ignt rn's List: China Holding U.S. Securities

• China's strategy was simple: block the open negotiations for two weeks, and then ensure that the closed-door deal made it look as if the west had failed the world's poor once again
• Sudan behaves at the talks as a puppet of China; one of a number of countries that relieves the Chinese delegation of having to fight its battles in open sessions. It was a perfect stitch-up. China gutted the deal behind the scenes, and then left its proxies to savage it in public.
• What I saw was profoundly shocking. The Chinese premier, Wen Jinbao, did not deign to attend the meetings personally, instead sending a second-tier official in the country's foreign ministry to sit opposite Obama himself. The diplomatic snub was obvious and brutal, as was the practical implication: several times during the session, the world's most powerful heads of state were forced to wait around as the Chinese delegate went off to make telephone calls to his "superiors".
• To those who would blame Obama and rich countries in general, know this: it was China's representative who insisted that industrialised country targets, previously agreed as an 80% cut by 2050, be taken out of the deal. "Why can't we even mention our own targets?" demanded a furious Angela Merkel. Australia's prime minister, Kevin Rudd, was annoyed enough to bang his microphone. Brazil's representative too pointed out the illogicality of China's position. Why should rich countries not announce even this unilateral cut? The Chinese delegate said no, and I watched, aghast, as Merkel threw up her hands in despair and conceded the point. Now we know why – because China bet, correctly, that Obama would get the blame for the Copenhagen accord's lack of ambition.
• So how did China manage to pull off this coup? First, it was in an extremely strong negotiating position. China didn't need a deal. As one developing country foreign minister said to me: "The Athenians had nothing to offer to the Spartans." On the other hand, western leaders in particular – but also presidents Lula of Brazil, Zuma of South Africa, Calderón of Mexico and many others – were desperate for a positive outcome. Obama needed a strong deal perhaps more than anyone. The US had confirmed the offer of $100bn to developing countries for adaptation, put serious cuts on the table for the first time (17% below 2005 levels by 2020), and was obviously prepared to up its offer
• But China's growth, and growing global political and economic dominance, is based largely on cheap coal. China knows it is becoming an uncontested superpower; indeed its newfound muscular confidence was on striking display in Copenhagen. Its coal-based economy doubles every decade, and its power increases commensurately. Its leadership will not alter this magic formula unless they absolutely have to.

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• China sent its troops into Tibet in 1950 and the Dalai Lama fled to India a few years later to establish a government in exile. Negotiations between China and the Dalai Lama's envoys were suspended last year, provoking violence in Tibet.
• The Washington Post reported on Monday that the Obama administration, in an effort to gain favor with China, put pressure on Tibetan representatives to postpone a meeting between Obama and the Dalai Lama until after the summit.

• Economically, Beijing is Pyongyang's major supplier of food and energy. Roughly 80 percent of consumer goods found in North Korea are made in China. Beijing is interested in North Korea's raw materials such as coal, iron ore and limestone as well as its precious metals such as gold.
  
• Drew Thompson is a China expert with the Nixon Center, a non partisan, public policy institution. "China definitely has influence and it has leverage. Often U.S. officials have stated that China is not using all of its leverage. And sometimes that simply refers to China's essential delivery of aid shipments, of food and energy, whereas the U.S. officials have stated in the past that if China would just turn off the oil and energy going into North Korea, then North Korea would have to respond. The Chinese are very reluctant to use that opportunity to really apply coercive pressure on North Korea because they believe that North Korea would not respond kindly and it would basically ruin or undermine the existing China-North Korea relationship and take away the ability that China currently has to communicate with Pyongyang fairly effectively. So China does have leverage, but they also, at the same time, feel a little bit helpless," he says.
  

• President Obama's decision not to meet with the Dalai Lama is a reminder of China's growing influence with Washington.

• The saving rate of American households has risen sharply since the beginning of the year, reaching 6.9 percent of after-tax personal income in May, the highest rate since 1992. In today`s economy, that is equivalent to annual savings of $750 billion.
• While a 6.9 percent saving rate is not high in comparison to that of many other countries, it is a dramatic shift from the household-saving rate of less than 1 percent that the United States experienced in 2005, 2006, and 2007.
• Without a fall in the dollar and the resulting rise in net exports, a higher saving rate and reduced consumer spending could push the U.S. economy into a deep recession. By contrast, the lower dollar makes reduced consumption consistent with full employment by shifting consumer spending from imports to domestic goods and services, and by supplementing this rise in domestic demand with increased exports.

