Is the PBoC going to stop buying USG bonds? Once again we are hearing very worried noises from various sectors about the possibility of a reduction in Chinese purchases of USG bonds. Here is what an article the South China Morning Post said:
China will press ahead with diversification of its US$3.2 trillion in foreign exchange reserves, the State Administration of Foreign Exchange (SAFE) said on Thursday, adding it does not intentionally pursue large-scale foreign currency holdings. Officials have long pledged to broaden the mix of the country’s huge reserves – as much as 70 per cent of which are now in US dollar assets, according to analysts’ estimates – but the process has been gradual.
“We will continue to diversify the asset allocation of our reserve assets and continue to optimise the holdings based on market conditions,” the foreign exchange regulator said in a statement, responding to questions about its reserve management from the public. It did not mention the US debt debacle. Top Republicans and Democrats worked behind the scenes on Wednesday on a compromise to avert a crippling US default and potential credit rating downgrade.
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.
It sounds like this time the PBoC might be pretty serious about diversifying their risk away from USG bonds, right? 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 hugely disruptive to the US economy and to the US Treasury markets?
No, they won’t. There is so much nonsense still being said about this, even by economist 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, the PBoC must export huge amounts of capital in order to maintain China’s trade surplus. In order the keep the RMB from appreciating, 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.
It is able to do so by borrowing RMB in the domestic markets, or by forcing banks to put up minimum reserves on deposit. 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.
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 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 pretty drastic. 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 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.
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. To make the explanation easier, let’s simply assume that the PBoC sells $100 of USG bonds.
The PBoC can sell $100 of USG bonds and purchase $100 of other USD assets. In this case basically nothing would happen. 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.
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.
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 euros to buy the dollars).
On the other hand, and for this reason, the Europeans 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 amount that Europe is importing must go up.
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. Why? Because 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.
A contraction in the US trade deficit is of course expansionary for the economy. Since the purpose of the US fiscal deficit is to create jobs, and a $100 contraction in the trade deficit will 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 less supply (or more) of USG bonds. It is of course possible that the USG ignores the employment impact of the contraction in the trade deficit, and goes ahead and spends the $100 anyway, but in that case unemployment would drop even more than expected.
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, in other words, they are worrying that the US trade deficit might contract. This is something we 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 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 trade protection.
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. Either they can neutralize the trade impact of Chinese purchases by buying US assets or they have to absorb the employment impact of deterioration in their trade account.
This, by the way, is a bad strategy for China but one that it seems nonetheless to be following. Commodity prices are very volatile, and unfortunately this volatility is badly correlated with Chinese needs. Since China is the largest or second largest purchaser of most commodities, stockpiling commodities is a good investment only if it continues growing rapidly, and a bad investment if its growth slows. This is the wrong kind of balance sheet position any county, especially a very poor country like China, should be engineer. It simply exacerbates underlying conditions and increases economic volatility – never a good thing, especially for a poor and undeveloped economy.
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. Chinese unemployment will rise because of the reduction in its trade surplus unless it increases the fiscal deficit.
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 the capital export comes with technology, and countries that import capital might be doing so mainly at the expense of domestic jobs. For this reason it is absurd to worry that China might stop buying USG bonds.
On the contrary, the whole US-China trade dispute is indirectly about China’s insistence on purchasing USG bonds and the US insistence that they stop. Because make no mistake, if the Chinese trade surplus declines, and the US trade deficit declines too, by definition China is directly or indirectly buying fewer USG bonds, and this reduction in bond purchases will not cause US interest rate to rise at all. If it did, it would be like saying that the higher a country’s trade deficit, the lower its domestic interest rates. This statement is patently untrue.
Inevitably whenever I write about trade and capital exports someone will indignantly point out a devastating flaw in my argument. Since the US makes nothing that it imports from China, they will claim, a reduction in China’s capital exports to the US (or a reduction in China’s trade surplus) will have no impact on the US trade deficit. It will simply cause someone else’s exports to the US to rise with no corresponding change in the US trade balance.
No it won’t, unless this other country steps up its capital exports to the US and replaces China – which is pretty unlikely. Aside from the sheer idiocy of the claim that the US does not produce, or is incapable of producing, anything it imports from China, the claim is irrelevant even if it were true. Trade does not settle on a bilateral basis but must settle on a multilateral basis. If the US imports less capital its current account deficit must decline, whether because of bilateral changes in trade or not. I explain this in a blog entry early last year.
The basic point is that if reduced intervention in Chinese capital exports causes a reduction in Chinese exports to the US to be matched dollar for dollar with an increase in, say, Mexican exports to the US, the story doesn’t end there. Since Mexico’s trade balance is itself decided by the relationship between domestic investment and savings, a rise in Mexican exports will mean a rise in Mexican imports. It may very well be that lower Chinese exports to the US are matched by higher US imports from Mexico, but this will come with higher US exports to Mexico. And if it isn’t Mexico, it will be someone else.
