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Did the Fed bail out China by buying Treasuries?

by Brad Setser
March 20, 2009

No. Not really. At least not in the sense that is usually argued. China has no need to sell foreign assets like Treasuries to finance its domestic fiscal stimulus so long as it is running a large external surplus.

But China could use a large buyer for some of its Agencies. Now it has one. Though here the Fed isn’t so much bailing China out as substituting for the falloff in Chinese and other central band demand.

And I would be curious to know if China is worried by the latest bout of dollar weakness or relieved that a weaker dollar is pulling the RMB back down. China’s biggest financial exposure isn’t to the equity market, it is to the dollar. It thus benefits financially from dollar strength. But a strong dollar also doesn’t exactly help China’s exporters. And exporters have long driven China’s policy choices.

Let’s start with the first point. Does China — as Felix’s correspondent implies — need to sell Treasuries to finance its fiscal stimulus?

The simple answer is no, it doesn’t.

Foreign exchange reserves can finance a current account deficit or a capital outflow. Foreign assets aren’t needed to finance a fiscal stimulus. The US is a case in point; it has financed a large fiscal deficit by selling dollar-denominated bonds — not by selling off its reserves. China would only need to draw on its foreign exchange reserves to cover its fiscal deficit if its fiscal deficit led to a trade and current account deficit.

And China no need to worry there. It isn’t Russia — a country that looks set to run both a fiscal and a current account deficit this year, and thus will need to draw on its reserves to meet the balance of payments needs associated with its fiscal deficit.*

Don’t take my word. Read the World Bank’s latest China Quarterly. Thanks to David Dollar, Louis Kuijs and the rest of the staff of the Beijing office, it remains the best single source for analysis of macroeconomic trends in China.

The World Bank forecasts that China’s fiscal deficit will expand by about 2.8 percentage points in 2009, with the fiscal deficit rising from 0.4% of China’s GDP to 3.2% of GDP (table 4)

The World Bank also forecasts that China will run a $425 billion current account surplus in 2008. That means Chinese investors — whether private investors or the central bank — will be net buyers of the world’s financial assets, not net sellers. China, like the Fed, will be buying Treasuries.

How can the fiscal balance deteriorate by 2.8% of GDP while the current account deficit deteriorates by only — according to the World Bank’s forecasts — 0.8% of GDP? Shouldn’t the fiscal deficit suck up some of the funds that China would otherwise lend to the world?

There is an easy answer here too: the rise in the fiscal deficit will offset a sharp fall in private investment, a fall that otherwise would have pushed the current account surplus up.

But aren’t China’s reserves falling because of China’s new spending plans? It is certainly rumored that China’s reserves fell by $30 billion in January. But the euro fell sharply against the dollar in January (after rising in December). Currency moves alone likely subtracted $40-50 billion from China’s reserves. If China’s reserves only fell by $30 billion, China was still buying foreign exchange in the market to keep its currency from rising.

Consequently, it is more accurate to say that China’s reserves are still growing, just at a much slower pace than before. More importantly, the currency slowdown in reserve growth isn’t due to a spending spree that brought China’s current account surplus down. Not at all.

Real imports — according to the World Bank (see Table 1) — fell by more than real exports in November, December and January. February will prove to be a bit different, but it is a month that is heavily shaped by seasonal factors. Nonetheless, China’s q1 current account surplus is on track to exceed its current account surplus in q1 2009, even with China’s fiscal stimulus.

On a rolling 12m basis, China’s trade surplus is at or near a record high, even including the February data. That may change if the global slump — now a quite severe global slump — continues to cut into China’s export and the stimulus reverses the slide in China’s (real) imports. But for now, China’s surplus is getting bigger not smaller.

So why has reserve growth slowed? Simple: private capital is leaving China. And that has nothing to do with the fiscal stimulus. It is tied to the dollar’s rise — and expectations that China might allow its currency to slide against the dollar to help its export sector.

For the year, the World Bank forecasts that China’s $425 billion current account surplus will lead to $425 billion in reserve growth, as “hot” outflows subside. That means that China will still be buying foreign assets, and unless something changes, it will still be buying Treasuries. Perhaps not quite at the same rate as before. But there is a difference between not buying as much and selling.

