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 dion

    “China likely has about $750 billion Treasuries.”

    It’s $727.4 billion (as of 31 Dec. 2009) to be exact.

  • Posted by dion


    …as of 31 Dec. 2008…

    quite obviously :)

  • Posted by Ron

    China should be worried about their dangerous over investment in US Treasury obligations. Washington ’s long-term choice is either repudiation or monetization. For monetization to be effective, the depreciation in the dollar would have to be substantial and this in turn would dramatically raise prices of imports for American consumers which would mean a tremendous drop in foreign imports. Debt monetization would cause more disruption to exporting nations than selective repudiation of Treasury debt.

    Washington has bailed out the banks, Wall Street & their Washington special interests and much of the cost is added to the national debt to by paid by this and future generations while real estate and investments continue to fall. Find out what a growing repudiate the debt movement could mean for treasury bonds, the dollar, gold and the stock market.

    The Campaign to Cancel the Washington National Debt By 12/22/2013 Constitutional Amendment is starting now in the U.S. See:
    Ron Holland

  • Posted by bsetser

    Dion — the US Treasury data is subject to large revisions over time, so it isn’t an exact total. or rather it is an exact statement of the known stock as of June 08 and subsequent flows that can be attributed to China in the TIC data. However, the survey usually reattributes a sizable fraction of the Treasury flow through London to central banks,including China’s central bank — so the US data tends to somewhat understate China’s US holdings. My $750b estimate assumes that some of the $75b increase in the UK’s treasury holdings since the last survey revisions (june 08, they show up as a series break in the data) should be attributed to China. I think that is a fairly safe assumption.

    My model suggests $738b in Chinese treasury holdings as of end dec, but my guess is that China will account for more of the flow through london from june 08 to june 09 than it did from june 07 to june 08 (that was when oil prices were high and it seems the oil exporters accounted for a reasonable fraction of the flow), and thus the model — which reassigns the flow through london on the basis of the last survey — will understate china’s portfolio by a bit.

    ergo, i consciously opted not to use the TIC total. incidentally, my estimates and the formal data always converge for treasuries and agencies in June once there is a survey data point; the goal of the model is to estimate the survey revisions.

  • Posted by Curious

    Is there any data to see which U.S. equities China has purchased? Name of the corporations?

    Looks like China is going to flip the coin. It’s absolutely amazing how much power Wen has gained in the international community. His comment was on headlined on CNN international all weekend…

  • Posted by bsetser

    No data …

    China’s leverage is an interesting question. It all ultimately hinges on China’s willingness to actually stop buying US assets (and presumably stop pegging to the $) if the US policies deviated too far from the policies China wants. So far China has never been willing to do that — and right now its actual portfolio decisions seem to me to be contrary to the media’s obsession with the possibility that China’s demand for treasuries will fall. China is likely to slow its treasury purchases ‘just cause it isn’t gonna keep selling agencies for ever. but it hasn’t been buying a ton of treasuries recently b/c the US was issuing more; it was buying treasuries b/c it stopped buying everything else.

    just saying.

  • Posted by Mark G.

    Too bad Wen. Majority of people who invested in this corrupt system lost money. The fortunate one’s shorted stocks, index’s and sectors and made a killing. Wen should start shorting the markets, basis trades vs. the US treasuries, agencies or stock holdings. With their reserves they could move markets and make a fortune. They need to learn from their mistakes and beat the round eye’s at their own game.

  • Posted by Thomas

    On a somewhat philosophical note:

    You write that China’s main risk is “the risk that the dollar and euro will eventually depreciate against the RMB, reducing the RMB value of China’s reserve portfolio.” (and I wrote similar things myself in the past, so I’m about to contradict not just you, but also myself)

    But is that actually correct?

    If one argues that the reserves are held with the view to eventually buying real goods and services abroad (years or even decades in the future), then a depreciation of US$ and Euro against RMB doesn’t actually “devalue” those reserves.

    They only get devalued if there is inflation in Europe and the US that is not offset by sufficiently high interest income.

    Because as long as there is no such price inflation in Europe and the US, China can still buy the same amount of real goods and services with its US$ and Euro holdings, even if those currencies devalue against the RMB.

    So the reserves may be lower when expressed in RMB terms, but the value of those reserves (as in: purchasing power) remains the same.

  • Posted by MakeMeTreasurySecretary

    Oh my, this is a Mel Brooks moment. You know, like: “Stand back or I shoot myself.” Only now it is: “Honor your obligations or we stop buying your stinking bonds.”

