Since this is another long posting, it might make sense to summarize briefly its two parts. In the first part, expanding on an OpEd piece of mine published by the Wall Street Journal on Monday, I argue that China’s “nuclear option”, which has generated a great deal of nervousness among investors and policy-making circles in the US, is a myth, and what the US should be much more concerned about is its diametric opposite – a tsunami of capital flooding into the country. I try to discuss the economic implications and perhaps the implications for asset prices.
In the second part of this posting I discuss the slowing of the Chinese economy within the context of what I believe to be its stop-go approach to economic policymaking. The one-minute take: I think policymakers will soon be stomping again on the accelerator, although there seems to be a real debate going on about whether this would be the proper policy response.
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An awful lot of investors and policymakers are frightened by the thought of China’s so-called nuclear option. Beijing, according to this argument, can seriously disrupt the USG bond market by dumping Treasury bonds, and it may even do so, either in retaliation for US protectionist measures or in fear that US fiscal policies will undermine the value of their Treasury bond holdings. Policymakers and investors, in this view, need to be very prepared for just such an eventuality
So worried have many been that last week SAFE even had to come out and calm people down. According to an article in the Financial Times:
China has delivered a qualified vote of confidence in the dollar and US financial markets, ruling out the “nuclear option” of dumping its huge holdings of US government debt accumulated over the last decade.
But the State Administration of Foreign Exchange, which administers China’s $2450bn in reserves, the largest in the world, also called on Washington and other governments to pursue “responsible” economic policies. The statement on Wednesday, one of a series that Safe has issued in recent days in an apparent effort to address criticism about its lack of transparency, also played down the chances of China making major further investments in gold.
It’s good that SAFE is trying to soothe worried investors and policymakers, although, as I have pointed out many times before, the last thing China needs right now is for the US “to pursue responsible economic policies” if that means bringing the government’s debt level down and, with it, US overconsumption and the US trade deficit. But the idea that Beijing can and might exercise the “nuclear option” is almost total nonsense. This cannot and will not happen.
In fact the real threat to the US economy is not the dumping of USG bonds. On the contrary, in the next two years the US markets are likely to be swamped by a tsunami of foreign capital, and this will have deleterious effects on the US trade deficit, debt levels, and employment. Investors and policymakers should be far more worried that China and other capital exporting countries are trying their hardest to maintain and even increase their capital exports, while the capital importing countries are either going to see capital imports collapse, or are trying desperately to bring them down.
June trade
On Sunday, for example, China released its trade figures for June. Here is what Bloomberg had to say:
China’s trade surplus widened to the highest this year and exports climbed more than estimated to a record in June, adding pressure on the government to let the currency gain after the U.S. said the yuan “remains undervalued.”
The gap increased 140 percent to $20.02 billion from a year earlier, the nation’s customs bureau said yesterday. That compares with the $15.6 billion median estimate of 24 economists Bloomberg News surveyed. Exports surged 44 percent and import growth moderated for the third month, rising 34 percent.
People’s Daily take on the numbers was a little different, stressing not the surge in June’s trade surplus but rather the relative decline in the trade surplus for the first half of 2010:
China’s trade surplus fell by 42.5 percent in the first six months this year from a year earlier to 55.3 billion U.S. dollars, the General Administration of Customs (GAC) said Saturday.
In the first half of 2010, exports rose 35.2 percent to 705.09 billion dollars while imports were up 52.7 percent to 649.79 billion dollars, the GAC said in a statement posted on its official website.
The trade surplus earlier in the year was low, at least in part I think because of a surge in commodity stockpiling which, in my opinion, should be treated as capital investments rather than as imports, but however you look at it, and especially when you consider the crisis in Europe, June’s trade surplus was very large, and I have little doubt we are going to see more big numbers over the rest of the year.
Needless to say, the US trade deficit has widened sharply. Here is Wednesday’s Financial Times:
A surge in imports from China pushed the US trade gap sharply wider in May, adding to a stream of weak data that has put Barack Obama’s administration under pressure for its inability to right the faltering economy and stimulate the stagnant jobs market.
The trade deficit grew by 4.8 per cent to $42.3bn, according to commerce department figures, the highest since November 2008 and at odds with the consensus of economists, who forecast the gap would shrink in May.
Trade surpluses must be recycled
What does all this have to do with foreign funding of USG bonds? Everything. The larger China’s trade surplus, the more capital it must invest abroad. This might not seem evident from the change in the PBoC reserves. Another article in Sunday’s Bloomberg had this to say:
China’s foreign-exchange reserves, the world’s largest, rose at the slowest pace in 11 years in the second quarter as expectations for a yuan appreciation diminished and the European sovereign debt crisis saw capital move out of emerging markets.
The nation’s holdings rose by $7.2 billion to $2.454 trillion yuan at the end of June from the end of March, the People’s Bank of China said today, the smallest increase since the second quarter of 2001. Reserves dropped 2 percent in May, according to data posted on the central bank’s website, the first monthly decline since February 2009.
PBoC reserves were up by a very small amount compared to the visible inflows. Part of this may be explained by losses on non-dollar reserves – which has no flow impact – but probably at least part of the reason may be hot money outflows, which seem to be picking up, and much of this is likely to end up anyway in the US markets.
Clearly the PBoC and (other Chinese entities) are continuing to accumulate huge amounts of USG bonds. So why not worry about Beijing’s “nuclear option”? For a start, unlike you or me the PBoC cannot simply sell Treasury bonds, pocket the cash, and go home. Dollar bills are just as much obligations of the US government as are USG bonds, only that they pay no interest. If the PBoC wants effectively to reduce its holdings of USG bonds it must swap them for something else.
How to sell USG bonds
There are broadly four ways it could arrange such an exchange. First, it could swap US Treasury bonds for other US assets. How would this work? Let us say that the PBoC decides to sell USG bonds and buy Manhattan real estate or IBM stock. Obviously the seller of that real estate or stock will now have a bunch of money that he needs to invest. Directly or indirectly (by buying another USD asset and so passing the problem onto someone else) the money becomes part of the pool of US savings that are available to fund the USG market.