So what has China been selling? Simple: Agencies. That isn’t because China needs the money to finance its fiscal deficit, or (more realistically) to finance large capital outflows. It is simply because China seems to have lost confidence in the implicit guarantee that backs the Agency market.

What is the Fed buying: Agencies.

That helps China. If SAFE wants to lighten up its Agency portfolio — and it has a lot of Agency MBS — it can now sell to the Fed. That facilitates its exit from its large position in the Agency market. I suspect that China alone accounts for about half of all central bank Agency holdings — it is a huge player. The Fed, in effect, is making it easier for China to sell long-term Agency bonds and shift into short-term Treasury bills — or whatever other asset China wants to buy.

That help though isn’t free.

The Fed’s move has pushed the dollar down v the euro. And helped push oil up. Neither helps China financially. If China wants to shift from say Agencies to bunds, it is now easier for it to trade its Agencies for dollars, but each dollar buys fewer euros.

The dollar’s share of China’s reserve portfolio exceeds the United States’ share of China’s imports. The more the dollar falls over time, the fewer of the world’s goods China can buy with all the dollars it has salted away. And the more the dollar falls, the more likely that the RMB will eventually resume its rise against the dollar.

That also doesn’t help China financially. China’s government has borrowed in RMB to buy dollars and to a lesser degree euros, effectively opting to hold more reserves than it needs to support its export sector. The ultimate cost of that policy hinges on the dollar’s ultimate fall v the RMB.

SAFE thus should want a strong dollar, as it is fundamentally long dollars. Relative to other reserve currencies. And relative to China’s own currency.

Then again China’s policy of building up far more reserves than it needs never made much financial sense. China wasn’t all that happy with a strong dollar, even if that was in its financial interest.

The RMB has appreciated far more in real terms over the last nine months — when it has been tightly pegged to the dollar — than it ever did back when the RMB was appreciating against a depreciating dollar. My guess is that Europe is far more worried by the dollar’s recent slide than China. China — or least its exporters — weren’t happy with the RMB’s recent strength.

The Fed thus, in some sense, bailed out China’s exporters far more than it bailed out China’s reserve managers.

Actually, it makes more sense to think of the Fed as substituting for China in the market for Agencies — and other central banks — than to think of the Fed as bailing out China and other central banks. The end of the foreign central bank bid, as global reserve growth slowed and central banks shifte dto Treasuries — has had a big impact on the Agency market. That wasn’t helping the US housing market.

Nor is the Fed just stepping in to buy the Agency bonds central banks now want to sell. It is also trying to substitute for the collapse in private financial intermediation here in the US. Private banks have gone from lending huge sums for almost nothing to not lending even when spreads are much higher for the same risk.

Put it this way: foreign central banks never bought anything close to a trillion dollars of Treasuries and Agencies in a single year. A half trillion or so of annual purchases was more than enough to have an impact ..

* Russia is effectively using its reserves to make up for the fall in the government’s export revenues. Absent a buffer of reserves, that short-fall would have required that Russia reduce both government spending and its import bill.

66 Comments

  • Posted by Indian Investor

    Mr. Stroupe, Thanks a lot for very clear analysis of the approaching dollar crisis. I assume a chaotic collapse of the dollar can result if a group of very large holders of Treasuries head for the exit together. Foreign central bank managers appear to be caught between the Devil and the Deep Sea. If they suddenly stop pegging to the dollar, it can have a huge negative impact on export profitability; closure of factories and much more massive unemployment will result. So they can exchange dollars for hard assets in a steady manner, even while continuing to buy enough to maintain a peg. Fed monetization does weaken the dollar, but several countries have had to dilute their currency in the global financial crisis through the monetization route to fund their domestic stimulus packages.
    Another option for FCB dollar exit is to offload US Treasuries in favor of other government debt. This will, for instance, strengthen the EUR against USD, without weakening RMB against EUR.
    I think there’s a good chance that the process of adjusting to a new reserve will take several years, due to constraints in implementing the domestic infrastructure programs in emerging markets. Unless countries like China are able to develop their local market for employment, they can’t stop pegging to the dollar.

  • Posted by Stefan

    The dollar can only crash if the Chinese and the Arabs give up the peg. And they will not. Simple. Even the Europeans and the Japanese eye the dollar and pursue their monetary policy relative to the value of the dollar.

