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China’s fiscal stimulus doesn’t necessarily mean that it will stop buying Treasuries

by Brad Setser
November 12, 2008

I tend to be a bit better at spotting risks than opportunities. I have long worried that China might conclude that it is no longer in its interest to continue to buy ever larger quantities of Treasuries, especially as it buys Treasuries terms that likely imply future losses for China’s taxpayers. But that doesn’t mean that I am among those who are worried that China necessarily needs to slow its Treasury purchases (let alone sell its existing holdings) to finance its fiscal stimulus.

Let me see if I can explain why.

The basic argument why China’s fiscal stimulus could put pressure on the Treasury market is fairly straightforward; just read the FT’s Alphaville.

The US has long financed its fiscal deficit by selling debt to China.

Indeed, the scale of China’s purchases over the last twelve months is hard to overstate. Some work that I am doing with the Council on Foreign Relations Arpana Pandey suggests that China’s monthly Treasury purchases over the last year (really the last 12 months of TIC data, so September 2007 to August 2008) have averaged about $15 billion or month – or just under a $1 billion a business day. And that total almost certainly understates China’s recent purchases of Treasuries. During the last year, Arpana Pandey and I estimate that China bought about $15 billion of Agencies in an average month. However over the last few months China has stopped buying Agencies – and increased its Treasury purchases. As a result, China’s recent purchases of Treasuries could easily have exceeded $15 billion a month.

Looking forward, though, the US fiscal deficit is poised to increase – almost certainly significantly. The Treasury also has to sell bonds to finance the revamped TARP. China by contrast plans to run a bigger fiscal deficit and spend (or so it seems) more at home. Combine those two trends and it seems to suggest that China will be providing a lot less financing to the US just when the US is going to be selling more Treasuries than ever before.

So why am I not worried? Because not everything else is equal.

China has proposed a significant (or so I hope, the amount of new money in the announcement still isn’t clear – and some reports suggest that new spending could be as little as ¼ of the $585 “headline” announcement) fiscal stimulus because domestic activity in China is slowing. If China’s firms are investing less and Chinese households are saving as much China’s government can run a larger fiscal deficit without cutting into its purchases of US Treasuries.

The fiscal stimulus, in effect, would offset a contraction of investment that otherwise would have tended to push China’s current account surplus up. It would absorb the surplus savings freed up by the fall in investment. Remember, a fall in the pace of import growth pushed China’s October trade surplus up to a record. That means China’s external surplus is currently growing – not shrinking. The stimulus may just keep it from growing more.

Similarly the rise in the US fiscal deficit is coming when private consumption is falling rapidly – and when it is likely that US firms will be scaling back their investment. That implies that the rise in the US deficit will come when Americans will have more money to lend the US government and the US will have a smaller need for financing from the rest of the world.

In broad terms, China’s fiscal stimulus will offset a fall in domestic investment more than it reduces China’s purchases of US debt. Chinese banks that previously were lending to China’s property developers will be lending to China’s government instead. And the rise in the US fiscal deficit will offset a fall in borrowing by American households and firms. As a result it won’t need to be financed as heavily by the rest of the world. China’s fiscal stimulus will do more to keep China’s current account surplus from rising than to bring China’s surplus down. The United States fiscal stimulus will slow the contraction of the US current account surplus from being too fast – not get in the way of a fall in the United States current account deficit. Under current circumstances, a rise in the budget deficit wouldn’t necessarily lead to a rise in the trade and current account deficit. Or to put it a bit differently, private investment around the world is likely to fall faster than private savings, freeing up funds for a global fiscal stimulus.

This story is a bit too neat; no doubt some things won’t perfectly offset. But it helps illustrate what I think are the dominant dynamics right now.

There is a second reason why I am not all that worried by China’s plans: I don’t see much evidence that China has scaled back its Treasury purchases.

Fiscal deficits are generally financed by selling bonds domestically, not by selling off reserves. They only produce a fall in reserves if the fiscal deficit pushes up domestic demand — and thus demand for imports — to the point where the country runs a current account deficit. Or if the fiscal deficit induces capital outflows. And for now, China is still running a large (in fact, based on the September and October data, a growing) trade surplus. In the near term, China’s import bill is likely to fall faster than its export receipts, so that surplus will remain. Absent huge hot money outflows that implies that China’s reserves will keep on growing. So long as China pegs tightly to the dollar, it almost certainly will keep on buying some kind of US assets. And so long as China finds Agency bonds too risky, it more or less has to buy Treasuries.