  • Posted by K T Cat

    “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…”

    The stimulus and related deficit spending mean nothing of the sort. It was a monstrous act of graft and corruption and it won’t do a thing for the economy. As soon as this becomes evident, the whole analysis falls apart. The Chinese will see that their holdings will never be worth more than they are right now.

    California just discovered that after their wonderful budget deal, they’re now another $8B in the hole. It will get worse as more businesses leave the state. They’re a microcosm of the US as a whole where governments are grabbing every source of income they can find to keep paying out all the promised goodies.

    There is an existential crisis coming for many state and local governments in the form of over-promised handouts and wildly underfunded pensions. Their defaults will rock the Federal government who, if the short history of the Obama Administration is any guide, will simply print money and hand it out to the stricken state and local governments.

    I’m sure you’re right about the calculations the Chinese are making today, but I think the landscape is about to change for them.

  • Posted by John McLeod

    in para 4: “But I am convinced that Wen’s comments were driven entirely by China’s worries about its Treasury portfolio either.” —> I think you meant —> “But I am unconvinced that Wen’s comments were driven entirely by China’s worries about its Treasury portfolio”

    Thanks for another update on your important thoughts.

  • Posted by Stefan

    The US budget deficit is going UP. The US trade deficit is going DOWN.
    More treasuries must be sold to critical (=market sensitive) buyers, less to uncritical/automatic (China, Japan, Arabs) buyers.
    Interest rates UP, China assets DOWN

    Budget deficits are inflationary. Idle money becomes flowing money. Money velocity increases
    => US consumer prices UP, US asset prices UP

    Sooner than expected: Fed action, incresing interest rates
    Treasuries COLLAPSE, real assets SOAR

    During the last five months, the US budget deficit was 750 BUSD. In February alone 190 BUSD. The market is full of paper waiting to lose its value.

    As private money became lost its velocity, the government had to pump in new money. But as the new money compensate for the loss in velocity, velocity will increase. Result money supply HIGH, money velocity HIGH.

  • Posted by Justin

    Brad –

    Is there a publicly available source for Chinese holdings of agencies?

  • Posted by Justin

    Apologies, found it in the Tic data…duh.

  • Posted by HZ


    I don’t know what is your take — I think China would be happy to lend multilaterally through IMF to many countries now that it is the largest manufacturer and creditor of the world. It doesn’t have enough confidence in protecting its own overseas assets to lend too much by itself so it currently mostly buys US Treasuries. The US equity for debt swap used to mean these funds (on a net basis) should translate into investments overseas from the States but the recent financial crisis has reversed that. To address that (without adding to US fiscal gap) China could lend through IMF instead — which gives it a multilateral shield it doesn’t have in bilateral lending. US and Europe need to agree to it, obviously and it is not clear that they are willing even though they are out of financial wherewithals to deal with global issues. I think this is a clean solution: it solves the needs for Chinese external savings due to a rapidly aging society and it provides funds to countries that are starved of funds to restructure and to invest with adding more debt burden to the mature developed economies. China is buying resource companies right now — which is undoubtedly a good investment but could generate a lot of political rancor if it is done on a very large scale. Would be a lot easier to lend through a multilateral agency — though China could own majority of the economic interest produced by its funds it won’t politically interfere in future distribution of resources.

  • Posted by Cedric Regula

    I think we should just give them the State of Tennessee and call it even. Tennessee has Ft.Knox and a great big Toyota plant. China should be happy with that deal. The benefit for Americans is if Tennessee becomes a Chinese province, it may get Al Gore to worry about China more.

  • Posted by John McLeod


    The NY Fed does have central bank holdings of agencies and treasuries updated weekly. We’ve posted the data set as a CSV at our blog (latest version at the above track-back, by the way). Brad and his friends are a lot more sophisticated than that, but I don’t think there is an official country breakdown. CFR has to dig hard to deliver a SWAG.


    America has been sending China and India significant bits and pieces of Tennessee for years. Unfortunately, that’s why their products often set off Geiger counters when they get to Europe :-(

  • Posted by bsetser

    the best easily accessible source of data on china’s agency holdings is the survey — China had $527b of l-term agences in june 08 and another $16.7b of s-term agencies.

    john — thanks for catching my error; you guessed my intended meaning correctly.