In other words this swap would have little net impact on the US market except perhaps to cause a slight increase in Treasury yields and an equivalent, and welcome, contraction in US risk premia. What if instead of leaving his money in US assets the seller uses the money to buy foreign assets? That will have the same effect as the second way the PBoC can swap out of USG bonds.
In the second way the PBoC could reduce its USG holdings, the PBoC could swap USG bonds for assets denominated in euros or yen. Of course any major exchange would immediately cause the dollar to drop sharply, giving the US economy an export-related boost as European or Japanese exports collapse and imports surge. There might be a short-term rise in US interest rates in this case, but this would be tempered because the expansionary effect of a surge in US exports would reduce the need for the US Treasury to borrow – remember it is borrowing in order to create domestic employment, and the less the employment it creates leaks abroad through the trade deficit, the less it needs to borrow.
Aside from the fact that a large swap of this sort would ensure that the PBoC sells dollar assets at artificially low prices and buys euro or yen assets at artificially high prices, there is a larger political problem with this kind of transaction. Europe and Japan would not be happy if PBoC purchases were truly significant and both countries would almost certainly retaliate strongly against Chinese trade.
They might also increase their purchases of USG bonds in order to reduce the currency impact of the PBoC’s purchases, which has the effect of recycling PBoC purchases into USG purchases anyway. Remember if Europe or Japan do not intermediate PBoC-related inflows back into the US, this is the same as saying that the US trade deficit migrates to a very unwilling Europe or Japan.
In fact recent reports that the PBoC has increased its purchase of yen is already causing worry about its exercising the nuclear option, although that is a mistaken reading. First, the numbers are small, and second, they are more likely to be shifting out of euros than out of dollars. Here is what the Financial Times said in an article last week:
China bought a record amount of Japanese government bonds in May, in an apparent move to shift more of its massive foreign exchange reserves into Japanese debt. Chinese net purchases of Japanese government bonds soared to Y735.2bn ($8.3bn) in May, far outpacing the Y541bn in JGBs bought from January to April, according to Japanese finance ministry figures.
The increase in JGB purchases comes as China appears to be diversifying more of its $2,400bn in foreign exchange reserves away from US Treasuries and, more recently, euro-denominated assets, because of sovereign debt problems in Europe.
Notice I have ignored the possibility that the PBoC buys assets other than in euros or yen, but aside from the fact that no other market is nearly deep enough to absorb significant purchases by the PBoC, the net result is no different. The destination country would be forced either to recycle the inflows back into the US (counteracting the effect of PBoC selling of USG bonds) or it would have to absorb the US trade deficit – something no other country is capable of doing.
The third way the PBoC could swap out of its USG bonds is to exchange them for hard commodities. Because of the positive correlation between Chinese growth and commodity prices, stockpiling commodities is a bad balance sheet decision for China.
Why? Because by locking in relatively “cheap” commodities if Chinese growth subsequently surges, or relatively “expensive” commodities if Chinese growth subsequently stalls, it will only exacerbate volatility in China’s already incredibly volatile economy. Remember that most analysts believe that quarterly growth, if correctly accounted, plunged from the low double digits in the last quarter of 2007 to zero or even negative in the last quarter of 2008, for example, before surging to low double digits again the last quarter of 2009. This is already an very volatile economy.
This exacerbation of volatility is made worse by the widespread suspicion that China has already stockpiled huge amounts of commodities, but the main point is that even if the PBoC were to do this, it does not change anything material. It simply reassigns the problem to commodity exporters, with almost the same net results, because if Brazil, say, sells more iron ore to China, Brazilians now have more dollars, which they must either spend on US imports – thus boosting US employment – or invest in US assets. In this case Brazil simply intermediates the former PBoC purchases of USG bonds.
It’s all about the export surplus
Finally the PBoC could sell US Treasury bonds and purchase assets in China. This would be most damaging for China because it would mean a drastic reversal in the country’s currency regime. The PBoC currently sells huge amounts of renminbi to Chinese exporters in order to keep down the value of its currency. Suddenly to switch strategies and to buy renminbi would cause the value of the renminbi to soar. This would wipe out China’s export industry and cause unemployment to surge.
So basically any sharp reduction in China’s Treasury bond holdings is likely either to be irrelevant to the US or to cause far more damage to China than to the US. I really don’t think we should waste a lot of time worrying about the nuclear option.
But that doesn’t mean there is nothing to worry about. In fact the problem facing the US and the world is not that China may stop purchasing US Treasury obligations. The problem is exactly the opposite.
The major capital exporting countries – China, Germany, and Japan – are desperate to maintain or even increase their net capital exports, which are simply the flip side of their trade surpluses. The major capital importing countries, on the other hand, are likely to see their imports plummet.
China, for example, is unwilling to allow the renminbi to rise against the dollar because it wants to protect and even increase its trade surplus. I already discussed the June trade numbers, and it is pretty clear that China is in no hurry to bring its trade surplus down. Remember that whether the surplus ends up as an increase in reserves or as hot money outflows makes no difference. One way or another the full current account surplus – most of which is the trade surplus – must be recycled abroad.
Japan is in a similar position. In Japan, consumption growth has been glacially slow, and any contraction in its trade surplus will lead almost directly to reduced production and higher unemployment, so Japan, too, is eager to maintain capital exports.
Finally Germany, like China, has been reluctant to put into place policies that boost net demand, and in fact the collapse of the euro means that Germany’s trade surplus will almost certainly grow. Needless to repeat, if the German trade surplus grows, so must its export of capital.
So who will import capital?
All the major capital exporting countries, in other words, are eager to maintain and even increase their capital exports. But the balance of payments must balance, and all that exported capital must be imported somewhere else. So what about the net importers of capital – aren’t they eager to absorb these flows?
