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“Not quite so SAFE”: This week’s Economics Focus column

by Brad Setser
April 24, 2009

This week’s Economist covers two topics that regular readers know very, very well: China’s reserve growth and China’s holdings of US debt.

The estimates for China’s US holdings in the Economist are based on the methodology laid out in a paper that Arpana Pandey and I did in January. But that paper was written before the Treasury released the results of its June 2008 survey of foreign portfolio investment and consequently the estimates in the actual paper are now a bit out of date. The last survey showed fewer Treasury purchases than we expected, and more equity purchases. * The estimates in this week’s Economist reflect the results of the last survey, and therefore differ from the estimates in the underlying paper. We should have an updated paper out soon as well.

The most recent US survey of foreign portfolio investment also showed somewhat smaller Chinese purchases of US assets from mid-2007 to mid-2008 than I would have expected — something I plan to discuss in more detail. That could be evidence of (modest) diversification away from the dollar from mid-2007 to mid-2008, but it equally could represent greater use of private fund managers. If China handed some of its reserves over to a private manager, the US survey data wouldn’t attribute those funds to China. The increase in China’s Treasury holdings last fall was far larger than can be explained by the underlying growth in China’s reserves — and one explanation for the strong recorded inflows would be that China was pulling funds out of privately managed accounts. Tracking China’s portfolio is an art not a science.**

The Economist closes with a key point: the main constraint on China’s reserve management is China’s own policy of managing its currency against the dollar.

China is trying to have it both ways. It wants to lessen its dollar exposure, but it also wants to hold down the yuan. The picture has been temporarily clouded by shifts in “hot capital” flows, but so long as China runs a large current-account surplus, its reserves will rise. In order to keep the yuan weak against the dollar, a large chunk of those reserves will end up in greenbacks. Beijing’s appetite may not match Washington’s growing need for cash. But China cannot sour on the dollar without letting its own currency rise.

China’s reserve growth has been temporarily held down by speculative outflows, but there are (tentative) signs those outflows have slowed — which implies that China’s reserves are likely to resume their steady upward march so long as China maintains a large current account surplus.

And that isn’t necessarily a good thing. Any abrupt change, of course, would be bad. The past several months have illustrated why gradual transitions that allow needed economic adjustments to take place over time rather than all at once are important. But I personally don’t think it is in China’s interest to continue to invest so much of its savings in US assets, especially on terms that imply likely losses for China’s taxpayers. And I equally don’t think it is in the interest of the United States to rely so heavily on a single country’s government for financing. A smaller US current account deficit, financed by a more diverse group of creditors, would be far healthier.

UPDATE: China’s disclosure that it has increased its holdings of gold from 600 tons at the end of 2003 to 1054 tons (worth $31b) now has attracted a bit of attention. But the rise in China’s holdings needs to be put into perspective. From the end of 2003 to now, I would estimate that China’s holdings of US Treasuries and Agencies rose from about $275 billion to $1250 billion, a rise of close to a trillion dollars. China reserves have increased enormously over this period, so it now holds more of everything. The suggestion that China has recently stepped up its gold purchases is far more significant than the total rise.

* The Setser/ Pandey methodology is pretty blind — it uses the pattern of revisions in the most recent available survey to estimate future revisions. It thus will miss changes in the composition of China’s portfolio due to changes in reserve management that occurred subsequent to the last published survey. I sometimes have a sense that things have changed, but I want my published estimates to be based on numbers that are replicable (with a fair amount of effort).
** If an informed reader thinks my estimates are off — or that I am missing something — do let me know. Feedback helps me improve my estimates.

39 Comments

  • Posted by liack

    you dont have to have a PhD to know that a single point of failure is a bad thing (for both countries)

  • Posted by K T Cat

    “A smaller US current account deficit, financed by a more diverse group of creditors, would be far healthier.”

    OK, so that’s not going to happen. Now what?

    ;-)

  • Posted by DJC.

