Brad Setser

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Change or more of the same?

by Brad Setser
June 4, 2009

Simon Johnson poses the core question facing the United States and China well:

If [China] doubles [its] holdings of US dollar assets over the next couple of years (let’s say, going towards $4trn), effectively financing our budget and current account deficit, will we all end up safer or more vulnerable?

China currently has a bit over $1.5 trillion in dollar assets, as not all of its $2 trillion in reserves (and more like $2.3 trillion to $2.4 trillion in government assets abroad) are in dollars. About ½ of the total is result of China’s purchases in just two years, 2007 and 2008. China’s trade surplus isn’t shrinking, at least not in dollar terms. Lex’s argument that China’s surplus is waning can be challenged.* And even if China’s trade surplus stabilizes in dollar terms and shrinks relative to China’s GDP, China is on track to double its foreign assets – and its US holdings – over the next four years. Think a $350-400 billion annual increase in China’s dollar assets, and a $500b plus increase in China’s foreign assets.**

That prospect should scare China’s leaders. China’s population thinks China has already invested too much in low-yielding dollar assets. Doubling down only makes the problem bigger. Bridgewater’s Ray Dalio noted in February:

But they [China] own too much in the way of dollar-denominated assets to get out, and it isn’t clear exactly where they would go if they did get out. But they don’t have to buy more. They are not going to continue to want to double down.

Nor should the US want China to double down. The past few months have made it clear that China’s dollar problem can quickly become America’s problem, as China’s doubts about the safety of its US portfolio reverberate through various US markets.

To be clear, the basic risk China is running hasn’t changed all that much recently. China’s government fundamentally is overpaying for dollars (and euros) to hold the RMB down to help China’s exporters. That policy always has carried with it a high risk of future financial losses.

The current crisis hasn’t changed that basic reality.

Sure, the US fiscal deficit is up, something China’s state media now likes to highlight.*** And the Fed has cut policy rates in the midst of a severe downturn. But that is only half the picture. Household savings are up. Household borrowing is down. The private sector’s financial deficit is way down. The trade deficit is down too. Foreign inflows finance a trade deficit not the fiscal deficit and, in my book, financing a 6% of GDP trade deficit is more risky than financing a 3% of GDP trade deficit.

What has changed is China’s own perception of the risks. China’s population wasn’t focused on the cost of holding more dollar and euro reserves than China needs back in 2005 or 2006. Now it is.

And, or course, the over time the size of China’s portfolio grew, increasing the scale of China’s exposure. That is the nature of financing an ongoing deficit. The longer the current relationship continues, the more dollars (and euros) China will hold, and thus the greater the underlying risk.

Simon Johnson focused on Geithner’s non-confrontational tone in Beijing. But the basic message in Geithner’s Beijing speech was clear: the goal of both US and Chinese policy should be to move away from the current unbalanced relationship.

Our common challenge is to recognize that a more balanced and sustainable global recovery will require changes in the composition of growth in our two economies. Because of this, our policies have to be directed at very different outcomes.

In the United States, saving rates will have to increase, and the purchases of U.S. consumers cannot be as dominant a driver of growth as they have been in the past. In China …. growth that is sustainable growth will require a very substantial shift from external to domestic demand, from an investment and export intensive driven growth, to growth led by consumption. Strengthening domestic demand will also strengthen China’s ability to weather fluctuations in global supply and demand.

If we are successful on these respective paths, public and private saving in the United States will increase as recovery strengthens, and as this happens, our current account deficit will come down. And in China, domestic demand will rise at a faster rate than overall GDP, led by a gradual shift to higher rates of consumption. Globally, recovery will have come more from a shift by high saving economies to stronger domestic demand and less from the American consumer.

Seems like a vote for change, not more of the same.

But what leverage does the US really have to change the basis of the relationship when it wants China to buy its bonds in the near term?