Here the situation is dire. The second largest net importer of capital until now has been the group of highly-indebted trade-deficit countries of Europe – including Spain, Greece, Portugal, and Italy. The Greek crisis has caused a sudden stop to private capital inflows, as investors worry about insolvency, and it is only official lending that has prevented defaults. These countries are unlikely soon to see a resurgence of net capital inflows. The world’s second-largest net capital importer, in other words, is about to stop importing capital very suddenly. I discuss this more generally in my May 19 blog entry.
This leaves the US. Because it has the largest trade deficit in the world it is also the world’s largest net importer of capital. So what will the US do?
At first nothing. As net capital exporters try desperately to maintain or increase their capital exports, and deficit Europe sees net capital imports collapse, the only way the world can achieve balance without a sharp contraction in the capital-exporting countries is if US net capital imports surge. And at first they will surge. Foreigners, in other words, will buy more dollar assets, including USG bonds, than before.
But remember that an increase in net US imports of capital is just the flip side of an increase in the US current account deficit. This means that the US trade deficit will inexorably rise as Germany, Japan and China try to keep up their capital exports and as European capital imports drop.
I have little doubt that as the US trade deficit rises, a lot of finger-wagging analysts will excoriate US households for resuming their spendthrift ways, but of course the decline in US savings and the increase in the US trade deficit will have nothing to do with any change in consumer psychology or cultural behavior. It will be the automatic and necessary consequence of the capital tug-of-war taking place abroad.
The US, in other words, is not likely to face the “nuclear option” of a Chinese disruption of the US Treasury bond market. It is far more likely to be swamped by a tsunami of foreign capital. This tsunami will bring with it a corresponding surge in the US trade deficit and, with it, a rise in US unemployment. It will also force the US Treasury to increase the fiscal deficit as more of the jobs created by its spending leak abroad.
Therein lies the problem. A reduction in net foreign capital inflows means a welcome decline in the US trade deficit, but the US is likely to see just the opposite. Foreign capital will push desperately into US markets and as an automatic consequence the US trade deficit will surge. So the problem isn’t too little capital inflow or a sudden boycott of USG bonds. On the contrary, the US will see too much capital inflow.
All this may turn out to be very bad for the US economy, but in the past massive capital recycling has usually been very good for asset markets. Might we see a surge in the US asset markets, at least until next year when Congress starts getting tough on the trade deficit? I would be willing to bet that we do.
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To move on to the second subject of today’s posting, net new lending for June was RMB 603 billion. This is a huge drop from last June’s RMB 1,530 billion but, before we get too scared, remember that last year saw an astonishing explosion in lending. June 2008’s total new lending was a more typical RMB 332 billion.
That leaves us with new lending year to date at 62% of 2010’s total quota. It is hard to read too much into this ratio. By this time last year we had already disbursed 77% of the year’s total, although a lot of that was short-term loans made to beat the quota. By comparison in 2008 total new lending in the first half of the year accounted for 50% of the annual total,
What’s more, these new lending numbers may be totally distorted. Charlene Chu and her team at Fitch Ratings, as usual way in front when it comes to sniffing out rotten things in the banking system, in a July 2010 report (“Chinese Banks: Informal Securitisation Increasingly Distorting Credit Data’) warns that there is an awful lot more “securitization” (also known as moving loans off the balance sheet) going on than is being recorded. Included in their rather disheartening report is this chilling passage:
Data on the sale and repackaging of loans into CWMPs has always been sparse, but, historically, observers have been able to track activity by the number of CWMPs issued each month using information collected by small third-party data providers. However, as public scrutiny of informal securitisation has risen, Fitch has observed a noticeable worsening of Chinese banks’ already poor disclosure of this activity.
Some banks very actively engaged in transactions last year are showing up in 2010 data as minimally involved, yet the bank’s own salespeople (responding to Fitch’s enquiries) state that business remains as strong as ever. Meanwhile, private placements of products to institutional investors are becoming more commonplace, most of which are never disclosed to any entity but the CBRC. Because of this worsening in disclosure, data from third-party providers is capturing less and less transaction flow, with as much as 40% of deals in H110 going uncaptured, versus less than 10% prior to end 2009.
I have no idea of whether or not something risky is happening here, but I usually take it as an article of faith that when bankers spend more time obfuscating transactions (for example, check out Naked Capitalism’s worrying take on the European Financial Stability Facility), it is because there is a lot more they prefer us not to see. Of course, I might just be wrong.
Real estate declining
At any rate credit creation drives growth in China, especially credit in the real estate market, and the slowdown in lending compared to last year seems to be having an effect. Average real estate prices across the country officially declined in June, with many of us believing that there is a lot more to come. Here is the relevant article in Monday’s South China Morning Post:
Mainland property prices in June recorded their first monthly fall since February last year, providing further evidence that a government drive to let the air out of an inflated market is working.
Average prices in 70 cities edged down 0.1 per cent from May, lowering the annual property inflation rate to 11.4 per cent in June from 12.4 per cent in the year to May and April’s reading of 12.8 per cent, the National Bureau of Statistics said on Monday.
Monday’s People’s Daily was a little less negative. The entire article says:
Housing prices in major Chinese cities rose 11.4 percent year on year in June, one percentage point lower than the increase in May, the National Bureau of Statistics said Monday.
Apartment sales are way down in most big cities and last week’s South China Morning Post reported a “shocking” number of empty apartments:
Mainland’s property market remains dangerously overheated and failing to tame the speculative bubble could threaten financial and social stability, a prominent economist said in an official newspaper on Friday.
Yi Xianrong, an economist at the Chinese Academy of Social Sciences, a government think tank in Beijing, noted estimates from electricity meter readings that there are about 64.5 million empty apartments and houses in urban areas of the country, many of them bought up by people wagering on a constantly rising property market.
In the overseas edition of the People’s Daily, Yi said the ”shocking” level of empty housing showed the dangers brought by the country’s property boom, which the central government has been trying to cool.