    China’s GDP to overtake U.S. by early 2020s

    Mainland to become world’s largest in about a decade, says Deutsche Bank

    http://www.marketwatch.com/news/story/Chinas-GDP-overtake-US-early/story.aspx?guid=%7BF82D6566%2DB725%2D4D5F%2DBAA7%2D30F0E5BC7AD3%7D

    HONG KONG (MarketWatch) — China will overtake the U.S. in terms of economic output within a decade, according to estimates released Thursday by Deutsche Bank, which said it had to accelerate its forecast of the mainland’s leadership in the global economy in view of favorable growth dynamics in emerging markets.

  • Posted by DJC.

    China Premier Wen Jiabao:

    The Chinese premier has called for the setting up of an Asian reserve pool to help the region’s economies tackle the economic recession.

    In a keynote speech marking the opening of the Boao Forum for Asia (BFA) summit in southern China, Premier Wen Jiabao urged freer trade and more regional cooperation in the face of the global financial crisis.

    “Asia is one of the most dynamic and promising regions in the world economy. Together, we take up 60 percent of the world’s population, a quarter of the global economy and a third of global trade,” Wen said in Boao town, south of China’s Hainan Province on Saturday.

    http://www.globalresearch.ca/index.php?context=va&aid=13252

  • Posted by Rajesh

    China’s currency reserves don’t have to be kept in dollars, but all the other alternatives are worse. And it is not simply a matter of trade policy, there is also the effect of capital controls which tilt transactions in the capital account (FDI) in one direction. It is easy to move capital into China; getting it out is harder.

    If GM invests a $1 billion in China, they write a check to the central bank which then prints RMB and places them in a Chinese bank account. If GM needs its $1 billion back (and I can’t imagine they have any use for the money), it has to find some other foreign investor who is willing to pay dollars for the Chinese company holding the assets. FDI tends to stay in the currency reserves.

  • Posted by DJC.

    China central bank governor Zhou Xiauchuan in March called for the eventual replacement of the U.S. dollar as the world’s main currency with special drawing rights, the quasi-currency issued by the International Monetary fund.

    The implication of such a policy would be a weaker dollar, as central banks move to diversify away from the world’s largest reserve currency. And that’s something that makes a number of policy makers, including officials from the 16-nation euro zone, nervous, analysts said.

    The main thrust of China’s message is that it wants to diversify holdings of foreign exchange reserves in a way that more closely mimics the make-up of SDRs, said Simon Derrick, currency strategist at Bank of New York Mellon.

    That means going from reserve holdings that stand at more than 60% dollars to around 44%. For the euro, holdings would rise to around 34% from 31%.

    http://www.marketwatch.com/news/story/chinas-dollar-dump-plan-g7/story.aspx?guid={DFCB68AC-8BC2-4359-A1CA-76542EAFBA1E}&siteid=yhoof

  • Posted by WStroupe

    Brad,

    China’s proliferation of new currency swap agreements, clearly aimed at bolstering bilateral trade with many partners across the globe, and its domestic stimulus packages, appear to be the beginnings of a multipronged strategy aimed at relieving China’s inordinate reliance upon trade with the U.S. Admittedly, this strategy could take several years to have a big impact on relieving China’s trade reliance on the U.S. market.

    But I’m wondering if, and perhaps how soon, China may see enough success so as to deem it possible to begin letting the yuan float more freely against the dollar, thus undermining its need to keep accumulating dollars?

    Is it possible that China’s efforts along this line may begin to succeed rather more swiftly than is generally assumed, so that its peg to the dollar might be loosened, or even destroyed, within a year or two? For example, what if the U.S. economy and market don’t recover anytime soon, or if the U.S. even moves into a much deeper recession, perhaps if the U.S. financial sector soon moves into a new round of turmoil? That might force China to really maximize its other options (trade with partners other than the U.S.).

    What would the monetary, financial and trade implications be of China eliminating its dollar peg sooner than expected? How would that affect the dollar itself?

  • Posted by bsetser

    if china let its currency rise v the dollar, that would tend to help us exports — and at the margin increase the price of some us imports, encouraging domestic us production where viable. chinese financing of other countries would allow them to run current account deficits — and some oil exporters investing heavily might end up importing a lot of say drilling equiptment from the US. the basic adjustment mechanisms here aren’t rocket science. in a lot of ways, i think it makes economic sense for a portion of china’s surplus to be absorbed elsewhere in the emerging world, tho that likely implies a rise in china’s relative influence.

    then again, china also will need to figure out how to protect its interests as an investor/ lender in unstable resource exproters, and history suggests that is a hard task.