    HZ — your suggestion //s a suggestion Dr. Summers made back in 2005, namely that large emerging economies channel some of their reserves through the World Bank which would invest in riskier assets for them, thus avoiding some of the political controversy … China at the time preferred to invest its own money. i don’t see that changing. i could though see china increasing its contribution to the imf — tis a fairly safe way to lend to some riskier Emerging economies.

  • Posted by bsetser

    Thomas — external assets can be used only to finance a trade deficit, to cover domestic capital outflows or to buy other external assets, so arguably — as you argue — only their external purchasing power matters. if that’s the case, China should be happy — its dollar and treasury and agency heavy portfolio has held up pretty well, and indeed gone up substantially in the crisis. a treasury bond buys more equity or more oil now than a year ago.

    on the other hand, china’s reserve growth often came at the expense of more domestic investment. think of the CIC. it could have borrowed in China to invest in China rather than borrowing in china to invest abroad. Given that China could have pursued a different policy mix that would have resulted in less gov. savings/ more domestic investment and fewer external assets, i would argue that it makes sense to take into account the rmb value of china’s foreign portfolio, as china in effect suppressed domestic demand to increase its foreign purchases during the boom.

  • Posted by Mitch

    The thing I’m wondering about now is what the constraints are on China’s behavior over time. If Chinese foreign asset purchases were sterilized by borrowing from Chinese savers, what happens when those savers start to retire? And how far in the future is that?

  • Posted by Qingdao

    So the only reason China buys U.S. debt in London rather than from the U.S. directly is because at the time of day they make the purchase the U.S. is asleep and the Brits are awake?

  • Posted by Don the libertarian Democrat

    I agree with you, hence this exchange with Dean Baker:

    From Dean Baker:

    “Why Is China’s Prime Minister Complaining About the Risk of Holding U.S. Government Bonds?

    By all accounts China’s Prime Minister, Wen Jiabao, is an intelligent man. Therefore he knows that China will lose a substantial portion of its investment in U.S. Treasury bonds. This raises the question of why he is complaining about the risks in China’s holding of U.S. Treasury bonds, when he knows that there is no risk, the investment is a sure loser.

    The loss will come for two reasons.

    First, the United States is running a large trade deficit. The only way that this surplus can be sustained is if the Chinese government and other central banks continue to buy up ever more U.S. dollars, thereby preventing the currency from falling. If the Chinese government ever stops buying vast amounts of U.S. dollars, the dollar will fall in value against other currencies (as it did in the years 2002-2007) causing China large losses on its holdings.

    But, this loss is China’s decision, not the result of U.S. government policy. As long as China wants to spend hundreds of billions of dollars each year propping up the dollar, it can prevent losses on its prior holdings due to a fall in the value of the dollar, but there would be no reason for Mr. Wen to complain about a policy that he or his successor will decide.

    China will also lose money on its bonds because the interest rate on U.S. Treasury bonds will almost certainly rise as the economy recovers. The Congressional Budget Office projects that the yield on 10-year Treasury bonds will rise from 3.0 percent today to 4.8 percent in a few years. This would imply a loss of about 15 percent in the value of a 10-year Treasury bond.

    For these reasons, Mr. Wen knows that China will lose money on its Treasury bond holdings. The news reporting on his comments should be asking why he is complaining about the risk of losses that he knows are virtually certain.

    –Dean Baker
    Posted by Dean Baker on March 13, 2009 7:23 PM ”


    Actually, that question was addressed:

    “China to stick with US bonds

    By Henny Sender in New York

    Published: February 11 2009 23:33 | Last updated: February 11 2009 23:33

    China will continue to buy US Treasury bonds even though it knows the dollar will depreciate because such investments remain its “only option” in a perilous world, a senior Chinese banking regulator said on Wednesday.

    China has used the dollars it accumulates selling manufactured goods to US consumers to accumulate the world’s largest holding of Treasuries.”


    “Mr Luo, whose English tends toward the colloquial, added: “We hate you guys. Once you start issuing $1 trillion-$2 trillion [$1,000bn-$2,000bn] . . .we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.”

    But remember this:

    “It turns out that 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. Lehman. Wamu. And the Reserve Primary Fund. Dean, Areddy and Ng:

    “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.”

    Once again, I see them weighing in on the option of defaulting on the bonds on our large banks, and other such assets. They are saying that they assume that the government is on the hook for guaranteeing the bonds, not the banks.

    It’s one thing to pay a premium for safety and liquidity, it’s another to be completely defaulted upon. Also, the don’t like the default trend line.

