Brad Setser

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China has more to worry about than its Treasury holdings

by Brad Setser
March 14, 2009

Premier Wen knows how to get attention; all he has to do is raise a few doubts about China’s ongoing willingness to keep on buying US assets. The FT, the Wall Street Journal and the New York Times — not to mention the White House — all took note.

Wen’s comments generally have been interpreted as a warning that China might lose confidence in US Treasuries. But the quotes that I have seen refer to China’s concerns about the safety of all of its investments in the US, not just its investments in US Treasuries. The New York Times reports that Wen said:

“We have lent a huge amount of money to the U.S. Of course we are concerned about the safety of our assets. To be honest, I am definitely a little worried.” He called on the United States to “maintain its good credit, to honor its promises and to guarantee the safety of China’s assets.”

I don’t doubt for a second that China is starting to worry that the scale of US issuance of Treasuries will reduce what might be called the scarcity value of China’s existing Treasury portfolio; creditors, after all, generally think debtors should limit the amount of new debt they take on. But I am not convinced that Wen’s comments were driven entirely by China’s worries about its Treasury portfolio either.

Remember, that Treasuries account for only about half of China’s US portfolio. China likely has about $750 billion Treasuries. But it also has around $500 billion of Agencies. It could have about $150 billion of US corporate bonds. It probably has invested in a range of money market funds, not just reserve primary. And China had about $100 billion in US stocks in the middle of 2008 — though those stocks are now worth substantially less.

Wen’s comments, at least to me, seemed to echo the comments that a host of anonymous Chinese officials made to the Wall Street Journal in January. Their main concern? That the US government wouldn’t backstop bonds that China thought had the implicit backing of the US government. China wouldn’t mind at all if the US provided a full faith and credit guarantee to the Agencies — or to any other financial institution that China had lent money to — even if this meant a larger US government debt stock. Dean, Areddy and Ng of the Wall Street Journal :

“Leaders in China, the world’s third-largest economy, have been surprised and upset over how much the problems of the U.S. financial sector have hurt China’s holdings. In response, Beijing is re-examining its U.S. investments, say people familiar with the government’s thinking. … Chinese leaders have felt burned by a series of bad experiences with U.S. investments they had believed were safe, say people familiar with their thinking, including holdings in Morgan Stanley, the collapsed Reserve Primary Fund and mortgage giants Fannie Mae and Freddie Mac.”

….. The Reserve issue “is causing a lot of concern with a lot of financial institutions in China,” said the Chinese official. Some officials expected that the U.S. and its financial institutions would better protect China from loss. “If the U.S. is treating us this way, eventually that will be enough cause for concern in the stability of the [U.S.] system,” the official said

I hear echoes of those concerns when Wen speaks about the need for the US to “honor its promises and to guarantee the safety of China’s assets.” And nothing probably matters more to China than the promises the US made about the safety of China’s half a trillion dollar Agency portfolio. This is what I wrote back in January:

“One of China’s main criticism of US policy is simple: the government didn’t stand by institutions that China expected the US to support …. China’s leaders believed that China’s investments in the US financial sector would be protected … . They weren’t. At least not consistently. And that clearly has had a big impact on China’s leadership. And if I had to guess, I would guess that the CIC was not the only institutions in China that had a bit of direct exposure to Lehman. SAFE turned conservative at the same time as CIC.”

The available data — and the TIC data only goes through December — suggests that China has lost confidence in all the assets that it thought had the implicit backing of the US government, not in bonds backed by the full faith and credit of the US government. Treasuries are the one US asset that China is still buying. The following chart — which shows my best estimate* of China’s purchases on a rolling 3m basis — speaks for itself.

To me the real story is that China’s reserve managers sought — more than most central banks — to boost returns by taking on more risk. Above all they opted for Agencies rather than Treasuries, and at one point had more Agency bonds than Treasuries. But China also started to buy large quantities of US corporate bonds in 2005. And then in early 2007 it started to buy US equities. The big surge in Hong Kong’s purchases of US equities in the TIC data is almost certainly a reflection of the activities of SAFE’s Hong Kong office.

As a result, China was caught in an uncomfortable position this fall. And it responded by dramatically increasing its purchases of Treasury bonds. It clearly lost confidence in Agency bonds — and seems to have slowed its purchases of US corporate bonds and US equities as well.

I consequently interpreted Wen’s statement as a statement of concern about the health of China’s entire US portfolio, not just China’s Treasury portfolio.

Of course, the decisions China took last fall mean that China’s portfolio is now more concentrated in Treasuries. It consequently has more reason to worry about the safety of its Treasury portfolio than in the past. At the same time, China wouldn’t have bought as many Treasuries as it did in the past few months if it didn’t still think that Treasuries are the safest US asset.

Indeed, I suspect that Chinese policy makers are caught between a rock and a hard place — as Chinese policy makers cannot choose between different fundamentally conflicting objectives.