  • Posted by Indian Investor

    I suspect the adjustment mechanism is even simpler than Dr. Setser’s comment suggests. There isn’t going to be any gradual, evolutionary process, as Geithner hoped, in this adjustment away from the US dollar. The day China decides to stop buying Treasuries is the same day that the US Treasury goes into its whirlpool, never again to surface in the same form. The only thing so far that’ stopping the US Treasury from going bankrupt is the Chinese population levels that are employed in manufacturing exports for the US market. But things are changing much more rapidly than I would have thought earlier. My earlier view was that there’re still another 4-5 years left before the US Treasury goes bankrupt. Now I’m not so sure about that at all.

  • Posted by jonathan

    Your point about what would be best for the US and China is well taken but it’s difficult to see how we get there. I can see China moving to a degree toward other Asian countries, which would not only raise their influence but their risk – unless they’re really, really raising their influence and even then. But more importantly, if these countries then take the Chinese money and in turn become US creditors with that “subsidy,” then in a certain sense that’s still China’s money.

  • Posted by Glen M

    Brad,

    Has China proposed any mechanism in which to buy a SDR reserve currency? If done by a place order system, it would allow them to distribute their US dollar losses (inevitable) to those countries who’s currencies make of the SDR.

  • Posted by Cedric Regula

    KCat:”OK, so that’s not going to happen. Now what?”

    The FED is doing $300B of QE which, maybe not so coincidentally, is about equal to China treasury buys in a good year.

    Of course now the Fed can’t stop.

    The Obama 10 year budget adds $9T in cumulative national debt. Add that to the current $11T public plus SS figure we have now. That adds up to $20T.

    Nothing for Medicare in that figure. The USG says that alone will bankrupt the USG in ten years.

    Taxes have to go up. Cap and trade is on the way because we have to save the planet from carbon. A recent study came out saying that will add $3000 to your utility bill. I haven’t seen any studies on what it does to the rest of the economy and prices.

    There are some good scientific studies saying water vapor is by far the biggest contributor to global warming…not carbon. But who’s counting.

    Not to worry. Everything’s good.

  • Posted by WStroupe

    Jonathan,

    What if the Asian and other partners of China don’t, in fact, become significant U.S. creditors with the Chinese money they earn from their increased bilateral trade with China? If the U.S. economy recovers, then they would likely become such. But what if the U.S. market doesn’t recover, or even declines much further? Don’t these up-and-coming partners of China have to be planning for a prolonged U.S. downturn, or even a lost U.S. decade, or worse?

    Indian Investor’s observation that matters are moving faster and faster is something I think we need to carefully consider. As he indicates, the coming of real trouble for Treasuries and the U.S. Treasury looks closer all the time, notwithstanding the [temporary] benefits of QE. It just seems more and more as if the quality of financing the Treasury is getting is becoming more and more questionable, precarious, iffy.

    I could sure see the ‘day of trouble’ for U.S. financing of its huge and growing debt coming within a year or two. Just my opinion, though.

  • Posted by Cedric Regula

    Brad:”if china let its currency rise v the dollar, that would tend to help us exports — and at the margin increase the price of some us imports, encouraging domestic us production where viable.”

    Being 75 miles from the Mexican border, I would condider it winning 2nd Prize if we could stabilize manufacturing in Mexico.

    Right now free trade with Mexico has degenerated to tons and tons of drugs and illegal immigrants coming this direction, and stolen cars going the other direction.

    That’s not the way I think it should work.