  • Posted by Kaiane

    US continues to issue Treasuries…Interest rates go up.
    China stops buying Treasuries…Interest rates go up. I see a trend here?

  • Posted by yoda

    that chinese portfolio manager should be shot for exposing the reserve two single asset class at hugest percentage (treasury and agency). that is sign of weakness in portfolio management. armagedon loss will be guaranteed for that chinese portfolio.

  • Posted by bsetser

    actual comments please, not excerpts — or insults. i have taken down more comments than usual on this thread as the seriousness of the issue warrants a serious discussion, not conspiracy minded comments.

  • Posted by Indian Investor

    Brad Setser: the US isn’t going to default on its Treasuries

    ME: Good words, we should inscribe them on the Bornholmer Strasse.

  • Posted by Indian Investor

    @Brad: Seriously, I didn’t make any comments before. Sorry if the comparison above to the fall of the Berlin Wall seems unlikely at this stage, I would totally understand that. I thoroughly enjoyed going through your “Lunar New Year” explanation in total silence yesterday.Also, had a good time going through your discussion of Wen’s two liner today, again in silence so far.

  • Posted by Indian Investor

    @Brad: I think there’s a lens through which you probably view the US Sovereign finances, rather than some conspiracy on your part. But it will be hard for you to identify the lens and arrive at a more objective assessment. But the objective assessment yields prescriptions that a very close parallel to what is already being done.
    The only way political power is useful to the US Treasury is in maintaining the USD’s reserve currency status. Its finances are secure for now because that status continues to be generally strong. Yet, THe USD as a reserve currency is under a very serious threat that isn’t easy to appreciate, especially in public fora.
    Suppose you take away that status, you have to reason with the other, more commonly factor of fiscal strength and stability. On that count the US Treasury has very serious weaknesses, to put it mildly.
    The challenge for the US is to re balance from relying mostly on geopolitical influence, to relying on strong basic fiscal stability. The most proximate attempt to do something similar was by Mikhail Gorbachev, beginning in the mid-1980s, through his Perestroika and Glasnost programs. These programs attempted to reduce the Russian Federation’s reliance on imports, control military spending, and adopt a less aggressive foreign policy. They were seriously constrained by resistance from the Soviet Military and Intelligence apparatus. Gorbachev’s re balancing did succeed for a very long time. It took till 1989, four years into the reforms for the Berlin Wall to fall. Two more years for the break up of the Soviet Union in 1991. And the Russian Federation was able to manage its finances all the way till 1998, when it finally defaulted.
    Today, you see that the US fiscal stimulus and monetary easing programs are neccessary; yet they increase the medium term risk by reducing the fiscal stability. Also, there is a good deal of resistance from the Pentagon to budgetary prudence on Military expenses.
    You’re inferring from the $1.8 trillion sales of US Treasuries in 2008 to private investors. The inference is that without financing from China, the Treasury can very well continue with its current programs. What you’re ingoring is that all investors are now depending on the maintenance of the US dollar’s reserve currency status, at least for a few more years.If China stops purchasing Treasuries, that will become extremely doubtful.
    Then, investors need to reason purely with the US public debt, its tax revenues and expenses. That reasoning doesn’t provide any re assurance.

  • Posted by WStroupe

    Precisely, IndianInvestor. Right now, global investors are assessing the value of investing in the dollar based more on the reflex psychology of extreme risk aversion, not based so much upon the deteriorating fundamentals of the U.S. economy and the escalating risks for the dollar. But eventually, as the negative effects of potent dollar-debasing U.S. monetary policy emerge, global investors will begin to assess the appeal of the dollar based more upon the genuine, negative fundamentals and less upon the reflex psychology – that will be profoundly bad for Treasuries and the dollar. When will that happen? If the more sane and reasoned psychology takes hold, or if the U.S. heads into a full-blown depression it could happen before the end of this year. Whenever the logical psychology begins to take the place of the reflex psychology, the Treasuries bubble will burst and the dollar will most likely go into crisis. The U.S. cannot hope to put its economic, monetary and financial house in order to avoid this bad end for the dollar. It will come – it’s only a matter of when.

  • Posted by ReformerRay

    Betser says: “Their main concern? That the US government wouldn’t backstop bonds that China thought had the implicit backing of the US government”.

    Well, join the crowd. It seems to me that the main concern of U.S. investors is to make sure that the U.S. government will backstop whatever bonds or other investments they have in the U.S.