1) China both wants to maintain the RMB’s link to the dollar and avoid adding to its already large dollar exposure. Yet so long as China pegs to the dollar and runs a sizable current account surplus, it is hard to see how China can avoid adding to its dollar holdings.**

2) China is torn between its interest as a creditor and its interests as an exporter. China’s commercial interests would be best served by an even larger US stimulus, one that helped spur US demand for China’s goods. China’s reserve managers though worry that the US won’t be able to finance a large stimulus and thus are worried that a rise in Treasury supply would reduce the value of China’s existing Treasuries. Never mind that China is sitting on large mark to market gains on all the Treasuries it bought back when 10 year Treasury yields were above 4% …. and never mind that China’s reserve managers — though not its exporters — hav benefited from the dollar’s rally.

Wines, Bradsher and Landler of New York Times correctly observe:

“The conflicting financial currents pose a dilemma for Beijing. The smaller the United States stimulus, the less its borrowing, which could help prevent interest rates from rising. But less government spending in the United States could also mean a slower recovery for the American economy and reduced American demand for Chinese goods.”

If Wen wants the US to run a smaller fiscal stimulus, I rather doubt it will be able to hit his growth target and also brag that China’s fiscal deficit won’t top 3% of its GDP …

3) China is torn between its desire to avoid taking losses on any part of its portfolio and its concerns that it now has too much exposure to the one borrower that is almost sure not to default — the US Treasury. After several years of taking on credit risk and market risk in an effort to increase returns, whether by buying Agencies rather than Treasuries or by taking on a bit of equity market risk — China’s reserve managers have returned to classic reserve assets. But given the size of China’s portfolio, that means that they now hold a huge sum of Treasuries. And concentrating China’s portfolio in Treasuries has risks of its own; the US isn’t going to default on its Treasuries — but that doesn’t meant that holders of Treasuries aren’t exposed to other risks, not the least the risk that the dollar won’t maintain its value over time.

China’s desire to have the US government guarantee the safety of its holdings of Agencies and the bonds issued by US corporations is also somewhat at odds with its concerns about the rapid growth in the outstanding stock of Treasuries. Bailouts do have a fiscal cost.

China’s overall portfolio has actually held up fairly well in the crisis. China was only beginning to shift out of traditional reserves assets when the crisis struck. Its overall exposure to risky assets, setting the Agencies aside, remains small. A US pension fund that had China’s modest losses in 2008 would be thrilled. But the losses China took on its forays into riskier assets seem to have focused China’s attention on the cost of accumulating so many foreign assets in a very real way …

One final point:

No one forced China’s government to hold a $1.95 trillion reserve portfolio — a total that rises to over $2300 billion if the PBoC’s $184 billion in other foreign assets, the CIC’s foreign portfolio and the State banks foreign portfolio is added to the total. China’s huge foreign portfolio is function of China’s own decision not to allow its currency to appreciate even as China’s current account surplus soared and private money poured into China.

China long viewed its massive reserves with pride, as a symbol of China’s strength. But they are also a burden. In some sense, China is only now waking up to the costs of holding far more reserves than in really needs. China is likely to take losses on China’s reserves — as it in effect overpaid for foreign assets to hold its currency down. If it invests its portfolio unwisely, it may also take additional losses. That in some sense is the bill for using the exchange rate to support China’s exports; it is a cost that China’s taxpayers will have to pick up. I have long argued that the benefits (rapid export growth, lots of investment in the export sector) associated with China’s exchange rate policy were front-loaded while the costs (export dependence, losses on China’s reserves) were back-loaded. The bill for subsidizing China’s exports during the boom is just now coming due.

Ultimately, the only way China can reduce the risk in its reserve portfolio is to stop adding to its reserves. The main financial risk that China faces, after all, isn’t the risk that the US won’t honor its Treasuries, or even the risk that the US would walk away from the Agencies. It rather is the risk that the dollar and euro will eventually depreciate against the RMB, reducing the RMB value of China’s reserve portfolio.

Update: Business Week’s Mike Mandel draws out something that I alluded to, namely that Chinese state investors likely hold some of the bonds issued by US financial institutions.

* The methodology used to construct these estimates is described in the paper that I did with Arpana Pandey on China’s US portfolio. Our estimates are based on the TIC data and the survey data. We simply smooth out the jump in China’s holdings associated with the survey by re-attributing some purchases through London and Hong Kong to China. China’s holdings of corporate bonds don’t show up in the survey (even though large monthly purchases suggests that China has a significant portfolio). Here I have summed up flows to estimate China’s stock. The data presented here differs from the data in our paper because it has been updated to reflect the results of the last survey, which showed substantially fewer Chinese Treasury purchases from mid-07 to mid-08 than we has expected on the basis of the revisions in the June 07 survey. I also explained how I try to track China’s portfolio in this Planet Money interview with Adam Davidson.
** If China sold dollars for other currencies while pegging tightly to the dollar, other countries would argue that China’s reserve managers were intentionally driving the RMB down against their currency to give China’s exporters a competitive advantage. Moreover, it is a little hard to see how the global flow of funds would reach equilibrium — given the size of China’s external surplus and the size of the US external deficit –if China wasn’t directly buying lots of US debt.


  • Posted by yoda

    like the way lehman brother’s fall ripple thru out counter-parties around the global. if devaluation of the dollar becomes momentum, then armagedon loss, mistrust, pain, and hate will be shared with people around the globe. yes, global armagedon depression.