And it is not just the real estate sector that seems to be slowing. John Garnaut has a very good (as usual) article in Tuesday’s Sydney Morning Herald about the hard economic choices China faces. He points out the recent decline in steel production and discusses what seems like major misallocation of capacity in wind power generation – a symptom perhaps of the haste to invest in prestige projects without clear economic benefits.
Meanwhile, perhaps as a harbinger of the coming debate about currency appreciation, China’s textile lobby group is issuing dire warnings. according to an article in Tuesday’s People’s Daily:
Half of China’s textile companies risk going to the wall if the yuan appreciates 5 percent against the US dollar, an industry lobby group warned.China National Textile and Apparel Council Vice-President Gao Yong attributed this knife-edge existence to the industry’s thin profit margins of around 3 to 5 percent. ”If the yuan actually appreciates 5 percent against the US dollar, over half of China’s textile companies will go bankrupt,” Gao said.
…More than 20 million people are directly employed in China’s textile industry, while a further 140 million are involved in cotton farming, according to the Ministry of Commerce. Therefore, a large upward revaluation of the yuan could cost millions of jobs.
Time to relax?
In this context it is interesting, and significant, I think, that I am hearing rumors that there is an increasingly urgent argument within policymaking circles about the whether or not we need to maintain relative tightening, especially in lending and real estate. One group – perhaps include the next generation of leaders? – has been arguing that it is too soon to start relaxing and that Beijing needs to keep its foot on the brakes.
The other group is claiming that the economy is decelerating too quickly, and it is time once again to reverse course. The head of one of China’s Big Four banks, for example, seems to agree with the latter. According to an article in Monday’s Financial Times:
Faltering confidence in the Chinese economy could threaten the plans of the country’s banks to shore up capital reserves, the head of China Construction Bank, has warned.
…Guo Shuqing, the chairman of China Construction Bank, said overall confidence in the economy was more of an issue than the availability of investor funds. “The risk is not the volume of issuance that will come from the banks, such as ABC’s IPO. It’s more people’s confidence, how worried they are about the Chinese economy in general,” he said.
Mr Guo played down concerns about China’s property bubble and the damage that could do the banks’ asset quality, saying “the value of mortgages is only about 15 per cent of GDP, much lower than in Europe and the US.”
…He also rejected alarm generated by a recent wave of reports about sky-high local government debt in China, which some analysts have put as high as Rmb7,000bn ($443bn). Mr Guo confirmed that the regulator had asked banks to slow lending to local government companies but said that many of them were in fact cash-generative businesses which could service their loans. “Quite a lot of these companies are commercial companies, which are operating businesses with cash flows, like tollways, ports and railways. Many of these cities and counties are developing very fast, so there is no problem in paying back these funds.”
Mr Guo quoted estimates of local government debt of Rmb3,000bn, only about one-third of which were to companies which are not generating cash flow. “The total government debt to GDP is very low in China. Even if it increased by about 10 percentage points, it would only be about 30 per cent. So it is very affordable.”
Obviously Mr. Guo has very different estimates – or at least definitions – of government debt levels than mine, but clearly he and many like him seem much less concerned about overheating than about a too-sudden stop. Regular readers know that in my view for the past two years we have veered from panic to panic – stomping on the accelerator at one time and then stomping on the brakes as few months later – and I think it is only a question of time before growth slows sharply, and we panic once again and stomp on the accelerator.
Perhaps not every research analyst agrees with me. In the the SCMP article cited above they quote a very welcoming Merrill Lynch as saying, about the renewed push among Chinese banks to expand real estate lending,“Banks always like to test the resolve of policymakers. We are glad to see more people are coming around to our view that there will be no policy reversal and policy easing very soon on the property front.”
But I am not sure there will be much alternative. Beijing wants to keep growth stable while reducing China’s reliance on the “bad” growth caused by real estate bubbles, unsustainable borrowing, and more excess capacity. But what if the only growth we’ve got is bad growth?
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“the US trade deficit will inexorably rise as Germany, Japan and China try to keep up their capital exports and as European capital imports drop.
I have little doubt that as the US trade deficit rises, a lot of finger-wagging analysts will excoriate US households for resuming their spendthrift ways, but of course the decline in US savings and the increase in the US trade deficit will have nothing to do with any change in consumer psychology or cultural behavior. ”
Apart from USG bonds (and some shares), what assets would China, Germany etc buy in USA? Vegas property?
USA consumer culture seems to be shifting toward saving and enforced thrift.
While purchases of USG bonds might hold up the US dollar value for some time into the future, and thus maintain cheap Walmart Chinese finished goods, there is a limit to the number of gee-gaws that increasingly nervous consumers buy.
Overseas credit may be available, but is it ‘wanted’? The USA property bubble has bust (and more to come), and banks are reluctant to lend in general (business or for mortgages) as there is more ‘off balance sheet’ debt yet to be marked to market and absorbed into their accounts. Government spending is USA, has, like Japan, been a gesture of ‘public works’, hardly the ‘engine’ of a future recovery.
Professor Pettis,
If you have time, could you make a list of recommended summer readings, related to your usual topics of international finance, monetary policy and history?
best regards
Excellent piece, as usual! Thank you for addressing the fears of the so-called “nuclear option.” That topic has created a lot of fear and sensationalism in American circles and hubris in Chinese circles, and needed a bit of sunshine. As usual, your explanations on such topics are refreshingly enlightening.
I know that you are a busy man, but please keep churning out your thoughts. They are definitely held in high regard.
Hi Michael,
I was wondering if you could elaborate on option 3 for the Chinese, why would investment in undervalued commodities cause increased volatility? I thought the root cause of much of their problem was either 1) political pressure on banks that causes all kinds of crazy development schemes to be funded on a local level 2) structural imbalance in their trade policies that ensure low household savings rates/consumption while promoting large SOE and coastal exporters.