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• China would like to tear itself away from the U.S. Treasury market but faces the prospect of a big capital loss on its large accumulated stock of holdings if U.S. Treasury bond prices were to rise or if the renminbi eventually appreciated in value against the U.S. dollar. The U.S. has become a lot less dependent on China’s financing of its deficits, particularly as the U.S. private saving rate has gone up and the current account deficit has fallen. Nevertheless, given the sheer scale of the U.S. deficit financing requirement—a budget deficit of about $1.4 trillion in 2009 and prospects of about $9 trillion of deficits over the next decade—sentiments in bond and currency markets are fragile. A precipitous action by China to shift out of U.S. dollar instruments (or even an announcement of such an intention) could act as a trigger that nervous market sentiments coalesce around, leading to a plunge in bond prices and the value of the U.S. dollar.
• China’s exports to the U.S. are dominated by manufactured goods and by machinery and transportation equipment (see Figure 2). China’s imports from the U.S. are largely accounted for by machinery and transportation equipment and crude materials, inedible, mineral fuels, lubricants and related materials

• One reason for the reserve slump: China has been stepping up purchases of foreign companies and natural resources. That reduces the amount of foreign currency Beijing must recycle into Treasuries.

• A stronger RMB [yuan] may seem to be in our interest—although I have my doubts, as noted below. But it may well be that a currency revaluation is simply not in China’s best interest at this point in time. The reason: China has an undeveloped financial system. Its banks are only just starting to go public and its capital markets are tiny by our standards. Currency fluctuations could, as a result, place great strain on the Chinese financial system at a critical juncture in its economic development. We may not accept that logic, but at least we need to consider the possibility that China may know a good deal more about the inherent risks in its financial system than we do.

• If China attempted to reduce its holdings of U.S. securities, they would be sold
  to other investors (foreign and domestic), who would presumably require higher
  interest rates than those prevailing today to be enticed to buy them. One analyst
  estimates that a Chinese move away from long-term U.S. securities could raise
  interest rates by as much as 50 basis points.26 Higher interest rates would cause a
  decline in investment spending and other interest-sensitive spending. All else equal,
  the reduction in Chinese Treasury holdings would cause the overall foreign demand
  for U.S. assets to fall, and this would cause the dollar to depreciate. If the value of
  the dollar depreciated, the trade deficit would decline, as the price of U.S. exports fell
  abroad and the price of imports rose in the United States.27 The magnitude of these
  effects would depend on how many U.S. securities China sold; modest reductions
  would have negligible effects on the economy given the vastness of U.S. financial
  markets. For example, Japan gradually reduced its Treasury holdings from $699.4
  billion to $582.2 billion from August 2004 to September 2007, a decline of $117.2
  billion. This shift appears to have had little noticeable impact on the U.S. economy. - ignt rn on 2010-01-21
• A potentially serious short-term problem would emerge if China decided to
  suddenly reduce their liquid U.S. financial assets significantly. The effect could be
  compounded if this action triggered a more general financial reaction (or panic), in
  which all foreigners responded by reducing their holdings of U.S. assets. The initial
  effect could be a sudden and large depreciation in the value of the dollar, as the
  supply of dollars on the foreign exchange market increased, and a sudden and large
  increase in U.S. interest rates, as an important funding source for investment and the
  budget deficit was withdrawn from the financial markets. The dollar depreciation
  would not cause a recession since it would ultimately lead to a trade surplus (or
  smaller deficit), which expands aggregate demand.28 (Empirical evidence suggests
  that the full effects of a change in the exchange rate on traded goods takes time, so
  the dollar may have to “overshoot” its eventual depreciation level in order to achieve
  a significant adjustment in trade flows in the short run.)29 However, a sudden
  increase in interest rates could swamp the trade effects and cause a recession. Large
  increases in interest rates could cause problems for the U.S. economy, as these
  increases reduce the market value of debt securities, cause prices on the stock market
  to fall, undermine efficient financial intermediation, and jeopardize the solvency of
  various debtors and creditors. Resources may not be able to shift quickly enough
  from interest-sensitive sectors to export sectors to make this transition fluid. The
  Federal Reserve could mitigate the interest rate spike by reducing short-term interest
  rates, although this reduction would influence long-term rates only indirectly, and
  could worsen the dollar depreciation and increase inflation. - ignt rn on 2010-01-21

