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China’s compensation for taking dollar risk …

by Brad Setser
May 9, 2009

I am at a conference and haven’t had time to delve into the results of the stress tests — or to really delve into Friday’s news flow. Normal blogging likely will resume on Monday.

In the interim though, I thought it would be interesting to do some quick calculations to see how much interest income China has been receiving on its US bond portfolio. The US BEA provides a fairly detailed breakdown of the United States’ income balance with China. As one would expect, the US is paying far more interest now than it did in 2000 — or for that matter 2004.

The US data likely underestimates payments made to China in 2008 — largely because interest payments are calculated — I suspect — based on the information in the survey data (if the US knows the coupon on the bond and the holder, it can estimate payments) and the 2008 data hasn’t revised to reflect the last survey. Moreover, the US data — even after the survey revisions — likely understates China’s holdings on US corporate bonds.

Nonetheless, it is possible to compare the interest the US is paying to China to a very rough estimate of China’s US holdings — and thus to calculate the implied interest rate China is receiving on its investment in the US. The average interest rate the US is paying has clearly turned down:

The estimate of China’s US assets I used for the calculation is very very rough — I assumed 70% of China’s total (non FDI) foreign assets are in dollars, and compared the rolling four quarter sum of interest payments to China’s estimated average holdings of dollars over the past four quarters. If I had taken the time to convert my monthly data on China’s estimated US holdings into a quarterly data series, I could have produced a better estimate — one that no doubt would show that China is receiving a slightly higher average interest rate on its US holdings. (the calculation above slightly overstates China’s holdings of US bonds, and thus understates the average interest rate on those bonds)

Directionally, though, there is no doubt that the average cash return on China’s bond portfolio is falling, as one would expect. And it no doubt has further to fall, especially now that it has shortened the maturity of its Treasury portfolio by buying so many Treasury bills.

While the market value of China’s long-term bonds soared during the crisis — that doesn’t provide much comfort to an institution that doesn’t mark to market. Conversely, China’s cash compensation for taking dollar risk is falling.

That though was a risk China’s government opted to take when it opted to maintain an undervalued exchange rate and thus to accumulate dollar assets. There was always a risk that the renminbi value of China’s dollar bonds would fall. And by say 2003 it wasn’t exactly a secret that the Fed tends to respond to a US slowdown — and a fall in US inflation — by cutting US policy rates.

35 Comments

  • Posted by Rajesh

    It would be nice if you could add U.S. inflation on the chart so we could get a sense of real interest rates. Some of the drop in interest rates are due to the drop in inflation after the dot-com bubble burst.

  • Posted by Thomas

    I agree with Rajesh. The nominal interest-rate doesn’t really matter all that much, the real rate of return is what counts.

  • Posted by Cedric Regula

    On Friday the buck fell in a pothole after bouncing along aimlessly ever since the March Fed QE announcement. Down 1.76% in one day!

    http://quotes.ino.com/chart/?s=NYBOT_DX

    Euro has strengthened as a result of Fed QE, even tho they did recent rate cuts to 1%. The Pound has been relatively strong, maybe for the same reason that bank stocks go up….something beyond rational comprehension.

    So far the t-bond shellacking hasn’t really correlated with any severe dollar weakness. By Wall Street standards, I’ve been up a handbag a day for 8 days on my t-bond short, then Thursday I had a two bagger. Friday was flat. Rest break I guess.

    I’ve had some worries the stress tests would re-ignite deflationary fears and support the long end on bonds. But no, huge supply seems to over ride everything so far.

  • Posted by Cedric Regula

    Then it’s always fun to look at minor currencies to gauge the world’s risk appetite.

    On Friday the heavies like Hungarian forint, Kenyan shilling,Estonian koon and croatian kuna all kicked the crap out of the greenback. What’s in your wallet?

    http://quotes.ino.com/analysis/extremes/Foreign_Exchange

  • Posted by bsetser

    If China arguably should care far more about nominal $ returns and changes in the USD (vis a vis the RMB or vis a vis a broad basket of china’s trading partners) — i.e. the purchasing power of china’s $ assets outside the US — than the US real rate (the purchasing power inside the US). A high real yield (nominal yields above nominal inflation) and a big dollar depreciation might not be great for china.

  • Posted by Cedric Regula

    Brad:

    Ya! That’s how it works!!!!