  • Posted by greg

    Indian Investor: In China there’s no system for the Govt. to distribute any unemployment benefits. If people don’t have jobs, they’ll go hungry after some time.
    There is no official unemployment benefit program in China. But there are a lot of unofficial ways for the government to distribute “unemployment benefits” to the unemployed. If you’re a state-owned employee and get laid off or made redundant, the common practice is for the company to pay some minimum wage for some time.
    The migrant workers are mostly peasants, who own some land. So in theory, they can go back to farm their lands.
    In today’s China, it’s highly unlikely that we will see massive hunger or starvation. The government has a lot of power and resources and they would find a way to distribute food and benefit if necessary.
    The unemployment problem mainly creates loss of income and reduction in demand and consumption.

  • Posted by Indian Investor

    Greg: The unemployment problem mainly creates loss of income and reduction in demand and consumption.

    Me: The US has what is among the world’s best systems of unemployment benefits. Still there are people who’re going hungry in the US even as we have this debate, because it takes 2 months or more for some of the benefits to start after they’re applied for. 38+ million, or more than 10% of the population in the US, is currently receiving food stamps. Food prices have gone up, not down, in the crisis, at least for the providers of those soup kitchen benefits.
    If this is the actual state in the US, imagine what it’s like in a country like China. Of course, we’re not even talking about the African least developed economies and the food crisis there.
    One of the big items for China to worry about other than its Treasury Bond holdings is the upkeep of unemployed people.
    Also, this is part of the lens. As Americans, most people at this forum have never seen beggary,lifelong homelessness, abandoned cripples, lepers,malnourished and illiterate children, hard labor foisted on children, workers who earn just enough for one meal a day despite 14 hours or more of effort.
    Most Americans imagine some kind of Western Utopia in a place like China, just counting its trillions in forex reserves.
    Employment is just a simple question of biological survival in most countries of the world, with the exception of the American Empire and its “Allied” vassal states, like the United Kingdom.

  • Posted by Rien Huizer

    Mr Wen is the chief operating officer of the world’s largest business congglomerate, the PRC. And he does what everyone in his position would do, he tries to get an advantage for his business: preferential treatment, well aware that the US gvt would break its own laws if it did so. The US (not a corporation, but a country where public opinion has some influence over policy and where laws are fairly unambiguous and strictly enforced) is aware that China is aware and wonders whether this is an implied threat (not to buy no more treasuries, but to abstain from stuff that is less desirable) that unless there are favors in return, China will not offer favors the US needs, orwheteher this is simply some form of propaganda for domestic consumption, to play to the feelings of the PRC’s shareholders. I guess it is both.

    In essence, China probably wants to express that (1) they will not diversify away from the USD (2) that they would be willing to invest in agencies if the US backing was unambiguous (3) that they expect to continue adding to their portfolio (meaning that domestic spending will not erase the trade surplus).

  • Posted by Indian Investor

    The importance of China’s Treasury holdings to ordinary Americans is underappreciated. The American Empire was never built with a popular vote. The real issues were hidden from the public through propaganda.
    Blaming the common Americans for this imperial overstretch is like blaming Ali the Muslim tuk tuk driver for the Emperor Aurangzeb’s actions. Poor Muhammed in the corner tea shop has probably never even heard of the Muhammed of Ghazni.
    Most of the common Americans don’t understand much about the outside world, and they just believe what the leaders say in the speeches and what the Ivy League graduates write in the newspapers about the reasons for all these foreign campaigns.
    The US Sovereign has become dependent on financing from the PBoC to maintain its creditworthiness because of the Imperial overambitions.
    Today, a large number of people are dependent on the social security and the Medicare programs of the Government.Besides many people’s pensions, bank savings deposits,insurance policies are all backed up by the creditworthiness of the US Treasury. If China is forced to offload the Treasury holdings, the dollar exchange rate will be so weak that it will be impossible to maintain imports of even basic neccessities, such as oil and commodities.Private investors will lose confidence in the Treasury Bonds and massive dollar printing will lead to hyperinflation.
    The Treasury needs to focus on staying solvent.If the Treasury goes bust, the consequence is that the whole US financial system will just break down. Everybody’s bank deposits, insurance policies, stocks, pensions, Medicare insurance, social security benefits … everything will just become worthless and unavailable overnight. Large tracts of the US military will have to be disbanded due to inability to pay salaries to the soldiers. Massive social and economic unrest will result if the Treasury defaults.Let’s hope the US takes a balanced approach to the crisis that they have taken till now, with the exception of the Geithner accusations about China’s currency.

  • Posted by Stefan

    In the coming three years we will essentially have 10% CPI inflation per year. The consumer price value of China’s 2 Tr USD will be 1,8 Tr next year, 1,62 the year after that and 1,46 Tr the year after that.

    Nominal salaries all over the worls rise. Real assets soar.

    Voila – that was the rebalancing. Wen saw it coming.

  • Posted by Stefan

    Sorry, forgot to add the mark to market losses of China’s bonds during the coming three years.

  • Posted by Stefan

    Today, China could have bought real US assets. E.g they could have spent 100 BUSD buying 500 000 US homes.

    But they did not do it. So they will be diluted over time. There is no way around it.

  • Posted by yoda

    “buying 500 000 US homes”??? i know that i shouldnt say it, but are you retard? buy a physical home? what for? to rent it out? and pay USA gov property tax? or you mean mortgage that can be defaulted by USA people any minute? China is already worry about agency, why would they alright own non-agency mortgage?