• The the very fact that so much of the finance flow has gone from shares to bonds is a clear indication that these funds are coming from governments rather than priate investors. And we have the corroborating evidence of themassive increases in the official foreign exchange reserves of the countires with large current account surplses. China has more than $1 trillion dollars of reserves. - ignt rn on 2010-01-21
• It is no longer possible to say, as it was back in the year 2000, that the U.S. current account deficit is sustainable bcause it is being financed by private investors who are attracted by the productivity and the profitability of the U.S. economy. The funds are coming into the U.S. economy now because foreign governments are willing to buy amounts of dbt that can finance the U.S. current account deficit. The foreign governments are willing to do that to sustain their export surpluses with the United States. But how long will they be willing to continue to do so? - ignt rn on 2010-01-21
• Foreign governments taht artificially accumulate dollar investments are foregoing the opportunity to invest those resources in their domestic economy. Their real return on dollar bonds is less than 3 percent even if the dollar does not decline, while direct investment in their own economies can be expected to produce substantially higher real returns. The oil-producing countries are already making plans to shift from portfolio investments to substantial infrastructure investments in their own countries, increasing imports instead of sending surplus savings abroad. - ignt rn on 2010-01-21
• Prudent investors know that portfolios should be diversified. The Chinese, with about $1 trillion os U.S. bonds, are taking a risk that would have to be called imprudent. Shifting a portion of that to equity investments, as the Chinese are now beginning to do, does not fundamentally reduce their exposure to the level of the dollar and to the correlated risks between dollar interest rates and U.S. equity prices. Even if the Chinese think the dollar is as likely to rise as to fall in the near term, it is very risky to have such a large amount of dollar investments. The value of the dollar portfolio is equal to about $1,000 per person in China, about the level of the total per capita income in China at the official exchange rate. - ignt rn on 2010-01-21
• The dollar must eventually decline as part of the trade adjustment process. Any investor who expects the value of the dollar to decline relative to other major currencies would want to shift from investing in dollars to investing in those other currencies. While investors like China that have a very large amount of foreign exchange invested in dollars might reasonably fear that in selling dollar bonds and buying bonds in other currencies they might hurt themselves by causing the value of the dollar to decline, those countries with smaller dollar balances can shift to euros or yen without such fears. In turn, the knowledge that others are selling will force even large investors like China to realize that they will face a loss if they do not diversify away from dollar bonds. - ignt rn on 2010-01-21
• Some central banks ,most notably the Chinese and Japanese, have also pursued a strategy of keeping their currency undervalued as a way to stimulate a trade surplus. while this strategy may be reasonable in the short run to increase aggregate demand and employment, it makes no sense in the long run to stimulate exports in exchange for perpetual IOUs when a similar stimulus to aggregate demand and employment could be achieved by better domestic policies. - ignt rn on 2010-01-21
• The Chinese have kept the yuan undervalued despite calls for greater currency flexibility from the United States, the G-7 (a group of high-income countries including Canada, France, Germany, Italy, Japan, United Kingdom, and the United States, and the International Monetary Fund because of a fear that a stronger yuan will cause a decline in exports that will make it more difficult to create the large number of jobs required to absorb the growing population and the shift of the labor force from agriculture to industry. China has agreed to move a more flexible exchange rate and has recently widened the daily limit in the movement of the currency, although without actually allowing it to appreciate that much. China has also established a goal in its recent five-year plan of eliminating the trade surplus, although again without taking significant steps to achieve that goal. - ignt rn on 2010-01-21

• Analysts say a decision by China to move out of U.S. government bonds, for economic or political reasons, could lead a herd of other investors to follow suit. That would drive up the cost of U.S. borrowing, jeopardizing Washington's ability to fund, among other things, a stimulus package to jump-start the economy. If China were to stop buying or, worse, start selling U.S. debt, it would also quickly raise interest rates on a variety of loans in the United States, analysts say.
• Additionally, the more China invests in U.S. debt, the harder it becomes for U.S. companies to sell their products overseas. That's because China's purchase of U.S. bonds makes the dollar stronger, particularly against the Chinese yuan, which has been kept artificially weak to boost Chinese exports. The relatively weak yuan remains one of the biggest obstacles to U.S. companies tapping the market in China, particularly lucrative now as Beijing embarks on $586 billion in infrastructure and other stimulus spending to keep its economy humming amid the global crisis.
• "This is a sign of the growing interdependence between the Chinese and U.S. economies, but also a sign of a relationship that is not healthy in the long term," said Eswar Prasad, an economics professor at Cornell University and a senior fellow at the Brookings Institution in Washington. "There are inconsistent policies on both sides of the Pacific that are working against a more flexible Chinese exchange rate and the reduction of China's large trade surplus. This is a problem for the United States."
• China's investment in U.S. Treasury bonds surged by $43.6 billion to $585 billion in September, pulling ahead of the Japan, which now holds $573.2 billion worth. Overall, analysts say China's holdings may be $800 billion or more. China is thought to be purchasing U.S. debt through third countries, purchases that are not immediately recorded by the Treasury as being held by China, analysts say.

• In contrast to Japan, one of the United States' closest allies, China is seen as less benevolent to U.S. interests. 