How would spending their foreign reserves on lakes of oil and mountains of gold effect either of these sources of volatility? Would it be the ramp up of prices for domestic consumers of the same products? (ie if China buys 2 trillion dollars worth of oil tomorrow, oil prices go back to 150 a barrel and the average Chinese consumer/industry gets punished?)
Professor Pettis, thank you again for such an informative post. How high do you think the U.S. U-6 unemployment rate will go?
Michael,
As usual, it is pretty clear that the kind of market intervention that China (and others) practices cannot go on forever. What you highlight here is that the domestic adjustment is likely to deviate considerably from more capitalist countries, in the sense that the coordinating role of finance/financial markets is far too limited. One would expect that the tension between the gvt’s strategic intent (to maintain the socio-political status quo) is incompatible with a growing share of domestically owned truly private firms, but more likely to produce a giant version of the Singaporean structure with large state-linked firms combined with MNCs (in China’s case including firms from the capitalist parts of Greater China). Neither of those responds to the standard financial policy repertoire as a more balanced economy with a large share of local (and unrepressed) SMEs would.
Unfortunately, as the Singaporean “model” also shows, even in a small country with far fewer coordination problems and a much higher level of gvt competence (and without the ballast of a poor rural population within its own borders), the SME sector struggles to become a defining element as it is in Europe, N America, Brazil etc (and even Taiwan) . SMEs face very hard budget constraints, lack status and access to gvt resources, compared to the much larger SOEs and MNCs. ( To what extent this should be ultimately harmful for economic development cannot be inferred from the Singaporean example because Singapore’s uniques situation allows this process to go on as long as the population accepts this style of policymaking, the policymaking bodies maintain internal discipline and its location factors remain attractive.)
Thanks for such an informative post sir.
Sir but in your opinion finally how this thing is going to get sorted out. I am not an economist but I am active player in stock market through technical analysis.
My query to you is this: Financially US is a mess. Almost all asset prices in US are artificially inflated including USD. Don’t you think sir that prudent policy for Obama admn shld have been to allow the contraction of economy & assets & find its true value by the market? Due to his stimulus & PRC accumulating the USD & USG Bonds US has has artificially inflated its asset prices. This has only aggravated the problems for US economy to recover.
As a stock market player, if I know that the real share value of a particular bourse is actually INR 100. And if currently it is trading at say INR 300. I know that today or tomorrow this share is going to contract & come down to its true value of INR 100. So naturally I will not like to suffer losses by investing at INR 300 in that particular share. I ll be waiting for that contraction. Don’t you think that big corporations & other big investors are not investing in US economy for the very same reason & hence the unemployment?
My idea is that if US wish to pay back all its obligations to China it will force China to evaluate RMB by at least 40 % or it is just going to default on some of its obligations. Is it possible?
It’s a huge trade imbalance, I think US & thus China may face at least 3-4 lost decades. Whats your opinion on this? I really wish to know. I think there are high chances of double recession. What you think about it?
Rien,AS some one operating from Singapore,I have some comments:
China follows to a large extent the development experience of so called Singapore model,that is economy dominated by MNCs and SOEs,SME is really insignifacant in Singapore,although I do not have the exact figures for China,but going by the fact that 50-60% of its export are performed by MNCs or their JVs,and the tremendous growth of its SOEs,it should not be very far either.
Singapore started its industralisation with a population of 2 million+,it is now 4 million+ with about 1.5 million foreigners.China now has 1.3 billion,so more than 600 times.
I always like to look at the industralisation process of Japan and South Korea,or even Taiwan,theirs were totally different,basically import protection,import substitution,and then export subsidy,hende the creation of Toshiba,Sony,Hyundai and Samsung.
The population of South Korea is 49 million,Japan has 127 million.
Of course South Korea and Japan industralised during the period when there was cold war,they were then both firmly in the camp of USA,and there was no WTC,etc
Personally I do not believe that a huge country like China should follow the example of tiny Singapore,although I have no doubt that the very self-assured Singapore leaders have taken big pride on this fact.and they do talk about this all the time.
news.xin.msn.com/en/singapore/article.aspx?cp-documentid
China interested in S’pore’s management of urban politics: George Yeo,foreign minister
Dear Professor Pettis,
I am as usual in total agreement with your macro economic analysis. As I understand the US will borrow more money as a result of spending more and since the US consumer is in no position to embark on such a spending binge the US government will have to take the lead. It seems to me the US. congress, is set on, not to spend on anymore stimulus’ and doesn’t seem to be changing it’s mind on that. Recent bills in support of the unemployed were refused. Many economists such as Professor Krugman have been arguing for more spending to no avail. Congress is not buying any of that. My question is how do you feel that will play out how will this fiscal spending take place? Is a rise of the dollar going
to do it?
I hope you find the time to reply.
Thanks
Jack,
Fully agree, and that is why I am so curious what the Beijing boffins are trying to do, in fact with Spore as a reference. But it is hard To put it mildly, the Spore model may have inherent diseconomies of scale. Also, it does not feel right for a superpower, it requires a certain degree of humility, rather at odds with mainland culture. Maybe they are just buying time, and for that this is an OK model that may please the big municipal gvts (I believe that Zhu Rongzi once made a remark along similar lines (suitable only for specific cities). If you cross a LKY with a DXP, you get something that hums along while feeling the stones. But who knows, someone may have found a way to extend the thing.
The flip side of this is why is this happening to the US?
This simple equation explains it.
G-T = S-I + M-X
Basically federal deficits can be financed domestically or by foreigners. US citizens either save more than we invest (S-I) or we import more than we export (M-X) with foreigners using the leftover dollars to buy assets.
If only we could look back from the year 2049.
Then we could discover which of these posts are more prescient.
So stick with Physics and the Natural world.
Studying this. Will never let you down.
thank you for the excellent article.
question to prof. Pettis and of course sophisticated commenters on this blog:
China was more or less pushed by the US to do something it doesn´t like too much – let the yuan appreciate.
the decision to let the currency float again came at the same time the euro depreciated from 1.50 to 1.20 – making european exporters more competitive compared to chinese ones.
you also cited the currency “stress test” that paints a dark picture for some industries should the yuan appreciate by 5% or more.
so wouldn´t make it perfect sense for China to diversify away from the dollar right now?