    Can’t treat one set of investors one way and the rest another way. China should be treated like everybody else in the same circumstance.

    However, Obama and team are apparently unwilling to say nea or ney on which private sector investments they will stand behind.

    The only simple solution is to promise to make good on all investments that occured in the regulated sector of the finance system. Bond sold directly by regualted banks and insurance companies cannot be voided.

    However, credit default swaps sold outside the traded outside the regualted system should not be made good for anyone. All deriatives should be declared by the U.S. government to be non-recoverable from the government if the firm that made the promise can no longer keep the promise. Those contracts are between private parties with no participation in any way by the Federal government.

    Now I will read what others have said to see how many agree with me.

  • Posted by DJC

    Globalization had been engineered by the Clinton economic team. Over the last three decades, globalizatin has created recurring trade imbalances between the US and China for trade to become a major point of conflict. Simultaneously, the US has become addicted to low cost imports from low-waged China to sustain low-inflation growth fueled by low-interest debt funded by the Chinese trade surplus dollars. The irony was that dollar hegemony as worked out by Robert Rubin under Clinton is based on using a trade deficit to finance a capital account surplus denominated in dollars. Rubin, a legendary Wall Street bond trader, figured out that the US can consume more than she produces at the expense of the exporting countries as long as US trade deficit is denominated in dollars that the exporting countries cannot spend at home without monetary penalties and must reinvest in US debts.

    An accommodating Federal Reserve under Alan Greenspan provided an ever increasing money supply to facilitate serial debt bubbles to keep US consumers spending even with declining real production. Countries exporting to the US had to invest their trade surplus dollars in US sovereign debt to finance the US trade deficit and the expansion of the US economic bubble by providing low cost imports to US consumers and at the same time provide to US consumers low-interest-rate loans collateralized by wealth effects created by serial debt bubbles. The Fed was in fact feeding a global bubble with fiat dollars.

  • Posted by DJC

    While China’s current account surplus continued to expand up to 2008, the growth in net capital inflow in 2008 accounted for 59% of the total increase in reserves. China’s current account surplus in 2006 of US$206 billion accounted for 41% of the increase in official reserves. China’s current accounts surplus in 2008 of $261 billion is nearly 11% of GDP or $250 billion.

    Much of these large capital inflows might have been motivated by market expectation that the RMB would continue to appreciate against the dollar at a rapid pace, and that having a short USD/CNY exposure was a high-yield zero-risk investment. Thus, rather perversely, while Beijing’s ultimate objective of bringing the value of the CNY more in line with the economic fundamentals should eventually lead to a more sustainable balance of payment position, the process of getting there is inflationary.

    Related to this question are the concepts of the ‘fair value’ and the ‘equilibrium value’ of USD/CNY. The former is the value of USD/CNY that is consistent with the underlying economic fundamentals while the latter is the value of USD/CNY that will help to close China’s balance of payment surplus. Current spot USD/CNY rate is already close to ‘fair value’. However, to close China’s balance of payment surplus, USD/CNY would probably need to decline by another massive 50%. A 50% appreciation of the RMB would cause unimaginable instability not just for China but the whole global economy. US retail trade would collapse and interest rate would rise through the roof.

  • Posted by HZ


    I think the time is changing. Firstly the obvious thing is the size of China’s reserves. It might have been manageable to do 10Bs of investment in Lat Am or 50Bs of investment in Africa, but not on the scale of doing hundreds of Bs or maybe even over 1T around the globe. Secondly a couple of years back US equity investors and European banks are happy conduits of Asian savings to the rest of the world. But the flow is reversing now. Thirdly China needs to be realistic: there is no way to expect windfall returns on a couple of Ts worth of assets (that would be an equivalent folly of privatizing the SS). The best one can hope for is a stable claim (in terms of real value) of the world’s future output to fund the eventual deficit from China’s demographic gap. The alternative of stimulating Chinese population growth would be ecologically unworkable. The fact China has mostly stayed with “safe” assets like the US Treasuries shows that they are realistic (they are satisfied with near zero real return so long as it is not negative return). But USD based financial asset is not necessarily a good long term match to China’s future needs because of the currency issue. A giant multilateral loan/investment to the developing world is a better match. The developing economies have the best potential to be both its customers now and likely suppliers in the future. And the social benefit of such investment on a global scale is obvious, esp at the moment when private investors are withdrawing.