  • Posted by bsetser

    Rien — interesting comment.

  • Posted by yoda{D69E1883-8A00-4F59-9DED-E701E15D9A59}&siteid=YAHOOB

    American International Group is set to pay $450 million of bonuses to employees of the unit that was largely responsible for the New York insurer’s collapse last fall, The Wall Street Journal reported.

    I think most money borrowed from China are used by Geithner as bonus money to AIG losers. no wonder chairman Wen is worried.

  • Posted by MakeMeTreasurySecretary

    I read with interest the paranoid predictions in some blogs about collapse of the dollar. (That’s not in Setser’s, who remains a voice of reason and a source of cool-headed analysis.) The dollar may be overvalued (I certainly think it is) but this is not the same as having zero value! If China stops buying treasuries or even sells all its US assets, the dollar will still not collapse. The value of the dollar will ultimately be supported by the strength of the American economy. In my view, there is still a lot of strength left in the US economy but is waning largely because foreign-government money supports the dollar at unreasonably high levels.

    That is why it is ironic that those who claim that they care about the US economy express worries that foreign governments may stop buying treasuries.

  • Posted by Stefan

    “physical homes” is what the US has been producing, as China has been producing manufacturing goods. Chinese goods crowded out labour from US manufacturing into construction.

    China bought pre-olympic oil at sky-high prices – they had better buy US homes at fire-sales prices. Yes, renting them out would be a possibility not to miss the train as inflation takes hold.

    I expect US NOMINAL GDP growth to be 10-12% the next few years and reach 20 Tr USD in 3-4 years. Those Treasuries China owns today will be diluted in real value and further marked down by rising interest rates.

  • Posted by Stefan

    China’s oil purchases last year were detrimental to the world economy.

    Were they to announce tommorrow that they are buying 500 000 US homes for 100 BUSD, that would boost the world economy.

  • Posted by Mike Norman

    Are you actually suggesting, or perhaps I should say, “worried,” that the U.S. Government would not make principal and interest payments on its securities?

    That would take an act of Congress.

    Foreign exchange risk is another matter entirely and it has always been present, but does not entail payments risk. If the Chinese are worried about currency fluctuation they should stop listening to U.S. demands that they boost the value of the yuan.

    Insofar as assets other than U.S. Gov’t securities the most effective way for China to ensure their long-term strength and stability, is to convince U.S. policymakers to employ more aggressive fiscal measures to increase aggregate demand. (Perhaps by following China’s example?)

  • Posted by Cedric Regula

    I think we should give them Texas and call it even. Texas has oil comapanies and quite a few semiconductor comapanies. China should be happy with that deal.

    One potential point of conflict that I heard on the David Lettermann Show is Bush is planning his Presidential Library. So far it includes the GWB 18 hole Championship Golf Course and the 200 acre Laura Bush Kidde Park complete with kidde rides and a petting zoo. No plans for any books, so I think the Chinese will be OK with it.

  • Posted by WStroupe

    MakeMeTreasurySecretary likes ‘voices of reason’ and disdains calamity howlers who warn about the risks of a dollar collapse.

    I’m all for reason over passion and calamity howling.

    However, may I point out that I was labeled a calamity howler in 2004 when I predicted the current financial and economic mess? May I also point out that I was further labeled a chicken little (the sky is falling, the sky is falling!) when I predicted in detail in early September, 2007 that the subprime crisis would not remain contained, but would spread to infect the entire global financial system, with huge negative economic and geopolitical repercussions for the U.S.?

    Please pardon my brief foray into horn-tooting. My point is simply this: We cannot be sure that the risks for the dollar in this deepening crisis will refrain from escalating to the point where they become critical – it is a real concern that U.S. policy may well be setting in motion forces to debase the dollar more than it can reasonably endure, perhaps sooner than is assumed. It is a valid subject for argument, and prudence DEMANDS that we do not make comfortable assumptions about the strength of the dollar, like so many persons made comfortable assumptions about where this crisis was going, only to be proven to be in massive denial.

    I, for one, prefer to be prudent, and examine all possibilities that are within the framework of reality – and a dollar crisis is, in my judgment, well within that framework. I think Wen and many others are increasingly concerned about that very possibility too.

    The U.S. is spending itself into jeopardy, because the Administration’s plan for getting the huge new budget deficits under control just isn’t credible. It’s based upon too many fantasy-based assumptions. The dollar is being debased by these policies. Will it simply weaken via inflation, something the U.S. actually wants (as long as the decline is orderly)?

    Or, will its inevitable decline become unstable and unmanageable? What happens to Treasuries and the dollar if/when global risk aversion subsides? What happens if the U.S. economy worsens, goes into full-blown depression, and global risk aversion intensifies as investors become increasingly worried about the safety of financial assets, like Treasuries? What if the “underlying strength of the U.S. economy” isn’t at all what many still assume it to be? These are all valid questions. Addressing them with what-ifs does not make one a calamity howler.

    The dollar may well survive this crisis intact. But what if it does not? Isn’t that a real possibility? I assess its chances as deteriorating, and I’m certainly not alone in that view. Jim Rogers and some other notable investors are increasingly worried about where the dollar is heading.