This is an abbreviated version of the newsletter that went out two weeks ago. Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at chinfinpettis@yahoo.com, stating your affiliation, please. Investors who want to buy a subscription should write to me, also at that address.
Thank you for explaining this in details so clearly.
Hello Mike,
Hope you’re doing fine…long time no hear.
One thing I have noticed over the years is that most economic and finance”experts” tend to forget the lessons of the past…History repeats itself and we are on the eve of a major depression like never seen before, sooner than anyone expects.
When the “too big to fail” will fail, when Europe will go to pieces and the US will go bankrupt, China will implode. I can’t wait to see 100 million angry chinese peasants walking over Beijing to chop the heads of every communist party member. LOL.
Sounds like fiction ? Wait and see.
I can already smell the right wing parties gaining votes in every european country and unemployment rising up to 25% and over. Politicians are useless, they have no power anymore over the financial system. Every single solution they’ve been using to help countries in difficulty is only pushing the deadline a little further ahead in time. But, inevitably, the shit will hit the fan.
Enjoy your summer ’cause this fall is gonna be a tough one.
So what happens when you analyze the flows outside the existing paradigm as in a third party (new entrant) into the reserve basket
Good article, I have two questions.
Why is a $100 drop in the US trade deficit necessarily expansionary for the economy? Could it not just represent a fall in imports of $100? In any case won’t living standards will fall, which is not perhaps the main point but worth noting.
Also for the commodity exporters can you expand on this bit: “Either they can neutralize the trade impact of Chinese purchases by buying US assets or they have to absorb the employment impact of deterioration in their trade account.” Why has their trade account worsened? If they are already exporting all their commodiites but now export them at a higher price, isn’t that an improvement?
Dear Professor Pettis:
Thank you for your thought-provoking and erudite article. It is amazing that this post was featured in FT Alphaville and there has not been one comment yet. I do have two questions about Scenario 2, with your remarks in quotations:
“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 euros to buy the dollars).” Why must the ECB create euros to buy the dollars? Cannot the PBoC make a direct trade of its US dollars with the ECB for the Euro bonds, without the ECB having to create Euros? Or is there just not enough European debt to cover China’s need to trade its US dollars? Please explain.
2. “Because 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.” Do you mean that if neither China nor Europe wants to buy $100 in US assets, then the US must either produce the $100 in imported goods and services or reduce consumption by $100? Or, put another way, the US imports $100 worth in goods and services in exchange for $100 in IOUs, but if neither China nor Europe wants to own its IOUs, then the US will have to produce/reduce consumption, thus reducing its trade deficit by $100?
I thoroughly agree that a reduction in Chinese purchases of USG bonds is not a worry for the foreseeable future, but I would be grateful for a further elucidation of the above points. Thank you.
Great article as usual Mr. Pettis.
Three questions:
1) What is the mechanism by which a reduction in Chinese gov’t currency intervention leads to a decrease in the US trade deficit in any sizable way? Would it be that the decreased desire of the world as a whole (PBOC not being fully offset by chinese private sector & rest of world) to hold USD decreases the trade-weighted value of the dollar, which increases imports of US goods? And to extent demand for US tradeables is inelastic, that money is likely to flow back to treasuries and other US financial assets?
2) Let’s say China wants to stick to a managed FX rate regime, but wants to slow their accumulation of dollar-denominated securities. Is there some way to link a certain % appreciation in the Yuan to reduction in the amount of dollars the PBOC must mop up? Or would speculative pressure mean any step short of eliminating the peg require interventions on roughly the same scale?
3) On Chinese gov’t purchases of commodities being an unwise decision — if China is naturally short commodities, why wouldn’t it be risk-reductive to accumulate commodity reserves?
Also what are to secondary effects of such an accumulation on the rest of the world economy?
earlier comment deleted. Could you say what happens when you introduce entry in the form of a new benchmark?
Hi Michael,
Great Article, and allow me to have a little inputs on your 4 points on China’s point of view:
1. Not a good idea since US bonds got downgraded
2. No markets is as big as US, and there are higher chance of protectionism in Europe than US
3. Oh Nooo…. we need to build more empty cities projects to buy more commodities. Buying commodities increase overcapacity problems.
4. This is even worse… we cant afford to have unemployment at home. Our people will take on the streets.
So from the above 4 points, the best option for China is still….. buy US bonds / assets. They are in a precarious situation. No way out for them.
Hi Michael,
I do have a question on the correlation of fiscal deficit and trade deficit. At times I wondered assume china right now have both trade and fiscal surplus. So on your point 4 it runs a trade deficit first then it runs a fiscal deficit to compensate the job loss.
