inversely correlated with Chinese needs.
Since China is the largest or second largest purchaser of most commodities, stockpiling commodities is a good investment only if China continues growing rapidly, and a bad investment if its growth slows. This is the wrong kind of balance sheet position any country should engineer. It simply exacerbates underlying conditions and increases economic volatility – never a good thing, especially for a very poor and undeveloped economy like China’s.
4. The PBoC can sell $100 of USG bonds by intervening less in the currency, in which case it does not need to buy anything else.
In this case, which is the simplest of all to explain, China’s trade surplus declines by $100 and the US trade deficit declines by $100 as the RMB rises.
The net impact on US financing costs is unchanged for the reasons discussed above (a lower trade deficit permits a lower fiscal deficit). Chinese unemployment will rise because of the reduction in its trade surplus unless it increases its own fiscal deficit. Beijing, of course, is in no hurry to try out this scenario.
It’s about trade, not capital
This may sound counterintuitive to all except those who understand the way the global balance of payments work, but countries that export capital are not doing anyone favors unless incomes in the recipient country are so low that savings are impossible or unless the capital export comes with needed technology, and countries that import capital might be doing so mainly at the expense of domestic jobs.
China's Worry, Not US
For this reason it is absurd for Americans to worry that China might stop buying USG bonds. This is what the Chinese worry about.
In fact the whole US-China trade dispute is indirectly about China’s insistence on purchasing USG bonds and the US insistence that they stop. Because remember, if the Chinese trade surplus declines, and the US trade deficit declines too, by definition China is directly or indirectly buying fewer US dollar assets, which in principle means fewer USG bonds.
And contrary to much of what you might read, this reduction in USG bond purchases will not cause US interest rate to rise at all. For those who insist that it will, it is the equivalent of saying that the higher a country’s trade deficit, the lower its domestic interest rates. This statement is patently untrue.
Pettis makes an irrefutable mathematical analysis that shows the idea the US should fear the day foreigners especially China would stop buying US treasuries is silliness.
Let's look at this from another point of view. Congress, the president, Bernanke, and many others all want the RMB (Yaun) to rise.
If the Yuan rises in value vs. the US dollar, the other side of the mathematical equation says the US trade deficit with China will shrink and China's unemployment rate will rise.
China, fearing unrest does not talk about rising unemployment. Thus, in spite of all the misguided huffing and puffing of numerous analysts, it is China who fears not buying US debt. Otherwise, they would not buy the debt.
Curse of Global Reserve Currency
The benefit (if one can call it a benefit) to having the world's reserve currency is the ability to finance endless wars and live beyond one's means. The mathematical counterpart is being at the mercy of foreigners on trade wars, outsourcing, and unemployment.
What's the Solution?
I have pointed out the solution several times, but this is a good time to repeat it.
Global Trade Solution: Hugo Salinas Price and Michael Pettis on the Trade Imbalance Dilemma; Gold's Honest Discipline Revisited
Bear in mind Pettis does not agree with a return to the gold standard.
Please see Michael Pettis Warns of "Virulent Political Turn Against Euro", Adds Clarification to "Gold's Honest Discipline" for additional comments from Michael Pettis.
Why China Will Not Stop Buying US Assets Recap
- China's unemployment would rise and so would its social problems. There are counterbalancing benefits but the former is what has China's attention now. Eventually the market will force China's hand, but when that happens it will be good for the US, exactly the opposite of what most think.
- China will not stockpile commodities as a solution because that is pro-cyclical. China has too much infrastructure building already and will cut back. Moreover, stockpiling commodities would add to China's massive price inflation problem. Thus, stockpiling of commodities is the last thing China needs to do.
- The US and possibly European markets are the only ones big enough and liquid enough to park reserves. Buying European assets would just transfer the problem to Europe. Moreover, Europe would resit far more forcefully than the US has.
Those are the hard realities of what is essentially a mathematical identity. One can debate what China should do and the consequences of proposed actions, but the math is not in question.
Pettis is formulating a non-gold-based solution and when it is finalized, I will get a look. I do not have a timeline on that.
In the meantime, the US worry is not that China will stop buying US treasuries, but rather the exact opposite.
Mike "Mish" Shedlock
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