  • Posted by gillies

    brad : “A smaller US current account deficit, financed by a more diverse group of creditors, would be far healthier.”

    the china-america dollar reserves problem is just another of those things that are “too big to fail.” capitalism – a self correcting system – is in rude good health, it is leveraged speculators who are in the sick bay. economics seems to have no word for the key concept ‘degree of fragmentation’ even though it is implied by all rules constraining monopolies.

    yes, more diverse creditors, holding more diverse portfolios is healthy. perhaps even more decentralised decision taking. definitely smaller banks and more of them.

    to illustrate this idea – imagine a game of football with one player (a big guy) per team. painful to watch. now imagine a game of football with 3000 players per team. equally painful. football (rugby football here in munster !) plays best with 31 people – that’s 15 per side and a referee – so capitalism works best with a certain balance, fragmentation, and of course regulation (refereeing.)

    the main purpose or regulation should be to avoid monopolies, or lumps of money or power so disproportionate that they threaten the overall game.

    “too big to fail” is too big to play.

  • Posted by Twofish

    Indian Investor: The day China decides to stop buying Treasuries is the same day that the US Treasury goes into its whirlpool, never again to surface in the same form.

    Don’t think so. Interest rates go up, things adjust painfully, life goes on. And then you have to ask the question of why China would want to make life tough for the United States. It’s not as if China wants to rule the world or anything like that.

    Indian Investor: The only thing so far that’ stopping the US Treasury from going bankrupt is the Chinese population levels that are employed in manufacturing exports for the US market.

    The big thing that keeps the US Treasury from going bankrupt is that it can print money. If you don’t have an external source of productivity, either interest rates or inflation will go up.

    Indian Investor: But things are changing much more rapidly than I would have thought earlier. My earlier view was that there’re still another 4-5 years left before the US Treasury goes bankrupt. Now I’m not so sure about that at all.

    It takes time for a big ship to sink. The United States has had ten years of probably the most incompetent and disastrous economic and political policies that you could imagine, and will you merely have moderate problems.

    Ultimately, you have to look beyond economics at people, and I have a lot of confidence in the American people and more importantly the American political and economic system to work things out.

  • Posted by don

    The Economist (for which I have little respect) “so long as China runs a large current-account surplus, its reserves will rise.” Again, cause and effect reversed. It is the increase in official reserves that drives their trade surplus.

  • Posted by don

    I don’t think the U.S. neeeds any net foreign borrowing. The problem now is that desired domestic savings is outstripping desired domestic investment, with a resultant deficit in aggregate demand. If foreign official inflows and the trade deficit were reduced, we would have less unemployment and less need for deficit spending by government to maintain aggregate demand.
    Nor do I believe the U.S. needs to borrow to fund bank bailouts. The bank losses should be borne by the creditors, including foreign creditors, with the sole exception of retail bank depositors.

  • Posted by Ying

    Gillies,

    There are military monopoly, financial monopoly, industrial monopoly and ….

    There is no shortage of monopolies today. Unfortunately one aspect of the whole will not be able to dominate others. It’s the same thing as to ask a child a question about what the power is. Different people might have different answer such as technology, knowledge, beauty, wealth or military etc. In Chinese words, these things change over time. Not sure about the solution though. Monopolies will never willingly to go away by themselves.

  • Posted by Twofish

    don: If foreign official inflows and the trade deficit were reduced, we would have less unemployment and less need for deficit spending by government to maintain aggregate demand.

    It’s certainly not obvious that this is the case. There are a vast number of jobs that depend on the trade deficit either directly or indirectly. Even if you were to make the argument that in the long run, that a more balanced trade deficit would create more jobs, in the short run, you are looking at a massive economic disruption as trade related jobs just disappear.

    You run into a trap in which if you sudden reduce the trade deficit, lots of jobs disappear, and to create new jobs you need some massive borrowing to create industries that create jobs, at which point the amount of credit that you need vastly increases.

  • Posted by Twofish

    gillies: economics seems to have no word for the key concept ‘degree of fragmentation’ even though it is implied by all rules constraining monopolies.

    The trouble is that in order to prevent concentrations of political and economy power, you need to concentrate political and economic power.

    Who watches the watchmen?

    It’s also far from clear tnat lots of small companies will be better for capitalism than a few big ones. There are just as many badly run small banks as there are badly run big banks, and a thousand busted small banks will give you as many headaches as one busted big one.

    It also doesn’t help that the standard operating procedure for a bank failure is to have the deposits absorbed by a bigger bank. If all you have are small banks, then that strategy won’t work.