There is a bit of evidence that suggests that China’s reserve growth – counting the growth of China’s hidden reserves – has slowed a bit in the third quarter of 2008. But the slowdown reflects a fall in “hot inflows” – not a fall in China’s trade surplus. The underlying dynamic is one where China’s government is still adding substantial sums to its external portfolio. $150 billion of reserve growth in a quarter is only seems small in comparison to the $200 billion or so in the spring.

I of course do not know for sure who is adding to their Treasury holdings at the New York Fed. But the pattern of past purchases suggests that Asian central banks tend to make more use of the Fed’s custodial facilities than the oil exporters. And I do know that right now China is the only major emerging economy adding significantly to its reserves. Consequently I would assume that the evolution of the Fed’s custodial holdings offers some insight into how China is investing its reserves. It consequently seems like SAFE is reducing its Agency holdings and adding to its Treasury holdings. That certainly is what the TIC data suggest China did in August.

Finally, I worry far more about a sudden fall in China’s willingness to buy US assets than a gradual reduction – particularly a gradual reduction that is tied to a large fiscal stimulus that increases China’s demand for US (and European) goods even as it reduces Chinese demand for US (and European) debt. The US can adapt to a gradual fall in China’s current account surplus that leads to a gradual fall in China’s demand for US Treasuries. Yes, that would put upward pressure on US interest rates. But if Chinese demand for US goods is growing (as its trade surplus falls), the US could scale down its fiscal stimulus without producing a big slowdown in the US. That is something that the US should want, not fear.

The more troublesome scenario is one where China suddenly stops buying US Treasuries – and where it stops buying Treasuries without increasing its purchases of US goods. The fairly sudden end of central bank demand had a big impact on the Agency market; a similar sudden end to Chinese demand for Treasuries could have a comparable impact. But for that to happen China’s current account surplus would need to fall sharply – or China would need to suddenly stop buying dollars and starting buying other currencies. Both are potential risks. Neither seems particularly likely right now.

So what do I worry about?

The risk that China’s surplus will prove far smaller than announced – and that the fiscal stimulus won’t be strong enough to offset China’s domestic slowdown. China’s current account surplus could rise even as China’s exports start to fall if China’s imports start to fall even faster.

I agree with Martin Wolf: China should, ideally, be doing more to stimulate its economy than the US, as that would help to facilitate global adjustment. Wolf writes:

If the US external correction is to be consistent with global growth, demand must expand vigorously elsewhere, particularly in chronic surplus countries. The new administration should lead the world towards an understanding of a point that concerned John Maynard Keynes: it is hard to accommodate countries with massive and persistent current account surpluses. The counterpart deficits, if prolonged, almost always lead to financial crises. The way out is for most surplus countries to spend more at home. The expansion programme announced by the Chinese government early this week is just a beginning. Instead of toying with protection, the Obama administration needs to focus on global imbalances. The immediate way to deal with this challenge is to demand a global fiscal stimulus, with surplus countries implementing the biggest packages.

I also worry about the risk that once current pressure on say Korea’s exchange rate diminishes, Korea will conclude that a depreciated won is in its own interest – -and resume intervening in the foreign exchange market both to rebuild its reserves and to support its export sector. Ragu Rajan of Chicago outlines this scenario in his contribution to VoxEU’s G-20 spectacular.* He writes:

“If we do nothing to address this issue (the absence of sufficiently large multilateral pools of foreign exchange reserves) we will set up serious problems for the future. We will emerge from the crisis with many countries attempting to build reserves through export-led strategies and managed exchange rates, aggravating the demand imbalances at the heart of the current crisis.”

A sustained effort to maintain undervalued exchange rates would tend to increase demand for US Treasuries. But it would slow needed adjustments in the global economy. I am still among those who thinks that a shortfall in foreign demand for US goods is a bigger worry than a shortfall in foreign demand for US Treasuries.

*Dani Rodrik’s G-20 communique is also worth reading; alas, the odds that the actual communiqué will be as substantive are rather slim.


