The interest rate on the 10 year Treasury note is somewhere between 4.0-4.1% — and the US seems to be having no trouble financing its current account (or its budget) deficit right now. The risk of hard landing remains just that, a risk — right now the market hardly seems worried about the United States’ still growing external deficit.
Consequently, this is a reasonable time to step back and look back at some of the arguments that Nouriel and I laid out in February, when we put forward the case that growing external imbalances posed a growing risk to the US economy. We did not suggest that the hard landing was imminent — we thought the risks were far higher in 2006 than in 2005. In 2006, the US external deficit would be bigger, one-off factors like the corporate tax holiday would have played themselves out, and Asian central banks would hold even more reserves than they do now — calling into question their willingness to keep on adding to their holdings of dollars. But we did argue that the risks were more immediate than most thought.
Some of the arguments that we made in February look pretty good three and a half months later. Korea’s central bank governor has not mastered the art of communicating with the markets. But it is still pretty clear that Korea thinks it has all the reserves it needs and would rather not continue to add to its reserves. Japan is out of the market, but its past intervention seems to have left a legacy in the market — the willingness of private Japanese investors to buy US debt hinges in part on expectations that the Japanese authorities will keep the yen from appreciating too much, and thus prevent dollar depreciation from wiping out the positive “carry” generated by higher US interest rates. Change those expectations, and US rates might change to compensate Japanese investors for the greater exchange rate risk. Above all, the burden that China has to bear to support the system seems to be rising. We don’t know the pace of China’s reserve accumulation in April or May, but I would not be surprised if both numbers turn out to be very high — reserve accumulation of $30b, or even $40 b, in May is not out of the question. Annualized, that works out to $360 b (20% of GDP) or $480 b (25% of GDP) — a phenomenal sum.
This was a key component of our argument: the burden China has to bear to support the system would rise, until it exceeded even China’s threshhold for pain – though the pain in this case is rather abstract. The pain comes from the growing gap between the coast and the interior and resulting social tensions from China’s unbalanced growth, future financial losses and difficulties keeping surging reserves from leading to a surge in the money supply. Jonathan Anderson of UBS estimates that China’s money supply should grow by about $70b a year, any reserve growth in excess of $70 b needs to be sterilized. If China’s reserves grew by $40 b in May (this is a pure guess), and 75% of those reserve were invested in dollars that provides $30 b of financing to the US. The US needs about $65-70 b in monthly financing to cover its current account deficit, so China’s central bank ALONE would be supplying just under 1/2 the needed financing.
China says it does not want to give in to US pressure — though I would note it also did not move when the Bush Administration refrained from public pressure. But if China tries to “punish” the US for its public criticism by holding on to its peg, China, in effect, has to keep on financing the US at a low rate. Rather than kow-towing to US demands to change its currency, China will just keep writing large checks to buy low-yielding US securities …
However, I think Nouriel and I did miss a couple of things in our Bretton Woods Two paper.
1) US assets could become more attractive relative to European assets if European interest rates fell sharply, not just if US interest rates rose. On the short-end, US rates have risen while European rates have stayed constant. On the long-end, US rates certainly have not risen (hence, the conundrum), but European rates have fallen. Bunds now yield 3.3% — well below Treasuries.
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