->if you can´t depreciate the yuan against the dollar – then try to weaken your direct export competitors (europe,japan) by buying their currencies (and assets)?
the latest data out of Japan, the purchase of Spanish bonds and the recent euro-dollar move (pushed by a strong hand) point in that direction.
and there are comments by a former PBoC advisor:
http://www.bloomberg.com/news/2010-07-19/china-should-pare-dollar-reserve-assets-ex-pboc-adviser-yu-yongding-says.html
“…China should reduce its holdings of U.S. dollar assets to diversify risks of “sharp depreciation,” Yu Yongding, a former adviser to the central bank, wrote in a commentary in the China Securities Journal.
The nation should convert some holdings currently in U.S. dollars into assets denominated in other currencies, commodities and direct investments overseas, he recommended. China’s dollar assets are surplus to requirements and the proportion is too high, Yu said.
“It’s completely possible and also necessary for China to expand direct investments in Asia, Africa and Latin America,” he wrote. “It’s also a rare opportunity for Chinese companies to acquire businesses overseas…”
Isn’t rather beside the point to focus on these reserves. I realize that they are somewhat large, and have accumulated rather quickly, but in reality, is the size of this “massive reserve pool actually that large, certainly not relative to pools of assets elsewhere. Rather they should be viewed for what they have accomplished, developing large swathes of jobs, employment and, essentially development, if not enable China to pass through the demographic hurdle of large groups of young and unemployed which will soon start to subside and turn in the other direction (moving from its demographic sweet spot). So, isn’t this discussion, like so many other in the popular presses really a misnomer, leading us to discuss that which is of little importance in the long run, the real questions we should be asking is how to transition the global economy toward a longer term, stable (if not ultimately more equitable, at least more broadly sustainable) global economy. Sure it will be interesting to see how China will deploy its future growth in reserves, assuming this occurs, as it is unlikely that it will change the composition of its current holdings, although future might be interesting to see, but will most likely, ultimately impact the competitiveness of other nations less amenable to broad jumps in the value of their currencies, portending potential economic conflicts. But really in the end, what we need to be asking is how to restart the global economy opn a stronger, more stable, long term growth projectory that benefits a wider number of participants in the global economy, while strengthening institutions (at all levels) to combat the local, regional and global problems that we are confronting over the medium to longer term (such as those around population, demographics, energy, water, food and the general environment understanding that while the global economy needs to move forward on all fronts it will take a patchwork of innovations to ensure the maintainence of a cooperative global family).
The CEO of Siemens just blasted Wen about Chinese ‘protectionism’. Throw that in with the head’s of GE, Microsoft and Google. My own view is that being as big and mostly poor as it is, China has no choice but to be protectionist in a way that will never suit MNC’s.
what a great post..
way to go..
thumbs up..
The first part of the article answered a lot of questions I had about what China can possibly do with all that US$ obligations.
I do still wonder why China buying hard assets around the world and therefore indirectly causing the capital inflows to the US you warn about to cause core inflation here. I’ve long thought that the end-run of Americans run up in debt and consumption must end in things we need becoming more expensive, while things we don’t need deflating along with our relative incomes. Is there a scenario of the four that leads to that? And if that can happen, why don’t we read about the Japanese household having difficulty making ends meet?
I have no clue as to what shape or form the end game will take, but given the monstrous size of these funds and how ever more unstable they are becoming it is hard to see any variation of a smooth landing. In fact we might have a contagion here with sudden collapse of all manipulated currency resulting in trade surplus countries after China trips. That means Germany will trip quickly behind China if it suddenly adjusts/crashes.
Japan post Nikkei crash might provide an indication of the results. It is for someone else to figure the curves and calcs, but when Japan recirculated their trade surplus in the 80s in everything from USG to the Rockefeller Center and then when they crashed all their assets lost in value a rough equivalency to whatever the trade flows they gained over and above what a non-manipulated Yen value would have allowed. This was also proportional with those assets the Japanese were only, in general, a percentage the asset dropped in value the % held by Japanese times the adjustment.
With the USG holdings the loss will be almost all currency adjustment as the Yuan likely goes to some level well past 3 1/2. With Germany it will be in the sovereign loans as all countries in Europe outside of France and Germany can find any upside in membership – they will pull declaring by fiat their Euro debt to the original home currency. What is German’s recourse? There is none.
This is a heck of a show coming. But like all major cusp points that have extreme overshoot there is nothing to be done in terms of timing. Could be this year or it could be in a decade. But its unwind will not be as long as the build – likely the unwind will be one amazing quarter. It wil be like watching Mount St Helens blowing.
The reason it has not occurred to date is that I think either subconsciously or as a plan, the US is willing to put up with China’s trade surplus as it is cheaper to do this than a war or an extra 100,000 men in Asia bases or another 2 aircraft carrier task forces. For Germany, despite many Europeans seeing the main advantage of Europe is to put a thumb in the eye of the USA hegemon, it suits America to have Europe always in such a wracked “beggar your brother” Euro system which makes Spaniards serfs of Germans and presents Germans with a hair raising political management problem. With a semi-permanent Euro crisis, France is less inclined to go adventuring in Rwanda and Germans less inclined to kick Americans out of the legacy bases. Everyone behaves – the critical 700MM Federal Reserve swap line is more effective than an occupying army. So while their is a lot of lip service from the USA, I think the USA promotes or at least allows the current imbalances for tactical reasons.
It would well serve the world’s economists to start critical appraisals along the lie of Professor Pettis so that, perhaps, the post-crisis China does not lash out and blame America.
It also should be remembered that the world was stunned that the feeble “old man” America was able to force a massive currency regime change in only one weekend in the Plaza Hotel. That capability is still in the cards America can play.
If this is “hand waving” – so be it.