So lets assume another situation that due to internal unrest, they spend so much on curbing unrest to the point that they have a fiscal deficit, will there be a trade deficit to compensate the fiscal deficit?
Superb post. Sometimes it seems like you are the only person who understands how it all works! Highly illuminating. Thanks.
Prof Pettis
Just to play devil’s advocate and look at what you’ve said in a simplistic manner: are you therefore suggesting that the solution to (at least some of the US’ problems is to reduce or stop capital exports (via bond purchase etc) because that will necessarily reduce the deficit experienced by the US? Surely you are not suggesting that the issuance and trade in bonds (typically seen as a financing tool of governments) is because of capital exports by a trade partner? granted, part of the problem may be capital exports, but would the situation arise if there weren’t a corresponding need/demand for them on the part of the US? Sometimes, figures and mathematical identities are not the whole story?
Let RMB appreciate more. Let Chinese companies and citizens more freely keep foreign currencies and go abroad to invest around.
Jack Smack, Europe will have a very difficult adjustment and some members will probably leave the euro, at least temporarily, unless there is fiscal centralization soon, but I don’t think Europe will go to pieces, whatever that means. The US will not go bankrupt, nor even close to bankrupt – a downgrade to AA by one of the three main agencies is hardly a sign of imminent bankruptcy. China will not implode, it will just slow sharply. And although we are certainly on the eve of a major slowdown ion global growth, I suspect the world will have seen much worse many times before. I am not sure the best alternative to inane optimism is apocalyptic fulmination.
S, I have no idea what your question is. What existing paradigm? There are a lot more than one reserve currencies and the biggest alternatives to the dollar are discussed in the piece.
Matthew, good questions. In my example a $100 fall in the trade deficit is caused by a shift in reserve accumulation from dollars to euros. In that case the dollar drops against the euro and US exports to Europe rise while European exports to the US decline and are substituted for by US production. It is possible of course for the US account to rebalance fully by a drop in imports and no substitution, but this would be caused by domestic US problems, not by a rise in the value of the euro. What would the impact be on US living standards? It depends. In the case of zero unemployment, it would cause household income to decline in real terms because of the rise in import costs. If there is unemployment it would have the same effect but this would be swamped by the employment impact, so that in the aggregate US households would be better off.
As for your second question, my piece was badly worded. I should have said “deterioration in the rest of their trade account”.
PPCS2, the money supply is not just cash in circulation but, depending on which monetary aggregate you use, includes ECB bonds. In principle the ECB and the PBoC could agree simply to do the swap, so that for example the PBoC gives the ECB $1 trillion in USG bonds and the ECB gives the PBoC $1trilllion equivalent in ECB bonds, but it is hard to imagine why the ECB would take on such a huge mismatch on its balance sheet simply because the PBoC didn’t want to hold dollars. And please see my response to Matthew, in which I think I address your second question.
Louis, First, a reduction in PBoC currency intervention means by definition (under current conditions) that the RMB must rise. It is only PBoC intervention that is holding it down. Second, it depends to a large extent on expectations. Remember that speculative inflows are themselves determined by appreciation expectations, so if the PBoC decided to let the value of the RMB creep upward at a faster pace in order to reduce dollar accumulations, it could set off a speculative frenzy of hot money inflows that would itself cause a surge in PBoC dollar purchases. Third, I think of long and short positions as a function of balance sheet correlation. If rising commodity prices are correlated with and improvement in China’s underlying economic conditions, then China is effectively “long”. Since Chinese demand is a major cause of rising prices, and Chinese demand is of course a function of underlying growth, I think of China as being long commodities.
Liaogz, there is a relationship between the trade and fiscal accounts, but many things affect the fiscal surplus or deficit, so it is hard to answer your question without setting too many other conditions. By the way I do not think China really has a fiscal surplus. It shows a fiscal surplus because it forces most fiscal expansion through the banking system, but this really is more of an accounting fiction than a reality.
Judy, I am not suggesting that the solution to the US problems is to stop capital imports. I am simply pointing out the relationship between the capital and current accounts and what the automatic implications are. I don’t know what you mean by saying that mathematical identities are not the whole story. In a very fundamental sense they are the whole story – in the sense that they cannot be violated and never will be, and so the whole story, whatever that is, must fit firmly within their constraints. Any ‘theory” of what China or the US can or should do that violates accounting identities is simply wrong – not wrong in the sense that it is a bad idea or that it will have sub-optimal consequences, but wrong in the sense that 2 + 3 = 12 must be wrong. It is a meaningless statement.
Again, you’re forgetting the human factor in the equation : when some European members will leave the euro zone, what would be the result ? It will not only affect Europe’s economy but the entire world’s. The domino effect will hit the rising ecomonies and China will have to deal with major riots. As you said: “it will just slow sharply”. The question is : how sharply ?