  • Posted by Twofish

    WStroupe: But what if the U.S. market doesn’t recover, or even declines much further? Don’t these up-and-coming partners of China have to be planning for a prolonged U.S. downturn, or even a lost U.S. decade, or worse?

    In the case of China, it probably doesn’t matter much. The things that China has to do are roughly the same no matter what happens to the US. Even if the US totally recovers, the economic situation of the last ten years will not repeat. By focusing on exports, China was able to generate employment for 50 million migrants. Even if everything goes back to 2007, China still has the problem of generating employment for the 400 million waiting in line after them. Now it will be easier to create jobs for 400 million than for 450 million, but not by much.

    WStroupe: As he indicates, the coming of real trouble for Treasuries and the U.S. Treasury looks closer all the time, notwithstanding the [temporary] benefits of QE.

    Well it is. If the economy does not improve, then there is no way that the US can maintain current spending patterns for five years without serious economic problems.

    OK, we agree on that….. Now what? Just because you will eventually run out of water doesn’t mean that you shouldn’t try to put out the fire. If we get to September, and the economy looks like it’s not improving then we have to try something else.

    What Obama is doing is dangerous, risky, and is setting the US up for tons of problems further in the future. The US is going to come out of this with a massive debt that it has to deal with. One reason that people are going after this plan is that this isn’t the first time the US had to do something similar. It took some massive deficits in the 1940′s and the 1980′s and the standard critique for why the Great Depression lasted as long as it did was that the governments weren’t willing to print massive amounts of money until World War II.

    But right now it doesn’t seem to me that there are any better ideas. The only alternatives that have been suggested seem to involve letting things fall apart and “magically” sorting themselves out.

  • Posted by gillies

    twofish – there is a name for letting things fall apart and magically sorting themselves out, it is called deregulation.

    next time we could try more regulation in the boom phase, and deregulation in the bust phase ?

  • Posted by Tono

    As usual, I am more concerned about QE than most. The coming Treasuries crisis and the dollar crisis will likely be one and the same. Lets not forget that the total current amount of QE on the table is $300 for Treasuries, $200 of agency and $1.25Tr of MBS, of which the Chinese have been strong sellers. In February they were net sellers for the second month in a row. We are also led to believe they are SHORTENING the maturity distribution, so they can continue their peg but buy shorter-dated paper. If this becomes a trend, it marks the beginning of the end. I’ve written more about that here:

    http://www.debtorsprisonblog.org/journal/2009/4/18/the-beginning-of-the-end-demand-for-long-term-us-debt-has-dr.html

    I’ve also been tracking the Fed Balance Sheet QE program on a weekly basis. I provide nice chart and overlay the 30yr yields to gauge the hidden costs of QE:

    http://www.debtorsprisonblog.org/journal/2009/4/24/fedbs-qe-weekly-update.html

  • Posted by Indian Investor

    The critical issue to understand is whether the US Treasury is solvent on a stand alone basis, or dependent on financing from foreign central banks, such as the PBoC. My reasoning is that if a Sovereign is able to pay interest out of the excess of its annual reveues over its outlays for operating expenses, sufficient to service its debt that is invested on items that create a long term benefit through expanding the GDP, it can be considered solvent on a stand alone basis. Think of this as a ‘debt trap’ reasoning for Sovereign finances. If a Sovereign is paying interest on its debt out of the realization from its borowings, it has reached the second derivative of debt growth.
    According to the latest (March 2009) monthly Treasury statement, (Table 09 on Page 30, Summary of Receipts by Source, and Outlays by Function)Total Receipts for the month was $ 128,957 million. Total outlays for the month were $321,230 million. The outlays for health ($33,463m), Medicare ($23,499m), and social security ($ 56,103m) alone total to $113,065m. Add the outlay for ‘income security’ ($52,521m) and you have a total outlay of $165,586 m, which far exceeds the receipts.The National Defense expenditure was $51,674 m in a single month.
    My calculation is that the US Treasury is hardly able to meet its obligations towards healthcare, Medicare and social security out of its receipts.
    In a situation where the Us Treasury’s operating expenses to provide regular services are far higher than its receipts, there is no justification for any private lender to consider it solvent and a worthwhile borrower on a stand alone basis. The US Treasury is in a permanent debt trap from which it will never be able to extricate itself.
    The factor that has been running the US Treasury is the private reasoning and assumption that the dollar hegemony will ensure continued purchases of US Treasury debt by foreign central banks. That has changed.
    It’s quite clear that going forward, China has no option but to diversify its exports away from the US, and the de-coupling is likely to belatedly begin. Foreign CB purchases are limited by the amount they need to buy to maintain their peg to the dollar. Given the crisis-driven expansion in US Treasury outlays and planned borrowings, there is a significant funding gap. Private lenders no longer have confidence to lend enough to meet that gap, because of geopolitical shifts that imply the collapse of the US military-diplomatic hegemony over the world.
    Pending any major unforeseen developments, the United States Treasury will spectacularly collapse before the end of Summer 2009.