    My foreign bond fund pays 7-8% annually, but up 10% in NAV in 6 weeks so far. Not bad for a 5 year average portfolio duration and average A credit rating.

    Compare that to a 5 year t-bond yield and the 6 percent (phony) inflation number we had last year..

  • Posted by Adam

    Brad:

    Why the 70 percent assumption? I assume that this is close to historic levels of holdings by the People’s Bank of China?

    Given that People’s Bank of China chairman Zhou Xiaochuan called for increased global use of SDR back in March, do you expect any sizable change in the composition of Chinese holdings in the near future?

  • Posted by Tarantoga

    The longer China reinvests their returns in the US, the more of the reinvestment will be needed for the US to pay the interest. Isn’t it great to be deep in debt?

  • Posted by FollowTheMoney

    The Austrian school of economics notes the magnitude of the decline mirrors the excesses and imbalances created in the prior boom.

    The current policy of trying to reflate the bubble, encourage spending, encourage more debt, more borrowing is not good news.

    The current playbook (printing and borrowing more) may have people excited for what the govt is doing now, but these are certainly not long term fixes.

    This is going to end badly, in my opinion a pop in the T-bill bubble and severe currency crisis may unfold 1-2 years out. Investors should get out of the market and buy ‘real’ assets.

  • Posted by Rajesh

    I am not particular which measure of inflation you use. CPI seems silly for China but the price of an ounce of gold or a barrel of oil or a ton of copper would give a sense of the purchasing power that the Chinese gave up to hold on to dollars in their currency reserve. In 2007 and 2008, the prices of industrial commodities and food went up; while the interest rate on their bond holding went down.

    The Chinese seem to be accumulating dollars when they had the least incentive to hold them.

  • Posted by Cedric Regula

    Except that the Dollar index went from 70 to almost 90 from mid 2008 on. Currencies of places that sell industrial commodities probably fell further.

    So it hasn’t been bad lately, but the party seems to be ending.

  • Posted by HZ

    Inflation rate won’t be very useful. China won’t be paying for things like rent (housing), health care, education etc from the US which are a big part of CPI. China will likely be buying commodities (volatile) and technology/equipment (non inflating if not deflating after adjusting for quality).

  • Posted by CJ

    A few weeks ago, Charlie Munger was asked what he thought of Chinese economic policy at the B-H annual meeting. I expected him to reply that their dollar holdings were a big risk for them, and that they were making an unwise trade. Instead, he said they were doing things ‘exactly right’.

    My understanding of his full point was that the Chinese are getting more than (short-term) employment gains and (value-losing) treasuries from their surplus-recycling. They are getting major capital investment in physical factories, worker training, etc. These assets have lasting value, and are being developed far faster than internal demand/financing would allow.

    So, if the value of the capital investment they get is high and lasting (which seems plausible), maybe they don’t care if their treasuries lose some value.

  • Posted by jonathan

    I know, mostly from reading your stuff, that the RMB has been essentially flat versus the dollar but isn’t there inflation in China? If we treat the two as pegged, then the nominal to real issue is domestic to China.

  • Posted by Awake

    Chinese economic policy has boxed itself into a scenario where the logical rules of the game dictate two scenarios- steadily increase holdings of dollars to hold down their own exchange rate (buy dollars), accepting ever increasing dollar risk to do so, or convert dollar holdings to other assets (sell dollars), causing their exchange rate to rise and export rates to fall.

    Their response? Politick their way out. Neither of these two choices is acceptable to the nation that has been “so helpful” and generous in terms of extending credit to the US, so there must be a way for the world to switch to a new reserve currency in a way that does not harm China’s existing dollar assets or unduly influence its exchange rate.

    I have little sympathy for the Chinese. They made their bed, now let them lie in it. At the end of the day, they won’t let the dollar crash – because they’d have 50 million people out of work in under a year with nothing to do except march on Beijing.

  • Posted by Twofish

    FollowTheMoney writes: The Austrian school of economics notes the magnitude of the decline mirrors the excesses and imbalances created in the prior boom. The current policy of trying to reflate the bubble, encourage spending, encourage more debt, more borrowing is not good news.

    That’s assuming the Austrians are right, and most economists believe that the Austrians are wildly wrong about about what happens in the middle of a credit bust, and that the correct policies are to do exactly the opposite of what the Austrians think should be done. I personally think that von Mises did some wonderful analysis of the “socialist calculation problem” and some very good analysis of what happens in a credit boom, but that he was totally wrong about what happens in a credit bust.

