What if China stops buying US Treasuries?28 June, 2012, 14:22. Posted by Zarathustra
I have been meaning to write this for quite a while. So here it is.
There is a belief among many people that because China has been buying a lot of US Treasuries securities over the past decade to a point that it become among the largest holders of US Treasuries, the moment when China stop buying US Treasuries or even start selling them would be disastrous. The expectations range from interest rates shooting higher to a debt crisis.
This is an absurd belief, but it is quite common even among those wise one. Russell Napier of CLSA, for instance, is normally a wise man with interesting insight of the stock market history. But when it comes to China stop buying the US Treasuries, this is what he wrote back in last year (12 December 2011):
As was inevitable, rising inflation in China, especially in wages, has led to reduced competitiveness and declining surpluses. Perhaps more importantly, this is occurring as China’s capital account has become significantly more porous. China reported a BOP deficit in September. If this continues, the Peoples Bank of Bank (PBOC) will be a seller of Treasuries, pushing yields higher, and a buyer of renminbi, thus shrinking or at least constraining Chinese domestic money-supply growth.
He late realises that while what he calls a "great reset" is probably underway already, US Treasury yields are not rising. To explain this, he blames Ben Bernanke, apparently, and like many hyperinflationistas, he mentioned German Reichsbank’s Rudolph von Havenstein, who was responsible for Germany’s hyperinflation in the 1920s and sowed the seed for the Germany paranoia of inflation today:
However, the shift of private-sector savings to fund the government has been underway throughout the period without the incentive of higher yields driving it. The great reset is indeed underway and the result is a continued subpar US economic recovery. Nobody seems to care much about this. If foreign central banks won’t print money to fund the US government, then the Fed will. Most thought that the "science" of printing money to fund government was buried in the Berlin-Dahlem cemetery along with the body of Rudolf von Havenstein (president of the German central bank in the Weimar Republic) in November 1923. It seemed that we forgot to put a stake through its heart, but dead it is and already the burden of carrying the US government debt is shifting away from the printing press and to its natural owner: the savers of America.
Because the foreign sector is not buying, and because the full-on quantitative easing has stopped for quite a while, he argued that the private sector has to pick up the slack, which is right, of course:
With foreigners’ share of the Treasury market declining and Fed ownership of the market peaking in 2Q11 the strain of funding the US government is increasingly falling on the US private sector. In the words of Foreigner, the purveyor of 1980s power ballads rather than financier of the US state, buyers are ‘gonna take a little time, a little time to think things over’. Having thought it over the foreigner is providing less of the funding necessary to support the US state and the funding holiday for the US private sector is over. The question no one asks is can the US private sector take up this increased burden and simultaneously provide more credit to fund private sector activity?
But is that really that much of a "burden" if the Chinese, and indeed the rest of the world, stop "funding" US budget deficits?
The reason is that foreign investment in US Treasuries (along with many other investments like stocks, corporate bonds) is part of the capital account surplus. By definition, current account, which mostly comprises of trade surplus/(deficit), has to be equal to the capital account in magnitude but of opposite sign. That is, if a country runs a trade deficit or a current account deficit, its capital account has to be in surplus and of the same size (allowing for statistical discrepancies). In the case of US, the current account deficit is financed by net foreign capital inflow in terms of portfolio investment, direct investment, etc, so to speak.
Now, the reason why China is probably no longer buying as much US Treasuries as it used to (or probably selling in the future) is that because China is not recording as large a trade surplus as it was, and capital is flowing out of the country. Because the balance of payment must sum to zero by definition, trade surplus and capital inflow combined in the past must be countered by central bank’s foreign assets accumulation, or foreign exchange intervention. The account for reserve asset is usually rather close to zero for a country with floating exchange rate, but for China, the accumulation of reserve assets means that it has to be negative. However, as trade surplus shrinks and capital inflow turns into outflow, there is much less need for foreign asset accumulation. Or indeed, if things are bad enough for China in a sense that trade balance turns into deficit and capital continues to flow out, the central bank will have to sell reserve assets (in this case, likely US Treasuries) to prop up the currency.
So is it time to panic that China is finally dumping US Treasuries? Is it time to panic that no one is funding the US government deficit?
The very definition of balance of payment accounts mean that if China stops buying US Treasuries and no one else outside the US is taking up the slack, the capital account surplus of the US will shrink, and will probably become a deficit when everyone else sells US assets, and that implies that, on the other side of the balance of payment, current account deficit will shrink, and will probably become a surplus when everyone sells US assets. That has to happen, by definition.
If that extreme thing happens, oddly enough, it means the US will run a trade surplus.
And let’s go back, once again, to this equation:
(S – I) + (T – G) = (X – M)
This equation says that private sector net saving and public sector saving must equal to more or less the current account surplus. In the past many years, the US has been running a negative current account, which means that the left hand side of the equation has to be negative. In Bill Clinton’s presidency, it was the private sector net saving which became negative, implying that Americans were taking more debts. As government budget surplus turned into deficit during Bush’s presidency, both private sector net saving and public sector net saving were negative. After the financial crisis, however, as the government deficit increased substantially, private sector is finally saving money on a net basis.
As mentioned above, if China stops buying US Treasuries, or even starts selling them, and if no one else outside of the US is filling the “hole” left by the Chinese, the private sector does appear to be the one that take up the burden. But here’s the deal: if no one outside of the US buys Treasuries (and stocks, investment, etc), current account deficit has to drop. "Worse" still, if people are selling financial assets, the current account will turn into a surplus.
The consequence of a current account surplus, surreal as it might seem today given the US is running a deficit, is that the left hand side of the equation will have to be positive. That means that either private sector saving is becoming more positive, or government deficit becoming smaller, or government budget being turned into, yes, surplus. Now you have a real possibility of both the private sector and the public sector are saving as the rest of the world stops investing in the US. In any case, lowering budget deficit (or turning into surplus) should make the US government somehow more credit worthy for those who currently believe that US government is bankrupt.
Of course, that is not something that is likely to happen: foreigners will still be buying US Treasuries because of its perceived safety, and the Chinese will not suddenly dump all US Treasuries they have. The bottom-line is: there is no reason why China selling US Treasuries could be disastrous. And, just stop this "the US needs foreigners to fund budget deficits" nonsense, because it is, well, nonsense.