Prof Pettis
The identities you speak of only apply to a part of the (big)picture, other parts such as the very real fact that modern governments needing to fund fiscal deficits and the implications of bond markets and capital exports form another part of the picture. Not everything can be simply explained away through identities.
As argued previously, in the long run, there is balance but we are not living in the long run now are we? The fact is, at any given moment, you might not find things neatly balanced out the way accounting identities are meant to be. The whole idea behind P&Ls and Balance Sheets are that they can only function based on the concept that there is balance, anything that upsets that balance is adjusted through reserves (usually, of course there are exceptions) and the same goes for national accounts and accounting identities. That does not mean that anything not captured by the equations does not exist but that adjustments are made and therefore they are “taken care” of.
Of course, there’s the idea of equilibrium and therefore balance at the end of the day but really doubt I’ll be around to see the long run or that I’ll really care when the day arrives. Economics and the state of the world’s finances is really not the last thing I’ll be really pondering at the end of the day LOL.
Thanks for your very educative post, Mr. Pettis. I have a question: you say that China has to invest their surplus in a market which is large enough and willing to accept such foreign investments. Then you explain that for the US economy as a whole, it would better to reduce those capital imports because it would create jobs, and a better economic multiplier than goverment spending.
Then, why on earth is the US willing to accept such foreign investments?
Prof. Pettis –
It seems as though if the Chinese decided to sell their US govt bond holdings, the result should be the same as any other situation where a large holder decides to sell an investment asset: demand goes down, so the price goes down. Of course someone else has to buy the bonds that are sold, but that is also true when a large holder dumps a stock, which certainly seems to drive the price down. Isn’t there a legitimate concern that at some point the price declines caused by that kind of large-block selling can reach a tipping point where it causes a mass exodus?
As for the option of buying commodities, I would have thought the logic behind that to be rather unassailable, if one thinks of the Chinese Central Bank foreign exchange holdings as an investment asset. What rational investor would prefer bonds paying a negative real interest rate in a currency that the US government is avowedly doing its best to depreciate, over real assets that have, over time, performed rather better? Personally, at this point, I would certainly rather own pretty much any hard asset than US govt bonds — maybe the CCB feels the same way?
Am I missing something here?
Jack in Davao
Hi Michael.
Great article, but I just have one question/statement. You said:
>In order the keep the RMB from appreciating, 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.
Maybe I am misreading this but you seem to be suggesting that this is something that occurs outside of trade. The PBoC is accumulating US reserves in its US reserve account because China runs a trade surplus with the US. Under a floating exchange currency this would have a tendency to push the exchange rate in favour of the US. In order to recycle the reserve back into the US reserve accounts of US banks the PBoC uses their accumulated reserves to purchase treasuries in the open market. This has 2 effects, one it allows the PBoC to maintain the currency peg, and two it maintains the US reserves in lending institutions at a level that allows them to continue lending (obvious since 2008 this is a moot point )..
So although you could say that PBoC “pays” for US dollars with RMB, I think this is a little misleading. What I would say is that the PBoC accumulated US dollars because it runs a trade deficit.
Sorry if I misinterpreted your point.
Thanks for the article,
a Question:
So how do yous see the endgame: That China let’s its currency appreciate, decreases/balances its CA and with US moving into a CA surplus and gradually paying down/inflating away its debt?
Although I understand the theory and the multilat-trade links, its difficult to see the global re-balancing occurring smoothly and with no shocks.
Thanks again,
SA
“If the PBoC decided to let the value of the RMB creep upward at a faster pace in order to reduce dollar accumulations, it could set off a speculative frenzy of hot money inflows that would itself cause a surge in PBoC dollar purchases”
That’s what I was hinting at. So in that case, what middle path is available to China if it wants to scale back current policy in a sustainable, non-destabilizing way? It seems that with US real interest rates expected to be low for some time, it will be very hard for the PBOC to reduce its intervention without letting domestic inflation expectations rise.
I understand your point about balance sheet correlation, but on the other hand, to extent external shocks (political uncertainty, increased finding and development costs, increased demand by other nations) drive up commodity prices, China is effectively short.
“If the Chinese trade surplus declines, and the US trade deficit declines too, by definition China is directly or indirectly buying fewer USG bonds, and this reduction in bond purchases will not cause US interest rate to rise at all. If it did, it would be like saying that the higher a country’s trade deficit, the lower its domestic interest rates. This statement is patently untrue.”
What happened in the mid-2000s? It seemed like low US interest rates were directly a consequence of the trade deficit and Chinese policies to recycle those dollars into financial assets. Let’s say a tariff wall went up at some point in that decade, and US consumers stopped importing Chinese goods. Wouldn’t interest rates have been higher in that scenario, as desired savings fall (US businesses having lower MPS than the Chinese)?
I would think that if China reduced its currency intervention, the US trade deficit would fall at the cost of higher interest rates reducing domestic consumption.