  • Posted by chaingangcharlie

    WSTRoupe :

    >it’s only a matter of when.

    Or, more precisely, only a matter of Wen ?

  • Posted by bsetser

    Indian investor — You were not the guilty culprit today. Some others were …

    incidentally, private demand for Treasuries in 08 was more like $1 trillion, tho a lot depends on how much of the $700b in foreign purchases of Treasuries really should be attributed to the official sector/ v foreign private investors. US purchases were more like $900b by my (rough) calculations.

    HZ — interesting idea.

  • Posted by ReformerRay

    “However, to close China’s balance of payment surplus, USD/CNY would probably need to decline by another massive 50%.

    Assuming value of the dollar is the only way to close the gap. If the U.S. economy keeps declining the gap will close.

    IF the U.S. decides to do the unthinkable and place a tariff on ALL IMPORTS manufactured in the five countries that create 2/3rd of the U.S. trade deficit, trade will become more balanced.

    If our foreign suppliers get rich enough and begin to pay high wages or if the U.S. gets better at electronic controls for machine tool or other new techonologies, the gap will disappear.

    Lots of way the world trade can come into a better balance. All of them are bad for the U.S. except advanced technology or deficit reducing tariffs.

  • Posted by WStroupe

    We might already be seeing the start of trouble for the Treasuries bubble. (Hmmm. Poet and didn’t know it!)

    If the price declines/yield rises on the longer-dated (10 years and greater) Treasuries that we have seen so far this year make a trend, then the trouble has already begun:

    This is already eating away at the holdings of official and private investors. We might see private investors begin to bail out of Treasuries, not China’s central bank. Then China’s CB would have little choice but to follow suit, and we’d have a real problem.

    Maybe Wen’s comments are aimed at pressuring the U.S. to make China a special case – ‘backstop our holdings, or face a sell-off’ ??

    Wen does a nudge become a threat?

  • Posted by Stefan

    I assume also Japan will play an important role going forward. Their trade surplus has turned into a deficit and demographics should support a withdrawal of foreign savings. =>treasury sales

    Later on, inflation and currency intervention could follow. =>treasury sales

  • Posted by Indian Investor

    Some elements of a lens are visible in this post. Wen’s statement is being interpreted more in the light of US interests, and less in the light of China’s interests. China’s main problem is to ensure employment, and improve the living standards of its people. That requires a lot more growth than they had from the earlier boom. The only feasible way for China to grow their economy is to industrialize their interior. As they stimulate their local economy with bullet trains, etc – their import dependence in the areas of natural resources and certain components goes up, not down. This takes you to the international finance domain – how will they finance their imports, in the face of reducing export proceeds?
    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.
    Instead they’re refusing to part with their Kung Fu dollar reserve in loans to other people, unless they get Panda Bonds for them. What this means is that you can’t pull a clever trick by borrowing their dollars, and repaying after a few years when the dollars crash. If you want to borrow their dollars, you have to give them Panda Bonds denominated in RMB, and you lose heavily if the dollar crashes later.
    What all this means for the US is that they get a few more years to handle their situation. If they judiciously reduce their dependence on imported oil, stimulate an electric car/hybrid car boom, and take the Pentagon uniforms to the cleaner’s, there’s a great deal of hope that they can extricate themselves without any default, etc. But as time goes by they need to get more and more aggressive in import substitution and go out of the way to encourage the use of alternative currencies as reserves.
    Given the convergence of China and US interests, China, according to me, should be a much closer US ally than “Europe”. The US should understand that the Russian KGB people are still waiting to see if they can retaliate for the Berlin Wall collapse.They keep instigating the Chinese to defect, and they’ve recently succeeded in getting Germany and most of Europe to their side as well.

  • Posted by WStroupe

    Indian Investor 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,…”

    How can they massively offload their USD holdings without taking heavy, unacceptable losses?

  • Posted by Andy Mok

    While China indeed faces a dilemma here, when viewed through the lens of domestic politics, it seems that reinvigorated demand for Chinese exports will matter more than nominal losses in China’s USD holdings.