Why banking system – banks – are not run as commercial entities, bur instead as government agencies? Because of this, banks must be purged of bad investments every 10 years, and households are forced to cover the bill.
Does it make any sense? I guess not, but why it is happening pretty much everywhere?
“This tsunami will bring with it a corresponding surge in the US trade deficit and, with it, a rise in US unemployment.”
I have 2 questions.
First, what role does final demand play in the equation? Would not a rise in unemployment further crimp final demand in the US?
Second, it seems to me that a plausible scenario would be for the temporary resumption of the cycle – capital inflows boosting asset markets leading to perceived wealth creation and greater spending. This would imply a halt in the deleveraging cycle? You rightly point out that at some point this becomes politically infeasible.
This analysis looks at only the positive side of the equation. Therefore, it is flawed. Yes, Trade surpluses must be recycled. Yes every dollar printed should be invested back. This theory holds as long as the U.S. dollar is accepted as the world’s only reserve currency. As the only reserve currency, the U.S. can print trillions of dollars with very little effect on its economy. Imagine every country in the world accumulating a trillion US$.
But the reality is different. Every risk should be considered. Today, the US$ reserve share has gone down to 57% from 63% a year ago. The whole world is panicking about the FED’s habit of uncontrolled unlimited printing. They are looking for ways out of the US$. The Russians, Chinese, Europeans and even the world bank had expressed this concern. With America’s wars and irresponsible military expenditures, sooner or later, the dollar will lose its reserve currency status and will be dumped for good.
This analysis is wrong and it breaks down at: “The third way the PBoC could swap out of its USG bonds is to exchange them for hard commodities”. There are 2 flaws in the theory here, first, the claim regarding the volatility of the Chinese economy assumes that commodities can not be held in reserve in the same way that T-bills can. T-bills do of course have inherently less risk although commodities have the potential for higher returns and the Chinese economy has averaged 6.5% growth over a 25 year period. In other words, Mr. Pettis cites a short-term anomaly (0% growth at one transitory point in history) to argue that the nation with the most consistently high growth rates, ever, anywhere, would not simply and naturally use stockpiles of commodities as stores of value.
Secondly, the theory that Mr. Pettis adheres to ignores the fact that demand for the dollar exists in nearly every nation in the world. The Chinese buy large quantities of oil from Angola for example… and all such nations have dollar related needs. The Chinese could therefore shed their dollar related assets incrementally, and at whatever pace they deem most beneficial for their economy. Relinquishing their dollar holdings would however take away the threat of a ‘nuclear option’ and it is this threat that keeps the USA from undermining the Chinese economy in a way similar to how Japan’s economy was damaged by the Plaza accords. When there is no military option to contend with the hegemony of a nation such as the USA, it should come as no surprise that nations will find other methods to protect their economies. The Chinese are clever… and if recent history has taught them anything, it is that we Americans will use our reserve currency status to serve ourselves first and foremost, and often. It is just sooooo easy to convince ourselves that what serves the USA… is in the world’s best interest. But manipulating the value of the dollar is not as easy as it once was, and the ‘nuclear option’, as a threat, is the reason why.
Rayllove, i love it when people who don’t know what they are talking about start listing all the ways professor Pettis is wrong. I think the entire thing went right over your head. By the way, the phrase “the theory he adheres to” is pretty funny.
JXu,
“By the way”, the brown stain on your nose would be less noticeable if you were to support your claims. Just explain ‘why’… and your insults, even those of such a petty and juvenile nature, will carry at least some weight.
Wow, that’s really going to be tough, Rayllove. Let’s see…
1. You say: ”first, the claim regarding the volatility of the Chinese economy assumes that commodities can not be held in reserve in the same way that T-bills can.” You’ve completely missed the point. He is saying that if China’s growth is positively correlated with commodity prices (and it is), then stockpiling commodities increases the economy’s volatility and that is a bad thing. This is basic finance.
2. You say: “Mr. Pettis cites a short-term anomaly (0% growth at one transitory point in history) to argue that the nation with the most consistently high growth rates, ever, anywhere, would not simply and naturally use stockpiles of commodities as stores of value.” He has not made that argument at all. I appeal to the professor. Is this even remotely what you meant to say? Rayllove, you have completely missed the point.
3. You say: “Secondly, the theory that Mr. Pettis adheres to ignores the fact that demand for the dollar exists in nearly every nation in the world.” Are you serious? If you ever find yourself arguing on economics with someone who ignores the fact that demand for the dollar exists in nearly every nation in the world, you should assume either that he is a total idiot with no experience at all of anything outside the US, or that you have totally misunderstood him. No one in the world who can use two- or three-syllable words can possibly ignore that fact. This is just silly. Read it again.
4. You say: “The Chinese could therefore shed their dollar related assets incrementally, and at whatever pace they deem most beneficial for their economy“, and you say that in the context of your Angola example. Are you serious? Have you looked at just the net monthly inflow and compared it to asset values elsewhere? Simply diverting 100% of additional inflows away from dollar, yen, and euro would be almost impossible after a few months, let alone actually reducing the reserves.
5. And as Pettis pointed out, even if it were possible to do what you say, it just shifts the problem. Angola, to use your example, would be forced either to buy dollars or to import US goods. There would be no reduction in US financing. Once again you’ve completely missed the point.
6. You say: “It is this threat that keeps the USA from undermining the Chinese economy in a way similar to how Japan’s economy was damaged by the Plaza accords.” Oy vey! Have you been reading Currency Wars again?
I don’t think anything you said makes any sense so let me rephrase: Is there any statement in your comment that isn’t silly, confused, or besides the point? Just take one statement, the one you are most certain about, and let’s debate it.
Rayllove, I haven’t responded to your disagreements because honestly, like JXu, I think you missed most of the points.