    Anyway we’ll find out over the next year or so.

  • Posted by WStroupe

    FollowTheMoney said “This is going to end badly, in my opinion a pop in the T-bill bubble and severe currency crisis may unfold 1-2 years out. Investors should get out of the market and buy ‘real’ assets.”

    Exactly.

    When the present rally on Wall Street folds, as it must inevitably do because it isn’t based on any solid turnaround in the fundamentals of the U.S. banking and/or economic sectors, then risk aversion will return with a vengeance and investors will flee back into the dollar (Treasuries) yet again, but not into anything but the very short-dated assets. Thus the Treasuries bubble will balloon to even greater proportions, so that when the rupture does come it will be a grand and very destructive affair.

    At some point fairly soon a “correlation of forces” (pardon the cliche) should arise wherein the investor reflex of taking refuge in the dollar gives way to a more reasoned and intelligent decision to take refuge in “real assets” such as those favored by Jim Rogers and George Soros, mainly those strongly oriented toward BRIC. These will emerge as more desirable stores of wealth, and eventually even as appealing profit opportunities.

    “Decoupling” is going to happen. I’m sorry that the term and concept have been discredited so much in the recent past via too much media hype followed by the severe buffeting BRIC and the rest of the emerging markets have been enduring in this present crisis. The beginnings of decoupling have been set in place and rapid progress can now be made over the next 12-24 months so that the inordinate reliance of the emerging economies upon the U.S. can be broken. Look at Brazil and China in the news, for but one example. So “decoupling” is one force of the correlation of forces that I think will bring about new equations in risk assessment – pointing away from the dollar and toward the emerging markets that are heavily oriented in real assets.

    Another of the forces is pointed to by China’s most recent warning that Treasuries and the dollar are not safe going forward since they both will be ravaged by the QE experiment.

    Yet another of the forces is over-supply of U.S. sovereign debt.

    Another is the impending, full-blown credibility crisis unfolding against the stress tests and their results. This heavily impacts fundamental confidence in the U.S. financial sector and the U.S. government.

    Another of the forces is the inevitable moves by China to decrease its own presently high exposure to the dollar, moves which I think it will not be entirely successful in masking from the markets. I don’t predict a big sell-off of Treasuries, but I do think China’s going to sell long-dated assets commensurate with the unfolding success of its “decoupling” efforts. It might look like conversions from long-dated to short-dated. Then it would expend the short-dated assets in conversions from dollar to other assets. This is going to take place over a number of months months, to perhaps a year or two or maybe even three, and without a big nasty sell-off that would shock the markets.

    BRIC sees its fortunes lie with each other and the rest of the world, and much less with the deeply troubled U.S. This is going to translate into real decoupling. That will be one of the big stories of this global crisis, that it actually worked to bring about decoupling. The negative repercussions for the dollar and the U.S. economy will be obvious going forward.

  • Posted by Twofish

    CJ: So, if the value of the capital investment they get is high and lasting (which seems plausible), maybe they don’t care if their treasuries lose some value.

    I also have broadly similar views. The thing about Chinese Treasury losses is that they are nicely hedged. If the RMB rises in value and the US dollar drops, then Beijing loses money, but in this situation there are about a dozen things that they can do to fix the problem, because a rising RMB and a weak dollar implies a strong Chinese economy.

    In a crisis, the dollar rises and the RMB falls, which means that when you have an economy mess, the reserves grow in value, and when you have a strong economy, the reserves drop in value. That’s what reserves are supposed to do.

  • Posted by Indian Investor

    Follow the money: This is going to end badly, in my opinion a pop in the T-bill bubble and severe currency crisis may unfold 1-2 years out.

    Me: I’m afraid the alarm bells might start going off all around the financial world well before then. I still haven’t taken any new position in the market and I’m still on a wait and watch mode. Many of the US Treasury’s programs are getting cancelled; for instance it’s now not clear whether they’ll be able to bail out large firms like GM; and whether the banks will continue to enjoy good credibility. Things fall apart, the Center cannot hold…

  • Posted by Cedric Regula

    Johnathon: re chinese inflation

    They do have inflation(or did). When a Chinese company puts their dollars in the bank, they want RMB in exchange and the PBoC must print them.