  • Posted by YZ

    Disclaimer: I’m not an economist, and have little experience in policy issue. Yet I do find this blog very stimulating, and would like to ask few questions from a native Chinese perspective. The only tools that guide me are my 1st hand experience and common sense.
    1) Responding to Greg’s comments: During the evacuation of three gorges’ area in China, a large portion of the central government’s reimbursement was missing in action. I can’t imagine the distribution of unemployment benefit to be done effectively in China. Furthermore, if migrant workers’ issue is not a serious problem, I doubt the government will discuss it openly to cause unnecessary tension.
    2) Responding to HZ’s comments: the idea of IMF involvement is very interesting. Just wonder why China would have to go through IMF, will it be more beneficial for them to initiate the dialogue directly?
    3) It does seem the Chinese government is much more active and outspoken during recent months. Although acknowledging the dire consequence of current crisis, it still looks forward to continual substantial growth. It reminds me two popular Chinese proverbs a) describing a nervous liar: “There is no 300 ounces of silver buried under here”; b) “Slap your own face until it swollen to appear to be well-fed”. When all the eyes of western world are upon China, and waiting for it to stimulate domestic demand, it’s hard for me to imagine a Chinese can change his spending habit on a dime. If past history is any guidance, they will certainly become more frugal.
    4) Given the apparent trade imbalance and its possible devastating consequences, it’s hard to imagine the Chinese government doesn’t hedge it in some way. Are there any data showing Chinese government’s current hard asset holdings if any?
    5) To my limited knowledge, US reserve currency status rests upon its superior military power. The recent harassment of US surveillance ship by Chinese military brought back my memory of 1999 US bombing of Chinese embassy and US spy plane crash with Chinese fighter jet in 2001. It’s hard to imagine Chinese government would forget the humiliation from the past. Am I reading too much into this?
    6) Recently the richest Chinese man disappeared under corruption charge. I could see the new riches in China must be quite nervous. Just wonder why US government doesn’t open the door for Chinese investor? Green card could be offered to Chinese investors and their children, tax could be waived upon rental income etc… What are the difficulties in implementing this policy? What are the possible risk of this policy?

  • Posted by MakeMeTreasurySecretary

    At a risk of overstaying my welcome, I would like to ask for some specifics regarding the concerns of WStroupe. (After all, this is a blog regarding flow of money, so the value of the dollar is germane.) WStroupe may be right and I will be the first to admit that ANYTHING can happen. With so much cash floating around and an out-of-whack financial system that can turn any mishap into a major disaster …

    However, I am curious, What does dollar collapse mean to WStroupe (or to Jim Rogers, or to Peter Schiff, for that matter)? Twenty, fifty or ninety percent drop from where it is now? Surely there would be losers but what about winners in the US economy? Will there not be any negative feedback to oppose the drop?

    My personal opinion is that the US has tremendous productive potential that is underutilized because, one of the primary reasons, we are stuck with an overvalued currency. Not very overvalued, mind you, but now we enter the domain of speculation since markets do not really work freely.

  • Posted by WStroupe

    Dollar Crisis:

    I think the problem for the dollar now is that the latest global bubble is much more directly in dollars, and it’s becoming a bubble with gigantic proportions.

    The previous bubbles were in assets which afforded several levels of indirection to the dollar, thus affording the dollar itself quite a significant degree of insulation from the effects of the bursting of those bubbles. That was true with the equities bubble circa 2000, the recent housing bubble, the recent commodities bubble, etc. Those assets were denominated in dollars.

    But this one’s directly in the dollar. That is profoundly more risky than were the bubbles in other assets. And it signifies much greater potential for inflicting direct harm upon the currency itself. Therefore, when it inevitably bursts, as ALL bubbles do, it’s anyone’s guess where the value of the dollar will end up. But I would argue its value will plummet – perhaps as much as 40% to 60% or possibly even more, in a very short time interval. It isn’t just the degree of loss of value – it’s also the swiftness of that loss of value, the attending global loss of confidence in the currency, and the degree to which the loss of value will feed back into itself – risking a stampede.

    Think for a moment about the dynamics of a bubble burst. The dynamics and role of human psychology always get magnified when a bubble bursts, for the simple reason that no investor wants to be the proverbial dumb ass that rides the asset down too far and gets left holding the bag, as it were. This dynamic almost always ensures that bubbles burst chaotically, not in an orderly fashion. Just replay the recent bursts of the housing and commodities bubbles. The bubbled assets were left in virtual wreckage, their values severely beaten down.

    This could happen to the dollar if anything emerges that makes some other asset(s) look more attractive. In fact, it absolutely MUST happen, because there will always be “the next bubble”. This is the terrible danger of bubbles. But the danger is absolutely colossal when you grow one that’s directly in the currency itself – you’re setting your currency up for a destructive fall. You’re no longer affording your currency the multiple levels of indirection to the asset bubble, and the immunity that goes with it. This is extremely shortsighted and risky behavior on the part of government policy makers and on the part of global investors, who are always the facilitators of the bubble-makers in government.

    I call this situation deeply ironic, for the dollar APPEARS to be strongly benefiting from this crisis, but in reality it’s being set up for a chaotic fall.