    We may discuss US macro here as much as we like, but when most of the world has de facto pegged themselves to the US, the only relevant macro is that of the entire world dollar zone.

  • Posted by Stefan

    The dollar printing may benefit the US more than it benefits China. And it may benefit Michigan more than it benefits Wisconsin. This does not necessarily mean that any serious tensions would arise between the geographical areas mentioned.

  • Posted by Stefan

    IF China would give up the peg, the dollar would depreciate, and the US would not need to print money.

    China pegging begets US printing.

  • Posted by WStroupe

    Stephan,

    The problem for the U.S. dollar is that if the U.S. economy and market doesn’t come back very soon, then the efforts of the Eurasia to make the transformation to a new driver, increased domestic consumption and increased trade within Eurasia, will get much greater impetus. If the rest of the world works to get past the U.S. market as the key global economic driver, then there’s much less reason and benefit in pegging to the dollar.

    In my view, by painful experience (this global crisis) Eurasia and Latin America are being forced to do just that. It hurts BIGTIME. But they’re doing it because they have no choice. The U.S. economy is unlikely to recover soon enough and energetically enough to derail this project. That bodes ill for the future of the dollar on the international stage.

    The rest of the world just waiting idly on the sidelines for the U.S. driver to recover is not an option this time around. The pain being suffered is far, far too great to consider that old option. And you’ve got potent new players like China in the mix, which you didn’t have before.

    Dollar pegs are getting much weaker legs. This crisis is a watershed for the dollar.

  • Posted by ole_charlie

    Barney Frank wants the Fed to have more oversight of the financial system. Hmmm, let’s give two quotes from guys at the Fed and let you decide if you want the Fed to have all the power to regulate our key economic component.

    “If we all join hands and go buy a new SUV, everything will be all right,” – Bob McTeer, Dallas Fed governor -2001

    “What we dearly want is for Americans to spend like Americans – to do the patriotic thing and go out and spend,” – Bill McDonough, head of the New York Fed, October ’01.

  • Posted by Indian Investor

    WStroupe: That bodes ill for the future of the dollar on the international stage.

    Me: I’m interested to know if you think a weak dollar will be good or bad for the US economy. As long as the US Treasury doesn’t face an external financing solvency crisis, the weaker the dollar, the better it is for the recovery of the US economy.
    As the dollar weakens, profitability of existing export businesses will increase, and foreign demand for US goods will probably increase as imports from the US become cheaper in local curreny terms.Both of these are good for employment levels in the US.
    There are some industries that are more labor intensive and less technology driven. In those businesses export prospects can only improve after a few years when the real wage levels of US workers are more in tune with wage levels abroad.
    Meanwhile the task is to reduce dependence on imports and create a situation of fiscal stability where the Treasury securities can be reliable without the dollar being the world’s only major reserve currency.

  • Posted by cmc313

    Dr. Sester & other esteemed colleagues:

    BOE, BOJ, the Swiss and the FED have all embraced quantitative easing. If the ECB adopts this policy as well, would it then become a coordinated policy to debase debt which winds up benefiting developed countries at the expense of China?

    My layman’s understanding is that the danger in printing money is that one’s currency loses value. But if all major economies start printing money in a coordinated fashion, their currencies should not weaken against each other. But their currencies would weaken against those of Asian exporters who happen to hold our debt. So the Chinese wind up having to revalue their currency while losing their shirt on all the debt securities they own. This in essense achieves the global re-balanching goal while helping developed countries escape from their high debt burdens.
    Could you tell me what’s the flaw in this line of thinking? Thanks.

  • Posted by LawrenceW

    The question should be
    “Did the People’s Bank of China bail out USA by buying Treasuries?”

  • Posted by bsetser

    right now dollar pegs are under strain because of dollar strength, not because the fed is printing money; to the extent that the dollar is now falling v the other major currencies that helps china’s exporters; and the concurrent dollar fall v euro/ rise in $ price of oil helps the GCC countries.

    cmc313 — if the ECB joined in, a coordinated monetary easing wouldn’t change the relative values of the major currencies, so China’s dollars would buy as many euros and india’s euros and pounds would buy as many dollar. And if china remains pegged to the dollar, it would join in the coordinated monetary easing. if the market didn’t believe that loose US monetary policy was right for China, hot money would start to flow into china. and if china wanted to maintain its dollar peg, that would imply either allowing the hot money inflows to push up China’s money supply (i.e. joining the coordinated monetary expansion) or doing a lot of potentially costly sterilization.