  • Posted by Rien Huizer

    bob in ma,

    Completely agre with your remarks here. (1) BW II (i.e. Roubibin’s one, not the thing that might emerge from current diplomacy) is not a self-stabilizing mechaism and probably unsustainable in the longer term. (2) there are no surplus countries pegging to the Yen or Euro (the latter may not be entirely true, the Euro plays a role in Russian FX policy and there are of course countries like Denmark and Sweden that peg. As to (1): the coincidence of two very large economies (and necessarily dynamic ones as well, with fast growing labor forces) having complementary political-economic value systems (China paternalistic/austere, US laissez faire (well, still??)/hedonistic) with Chjina in the role of the patient frugal hard worker and the US is the role of the immature spendthrift lazy heir, may have only a couple of years to run, unless the US and China converge whilst simultanueously reversing BOP trends. Hmm (2) Japan actively discourages the use of its currency as a reserve asset (in fact, the opposite viz JPY carry trade) and the EU is ambivalent.
    What happened to the good old situation where countries with fast growing economies and demographic pressure (your typical LDC or emerger) were also natural capital importers?

  • Posted by Twofish

    Rien Huizer responds: What happened to the good old situation where countries with fast growing economies and demographic pressure (your typical LDC or emerger) were also natural capital importers?

    I don’t think it ever existed. It’s hard to argue that too many emerging markets have actually benefited from importing the capital. The problem is that at the first problem, capital runs away leaving the LDC worse off than before.

    Part of the reason China is very careful about foreign investment is because it had really bad experiences in the 19th century and early 20th century with it.

  • Posted by aim

    DJC responds:
    From reading a Chinese economics website last night, the Governor of Chinese Central Bank (equivalent of Helicopter Bernanke of US Federal Reserve) stated that he will not rule out the devaluation of Renminbi (Chinese currency) to stimulate export in order to maintain the economic growth. The governor (Zhou Xiaochuan) mentioned this in answering reporters’ questions when he is currently in Brazil for an international meeting. Some high profile Chinese economists in banks and in academia also expressed their support for yuan devaluation…

    I was in Walmart the other day and actually saw a 90% off sale… all on Chinese made stuff. Better crank down that exchange rate when you practically are going to have to start giving it away!

  • Posted by bsetser

    bob in ma — conceptually i agree with you. h..ll i have spent most of the last four years arguing that the us cannot count on unlimited credit from the rest of the world no matter what (2fish and bob in ma — look at ext debt to GDP as well as public debt, the us doesn’t look as good there, especially if ext. debt is scaled to exports … and the real risk for foreign creditors is devaluation not default)

    but right now the forces in china pushing to keep the rmb constant v the $ seem a lot stronger than the forces pushing china to slow its $ purchases. China talks a bit about not wanting to hold even more claims on the us, but when it makes policy choices, it always seems to prioritize the exchange rate.

    the gulf doesn’t have much spare cash at current oil prices so it doesn’t matter as much as it did three months ago.

  • Posted by adiemuso

    to stabilise, someone has to give way. so which is the better option? a stronger Yuan or a stronger USD?

    now spending 4 trillion CNY is no mean feat. and if they are gonna be a nett importer, a weak CNY does no favours apart from a rise in USD denominated Chinese held assets.

    Which in my view, becomes very tempting even to the most determined asset manager to sell them off.

    A stronger CNY renders their USD denominated Assets weaker and their account balances susceptible to huge disturbing swings. We all know that is not ideal.

    So a flat CNY vs USD is most ideal, but how feasible is that in the current economic conditions? With virtually the world’s real economy coming to a standstill, can the two major trading currencies remain status quo without significant damage to either party?

    just a stray tot, the abandoned TARP bailout linked to the 4 Trillion CNY?

  • Posted by Rien Huizer


    LDCs that imported lots of capital (ans had fast per capita growth as well s fast population growth overall) were plentiful in 4th quarter of the 20th century. But you are right, whether it did them any good (I guess that’s what you mean by benefiting) depends on what you see as benefit. Some people got rich probably, and the ones that imported capital and grew, grew (that may be a benefit). As to the ones that imported capital and did not grow, there is quite a lot of academic speculation about why. And there are ones that did not import capital and (neverthesess) grew. All I meant to say is that there used to be a fashion that LDCs would import the savings that they could not gnerate themselves, purportedly for financing investment/growth. No suggestions on my pasrt that something was “beneficial” (as stated many times, I have no idea of what is good for a country, only for individuals or groups within a specific country and the links between macroeconomics and group interests are usually quite complex, but it is individuals and groups that drive policy, for their own benefit, not populations. But in those days LDC politicians liked to import capital (not seldom with a little for themselves on the side).