  • Posted by WStroupe

    Indian Investor said: “Pending any major unforeseen developments, the United States Treasury will spectacularly collapse before the end of Summer 2009.”

    There’s a compelling logic to this position, when one considers ALL the relevant facts. It’s hard to see around this prediction, though the timing (by the end of this summer) is perhaps up for grabs. Having said that, though, I think it’s certainly possible, maybe even likely, that late summer/fall of this year will bring the great upheaval most of us are worried about, but tend to deny or put off to a much farther time out, maybe 2-5 years in future.

  • Posted by gillies

    yes. if a lobbyist makes a campaign contribution to lawmakers who pass a measure that is favourable to the interests of the lobbyist who is then in an enhanced position to make campaign contributions to lawmakers . . . .

    is that a bubble ?

  • Posted by gillies

    i think the point i was replying to has disappeared ?

  • Posted by jonathan

    I see the IMF is going to issue bonds but I don’t know from the brief news story how that differs from the NAB (new arrangements to borrow – love that one) potential they have.

  • Posted by WStroupe

    Emerging economy governments, smartly, want higher yields from IMF bonds than Treasuries offer, and they want more power in the IMF, before they invest. See: http://www.bloomberg.com/apps/news?pid=20601087&sid=ai8Eko7vcXBk&refer=home

    I think they’re going to demand that the SDR basket be widened to include more key currencies, too.

    I think we’re perhaps a few weeks/months from seeing the IMF bond idea coming to fruition, but I think it will happen this year. That’s going to afford China and other central banks a means of expending some dollars to buy the new IMF bonds, offloading some of their dollar risks onto the IMF.

    Might this IMF bond offering really begin to compete with/endanger the bubble in Treasuries if and when central banks increase their moves to place more and more of their forex reserves under IMF management? If we were to soon see CB purchases of Treasuries dented by CB purchases of IMF bonds, global investors might discern a new trend – could catch fire at some point and make investors seek to protect their investment from a potential bursting of the Treasuries bubble. They might seek to hedge potential losses in Treasuries by moving some wealth into certain opportunities in some of the more stable emerging markets and into non-financial (hard) assets, rather than keeping too many ‘eggs’ in the Treasuries basket. We’ve seen this outrageous, excessive and unsustainable piling into Treasuries (short-dated), for safety, but also, very significantly, for the very high liquidity it affords. That implies investor wariness as respects dollar-denominated assets, and it implies a radically heightened readiness to move at once, if need be, to something else, if and when ‘something else’ becomes more attractive as respects profit and/or safety.