  • Posted by Indian Investor

    Suppose you’re a private investor considering lending to the US Treasury, in the absence of the reserve currency status. What I know is that the total public debt is around $10 trillion. Fiscal deficits will rise a few trillions more. Of that $10 trillion, a very large chunk is held on an intra-governmental basis. I remember a comment from Brad Setser in which he said that if you subtract that part, the debt/GDP ratio is just above 40% (I thinkt he actual number is 43%, or whatever, I’m going by memory and sometimes I make tremendous gaffes with the numbers that jump out of my memory).
    Now, I’m not sure what the income from taxes is, for the US Treasury, though I know the US Govt. expenditure is around 20+% of GDP.
    The above numbers don’t include unfunded liabilities for social security and Medicare that may arise in the future. But I remember reading a column by Paul Krugman where he discounts the demographics data on retirement, and his column made sense.
    Also, I’m not sure if the Treasury is in what’s defined as a “debt trap” – i.e. an entity needs to borrow more to pay interest on its current liabilities, taking you to the second derivative of debt growth, from which the entity is unlikely to emerge solvent.
    If somebody can share historical information about the level of US Govt. revenue in comparison with its expenses, I’d be happy to change my views accordingly. My doubt is whether , when you remove the reserve currency effect, the US Treasury finances are strong enough to attract confidence in the minds of private investors.
    Politically, the Treasury is better off being beholden to a foreign sovereign whose native population is dependent on the US economy for employment. This is a temporary state for China, of course.But for now this seems better than being dependent on private investors who tend to form a cartel and extract concessions when the Sovereign finances are in trouble.

  • Posted by Cedric Regula

    Here’s the CBO website. They have the current budget estimate and also historical data. I think last year total federal tax receipts were $2.7B.

    But trouble brewing already for this year’s estimate……

    WASHINGTON (MarketWatch) – The U.S. federal government budget widened to $192.8 billion in February as tax receipts plunged to the lowest level in 14 years, the Treasury Department reported Wednesday. It’s the second largest monthly deficit on record, exceeded only by $237.2 billion gap in October. For the first five months of the fiscal year, the deficit has increased by a half trillion dollars to a record $764.5 billion. Outlays were flat compared with a year earlier at $280.1 billion, while receipts dropped 17% to $87.3 billion, the lowest since February 1995. In February, individual income taxes fell 64% to just $8.7 billion. That’s the lowest monthly total for individual income taxes since May 1985

    The total government debt is $11T. About $6B is “public” debt. The other $5B “intergovernmental debt” is largely the social security “trust fund”. The $5B is the amount that was left over when social security was deducted from our paychecks for the last 50 years. It is known as the “surplus”, and the reason there is a surplus is to cover the retiring baby boomer demographic. The reason it is now called “intergovernmental debt” is that Congress immediately borrows it as it gets paid, at a 2% interest rate irregardless of the inflation rate, and adds it to current tax revenue which reduces the apparent size of the quoted fiscal deficit.

    So if we find out that it is not ours afterall, then we have been living in a country with a 50% income tax rate (don’t forget state,local and medicare), like maybe France, except without the national health care and social security.

  • Posted by Cedric Regula

    whoops…make that last year’s tax receipts were $2.7T.

  • Posted by Glen M

    Michael Pettis, I feel, has summed the issue up best…….

    I think the chance of the US defaulting on its debts are pretty close to zero and, if it ever got to that, it would be because the US and the world are in such dire straits that no one would pay much attention to Premier Wen’s concerns. But the fact is that China has already taken a huge loss on its reserves. When undervalued Chinese goods priced in RMB were exchanged for overvalued bonds priced in dollars and euros, the loss of Chinese blood and sweat automatically occurred. The rise of the RMB against the dollar does not create that loss. It only recognizes it.

    As for whether China can slow down the purchase of dollar bonds, this is, I think, a huge misconception. It is impossible for a country to run a current account surplus with another country unless it recycles the flows back in the form of asset purchases. China can only stop buying US dollar bonds if it also stops running a trade surplus with the US, and if it did, the expansionary impact on the US economy would mitigate the need for the US government to run a fiscal deficit. By the way the idea that this money was “lent” to the US is not correct in the sense that you might lend money to your friend. Chinese purchases of US Treasurys are the automatic outcome of China’s running net exports to the US. I am quoted in a Globe and Mail article yesterday explaining why.

  • Posted by Indian Investor

    @Cedric: Thanks a lot for the info. I looked up that the total government expenses were $ 2914.9 billion.So the US Treasury seems ok in terms of cash flow. In 2008, they had an income of $2.7 T and expenses of $2.9 T. Brad Setser might be right in terms of financing Treasuries from private investors, though it’ll take a little more than 15 minutes’ thinking to understand this better.

  • Posted by Indian Investor

    So, If China were to offload Treasury holdings massively, private investors might still purchase T-Secs.This is on the basis that the Sarkar will levy higher taxes,control the expenses, and slowly pay back its $11 trillion debts.Cedric, thanks for clarifying the intra-governmental debt holdings. They need to pay that back as well.
    The only thing that’s stopping a Tariff appears to be the consideration of a currency/balance of payments crisis.