    Thru most of the decade the PBoC has been fighting inflation. They have been raising interest rates but that along didn’t do it. Then they went the bond sterilization route a bit. Then they finally raised the state bank’s reserve requirements to drain liquidity. I think Brad has referred to dollar reserves at state bank level as “hiding reserves”, but I think it may really be monetary policy.

    In fact raising reserves/raising capital requirements are the last tool our Fed has left to drain liquidity when that day comes. It should “work”, but then again it will be a matter of when the Fed really wants to put the brakes on. They seem to have a higher tolerance for inflation/asset bubbles that the rest of us.

    So it will be “Your Tax Dollars Not At Work”, but, what the hell, it’s a government program.

  • Posted by gillies

    bubbles -

    a bubble is when interest rates are less than inflation – so that people are in effect being paid to borrow money. people being paid to borrow money buy anything that might go up in value. then things go up in value because people are being paid to drive them up.

    sorry to be simplistic.

    so when the tide turns, many loans are not covered by the income if any generated by the purchased asset.

    so the whole bubble – outcome now being obvious to all – is caused by negative real interest rates.

    so what is the cure ? whatever policy you like – policies that lower interest rates further, or policies that raise interest rates.

    so how do you know if it is working ?

    the problem is caused by negative real interest rates – so the problem is only over when real interest rates are positive.

    as when interest rates are zero and deflation at -5%.

    so we will soon be out of this ?

  • Posted by Cedric Regula

    gillies:”so we will soon be out of this ?”

    The problem right now is interest rate policy in ineffective, ie. influencing spending/investment thru the price of money.

    We are in debt deflation fighting mode now, which is being fought with fiscal bailouts and Fed quantitive easing…ie adding quantity of money.

    Typically recessions that start with financial rather than business cycle reasons take longer…historically 2 years based on global studies. If they are global busts ,that is the worst case.

    But we have the unprecidented situation where the consumer is maxed out on credit, many corporations too, an unwillingness by corporations to invest in the US due to percieved inadequate returns, and a government that is on the way to being maxed out.

    The academic solution to this is to wipe out all debt and start the game over again, but creditors and savers don’t like that solution very much, and many of us don’t really want a job so we can grow the economy again.

    So the likely path is similar to Japan. A slow healing of the financial system and borrowers slowly paying down debt. We just need to keep the economy alive enough so that can happen.

  • Posted by djc

    The government has pumped billions of dollars into construction projects and other spending aimed at stimulating demand and propping up growth. Recent improvements in manufacturing, auto sales and real estate transactions are seen as evidence the strategy has begun to work, despite persistently weak demand for Chinese exports in overseas markets.

    “Deflationary concerns appear to be subsiding as the economy shows signs of recovery,” Jing Ulrich, chairwoman for China equities at J.P.Morgan said in a report to clients.

    http://www.nytimes.com/aponline/2009/05/10/business/AP-AS-China-Inflation.html?_r=2&partner=rss&emc=rss

  • Posted by Twofish

    gillies: so the whole bubble – outcome now being obvious to all – is caused by negative real interest rates.

    Something like that.

    gillies: so what is the cure ? whatever policy you like – policies that lower interest rates further, or policies that raise interest rates.

    The thing about these credit bubbles is that eventually they blow up, at which point markets break down and you can’t get credit for useful things. At that point, the anti-Austrian solution is to flood the markets with money to push down the cost of risk and to push down the price of things that were built during the credit bubble so that the markets clear.

    The big mistake is to try to fix a credit bubble once you are no longer in a credit bubble.

    gillies: so how do you know if it is working ?

    When people are no longer in desperate fear of losing their jobs.

    gillies: the problem is caused by negative real interest rates – so the problem is only over when real interest rates are positive.

    No. The problem is caused by negative interest rates which causes a boom and then a bust. In the bust, the credit markets break down, and people are no longer willing to lend at any price, so the thing to do is to dump money from helicopters.

    We are not dealing with a credit boom. We are dealing with a credit bust.

  • Posted by Cedric Regula

    We should also realize that a credit bust is not our only problem. The credit boom covered up a lot of structural problems with the economy which remain and get more pressing everyday.

    Health care is one of the many structural problems, and medicare in particular. Obama just announced today that the goal is to reduce medicare spending by 1.5% a year for the next ten years. A lofty target for something that has gone up at 8% a year for as long as I can remember.