That question misses two key points. First, the trade deficit is down, so the US actually needs less financing from the rest of the world right now than it did in the past. It isn’t clear to me that the US relies more on China now than it did back in 2007 and early 2008, when China’s reserves were growing faster and the US external deficit was larger. Second, China’s own concerns about its dollar risk could generate a larger constituency for change inside China.

Until now, China’s policy has been dominated by concerns about the impact of any change in China’s exchange rate on China’s exports. Yet it is hard to see how China can realistically scale back even the pace of increase in its dollar exposure so long as it is running a large trade surplus and pegging to the dollar.

Chinese policy makers have been searching for a way to avoid adding to their dollar exposure without changing their dollar peg. Here though, I suspect that my colleague (boss, actually) Sebastian Mallaby is right: China’s efforts won’t get China very far so long as China’s capital account is closed and China pegs to the dollar. As China comes to the same realization, the pressure on it to adjust its policies will grow.

Of course, a world where China provides the US will less financing implies adjustment in the US as well. A China that imports fewer bonds will tend to buy more imported goods – which will help some parts of the US economy. But it won’t help sectors with large borrowing needs. Including the US government.

The troubles the dollar has faced recently suggest that the market wants the US to continue to adjust. It now seems as though there isn’t lots of demand for US asset at current interest rates in absence of an acute crisis. The external financing that would be needed for US demand to spur a global recovery may not be there. Market pressures then could spur a more balanced global recovery. A weaker dollar will help bring about a rebound in US exports just as stronger currencies abroad will push other countries to take steps to stimulate their own economies.

Change isn’t without its risks. One of the key factor pushing China to adjust – its concerns about the safety of its US portfolio (or, in my view, its China’s belated recognition that holding its exchange rate down has costs as well as benefits, as it requires continuously overpaying for dollar and euro denominated bonds) – also makes the market nervous. And a nervous bond market tends to make policy makers a bit nervous.

On the other hand, if China (and the US) double down, the underlying problem would in some sense only get worse. The basic issues won’t change. But the stakes will be even higher.

Over the past couple of days I discussed the Sino-American financial relationship with CNBC Europe, NPR’s All Things Considered and public radio’s On Point. I tried to argue that neither the US nor China should seek to maintain a world where China saves and lends and the US (households as well as the government) borrows and spends. The goal should be the creation of a more balanced relationship – one where the US doesn’t require so much Chinese financing and China doesn’t need so much US demand – not a return to the old unbalanced relationship.

The sources of pressure for change are increasingly obvious. Even in China. That’s good. But transitions aren’t easy. Deficits – even shrinking deficits – have to be financed. And financing an orderly (think gradual) adjustment poses particular challenges.**** For everyone.

* China’s trade surplus in the 12ms through April reached $315b, v $255b in the 12ms to April 2008. The surplus in the last three months of data was $37b – v $39b at this time last year. That is encouraging – not growing isn’t the same as shrinking. Especially when China is stockpiling commodities, and thus somewhat artificially increasing imports and reducing its surplus. Let’s see what May tells us – if China really is going to lead the world out of the current slump, its surplus should shrink.
** I am assuming that China’s reserves resumed their upward March in the second quarter, as renewed confidence in China ended hot money outflows. Generally speaking, China amount of foreign exchange China has to buy to manage its exchange rate rises when the dollar is depreciating.
*** China Daily, via Charles Wallace of the Big Money: “The government and experts have expressed concern that Washington’s mushrooming deficit, generated by massive government borrowing to fuel its economic recovery plan… will undermine both the dollar and US bonds.” Funnily enough, I never heard China express comparable concern about the United States ballooning trade deficit from 2003 to 2006, even though that was a more direct threat to the value of the dollar. Call me cynical.
*** During an orderly adjustment, China’s dollar holdings – and thus its exposure to the US – would continue to rise. But the pace of increase would slow, until a new equilibrium was established, one that didn’t require ongoing Chinese purchases. The problem is that China’s exposure needs to rise even as China’s surplus with the US shrinks. Basically, China needs to bear the financial costs of supporting the dollar without getting the trade boost it got before. This shouldn’t be a surprise. I – and others – have long noted that the same folks who financed the expansion of the US trade deficit would likely need to finance its orderly contraction. But it isn’t clear that Chinese policy makers really ever thought out the end-game (i.e. their exit strategy from the dollar trap), despite their reputation for thinking about the long-term.


