Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

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Worry about a fall in China’s demand for the world’s goods, not a fall in China’s demand for Treasuries

by Brad Setser
January 18, 2009

Last week, Sam Jones of FT’s Alphaville wrote:

If the Chinese economy collapses, or even slows dramatically, then the raison d’etre for the country’s huge FX reserves – as a sterilisation measure to dampen domestic inflation – will evaporate. With that, so will China’s US Treasury holdings.

Or alternatively the Chinese could devalue the yuan. Either way, the US will be in trouble.

I like a good China scare as much as any one. But the first concern is, I think, off. A slump in China doesn’t mean an end to Chinese financing of the world, or even necessarily a fall in China’s reserves. Let me see if I can explain why.

Suppose China’s economy slows sharply — a not-impossible development given the rather starling fall in the OECD’s leading indicators for China. How would that impact China’s balance of payments?

The first impact is rather obvious. China would import less. It would buy less. And since the rise in Chinese demand helped push the price of various commodities up, it stands to reason that a fall in Chinese demand would push prices down. It probably already has. That implies a big fall in China’s import bill, and a larger trade surplus. A slowing global economy would hurt China’s exports, but in this scenario China would slow more than the world. That means China’s imports would fall more than its exports. China’s trade surplus would rise.

But, you might say, the current account surplus is determined by the gap between savings and investment. Why would that change in a slowdown? Simple. China’s slowdown reflects a fall in investment (especially in new buildings and the like). Less investment and the same level of savings means a bigger current account surplus. In practice, though, savings would also likely fall a bit — as a slowdown would cut into business profits and thus business savings. It possible that China’s households would reduce their saving rate to keep consumption up as their income fell. But it is also possible that Chinese households might worry more about the future and save more. My best guess though is that the fall in investment would exceed the fall in savings, freeing up more of China’s savings to lend to the world. That surplus savings has gone into Treasuries and Agencies in the past.

The second impact is harder to assess. A big fall in output might lead China’s savers to lose confidence in China, or rather to lose confidence in the RMB bank accounts as a stable store of value. The big fall in output might, for example, create expectations that China would devalue the RMB v the dollar — and Chinese households, anticipating the devaluation, would have a strong incentive to hold dollars. That likely means a rise in capital outflows.

Since reserve growth is a function of both the current account balance and capital outflows, it is possible that the rise in capital outflows could overwhelm the rise in the current account surplus. That seems to be what happened in q4.

In the absence of such outflows, though, the rise in China’s current account surplus would imply that China almost certainly would continue to add to its Treasury holdings. And even if there are large outflows — so large that the outflows exceed China’s current account surplus and China’s government has to dip into its reserves to meet the surge in Chinese demand for dollars — China would still be financing the rest of the world. The accumulation of foreign assets by private Chinese savers would substitute for the accumulation of foreign assets by the central bank, but money would still be flowing out of China. And some of that outflow likely would still make its way into Treasuries. Private Chinese demand for bank deposits would rise, and the world’s banks might decide to play the yield curve and increase their Treasury holdings. And if say Hong Kong intervened to keep a big inflow of funds into the the Hong Kong dollar from pushing the Hong Kong dollar up, the rise in Hong Kong’s reserves might increase the HKMA’s purchases of Treasuries.

The key point is that as long as China runs a current account surplus someone in China will be adding to their stockpile of foreign assets. It just may not be the government.

As importantly, the raison d’etre for China’s foreign exchange reserves isn’t “as a sterilization mechanism to dampen inflation.” Rather the opposite. The raison d’etre for China’s reserves is that China didn’t want the RMB to rise against the dollar, or at least not to rise by all that much. For most of the past six years, that has required the purchase of dollars by China’s government, as private demand for dollars fell far short of the private supply of dollars at the prevailing exchange rate.

The rise in China’s reserves, in turn, threatened to push inflation up. When the PBoC buys dollars, it sells RMB and thus in the first instance increases the amount of money in circulation. Since the PBoC wanted to avoid a rise in inflation, it then sold sterilization bills to remove the currency it printed to buy dollars from circulation. The net result is that the PBoC is left with a bigger balance sheet, one where it has more foreign assets and more domestic liabilities (the sterilization bills).

But China wasn’t buying dollars to hold inflation down. It was buying dollars to hold the RMB down. To keep the weak RMB and the expansion of the PBoC’s balance sheet from stroking inflation, the government had to “sterilize” the growth in its reserves and to run a tighter fiscal policy than otherwise would have been the case.

Think of it this way. A central bank that is buying reserves is growing its balance sheet — as it is adding to its assets. Some central banks expand their balance sheet by buying domestic assets (the Fed, for example). Others expand by buying foreign assets (the PBoC). The rise in the asset side of the central banks balance sheet is offset by a rise in its liabilities. If it doesn’t sterilize, the amount of cash outstanding increases. Cash, remember, is a central bank liability. If it does sterilize, the amount of sterilization bills rises. The PBoC was sterilizing because its balance sheet was growing faster than the economy’s need for new money, and it didn’t its balance sheet expansion to lead to a rise in inflation.

Now, as Michael Pettis observes, China potentially faces the opposite problem. Money is flowing out, reserves are no longer growing, deflation is a bigger threat than inflation and banks may no longer want to lend. I wouldn’t worry too much though about the risk that the money supply will shrink just because China’s reserves aren’t growing. Growing reserves can lead to money creation. But so can the same stock of reserves and less sterilization. And the PBoC has enormous scope to reduce the scope of its sterilization operations. The recent cut in the reserve requirement is an obvious example. Moreover, if the PBoC wants to expand its balance sheet, it always could start buying domestic Chinese bonds. The real challenge — as the US and UK are discovering — is getting the banks to lend in a shrinking economy!

Bottom line: A big fall in activity in China will tend to drive China’s trade surplus up. It thus would tend to increase — not reduce — China’s (net) purchases of foreign assets. Someone in China will still buying foreign assets — and likely providing indirect support for the Treasury market — even if it is not China’s central bank. A big fall in activity also means less Chinese demand for the world’s products — as well as less Chinese demand for China’s products, which frees up capacity to export. That adds to the deflationary forces in the world economy.

And right now, the risk of a shortfall in global demand strikes me as the bigger risk than a shortfall in demand for Treasuries. The last thing the US should want is a larger Chinese current account surplus, even if a larger suplus would increase China’s capacity to finance the US deficit.

What then should China do if the OECD’s indicators prove accurate?

David Dollar’s suggestions seem pretty good to me.


  • Posted by Observer

    Fixing the exchange rate regime is probably the most potent industrial policy out there.

    And yes, gray income is a very powerful disincentive because it erodes a significant portion of incipient capital upfront with no guarantees whatsoever that the pigs won’t come back for more in the future. Let me ask you a question: would you invest in a mutual fund that has a front-end load of 5% and discretionary management fees of 5~10%, or one with .5% and minimum management fees? Please don’t say this is hard to decide.

  • Posted by Ian

    What about the hot money flows? Even if China continues to post a current account surplus (as it should be expected to as part of its ‘export-led growth’ strategy), the balance of payments also consists of the capital account, right?

    What if distress selling of RMB-denominated assets for repatriation to repay USD-denominated debt causes the hot money outflows to surpass the current account surplus?

    Would we not see a downward pressure on the peg? If so, would not US treasure purchases exacerbate the devaluation pressure? So rather than increasing its USD holdings, the Chinese central bank would be obliged to sell off US T-bills to defend the peg.