Judy – government spending (and therefore borrowing) in the US have been in large measure a response to high unemployment. To the degree that this is caused, or exacerbated by trade imbalance with China, it can absolutely be said that the trade imbalance compels the US gov to issue debt. Political irresponsibility and a faith in the efficacy of stimulus have also contributed, to be sure, but the trade deficit is the critical ingredient.
Jack – I also find it hard to believe that interest rates wouldn’t rise in the event of China abandoning US treasuries. This would visible… it would be a “big deal”. Additionally, it seems to me that prof. Pettis fails to take into account the other effect of smaller trade imbalance with China: higher prices. Chinese trade subsidies (taken cumulatively) have kept US consumer prices down. Were China to stop buying bonds, and inflation to rear its head — how would interest rates do anything but go up?
With regards to commodity reserves, prof. Pettis’ point is that commodity values are largely correlated with Chinese economic performance. In the event of a downturn, the value of these assets would fall at the worst possible time for the Chinese government and the PBoC. Much better is something that increases in value when times go sour — something like US bonds. Or perhaps gold….
Hi Michael,
A great article to present an objective view of this normally confusing issue to many, even many known and self-claimed known, economists.
I think the view of impact on US economy by capital goods changing hands is too simplified. It did not count the nature of possible deep debt deflation of a massive exodus of US asset.
While Alternative-4 is the most natural way to cure the current situation, it is the least possible way for the PBoC to take ( unless being forced ) because it literally in RMB term decreases the value of its foreign reserve (increase its civil obligation in the same process). The current foreign reserve policy is a result of the power structure nature of China: government want to hold most of the asset and decide to distribute it anyway it wants without a formal way to collect the consent of its citizen. To let it go means to share the economy wealth with its citizen ( who hold RMB asset ), the government is not gonna to let it happen without being forced.
Prof Pettis,
2 Questions
1. Do you feel that over the next 10 years US service sector employment will lag manufacturing employment
2. How confident are you in the US demand given US demographic trends to an older country more inclined to save
Thanks
Prof Pettis
Please one more question
I would also like to ask where you see US GDP growth in 1-2 years if China does slow to 3-6% during the same time?
“[I]t would be like saying that the higher a country’s trade deficit, the lower its domestic interest rates. This statement is patently untrue.”
How should we reconcile this with the Greenspan/Bernanke idea of a “savings glut” as the counterpart to the US trade deficit? If foreigners decide to use the proceeds from selling goods to Americans to buy US financial assets (rather than to buy US goods), won’t that drive up the price of US financial assets (lowering interest rates)?
Thanks. Your blog is excellent.
“Because make no mistake, if the Chinese trade surplus declines, and the US trade deficit declines too, by definition China is directly or indirectly buying fewer USG bonds, and this reduction in bond purchases will not cause US interest rate to rise at all. If it did, it would be like saying that the higher a country’s trade deficit, the lower its domestic interest rates. This statement is patently untrue.”
It seems to me that if the trade surplus declines, that more capital will be in the hands of American corporations and citizens, and that American entities are more likely to invest that capital in American assets than American debt than China is. (because it is much more difficult for the PBOC to invest a trillion dollar portfolio in Americans assets sensibly than it is for Americans to do the same). And as you said in addressing the case of China buying USD assets and selling US bonds, the effect would be for US bond yields to go up. Therefore a decline in the US trade deficit would cause bond yields to go up.
Does my logic seem sound?
China should continue making efforts to conduct it’s international trade without using dollars, like using mutual currencies with it’s partners and barter trades whenever possible. This way I believe will significantly reduce US dollars holding.
Again, it seems to me that there are many who still believe the USD, as the reserve currency, is good for the American People and the American Economy, to whit neither is correct. Further that the US needs financing, what Michaels seems to be saying, under current experience, the US needs financing relative to the ROW needing growth. The dangerous implication, dangerous as misleading, that Chinese Reserves are savings as your or my savings misses the point. The danger is how the reserves have been used, and for what purposes within the domestic economy, and how the domestic populace has come to believe that savings are a result of hard work, rather than a function, directly and indirectly, that has enabled the real building of roads, bridges, ports, airports, schools, and most importantly employment as China has walked through its demographic “sweetspot”, where if it hadn’t been used as a tool for see how good we are doing, and your reward is just around the corner, as the country gets stronger, your opportunities will increase….the convex of that concave is where the danger lies, unfortunately most won’t appreciate such, because they haven’t experienced the alternative and were happy to have marginally better living conditions, as they should have been, while waiting for the due, as the foundations became stronger around them, problem being the forces that enabled the transition, might short-sightedly, jeopardize their positions as they seek more of the same benefit, as they seek to further entrench their parachial interests. This has happened all too often throughout history.