JXu, MP,
The post is rife with the likes of:
“Why? Because by locking in relatively “cheap” commodities if Chinese growth subsequently surges, or relatively “expensive” commodities if Chinese growth subsequently stalls, it will only exacerbate volatility in China’s already incredibly volatile economy. Remember that most analysts believe that quarterly growth, if correctly accounted, plunged from the low double digits in the last quarter of 2007 to zero or even negative in the last quarter of 2008, for example, before surging to low double digits again the last quarter of 2009. This is already an very volatile economy.”
“This exacerbation of volatility is made worse by the widespread suspicion that China has already stockpiled huge amounts of commodities, but the main point is that even if the PBoC were to do this, it does not change anything material. It simply reassigns the problem to commodity exporters, with almost the same net results, because if Brazil, say, sells more iron ore to China, Brazilians now have more dollars, which they must either spend on US imports – thus boosting US employment – or invest in US assets. In this case Brazil simply intermediates the former PBoC purchases of USG bonds.”
This is merely an argument built on one unsupported claim after another. It is easy to see why JXu thinks that support can be established on statements such as: ” You’ve completely missed the point”. A claim like: “it will only exacerbate volatility in China’s already incredibly volatile economy”, supported by: “Remember that most analysts believe that quarterly growth, if correctly accounted,” which is another unsupported claim, followed by what is presented as a substantiated conclusion: ” This is already an very volatile economy.” But of course unsupported claims do not support unsupported claims, they instead only deceive the readers who want to believe what they are reading. This may be a clever way to sell books to those who need to strengthen what they want to believe, that China’s unprecedented success is a fluke, or whatever, but it is dishonest writing nonetheless. In other words, just saying that China’s economy is ‘incredibly’ volatile, is not just hyperbolic and a solicitous effort to call attention to your book, it is also devious in regards to your “points”. Which you ultimately accuse me of not being able to understand as part of yet another unsupported claim.
The implicit rules of argumentation are simple, if you make a claim it must be supported. If you say for example, “I think you missed most of the points”, you only need to say ‘why’. Perhaps I did fail to grasp something, but what? What is your point? Volatility? How about providing me with something from the article above that gives substantive support to that claim. You and your followers can from here forth edit out all of the cheap insults… all it takes is making an assertion and then following that with one sentence after another that adds support thereto.
The barrage of insults without substantiation says more about this site than it does about me. If your intentions are to drive away anyone who might diminish the saleability of your book, consider this conversation to be successful. I tried to participate here in good faith but I should have known better than to disagree with someone in the book business. Perhaps you and Yves Smith could advertise for each-other.
JXu,
It is obvious to me that a “debate” with you would be pointless. You are taking liberties in your argument that go like this:
“1. You say: ”first, the claim regarding the volatility of the Chinese economy assumes that commodities can not be held in reserve in the same way that T-bills can.” You’ve completely missed the point. He is saying that if China’s growth is positively correlated with commodity prices (and it is), then stockpiling commodities increases the economy’s volatility and that is a bad thing. This is basic finance.”
But why is this “basic finance”? Because you say it is? What about the 27 mile’s worth of tanker ships that have been used to stockpile oil over the past year or so? Where is the ‘volitiity’ caused by that stockpiling. Oil prices have in fact remained stable during this period. One could argue that oil prices have consequently remained artificially high, but that would be a positive for the future prospect of Chinese stockpiling. Yet, insofar as your argument is concerned, resulting ‘volatility’ is a foregone conclusion. In an argument that your opponent (me) has openly questioned whether volatility is even an issue. But without ever giving any reason for why the resulting volatility is a ‘given’, you disregard my side of the argument as “silly”, all based on an unsupported claim that is based on other unsupported claims as far back as I am privy to. That is not debating unless unsupported name-calling is considered acceptable, I draw the line at supported name-calling.
The recent economic crises did after-all cause the global economy to shake from its foundations. It would therefore be “incredible” if the Chinese economy were devoid of volatility, but the Pettis hyperbole ‘adheres’ to the opposite position in regards to volatility, as if more than 25 years of averaging 6.5% growth is not worthy of consideration.
So… as if nobody in the world could possibly have anything to say that might refute MP, you give yourself these liberties as if reality itself is yours to dictate. How does someone ‘debate’ with those who hold the delusional view that the burden of proof rests on the shoulders of everyone they disagree with but not on them or their ilk? How could for example the consideration I brought up in my first comment referring to the average of 6.5% growth over a 25 year period not make “any sense” regarding a claim made by Mr. Pettis that “cites a short-term anomaly (0% growth at one transitory point in history [based on: "most analysts believe that quarterly growth, if correctly accounted"] ) to argue that the nation with the most consistently high growth rates, ever, anywhere, would not simply and naturally use stockpiles of commodities as stores of value”. How does that statement of mine warrant this: “Is there any statement in your comment that isn’t silly, confused, or besides the point?” Do empirical references seem “silly” to you? Perhaps that is why you are confused about what is a given and what is not. In any case, no thanks on the ‘debate’.
Seems to me that the Chinese government needs to execute a graduated funding of a social safety net beginning with a retirement type social security fund. The tax on employees could be staggered to kick in on a slowly escalating scale some years behind beginning benefits.
In effect, the Chinese consumer would be instantly wealthier and the graduated funding would spark consumption across the entire economy (creating a significant improvement in rural wealth where the aged are more concentrated).
China would be able to retreat from the posture of a net investor in the U.S. They Yuan could be allowed to rise in value on the back of stronger domestic demand. U.S. bond investment pressure would be likewise be decreased.
Because China has complete control over the slow roll out of the new safety program they would be able to exercise strong control over demand growth among what is a very poor demographic which seems likely to reduce social unrest risk.
Obviously, nothing is so simple, but I can’t see many other good alternatives for the Chinese economy.
This issue as you present it seems to center around the idea that China “won’t dump” Treasuries and GSE agencies. Given the reality that the US needs to borrow over a trillion bucks in the next year from somebody, it seems to be the real issue should be that China fails to deliver sufficient appetite or demand for Treasuries bills and notes yielding nearly zero to 2.5%. Further, that seems to be what has happened over the last several months.