    But is that enough? Obviously health care is an extremely complicated subject…one that I’ve not taken the time and energy to study and come up with any intelligent ideas.

    However, I do know that in the old days Americans used to be scared to death of anal probing, but today we have come to expect it as an “entitlement”.

    Back in the ’50s when space aliens invaded Roswell, NM, they terrorized humans with the practice of anal probing. Fortunately, the USG defeated the space aliens and interred the captured survivors in Area 51. They then began to reverse engineer alien technology and this led to the development the proctoscope.

    The military of course wanted the technology for use as an interrogation procedure(one that was supported by a young Nancy Pelosi, by the way) but a file cabinet hacker took advantage of lax base security and stole the plans and blueprints. He sold them to the medical industry who in turn developed the colonoscopy procedure and sold the American public on the idea that this is a vital part of your annual medical exam.

    So the $200 annual exam has turned into a $3000-$6000 exam depending on what part of the country you live in. And I’ll bet some old timers in Roswell long for the good old days when space aliens just did this for free.

    So the problem seems to be expensive technology. But we have lots of cases outside the medical field where tech advances lower the price of products. Generally this is accomplished by increases sales volume which lower development and capital equipment cost on a per unit basis.

    So will the USG try doing the same? Universal coverage and more frequent exams?

    I really don’t know, but something needs to be done about the system.

  • Posted by q

    cedric, technology will only lower the price of products if it is associated with higher productivity. in health care productivity has created a lot of new work. perhaps you could create an anal probe robot.

  • Posted by Twofish

    Cedric: So the problem seems to be expensive technology.

    The basic problem isn’t expensive technology, it’s expensive people. If you look at the cost of medical care most of it goes to people.

    Cedric: But we have lots of cases outside the medical field where tech advances lower the price of products.

    If you believe that Baumol’s explanations, that’s actually the problem. As auto worker can make one, fifty, a hundred cars. There’s no limit to the productivity of a manufacturing worker. However you can’t increase the productivity of doctors, nurses, or teachers much, so over time you see increases in the wages of doctors, nurses, and teachers.

  • Posted by chaingangcharlie

    Cedric -

    best laugh I had all day :-)

  • Posted by DOR

    China’s urban consumer inflation was less than 1%, year-on-year, in the past six months and –0.6% in Q-1 2009. In the first six years of the decade (2001-06), inflation averaged 1.4%; in the following 8 quarters, it was 5.5%, but was just +0.2% in Q-1.

    If that’s what is meant by “Thru most of the decade the PBoC has been fighting inflation,” then they are the absolute master of that particular game. Not only did each of their efforts fail (raising interest rates, issuing sterilization bonds, raising band reserves), but the outcome was complete success!

    Or, alternatively, perhaps the PBoC really spent more than half of the decade fighting DEflation, and finally beat down that horror just in time for global external demand to tank. Seems like the more plausible explanation to me.

  • Posted by DOR

    Obvious error. China’s CPI (YoY) in January was +1.0%, Feb -1.6%, Mar -1.2%. That averages -0.6%, not +0.2%.

    Apologies.

  • Posted by Cedric Regula

    Ya, raising bank reserves worked! And the global bust is now causing deflation.

    I don’t have the official data series for the entire decade, I was just remembering a news report. It focused on the 2003 thru 2007 period where the PBoC was trying to fight inflation various ways and also limit over-investment in certain industries(aluminum was one they were worried about). The news report did say inflation hit 8% for some period of time.

    So I guess that saying “most of the decade” is incorrect and it was probably only during the period that the trade surplus was rapidly going up.

    But the main reason I remembered this is that raising bank reserves will be the only tool left that the Fed has if and when the US economy ever recovers.

  • Posted by RebelEconomist

    Interesting comment, Twofish:

    “The basic problem isn’t expensive technology, it’s expensive people. If you look at the cost of medical care most of it goes to people.”

    I would be interested to know of evidence that supports this statement. The issue is one that often arises.

  • Posted by Twofish

    RebelEconomist: I would be interested to know of evidence that supports this statement. The issue is one that often arises.

    It’s rather straightforward. Take a tuition bill or hospital bill, and then do some leg work to follow the money.

  • Posted by RebelEconomist

    As usual Twofish, you are high on contrary opinions and low on evidence.

  • Posted by scrap metal recycling

    Is it time to learn Chinese yet?

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