  • Posted by Brick

    I must confess I had not thought about what China would do with its European surplus and the damage it would do to the European economy would make it a non starter. China would however be paying more for its imports so I wonder if it could shift its surplus to Australia and Brazil. I guess that would not be a solution either because it would damage its export business. The implication might be that they would have to support the dollar whether they like it or not.

  • Posted by Glen M


    Good for you pointing out the Euro-Yuan / trade part of the equation. It is all to often overlooked. It should also be noted that while China has been worried about the value of their holdings, they were buying USD when it was falling and ignoring the EURO while it was rising.

  • Posted by Twofish

    chaingangcharlie responds: Hmm. Here in UK, when people die we don’t generally hire professional mourners to come in to bare their chests & weep & wail for us.
    I understand there are parts of the world where this is perfectly normal.

    I’m ethnic Chinese, I’ve heard about professional mourners, but I’ve never met any or been to any funeral where they have been used. The Chinese people I know, would find the whole concept of professional mourning to be sacreligious and offensive, but I’m sure that given the diversity of Chinese and Chinese customs, there are parts of China and Chinese people for which this is normal. I just personally don’t know of any.

    chaingangcharlie responds: I understand there are parts of the world where this is perfectly normal. Knowing this, I can make accurate predictions about people’s behaviour, given knowledge of their ‘culture’.

    Maybe. Provided that you have your facts right, but I’ve seen a lot of total nonsense come out of this. If you start with the belief that Chinese in general hire professional mourners and start making conclusions based on this, then you end up with utter nonsense, since the Chinese that I know would find the concept of a professional mourner offensive.

    chaingangcharlie responds: If I call a Buddhist Monk ( for eg) a flat faced a-hole, I could predict a different reaction than if i did ditto to a truck driver from Pasadena.

    Maybe, but that has little to do with being Chinese since an American Buddhist monk would likely react better than a Chinese truck driver. But even that is a stereotype. I’ve known some nice truck drivers, and there are Buddhist monks I think would react badly, the Kung Fu Buddhist monks of the Shaolin Temple or the monks that were involved in the Tibetan demonstrations last year.

    chaingangcharlie responds: If the notion of culture is thus helpful predictively speaking, I don’t agree that it can possibly be altogether vacuous.

    First you need to not generalize and get the facts right. Starting from the premise that Chinese hire professional mourners, save lots of money, or don’t drink alcohol will get you utter nonsense, and invariably the one common trait that I find among people that do this sort of thing is that they don’t know that many Chinese, and they don’t actually check the facts to see if their predictions work.

    Second, I’ve found that when “culture” does matter, it’s usually “professional culture.” An Buddhist monk may react differently than a truck driver, but that has more to do with being a monk and a truck driver than being Chinese or American.

  • Posted by Twofish

    Looking at stereotypes is interesting, but I don’t think it is that predictive. When I think “Chinese” the things that come to mind are physics professor, business tycoon, Wall Street banker, fundamentalist Christians. That tells you more about me than it does about China, which is my point.

  • Posted by Indian Investor

    The People’s Bank of China is behaving like a Shaolin Temple. They don’t want the dollar to crash till the Chinese export workers are home and dry, probably making electronic trinkets to monitor the temperature in Dutch greenhouses instead. Till the dreaded US Dollar crashes down, Americans will remain Standard and Poor – more than 38 million of them are living on food stamps, and 700,000 of them need to have their benefits extended because they haven’t got another job after a full year. Meanwhile there seems to be a secret Return of the Red Dragon treaty between the US and China. The markets are going up, or remaining steady, while the US Dollar is exhibiting what you might call as a Bungee Jump Pattern.