  • Posted by Twofish

    Rien: All I meant to say is that there used to be a fashion that LDCs would import the savings that they could not generate themselves, purportedly for financing investment/growth.

    A lot of this involves a “colonial missionary” mentality. Since these savages are obviously too stupid to look after themselves, it is our duty to “help” them, which incidentally puts we civilized beings in a position were we control their economy, but it’s all for their benefit. How nice of us to be overlords.

  • Posted by locococo

    All of this means we ve got a classical chicken chick game going on here. It s not the liquidity trap it the chinese one (trap tarp whatever) that s being set up here. First the agencies were filled up – them stop buying – then the fed bs started soaring with em securities backed securisties – them buying treasuries… and them not blinking still is what appears to brad. And ben the man showing em his balance – see see i will press the buttom i m mad i m gonn go blast listen to this stiglitz guy booom i will do it, don t force me to… And them saying back please do be our guest here – but we ll devalue even more. We ll go down faster than you can. You can t devalue anyhow without them europeans and them korean guys and the mexicans bandidos and the zealanders help you to and them banks of yours that not exist. You re all loco in your cocos es.

    So who s really buying all the treasuries today? Think them really buy em up? Or are the swaps ? and what for are treasuries being borrowed for. A black swan one? And what for excess reserves are there ?

    Think first. Then think a bit more. Then post some more.

    with no disrespect in tiz mutual fund, khm world.

  • Posted by df

    Problem for China is they are dependant on export.
    They may devalue some more the already undervalued RMB but it won ‘ t change the dynamic of western markets nor the one of its asian partners.
    There s a depression going on, it has been self evident that it was bound to come for more than 5 yeas now.
    The only thing China should care of is boosting internal demand through public spending and money printing. Send cash to the local chinese peasants, use helicopters if needed.
    The RMB/dollar exchange rate is becoming more and more an irrelevant question simply because international trade is falling and will keep falling.
    Remember the 30’s. In depression times international trade falls faster than GDP.
    Of course it would be better not to aggravate this fall by protectionist measures, but with or without them the fall is bound to happen because it is related to the fall in demand for non local goods.

    My bet is that western companies short on cash, will come begging their home states : please save us.

    Now according to you : what are the chances that home governments in exchange for the help will ask for employment to be saved in the home countries and suppressed elsewhere ?

    Let s see how the GM case is dealt first.

  • Posted by aud

    There`s a nice one out on CITICs family derivative specs business. cycle.

  • Posted by Rien Huizer


    That view has some merit, but, unfortunately, I’ve met lots of people in “civilized” (no doubt you would put the Middle Kingdom in that category) who have all kinds of lofty ideas and would, if endowed with any political power, fight like lions to let Joe taxpayer ( a much less civilzed, possibly subhuman being) pay for development assistance. Anyway, I’ve no strong feelings against development assistance as long as it benefits me. If it does not, as with any kind of policy, I’ m against it.

    But there are people, even politicians in weakly contested systems, who believe that rich country generosity can help the people in poor countries achieve a higher standard of living. These people are, of course, paternalistic. The same term the eminent scholar of socialist or centrally planned systems, Janos Kornai uses.. So perhaps the good folks in the State Council harbour similar feelings towards places like Guizhou and certainly towards Congo. Paternalism is an attitude of politicians that leads to suboptimal results and I have little respect for it, of course unless someone feels paternalistic towards myself.

  • Posted by glory

    “there are no surplus countries pegging to the Yen or Euro”

    might they to (a reallocated) SDR?

    Gordon Brown said Tuesday the surplus-holding Gulf States, many of whom already peg their currencies to the dollar, were ready to extend money to an IMF bailout fund at the G20. The question is could that money be channelled through an SDR framework?