    The alternative is a revaluation – and then letting the RMB float, which would allow China to adopt its own monetary policy. The RMB value of China’s foreign assets would fall. But that is something that China is almost certain to have to accept at some point or another in any case. the only real question is when.

    Right now my sense is that China wouldn’t mind a weaker dollar/ looser US monetary policy all that much — as that helps reflate its domestic economy, and that presumably is china’s primary interest. it seems to me to be a strange time for China to start worrying about the external value of its portfolio now. the time to do so was a few years back, before China opted to buy up a lot of reserves it didn’t need.

    My view tho is shaped by my strong belief that China will eventually have to revalue its currency v a basket of euros, yen, pound and dollars, and thus China will take losses on its reserve portfolio (in RMB terms) independently of the policy course the US and others adopt. the underlying pressure from China’s large current account surplus implies as much. China could have protected itself by lending its savings surplus out in rmb — i.e. refusing to buy $ or euro denominated debt, and thus refusing to take the currency risk. It didn’t, and the US never committed to using monetary policy to maintain the dollar’s external value. Chinese policy makers knew the risks they were taking, and still choose to take them.

    It is now just struggling to accept the costs of that policy, just as the US is struggling to accept the costs of its policy of allowing a host of financial institutions to lever up on the back of an (implicit) government guarantee, an arrangement that let the banks pay themselves very well when markets were rising and stick most of the downside costs to the us taxpayer.

    neither the US nor chinese nor European taxpayer is going to come out of the experiment of allowing massive global and internal imbalances to go unchecked all that well.

  • Posted by bsetser

    Lawrence —

    the PBoC subsidized Chinese exporters, and as a by product bought a lot of treasuries. it never bailed the US out. its treasury purchases rose recently only because it was selling agencies (and perhaps equities), not because it was buying more us debt.

    and in my view, huge chinese inflows helped to create the conditions that led the US gov to need to bailout the financial sector. helped create doesn’t mean caused — only that chinese policy contributed to the permissive financial conditions that led to large bad bets.

  • Posted by entropymin

    http://entropymin.wordpress.com/2009/03/22/follow-the-romans/

    Debasement of currency has always been a sign of weakness and desperation, rather than financial sophistication. It is yet another iteration in the vicious cycle of inflation and debasement. Nixon would be proud.

    Instead of snickering over how clever this move is, sticking it to the poor foreign bastards who have no recourse, anyone who cares about this country should despair…

  • Posted by John

    “My guess is that Europe is far more worried by the dollar’s recent slide”

    that is not true. Euro needs to stay above 1.16-1.20 to survive, it’s that simple. Were them worried when the usd was heading down the last 5 years ?

  • Posted by gillies

    capitalism is a very resilient system. put people in gaol and take away all of their money – and they quickly find other ways to trade and keep count of who owes what to whom. cigarette standard. heroin standard.

    since 1971 the dollar and its allies are not a commodity nor a store of value but just a credit note from some controller of pixels, that is trusted because it is trusted.

    printing that fiat currency looks simple, but the maintenance of trust is very complex.

    when the g20 meet in london ( yes, i was wrong – remember i guessed that this bit of history would be made in paris ? ) they will try to agree levels of currency debasement that will ease the pressure on borrowers without triggering fury on the part of the savers and taxpayers.

    jl says : “i dont think it’s a good idea to discuss the topic on this board because of all the conspiracy “nuts” who fail to understand the world’s global imbalances…”

    but the mob who stormed the bastille may not all have had phds in politics and economics, either.

    u s c e os currently earn 350x average workers’ wages. what part of that does anyone not understand ? the g20 will meet against a background of dissent and may be upstaged by street theatre. in democracies ignorance is power.

    if the mob has concluded that they are short changed by a global elite of pixel shufflers who always load the dice against the punters and in favour of the house, might they be tempted to burn down the casino ? and who can blame them ?

    i think that the meeting is being held in london because there is a growing feeling among otherwise disparate nations that we now have to negotiate our way out of ‘dollar hegemony.’ meeting outside of the u s is significant. the next ‘bretton woods” will not be a u s vacation resort – and it definitely won’t be held around a pool in boca raton, florida.