  • Posted by Indian Investor

    Following is my summary of Brad Setser’s reasoning on recent global capital flows. The IMF COFER data is the source of the forex reserve position of global central banks. PBoC’s reporting of its forex reserve position, including the line item on ‘other forex assets’ of China’s banks, provides the total forex reserves number for China. The annual TIC survey of foreign holdings of dollar denominated securities provides the percentage of dollars in China’s forex reserves, as of June every year.
    The latest survey data showed that as of June 2008, of the total forex reserves from the COFER data, only 34% was accounted for in terms of dollar holdings, as opposed to 45% previously. This is a major indication of a global shift in the composition of forex resevre composition away from the dollar.
    However, adding the increases in the Fed’s custodial holdings of Treasuries on behalf of foreign official investors, from the week ended March 04 2009 till April 22 2009 you get a total increase of $74,797 million, or around $75 billion. Historically, the Fed’s custodial holdings track the estimated total dollar-denominated reserves. Brad Setser’s opinion is that the $75 billion increase since the end of February 2009 may not have happened without Chinese purchases of Treasuries.
    According to me there could be two alternative explanations for this rise. The increase could be due to foreign CBs shifting their existing holdings away from the secret banking zones and tax havens to the Fed. Or it could be due to recent purchases by foreign CBs.
    In the latter case, it’s quite possible that the recent rally in stock markets caused an outflow of USD into emerging markets. This would have been offset by foreign CB purchases of Treasuries to maintain their dollar peg.TIC data till February 2009 doesn’t show such an outflow. There was an outflow of around $27b in Jan 2009 towards purchases of foreign bonds by US residents, and otherwise there’s been a capital inflow to the US.
    There has been some FII activity in emerging market stock exchanges but I don’t think that’s significant enough to justify an increase of $20 b and $41 b in the Fed’s custodial holdings in March and April 2009 respectively.
    The only hope is that a new cycle is developing, with increased flows into emerging market stocks justifying higher foreign Treasury purchases, which in turn will fund US Treasury’s economic programs.
    Meanwhile a new Department of State Green Revolution is taking root. Lenovo, Dell and Compaq are now manufacturing green computers, with recycled materials and lesser energy consumption.Some green-certified buildings are being built.
    Perhaps this is what Dr. Bernanke was referring to as ‘green shoots of recovery’.
    I have till tomorrow morning to make up my mind on what’s really happening. If the Fed’s custodials are not new foreign purchases, as I mentioned above, the US Treasury funding shortfalls will cause the alarm bells to ring loudly and insistently, triggering global pandemonium, before hte summer is up. April os a good month for the US Treasury. The April 2009 tax collections will be used to shore up the floundering General Motors Corporation for $50 billion.

  • Posted by Twofish

    Indian: The critical issue to understand is whether the US Treasury is solvent on a stand alone basis, or dependent on financing from foreign central banks, such as the PBoC.

    This analysis doesn’t work because all governments are insolvent.

    Indian: My calculation is that the US Treasury is hardly able to meet its obligations towards healthcare, Medicare and social security out of its receipts.

    And none of this matters because governments can raise taxes or print money. You need to look at the degree to which the US can raise taxes (and it could raise them quite a lot) or print money (which in the case of the US is infinite).

  • Posted by Cedric Regula

    So…there you have it, Injun. The USG can raise taxes a lot and/or print an infinite amount of money. Some news that will make all Americans, and creditors, sleep better at night, I’m sure.

    But timing this is difficult. The Fed is going thru an experiment right now with $300B of QE in an attempt to find out how long the fuse is before it lights something on fire, and what that something will be. Some people think the Fed will try printing far more than $300B.

    The Japanese did $300B of QE around the 2002 time frame. They are about half the size of the US economy. The results were kind of like a dud going off, a tiny impact in reversing stag-deflation. But Japan was a net exporter, and has a high personal savings rate and large private savings pool.

    So past performance in Japan does not reflect future performance in the US. However, there are now concerns about whether the Japanese government is “solvent”… er, I mean can it service and/or roll over its debt in the future.

    And we know in the case of the US, we are now more and more t-bill financed than t-bond financed, so we are like a hedge fund(Treasury) with the backing of a Pawn Shop (Federal Reserve balance sheet assets) that is lucky enough to have a printing press with plates that pump out a reserve currency!!!!

    So put that in your hookah and smoke it. Your forcasting ability will be just as good as a Cray computer running an economic model.

    On the other hand, this last month I made 10x more with my double t-bond short than I would have made being “long” and collecting the interest. Still I do worry that we may print some deflationary econ data later this year that may present some bumps in the road to a short position.

  • Posted by Raj Yerasi

    I have a big-picture question (for Brad or anyone who cares to respond)… Let’s say China keeps its currency pegged to USD at the same rate. Given the recession in the US, the trade deficit narrows, which means China buys fewer US Treasurys. Setting aside other factors, that by itself puts upward pressure on Treasury yields.