  • Posted by ReformerRay

    Glen M is correct when he says that money sent to China to purchase imports to the U.S. must return to the U.S.

    However, it can take a cirtitous route. It could be sent to Germany to buy a machine and Germany could kick it around but ultimately it will return to the U.S. because ownership of an asset that pays interest or dividends is prefered to cash.

    It must return but the dollars can be spent on anything in the U.S. Does not have to be Treasury bonds. Japan started the tradition of buying Treasury bonds when the U.S. public became outraged that a Japanese businessman was in negotiations to acquire Rockfeller Center, ages ago.

  • Posted by MkeC

    Indian Investor, you said:

    “One way to do that is by aggressively attacking the dollar. If they come together with Russia, Germany, France, Iran, Venezuela, etc – they can massively offload their USD holdings,break the OPEC cartel, use the RMB as a reserve currency in their region and proceed with a much reduced dependence on US exports.Their frequent musings on how to preserve the value of their Treasury bond whistles indicate that they’re not prepared to do that.”

    Whether China is prepared to do this or not, this scenario seems pretty absurd. Why would France or Germany ever “come together” with China to break the reserves status of the dollar in favor of RMB? France and China seem on the perpetual verge of economic boycott and why would Germany ever seek to displace the US in favor of China of all countries?

    Why would you ever think China has the capacity to do this even if they did desire it?

  • Posted by Cedric Regula

    Dollar discussion

    Bernanke was just interviewed on 60 minutes tonight. Along with going over everything we here know already, he also indicated the Fed wouldn’t have any trouble draining liquidity once the economy starts to recover. (i.e. once the velocity of money picks up, and the potential 6:1 money multiplier kicks in for an 8% reserve fractional banking system).

    If that’s so, then it sounds like the Fed can control local inflation(I’ll still have some doubts if their level of acceptable inflation is the same as the one I like).

    But then we still have the fiscal deficit, a trade deficit that tends to get larger as the US economy improves, and on the financial side we may get a replay of US investment finding better returns offshore.

    So these are all factors that weigh heavily on the external value of the dollar.

  • Posted by WStroupe

    Cedric Regula,

    What Bernanke says and what Bernanke can successfully accomplish are two very different things. Just replay his unfulfilled claims to date. For but one example, he hasn’t been able to alleviate the massive credit seizure. It’s too stubborn, up ’till now.

    When Bernanke tries, in future, to mop up all the massive excess liquidity he’s flooded the system with, he’ll have to tighten – that means interest rate hikes, among other things. But the U.S. economy is most likely to continue to be very frail for some time, and it isn’t likely to be able to withstand tightening without being plunged into a second round recession. Bernanke isn’t very credible.

    Of course, it’s his job to put the best spin on things, so no one should be surprised that he’s attempting to bolster international confidence in the deeply troubled U.S. economic house.

  • Posted by Cedric Regula


    “For but one example, he hasen’t been able to alleviate the massive credit seizure. It’s too stubborn, up ’till now.”

    That’s because we are in a liquidity trap, and on top of that in a credit bubble. So goosing up the money supply doesn’t work because the velocity of money headed towards zero.

    Success was what was worrying me, because the normal Fed tools like selling short term treasuries thru FOMC transactions to drain liquidity and influence up short term rates are no longer available. The Fed got rid of all their cash and treasuries when they traded them for illiquid collateral.

    So they still have some other unconventional choices, like paying interest on bank reserves at the Fed, issuing Fed sterilization bonds, or even increase the banking system reserve requirement.

    But like you say, when it comes time to do this , will they, or will we get another Greenspan moment with his 3 year long slow interest rate hike, so as not to “damage” anything. haha, look how that ended up.

  • Posted by HZ

    First is political reality. China and India are not exactly on the most friendly terms, e.g. IMF is generally regarded as politically neutral.
    Second is safety. China does not have the power to enforce its claims across the globe so it would not want to take risk in very large scale investments and is locked in with the US where protection of property is better than most. IMF on the other hand represents the international community. Default to the IMF is non-existent.

    Take the India idea: an investment today in Indian infrastructure at the size of say 10% of Indian GDP would surely produce better marginal return relative to the same investment in China or developed economies where infrastructures are already in good shape. If India GDP grows at 6% and the investment returns 3%, 30 years later the claim on Indian’s GDP will fall to 4.2%. And if it is then paid pack over 10 years, it will be less than 0.5% of GDP per year. But from the Chinese perspective the real purchasing power of the investment will have grown to 2.42 times the principal. More importantly an equivalent USD based investment, even if real purchasing power is maintained, can not be safely withdrawn because of the currency issue, unless there are enough products that US can provide to China. But US economy is serviced based. Will baseball/NBA/Hollywood or financial services meet Chinese retirees’ needs? Will the medical services do (at a price many Americans couldn’t even afford)? University education is a potentially good US export but only relatively few Chinese (percentage wise) could possibly take advantage of it. So are real estates or tourism. So you see even if there is no significant inflation in the US it will be hard for China to spend its USD income. And if it tries to sell USDs to buy from other countries it faces the currency issue. On the other hand India’s much younger population could easily produce products for the older Chinese at an affordable price. So India could easily return Chinese investment in real term through a trade surplus with China.

  • Posted by ReformerRay

    The U.S. needs an explicit policy on which bonds the government will back going forward.