Michael where history often provides good examples, and does, in a somewhat altered fashion, I do wonder how altered dynamics, a vastly increased world population, where only marginally have countries been able to increase the land through reclaiming the sea, coupled to the very different information compression and speed experience of the present era alters this. I suspect through compression rather than alteration of the nature of the experiences, lending to increases in uncertainty rather than material alterations to how things play out. Although fictions will continue to abound. The simplicity of your argumentation is unparalleled and appreciated in this compressed era of much popular delusion globally on too many issues of vital importance to the future.
Finally, people, the functions of the “system”, although popularly conceived in the popular media, and in a convulated and simple-minded, rather than simple way should not be viewed as you would view your personal wealth formation dynamics, these are too very different beasts with very different dynamics. The purveyors of such perspectives, knowingly or unknowingly, bemusedly where they usually occupy very different ideological spaces, portend to the very lowest qualities of the human species.
Hi Michael, You’ve explained this so many times now. There is little doubt in my mind that it is pretty much as you say it is. Way back in 2009 I was appalled that Mr Bernanki was blaming the saving patterns of Chinese people saying they were glutinous in their level of savings and you agreed that this was indeed part of the problem. I had in mind poor hard bitten Chinese peasants and blaming the powerless was what I found appalling. Meanwhile US domestic commentators were saying that US citizens were being spend thrifts and the deficit was their fault. Now, thanks to your efforts many people know better what is really going on. Unfortunately many that should still do not. Perhaps someone needs to develop a graphical model of this to show it in a more visual way. A New Zealand economist built a real physical model of the UK economy. It has recently been restored. I’ve seen it and I think it rather good but I’m biased.
http://en.wikipedia.org/wiki/MONIAC_Computer
Surely on an issue of such importance it would be worth while developing a graphical model, perhaps based on water flows and hydraulic pressure. What can be done is truly amazing. Check this out if you haven’t seen it yet.
One problem to be overcome or perhaps merely an exciting challenge to represent graphically for an imaginative visual artist is the issue of money creation. Physical items like gold can’t be created at the click of a computer keyboard. But central banks and even main street banks do it all the time. So there would have to be a source of additional “water” if it the analogy was to be hydraulic. Otherwise the system, as you have described it seems pretty well closed and, it seems to me, could be modeled with pumps and clear pipes and colored water. I am bearing in mind that you have already done much more than your share of the heavy lifting with this blog.
This video is so worth watching, as it relates to this and the coming global economic collapse:
http://goo.gl/2vFgp
” If it did, it would be like saying that the higher a country’s trade deficit, the lower its domestic interest rates. This statement is patently untrue.”
Yet is it not true that a cerain South America country (ies) with fiscal surpluses, trade surpluses and currencies appreciating against the dollar, are nevertheless paying 10% on 2 year bonds in local currencies? (The disclosed policy reason is to fight local price inflation.)
This does appear patently absurd. Yet what is the answer, other than to buy those bonds?
Michael,
Firstly, thanks, as always, for another straightforward, logical piece.
Secondly – and please bear with me here – there’s another, perhaps even simpler way of looking at this:
When it comes to wholesale amounts of dollars – that is, let’s forget about notes and coin – US dollar funds never leave the United States. They never leave the US because they necessarily can’t. Wholesale amounts of US dollar funds are, rather, merely shifted from one US-domiciled bank account to another.
That is, the dollars that the PBoC regularly receives are already in the US banking system. They can’t be anywhere else. When the PBoC “buys” US dollars, it’s merely receiving a credit in one of its vostro accounts in a US bank – receiving a credit from a “seller” whose vostro account has just been consequently debited. So, when people talk about US dollars “coming to China and then out again”, that’s not actually what happens.
So, if, flowing with the argument, China sells bonds:
Let’s say China sells bonds to UBS in London. Let’s say UBS banks with Citi in New York. Then UBS’ vostro account at Citi NY will be debited. China’s vostro at perhaps another bank in New York will be credited. The point is that at no stage do USD funds ever leave the United States – they can’t. And if that’s true, then whether China, in particular, does or doesn’t own what we think of as USD assets is quite irrelevant.
And let’s not get sidetracked by some idea that China will only “bank” with the Fed – that it will only deposit funds with the Fed. That’s not true (to the extent that it’s even relevant). Before I became a lowly-paid schoolteacher in China I used to run the funding desk at Australia’s largest commercial bank – Australia, as a matter of course, running current account deficits and thus being a borrower in the markets -and used to regularly borrow shitloads from the PBoC, a billion at a time, and those funds, of course, were merely transferred from the PBoC’s vostro in New York to mine in New York – never leaving the USA and necessarily unable to.
Do tell me if I’m missing something (I probably am!).
