On September 21st the Fed announced that it would be selling $400 billion in short-term Treasurys and buying $400 billion in longer-term Treasurys to replace them – a maneuver titled “Operation Twist.” Atlanta Fed president Dennis Lockhart explained what it would mean for the economy: “It means lower interest rates – a lower cost of borrowing – across a whole spectrum of loan maturities.” Is he right? Well, China, Russia, and Brazil have conducted their own version of Operation Twist over the past several years, replacing roughly $330 billion in short-term Treasurys with long-term ones. The 10-year Treasury rate went sideways over that period, as shown in the figure above. Whereas the BRIC* Twist may have put some modest downward pressure on longer-term rates, other factors overwhelmed it. Don’t expect much from the Fed’s similar-sized version.

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Chinese Premier Wen Jiabao recently hinted teasingly that China might buy more risky-country European debt; a “helping hand,” he called it.  Yet even if China follows through, it is unlikely to increase its intended purchases of European debt but rather just change the composition.  China’s euro purchases have increased dramatically over the past two years (we estimate these to be ¾ of reserves purchased in excess of the change in China’s U.S. asset holdings).  Most of this can be presumed to have been invested in German bunds, Europe’s closest thing to U.S. Treasurys.  Chinese euro purchases over the coming twelve months equivalent to those of the previous twelve months could cover the entire 2012 net financing needs of Portugal, Ireland, Italy, Greece, and Spain (PIIGS), as the figure above shows.  Every euro China invests in new PIIGS debt, however, can be expected to come at the expense of bunds.  Such a diversion would push up German interest rates—precisely what Germany wants to avoid by resisting eurobond issuance—without giving Germany any greater say over eurozone fiscal policies.  Chancellor Merkel therefore gains little, if anything, in making political concessions to secure Wen’s “helping hand.”

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“How China’s external current account surplus will evolve in the coming years is one of the key questions on the economic outlook for China and the global economy both,” said a World Bank official in Beijing recently. The IMF presented its own answer to that question in a July 2010 report on the Chinese economy, forecasting a gentle, steady rise in China’s current account surplus, relative to its GDP, as shown in the top figure above. The forecast comfortingly shows the surplus staying well below its 2007 peak. Yet since China’s economy is growing much faster than the world economy, the IMF understates the upward trajectory of China’s growing imbalances with the rest of the world. This we show in the bottom figure, which projects China’s surplus relative to world GDP using the IMF’s own assumptions. By this measure, China’s surplus will surpass its 2008 peak within two years. If China continues to recycle dollars abroad at this pace, the global economy will become considerably more vulnerable to shocks from capital flow reversals.

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The yearly U.S. trade deficit peaked at 6.4% of GDP in August 2006. It improved significantly after the financial crisis, bottoming out at 3.6% in January 2010. This swing provided a boost to GDP and nudged the U.S. external balance toward a more sustainable level. The deficit then resumed an upward march, reaching 4.3% by November. A closer look at America’s bilateral trading relationships since the deficit high-point in 2006 reveals a significant improvement with many countries, and only a small deterioration with a few others. China – with which the U.S. has its largest deficit – is the conspicuous exception, as the figure shows. 2011 looks set to be a year of yet further-rising trade tensions between the two countries. Read more »