   

   Many economists are concerned about U.S. reliance on China for funding. By buying Treasury bonds, which are denominated in dollars, China is able to keep the dollar strong compared with the yuan. As a result, Chinese exports are cheaper relative to U.S. exports. 
• "This is an unhealthy relationship," said Brad W. Setser, geoeconomics fellow at the Council on Foreign Relations. "The U.S. relies too heavily on subsidized financing from a non-democratic government. And China is still a poor country that has in turn invested too much of its national savings in the United States. There remains an underlying financial vulnerability if China were to scale back its purchases. It could deliver a shock to the United States."

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• But China could reduce or halt future purchases. A less ravenous appetite for Treasurys is already evident: a New York Times article in January was titled: "China Losing Taste for Debt From U.S." One reason for fewer purchases would be diversification. Another would be to divert money toward its own 4 trillion yuan ($586 billion) stimulus package.
  
  Reduced demand for Treasurys would drive up U.S. interest rates, probably pushing down home prices even more than they've already fallen, and also could start a run on the dollar.
  
  This is why Secretary of State Hillary Clinton pleaded with the Chinese government last month to keep the loans flowing to Washington, D.C. ("So by continuing to support American Treasury instruments, the Chinese are recognizing our interconnection.")
  
  This is also why, at least in part, U.S. taxpayer dollars were used to bail out Fannie Mae and Freddie Mac last year. A Business Week article says that foreign bankers were worried, especially China, which owned around $376 billion of Fannie and Freddie debt. "Treasury saw foreign governments getting the willies," a Senate aide told the magazine.

• What happens if China suddenly decides that its appetite for Treasurys is sated, or worse, decides to start dumping a significant portion of its holdings? A big sale of Treasurys could cause longer-term interest rates to shoot up since bond prices and yields move in opposite directions.
• Since the beginning of August, the dollar has fallen nearly 3% against the euro, yen and a basket of four other major currencies. The weakening greenback could lead to more inflation concerns, which would dilute the value of China's Treasury holdings.
• There's also been this week's tire tariff tizzy. Some have speculated that a trade war with China could result in China selling some of its U.S. Treasury stake as retaliation for any further tariffs on goods imported from China.

• Even though China is probably not going to unload Treasurys en masse anytime soon, there are legitimate concerns about what might happen if China slowly started diversifying out of U.S. bonds.

  Smith said that China, as well as other emerging markets, may use derivatives contracts to try and hedge their bets on Treasurys and move into other assets instead.

  "The fear with China is they may be swapping Treasurys for commodities. So even though they still own a lot of Treasurys, you could wake up one morning and find that they don't have as much," he said.

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• "We have lent a huge amount of money to the U.S., so of course we are concerned about the safety of our assets. To be honest, I am definitely a little worried," Chinese Premier Wen Jiabao told reporters at his annual news conference today.

• Pessimists argue that the United States is accumulating debt at an unsustainable pace and that capital should flow from capital-abundant economies (such as the United States) to capital-scarce countries (such as developing economies), instead of the opposite. - ignt rn on 2010-01-20

• This coming rise in household saving will eventually be good for
  the U.S. economy. It will make the United States less dependent on
  capital from the rest of the world and permit American businesses to
  raise the rate of investment in the equipment, software, and structures
  that increase productivity and the future standard of living. But a
  higher U.S. savings rate will also pose a challenge for the rest of the
  world, because it will mean a reduction in the exports to and an increase
  in the imports from the United States. - ignt rn on 2010-01-20
• The coming rise in the U.S. savings rate could temporarily cause
  a serious problem for the U.S. economy as well. As consumer spending
  falls, gdp and employment will also decline. This decline will last until
  net exports increase by an equal amount. If markets function well, the
  higher savings rate will quickly put downward pressure on real interest
  rates, causing the dollar to become more competitive—until the rise
  in exports and the decline in imports return total gdp to its full
  employment level.However, there is the danger of a time lag between
  when the savings rate rises and when the U.S. trade deficit declines.
  Such a lag would cause a slowdown in the growth of output and
  employment, potentially leading to a recession. - ignt rn on 2010-01-20
• Foreign governments would thus do well to anticipate the coming
  rise in the U.S. savings rate. By permitting more exchange rate adjustment,
  foreign governments could mitigate the adverse cyclical eªects
  in the United States of a higher U.S. savings rate. Because it takes time
  for trade flows to respond to exchange rate adjustments, it would be
  best to allow exchange rates to adjust before the U.S. savings rate rises.
  Equally important, the United States’ trading partners must find ways
  to increase their domestic demand in order to maintain their output
  and employment even as exports to the United States decline. A
  failure to achieve both types of adjustments could lead to a wave of
  protectionist policies that would be in nobody’s interest - ignt rn on 2010-01-20
• This downturn would be exacerbated if foreign governments
  restricted imports from the United States or prevented the natural
  downward adjustment of the dollar exchange rate.The political response
  in the United States could easily be the imposition of protectionist
  policies, including tariªs and quotas on imports. - ignt rn on 2010-01-20