P.S. As a complete aside, I once took on the Australian Tax Office (ATO) on this very thing. There was a tax in Australia, a Financial Institutions Duty (FID), that was levied on bank deposits. I argued that my bank’s billions of US dollars were exempt from FID as our borrowed USD funds never actually left the US to become deposits in the Australian system – that these funds just moved around in the American banking system and never left those shores. I won.
Dear Prof. Pettis,
What if the current American austerity debate causes a reduction in USG bonds, how would that affect China’s capital exporting scheme? Would they merely be forced into one of the four options you mention, and how likely would it be that they would accept a small rise in the RMB as opposed to investing in risky asset classes?
Many thanks!
Such a clear, well-structured post. Which unfortunately might mean mainstream commentators will be unable to read it.
Professor Pettis
I’m not sure I understand where you’re heading, so I’ll give you my interpretation.
A reasoning in a global context differs from an individual reasoning. Sometimes we read that money moves into stocks or out of the market. Individually this makes sense as you can change the allocation in your portfolio. However from a global view it doesn’t because stocks and money are always possessed by someone on this globe. And the same goes for bonds as someone will always buy what is offered by someone else.
But the real issue in the mind of people is the price fluctuation. When large institutions want to get rid of large holdings the price drops (slowly) as they liquidate or diversify away and buyers are only interested in the asset at a lower price. In this context the diversification of the PBoC could lead to a downward price spiral and Brad Setser once warned that a bond crisis will precede a dollar crisis.
I still wonder whether the PBoC really will diversify. Are they willing to bear the trade and consequently the internal economic consequences? I don’t think so.
Moreover the alternatives are limited and many less liquid.
Sorry for the ambiguity. I was referring to a reference asset or basket (SDR+Au for example); isn’t that what the fight over IMF leadership % pitting the EU vs. the US all about medium term? Much was made of the appointment of a sr. level mainlander along with Lagarde.
So what happens the day after? The ideology of globalization may be incompatible with the present clearing system (western wage supliment in exchange for funding prioirty – which itself is incompatable for the EM as they shift to a more developed model). Gov’t will always be moved to lean against the market until the very last minute (M2M accounting, national security among other tactics) – like for example Greece/Italy.
I realize this is a rather small transaction, but the recent attempt by the China Minimetals to bid for African copper assets was broken up by the Barrick Gold of all companies (along with the RTP and other Aussie deals). Blocking strategy for option 1?
If we went to balanced trade would we not be repudiating the entire ideology of globalization, which has been decades in the making and focused on driving growth in the financial complex to facilitate the capital importation (benchmarked against cheap energy or overvalued dollar two sides of the same coin)? A recent commenter asked Buffet on a financial network about TBTF and the Fed’s doubling down. His retort was that the US simply can’t wind down the banks or it risks ceding its supreme position in the global financial complex.
If balanced trade did arrive it may level the playing field but the slide down for the US consumers would be highly unwelcome but unavoidable (with no immediate or clear catalyst to drive a move back up the ladder). Would the COLA adjustment not be disproportionately unfavorable for the US vs. the global peers merely on a GDP per capita (or resource utilization) basis? Obviously much bigger structural issues at play here as regards patent diffusion (education), innovation, resource competition (usage) among others, but just moving to some artificial accounting identity really seems an overly simplistic formulation as regards the lasting impact of moving to a more balanced trading position with the rest of the world (keep thinking of analyzing the banking system in 2006 ignoring the OBS machine)
Have you given any thought to what the potential drag on growth would be on US GDP growth from such a shift – including what the impact to US consumption from a multiplier effect might be? Also presumably in such a situation where the world moved to a more neutral account, would the shrinking US debt machine be able to subsidize the level of flation needed to keep some form of wealth effect (risk assets) intact.
So , in short (or long) do you think the US or China has more to lose by a theoretical sizable move up in RMB (putting aside talk of a China spring).
Apologies in advance for lengthy post
Dear Michael,
Would you like to join Shih & Walter’s discussion regarding the future of the yuan? I so look forward to seeing your view out there. Thank you.
FYR: Topic: “What is holding back the yuan from becoming a major global currency?”
Address :
What is holding back the yuan from becoming a major global currency?
https://www.gplus.com/China/Discussion/What-is-holding-back-the-yuan-from-becoming-a-major-global-currency#.TlM3Yjv5Vj7
@27 Costard
not saying that the trade deficit does not “contribute” to government borrowing but to attribute high unemployment solely to the trade deficit would be erroneous. more importantly,US national debt does not hit 14 trillion and counting solely because of a trade partner or even largely because of a trade partner’s. one could easily say that implementing and extending tax cuts started in the bush era is a main factor in the equation
@Judy 46
The main factor in the current US deficit is the loss of revenue and growth from the 2007-present housing bubble collapse:
http://www.cbo.gov/ftpdocs/89xx/doc8917/Frontmatter.1.3.shtml
The Bush tax cuts, Medicare prescription drug reform, and the Iraq/Afghanistan wars were all technically affordable and would have, in lieu of the late 2000s crisis, left the US with debt equal to only about 1-2% of GDP.