  • Posted by DJC.

    Interesting. Does the US really want China to be a democracy when it comes to Chinese purchases of US Treasury debt?

    China’s Global Times newspaper, which is affiliated with the Communist party, said 87 percent of Chinese respondents in an public poll considered China’s dollar-denominated assets unsafe and opposed buying U.S. securities. “Ordinary Chinese people are discontent with the declining value of China’s huge foreign exchange reserves denominated in U.S. dollars,” the newspaper said.

  • Posted by Rien Huizer


    “Rien — economics is actually easy. and exchange rates consistently have an impact on trade flows, despite all the arguments that are put forward to contrary.

    china’s move v hte euro (big depreciation) clearly had an impact of china’s trade with europe (dramatially increased the pace of export growth).

    when RMB was appreciating v USD the pace of growth of china’s exports to US fell. As expected. furniture makers who had shifted to china started to think about shifting back to the US. Companies started factoring in higher future wage costs in china, which affectings future sourcing decisions. And so on.

    and if you look at changes in the EUR/ USD they clearly have had an impact on the trade balance.’

    Of course exchange rates have an influence. But the stuff has to be made somewhere, the factories are now in China and China’s surplus labor is still there and not easily redeployed. The fist response is to try and redeploy to other markets (buyers will not ccept higher import prices unless there is no alternative), the second to become cheaper.

    I guess China will go for a higher CNY
    (1)(trade weighted of course not only vs the USD)
    (2) once it is pretty sure Chinese producers have some bargaining power except price. In fact if they did not reach that stage, their developmenta strategy would have failed: they would have produced a state with high output, persistently low wages and a low employment share. Not a recipe for industrialization with social stability.

    A bilateral USD RMB depreciation while the EUR and the JPY stay where they are vs the USD would probably OK. A smallish CNY/ USD appreciation while the US dives further against (esp) JPY and EUR, looks problematic. One reason this Chinese public discourse of some form of mulitateral approach has emerged is that the others realize that the pressure on the Chinese is mounting, domestically and from the US (the crisis gives the US rare bargaining power)
    and that the run the risk that China (in mercantilist terms, well understod in China, Europe and Japan) will rob the others to pay the US..

    So, yes, I know that currency movements affect trade flows, even between China and its partners. Butwould expect those currency movements to be heavily contested, both domestically and from China’s other trade partners and that China would probably prefer some new (and more inclusive BW.

  • Posted by Csco

    “Brad, I frankly don’t understand why the entire focus is on the fiscal deficit not the external balance”

    Because people even in the professional world are caught up in the same type of thinking – albeit usually without the openly crazy rhetoric – that dominates the comments section of this very blog. China is ascendant and all-powerful, America is hurtling into oblivion. (And it’s already half-way there.) It doesn’t matter what data say, it doesn’t matter what factual, rational and logical work-throughs come up with. Somehow all scenarios must be made to fit into the China Up / America dead model. That’s the buzz, that’s all anyone wants to talk about, that’s all anyone wants to read about. “Will the CNY become the new currency? Oh no!/Awesome!” “What convoluted fiction will send America to third-world status, because I’ll believe it!” Or DJC’s daily comments explaining how stupid the “stupid Americans” are how their country is doomed. The level of discourse here seems to be the same as is found in opinion columns, news articles, financial investment newsletters, and on the trading floor (either held opinion or catered-to opinion).

    It’s next to impossible to bring context to a popular story.

  • Posted by geert

    “Today’s solutions causes tommorrow’s problems”
    I very much like that sentence but I think you need to take it a little further.
    As today’s solutions require far more drastic interventions than in the past, will our problems tomorrow be more challenging too and require even more drastic measures?