  • Posted by surprised

    i am bit surprised Brad has yet to comment or blog on the prospects for a new global reserve, and it’s indications for the u.s. economy and/or China….

  • Posted by WStroupe

    Indian Investor,

    I think a somewhat weaker dollar is good for the U.S. economy in the sense that it helps U.S. exports. But the U.S. export sector, no matter how vigorous, can’t save a U.S. economy that signed onto the “New Economy” model (asset-based economy)to such a great extent.

    And a steadily declining dollar is bad for U.S. finances and for its financial system itself because it undermines foreign appeal for the dollar as a safe store of wealth. At present, with the huge Treasuries bubble and huge new sums of public debt coming online, that last thing the U.S. needs is to see international appeal for, and confidence in, the dollar get undermined. That would portend that the Fed would have to go to profound lengths to try to replace flagging foreign demand for U.S. debt. And that money creation would not just weaken the dollar, but it would undermine its value, and that would further undermine its international appeal. Then you’d risk having investors stampede out of Treasuries and into whatever asset(s) will become the next bubble.

    The Treasury and Fed are already on that path with their big issuance of new debt and with the Fed starting to buy it up. If this continues, and accelerates, as I think it will, then we’re on the road to undermining the currency, not just declining it to some extent.

    Brad,

    I think it would be more accurate to say that the dollar pegs are under increasing strain because of dollar volatility. Up until last summer, it was dollar weakness, and now it’s dollar strength. The dollar is giving everyone a real roller-coaster ride. It’s losing some appeal due to its wild volatility. Now, with the Fed printing money, it’s likely to swing in the opposite direction (weakness) and its likely to go much further into weakness than is desired, and much too fast than is desired. “Stability” and “dollar” have become antonyms, whereas they used to be synonyms. That’s distinctly unappealing to CBankers around the globe. Also, the weaker dollar reflating the U.S. economy is, to my mind, a bit of a conundrum. Why? Because the U.S. is trying to revive securitization (in other words, revive the asset model economy). I don’t see that happening anytime soon because of the massive cleanup of assets that has to be done (some estimates at more than $10 trillion worth). Unless you think reviving securitization has a chance of miraculously removing the toxicity of these assets? I don’t know. Global confidence in the asset-based model has been so shaken, and assets have been so poisoned. I just don’t know. I’m afraid that while the incredibly costly attempts at revival of securitization are being enacted, the job losses and consumer spending contraction may well become so severe as to nullify any benefits of an attempted revival. Because, the revival attempts rely on ‘trickle down’ in the sense that wealth will supposedly trickle down to consumers, thus lifting the real economy out of recession/depression. I’m dubious that it can do so in the relatively short time required to turn the U.S. around. And I think foreigners like China are getting more and more dubious about this too.

  • Posted by Mark

    US does not need to draw on its reserves because it sells dollar denominated bonds. How does China do it? I infer that they use their current account surplus to fund their fiscal deficit. Is this correct? A little confused…

  • Posted by RebelEconomist

    Brad,

    You repeat this argument again and again on your blog, and it is disingenuous: “the US never committed to using monetary policy to maintain the dollar’s external value. Chinese policy makers knew the risks they were taking, and still choose to take them.”

    It is unlikely that changes in the external value of the dollar could be sufficiently large to generate damaging losses for China without slippage of the internal value of the dollar, and the US do commit to that “stable prices” in the Federal Reserve Act. What is worrying the Chinese is the growing prospect of inflationary repudiation of US debt.

  • Posted by Jeff Benson

    So you’re suggesting a severely weakening dollar and a rise in inflation? I think you’re right. I think that if FCBs holding reserves in dollars begin to diversify away from USD, we’ll be at risk of hyperinflation. I think risk aversion, de-leveraging, re-regulation, and de-globalization will wreak havoc on the dollar.

  • Posted by Jeff Benson

    I should add, take into context the shear magnitude of the hole the Fed and Treasury are trying to fill. I don’t think you can’t resolve a loss of that size with shear monetary policy…or maybe, if you’re willing to compromise foreign trust in your currency, you can.

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