    Please see my blog posting on this:

  • Posted by Indian Investor

    @WsTroupe: What China means by not having an alternative isn’t mark to market losses on the forex reserve. They mean the impact on employment levels. There’re already 20 million migrant workers unemployed, by the Govt.’s own estimates. If the profitability of exports drops, more factory closings, etc could trigger more serious problems. What they mean by exports as “a stop gap arrangement” is as follows: As their domestic stimulus sinks in and creates more opportunities, they can replace the export jobs with local ones.
    The US needs to think more seriously about domestic employment. There’re more than 38 million people in the US receiving food stamps and the official unemployment rate is above 8% now.The US is more complacent about employment because they have the unemployment dole. 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 isn’t any quick-fix, overnight, Pacific Command Neoconservative solution to the US employment crisis.
    There were supposed to be plenty of projects to re build the Govt. buildings, re work the highways, put computers in every school and so on. I’m hard pressed to know whether any of that is happening or not. How many tons of steel is the US Steel Corporation making, and what orders have they got from the Obama Administration?No idea. People are always busy criticizing China policies and such like. It doesn’t get a single job for a single American.

  • Posted by HZ

    Glad you find it interesting. I can even propose the terms for the investment: through IMF loan to the countries that have the right institutions in place, backed by said countries future tax revenue, at a variable real interest set to 1/2 of the GDP growth rate (so for US that is about 1.25% — seems fair, and also incentive to invest in countries with high GDP growth potential; this will be way below market spread for developing economies) ensuring both a fair return and a diminishing share of a growing pie (no escalating debt burden). Should also cap per country limit and cap eventual future payment each year in relation to GDP.
    Call it the world’s SS fund for China through the IMF.
    BTW an obvious good target recipient is India. Would India be happy with a 3% (real) loan if it gets 6% annual growth? I should think so.

  • Posted by yoda

    “China, according to me, should be a much closer US ally than Europe”???

    USA never see China as ally. not USA gov. certainly not USA people. China will make armagedon loss if it think it can, til USA turns it back and make China kneel and beg for its life.

  • Posted by yoda

    “backstop our holdings, or face a sell-off”??

    how can USA backstop treasury and agency? i only see armagedon loss for treasury, agency, dollar holders. default -> armagedon loss in treasury and agency. print dollar -> armagedon loss in forex and currency. and Obama is bring the world closer to armagedon in the world thru borrow and spend. do we have third choice?

  • Posted by WStroupe

    Indian Investor, and yoda:

    It truly does look to me as though the famous China-U.S. unspoken “deal” is rapidly withering on the vine, with little or no hope of revival. It’s an artifact of the old global order, the one that is already passing away, and a new one is very rapidly taking its place. The new one looks very much like one not centered any longer on the U.S. and the dollar. That’s reality in-the-making as U.S. financial/economic power wanes and as this crisis rips the old order to shreds. It’s new rules now, new realities, new challenges and new opportunities. Trying to bring back the old order, trying to revive it and make it stand on its feet, isn’t working and isn’t likely to work.

    I happen to think the knee-jerk global rush into the dollar for safety is only masking this reality, only giving false hopes that the old order can be mildly reformed and revived, and only delaying (temporarily) the emergence of whatever new order is being born now. Whether the new order can be formulated and shaped by the G20, or whether it will simply strut onto the global stage and beckon the globe’s powers to adhere to it, I don’t know. But the old order is passing away. I think that anyone whose “lens” won’t show that fact is a person who holds a faulty lens.

  • Posted by MakeMeTreasurySecretary

    The crucial point, which premier Wen certainly understands unlike most Americans, is that the dollar is overvalued and that devaluation of the dollar will be a problem, for China, and a solution, for America.

    Look at the “worst case scenario”: The dollar loses most of its value. The real economy of America, such as it is, will remain intact on the day after devaluation. The real economy will then recover much faster than would have without the devaluation. In my opinion, a much more realistic scenario is that the dollar has to drop only modestly before we see significant improvements in the vital statistics of the American economy, including the balance of payments. Not because the US will be able to compete in making clothes hangers …

    Unfortunately, the China’s prop for the dollar and treasuries has been distorting market mechanisms and has not allowed the necessary adjustments. (Unkind souls call this prop a “manipulation”…)

    Thanks to China’s economic policy vis-a-vis the dollar, we are undergoing “wealth reduction” through deflation instead of seventies-style inflation. One might say that both are unpleasant and lead to the same net result (i.e., the US becoming poorer in comparison to the rest of the world). I do not quite agree but it is a different issue.

  • Posted by yoda

    “devaluation of the dollar .. a solution, for America”??

    when such thing comes and picks up momentum, make no mistake about it. armagedon loss, mistrust, pain, suffering, fear, and hate will be shared with people around the globe.

  • 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.