Of course, none of this vouches for the enactment and subsequent extension of Bush tax cuts being fiscally sound ideas.
GV:
Might it be possible that Michael isn’t heading anywhere merely describing, I rather enjoy the latter. I dare guess that reality would as well.
Judy:
In reference to your post to 27costard, interesting, and agreement as regards tax cuts, obviously at a period of increasing government expenditures, to make such would lead to debt, also some growth, more debt as was knwon, as it it turned out, but what of the function to global growth, globally, of which so many benefited in the 2000′s, any comment? Likely directions?
Dear Prof.
I have been reading your book, The Volatility Machine. You mentioned in your book that the “capital structure framework is applicable to all the so-called emerging markets”. As China’s financial system was more relatively closed and different from other less developed economies before, problems in China’s financial sector was from internal conflicts other than external shocks. Do you think the framework you established in the book is also applicable to China? Thank you.
Kind regards,
Michelle
Michael,
What are your thoughts about Jing Ulrich’s article in the Financial Times on Aug. 23? I clearly remember in 2009 how she loudly assured the public of the stability of the bank system and that NPLs would never be a problem for China.
She seems to be changing her tune now. She carefully avoids talking directly about NPLs (or even “UPLs”, underperforming loan portfolios), focusing her language on the dangers of inflation. But she does mention some things that I believe I have read somewhere, many many times, before …
“Strict controls over interest rates have pushed real savings growth into negative territory, forcing the average citizen to seek out alternative – riskier – means of preserving wealth, which in turn discourages spending, since personal net worth has become more volatile.
“To support growth without stoking inflation, China’s policymakers may also aim to improve the allocation of capital to the more efficient private sector.
“At the corporate level, capital has historically been allocated inefficiently, with an imbalance in access to credit, i.e. large state-owned enterprises have the clout to obtain more favourable interest rates and terms whereas private companies – which account for 80 per cent of employment in China and 60 per cent of gross domestic product – lack the bargaining power to access cheaper bank credit. “
Professor Pettis, I think there is a flaw in your argument regarding option 2: if China government sells $100 USG and buy European bonds with this $100. The reality is that European government will be more than happy to welcome such capital injection from China, given the fact that the peripheral economies’ bond yields have nowhere but to go up without monetization from ECB. In fact, it is almost reverse now that it is China who is not willing to buy ITalian/Spanish bond, being aware of the default risk; rather than European governments refusing to take in China’s surplus reserve. A Euro-bond guaranteed by all the members, however, would solved this dilemma.
In reply to 45 Michelle: What is holding back the yuan from becoming a major global currency?
Here is my answer: it is China herself who holds back the yuan from becoming a major world currency: http://blog.chinatells.com/2011/05/5015
@#46 Judy
right on! George W. Bush added $6T to the Federal debt, and we can probably find half of it landing in the foreign exchange reserves of China, Japan, and Russia, in that order.
I am finding that the Modern Monetary Theory has a better theory to explain what has been going on with the economy. I have not been able to understand how the U.S. government could default on its Treasury Bills and Bonds. When these IOUs mature and become due, why couldn’t the U.S. Mint just print more “Benjamin Franklin”s to pay off the bonds? Yes if the debt limit is not increased, the Federal government may not be able to pay its vendors and employees, but the Federal Reserve can pay off the Bonds, right? Bill Mitchell of Australia called it correctly. He actually expected flight to U.S. bills given the D.C. stalemate, and the media and the traditional economists fed off each other by giving weight to the rating-downgrade put out by an already discredited S&P. http://bilbo.economicoutlook.net/blog/?p=15542
A Florida economist talks about the “cognitive dissonance” of mainstream economists. http://bilbo.economicoutlook.net/blog/?p=15827
The Walmarts and Macys of America are giving orders to China because they think the American consumers want only to buy cheap goods. Americans may be willing to buy crappy products because globalization has been giving us cheap prices, but we certainly don’t want to make crappy products. Why aren’t the mainstream economists and politicians asking why the Big Three can’t make cars like BMW and Mercedes, and take over their export markets? That would represent more than $100B in trade deficits. Now that is an area where Americans would be able to compete with pride.
Japan tried strategy #1 in the mid-80′s, didn’t they? Back then, Japan a bunch of trophy US properties that eventually hurt many of their industrial power houses (think of Mitsubishi buying Rockefellar Center in New York in 1989, which caused a huge backlash and then lost value, and Sony buying Columbia Pictures also in 1989, whereupon the Columbia Pictures division wasted so much money that eventually the quality of Sony products esp. televisions declined precipitously, causing them to cede leadership to Samsung.)