    However, the Fed wants to keep Treasury yields low to keep mortgage rates low to help support the housing market. The Fed also wants to avoid deflation at all costs. Therefore, the Fed will continue buying USTs, and China buying fewer USTs just means the Fed has to buy commensurately more to keep the yields at the same low level.

    At some point, that could mean more than just mild inflation. It could mean inflation in excess of 3%. If the 10-year Treasury yield is kept below 3%, then that implies a negative real interest rate on the long end.

    I guess my question is, is this possible to achieve, in practice? Or would investors just dump their Treasurys (why hold onto something with a negative real yield), thereby pushing the yield up? And if the Fed responded by buying more aggressively, then that would increase inflation expectations even further, making the Treasury yield even more negative, causing more investors to sell, basically causing a downward spiral. In which case, the Fed would lose the ability to sit on the yield curve at the long end.

    Is this a real scenario? How would things likely play out? In addition to the Chinese buying fewer Treasurys, one could posit other phenomena (like peak oil causing inflation again) that could jeopardize the Fed’s control of the long end.

    Thanks,
    Raj

  • Posted by Cedric Regula

    Raj:”Is this a real scenario?”

    Any other scenario would be unreal. To continue along this line of thinking, a rational market would demand a real return. Since all interest rates should go up with t-bond rates, we kill old mortgage paper(and the banks and investors holding it) and new mortgage rates go up, killing housing prices more.

    The Fed could try and buy all debt past and future, but we would get a currency crisis along the way. By now private capital is wiped out.

    The final hypothetical endpoint is the Fed and Treasury IS the financial system and the US is the only country that uses Dollars. In other words, we become a perfect communist country…by accident.

  • Posted by WStroupe

    Raj Yerasi,

    The USG is indeed playing ‘chicken’ with just the kind of downward, self-reinforcing spiral you outline.

    They’re putting the proverbial microphone ever closer to the speaker, hoping to get a controlled, short-lived screech out of the sound system, a screech that livens up the presently dead securitization party again. They are assuring everyone that they can manage things to keep the ‘screech’ from becoming an ear-deafening howl that swiftly blows out the amp.

    Maybe they can manage it. But very likely, they can’t as well as they think they can. As someone here said, it’s an experiment, but with gargantuan stakes and risks. Someone else here asked what choice they have? None I can think of, none that are viable or acceptable.

    QE, where you issue new debt and then just print money to buy it up yourself, is dangerous for the reasons you outlined. Dangerous self-reinforcing feedback scenarios that aren’t easily controlled can get started.

  • Posted by SLR

    Brad,

    Were you misquoted by the Economist article or will the following information be clarified in your updated paper on China’s 1.7 Trillion Bet? In the Economist article it states that 30% of treasury purchases were made through London from 2006. Yet on page 12 of your January 2009 paper, it almost doubles that number to 59 percent. Has the data changed?

  • Posted by bsetser

    SLR — I was not misquoted. the 59% number was for the period between the June 2006 and june 2007 surveys. That was the best available data when we wrote the initial paper. From June 2007 to June 08, china accounted for only 13% of Treasury purchases through london. taking into account the larger scale of the slows from june 07 to june 08, the weighted average over the two year period was a bit over 30%.

    basically, the 07 survey proved to be a bad guide to the 08 survey. in 08, Russia and Japan were larger buyers through the UK than I expected, and China was a smaller buyer — i.e. the 07 survey was an imperfect guide to the 08 survey.

    china incidentally accounts for a larger share of the Agency flow through HK and the UK than of the Treasury flow.

  • Posted by DOR

    DJC,

    It took a couple of minutes, but I finally came up with a couple of scenarios whereby Deutsche Bank’s prediction of China overtaking the US by 2020 might come true.

    Scenario A: China grows in real terms by 13.5% p.a., the US by 0.5% p.a.
    Scenario B: China grows in nominal terms by 13.5% p.a. and at the last minute revalues by 23%; and the US grows by 0.5% p.a.

    Can’t seem to get to the 2020 date any other way.

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