    I vote for a distinction between those creaated inside the regulated system and those created outside the regualted system.

    That would make all agencies safe. Also all bonds sold by private banks and private insurance companies.

    In my terminology, credit default swaps are not bonds, they were not created inside the regualted system and they are not traded on a public forum. THEY DO NOT DESERVE PROTECTION BY THE FEDERAL GOVERNMENT.

    No more money to AIG to be used to pay creditors who purchased credit default swaps from AIG.

  • Posted by WStroupe

    I don’t quite buy the conclusion that China is caught between a rock and a hard place; I think it does have options to decrease is exposure to the dollar without selling off dollars and triggering a dollar panic in the process.

    The problem with present and ongoing analysis of the makeup of China’s reserves and its actions regarding those reserves is that almost the entire matter is clouded by China’s opaqueness. Therefore, present analysis has to rely on whatever traces of China’s actions can be garnered from various reports, surveys and the like, combined with best-guess analysis. I’m not criticizing that process of analysis – I’m just reminding everyone that it is not at all conclusive. It assumes we know, or can know, more about the composition of China’s reserves than China itself lets be known. We don’t know what diversionary tactics China may be employing to throw us off the accurate trail. Hence, I would caution everyone not to come to a firm conclusion (China is between a rock and a hard place) based on the available ‘evidence’, such as it is. That evidence is really mostly soft and only tentative, and subject to ongoing alteration as new, hard evidence emerges.

    I think one important clue as to China’s options to significantly reduce its exposure to the dollar is its policy of resource buys, which it is ramping up. I repeat my caution – we may well discover, down the road several months, that China ‘fooled us’, that it did have viable options, and that it undertook diversification out of the dollar without our being able to discover the fact.

  • Posted by WStroupe

    According to the latest TIC report for January, China’s purchases of long-dated Treasuries slowed almost to a crawl. It’s been moving out of almost everything (agency, corp bonds, etc) into short-dated Treasuries – from where it can move fast and where it won’t risk suffering so much erosion of its holdings. The long term picture is that China is significantly slowing its purchases of U.S. assets.

    I believe that as it increases its purchases of non-dollar assets, including hard assets as in its resource buys, its exposure to the dollar will fall significantly from where it is today. I think China’s getting burned by U.S. assets, as Brad has documented, has only dramatically increased its urgency and determination to reduce its exposure to the dollar, but doing so in a mostly opaque manner, and without risking triggering a dollar panic.

  • Posted by greg


    Your recent article at Asia Time Online has accurately grasped the sentiments and on-going discussions about the potential risk of holding large US Treasuries, in my opinion.
    In the area of economics and financial matters, there are close interactions between the public discussions and debates and China’s policy making, as have been known for years. Mr. Wen’s publicly expressed “worries” about the risks of China’s large Treasuries holdings reflects the current on-going discussions.

    Chinese officials have recently publicly said that they are thinking of ways of using the fx reserves to serve domestic needs. The series of natural resources deals signed in February indicate that this is not mere lip service. China has also sent two trade missions to Europe recently, one for procurement, the other for potential acquisition. The heightened activities reflect the urgency and anxiety of China’s policy-makers.

    Also, as HZ proposed above, China actually has engaged in a number of deals in Africa where China would package a natural resource deal with infrastructure building for the host country (e.g, a 30-year mining agreement combined with low-interest loan to build local roads, schools and hospitals paid for with income from the selling of the natural resources). I remember there was a similar deal with Argentine (or Brazil) a few years ago. We may see more of the similar deals.

    From the above, it may not be too difficult to sketch out China’s diversification strategy:

    Large-scale natural resources deals – As world’s largest commodity buyer, it’s a good strategy to lock-in long-term natural resource supplies
    Procurement of commodity and capital equipment – According to Phoenix TV network in Hong Kong, China has completed its first stage of strategy oil reserves with all the oil bought at the recent low price. China is now in the process of selecting and constructing sites for the second stage oil reserves. The European procurement trip also reflects such a strategy.
    Overseas acquisitions – China can acquire stake in or outright acquire natural resource companies if the political climate permits. In selected industries, China may also finance its corporations in making foreign acquisitions – the recent second European trade mission is such an example.

    Notably, China has entered into currency swap agreements with a number of neighboring countries/economies, including South Korea, Hong Kong, Malaysia, and Belarus. These agreements are experimental in nature, but can be considered that China is preparing for a world when dollar may not be the only reserve currecy.

  • Posted by don

    “I have long argued that the benefits (rapid export growth, lots of investment in the export sector) associated with China’s exchange rate policy were front-loaded while the costs (export dependence, losses on China’s reserves) were back-loaded. The bill for subsidizing China’s exports during the boom is just now coming due.”
    I’m not sure how big the back-loaded costs are, properly measured. Without the currency interventions, China might have a much smaller economy and less reserves. They might be less export dependent, but this might be because their economy would be smaller and they wold have less to lose, in an absolute sense. It sounds to me sort of like asking someone whether they want more income, on grounds that their tax burden would increase.

  • Posted by Mortgage Calculator London

    Losing confidence in US treasuries? Who’s surprised at that one? However, I reckon China will keep on buying US assets until the bitter end.