    SDRs potentially address another problem facing the system too. As Fred Bergsten, director of the Peterson Institute for International Economics, wrote in the FT a year ago, they could help restore faith in the dollar itself. His argument being, surplus nations in many cases have no choice but to bankroll the US debt, as diversifying into non-dollar denominated assets would have drastic consequences on their own currencies.

    “Many dollar holders, including central banks and sovereign wealth funds as well as private investors, clearly want to diversify into other currencies. Since foreign dollar holdings total at least $20,000bn, even a modest realisation of these desires could produce a free fall of the US currency and huge disruptions to markets and the world economy.”

    He adds the problem is further heightened by the fact that none of the countries into whose currencies the diversification would take place want to receive these inflows either. Through an SDR substitution account though the following could happen:

    “Instead of converting dollars into other currencies through the market, depressing the former and strengthening the latter, official holders could deposit their unwanted holdings in a special account at the IMF. They would be credited with a like amount of SDR (or SDR-denominated certificates), which they could use to finance future balance-of-payment deficits and other legitimate needs, redeem at the account itself or transfer to other participants. Hence the asset would be fully liquid.”

    Via this system all countries would benefit, he says:

    “Those with dollars that they deem excessive would receive an asset denominated in a basket of currencies (44 per cent dollars, 34 per cent euros, 11 per cent each yen and sterling), achieving in a single stroke the diversification they seek along with market-based yields. They would avoid depressing the dollar excessively, minimising the loss on their remaining dollar holdings as well as avoiding systemic disruption.”

    Meanwhile, the US would be spared the risk of higher inflation and potentially much higher interest rates that would stem from an even sharper decline of the dollar. As the cost of protecting against US sovereign default in credit default swaps increases, it’s certainly a case worth considering, especially as a proposal for a special one-time allocation to double the number SDR in the system is already in place. To go through, the proposal needs three fifths of IMF members (111 countries) with 85 per cent of total voting to accept it. As of March 2008, 131 members with 77.68 per cent of voting power had accepted it – reflecting the level of the demand for the measure. Approval by the US would now put the amendment into effect.

  • Posted by a

    ” i.e. the flow of funds is somehow favoring the dollar”

    The correlation between dollar/oil price is large. Is it possible that the oil-producing states are in fact in the euro zone and have recycled their dollars, surreptitiously or otherwise, by paying for euro assets? Now that the price of oil has fallen, they are now converting in the other direction.

  • Posted by Twofish

    df: Problem for China is they are dependent on export.

    No they aren’t. Chinese exports get a lot of attention because they are politically sensitive in the West, but all this attention overstates the degree to which Chinese economic growth is export driven.

    There are parts of the Chinese economy that are export driven, but there are also very large parts that are not.

    df: Now according to you : what are the chances that home governments in exchange for the help will ask for employment to be saved in the home countries and suppressed elsewhere ?

    They would if they could, but they can’t so they won’t. One big difference from the 1930’s is that multinational corporations have global supply chains. Tariffs would be suicidal for General Motors since it means that it couldn’t important any parts for its American factories.

  • Posted by Twofish

    glory: “Instead of converting dollars into other currencies through the market, depressing the former and strengthening the latter, official holders could deposit their unwanted holdings in a special account at the IMF. They would be credited with a like amount of SDR (or SDR-denominated certificates), which they could use to finance future balance-of-payment deficits and other legitimate needs, redeem at the account itself or transfer to other participants. Hence the asset would be fully liquid.

    I don’t really see the point of this. If the IMF takes dollars and issues SDR’s, then who bails out the IMF, if there is a currency mismatch between SDR’s and dollars? Also what does the IMF do with all of the dollar assets that it gets?

    The problem with SDR’s is that it’s really difficult to have any sort of currency that no one really uses. What’s the point in putting your money into something that you can’t use to go to a corner store somewhere and buy a stick of gum?

  • Posted by Patrick

    bsetser: “i am assuming that China’s financial judgment about the long-term value of treasuries has nothing to do with its decision to purchases them”

    There are also clear political motivations for the Chinese to continue as the arrangement gives them enormous influence in Washington that they would not otherwise have.

    If the US decides to scale back its imperial reach in a big way – perhaps to cut military spending or out of sheer exhaustion – then the Chinese may re-evaluate the political return on their investment.

  • Posted by anonymous


    Regarding quantitative easing, FT Alphaville seems to think it’s already happening.

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