"Worry about a fall in China’s demand for the world’s goods, not a fall in China’s demand for Treasuries
Last week, Sam Jones of FT’s Alphaville wrote:
If the Chinese economy collapses, or even slows dramatically, then the raison d’etre for the country’s huge FX reserves - as a sterilisation measure to dampen domestic inflation - will evaporate. With that, so will China’s US Treasury holdings.
Or alternatively the Chinese could devalue the yuan. Either way, the US will be in trouble.
I like a good China scare as much as any one. But the first concern is, I think, off. A slump in China doesn’t mean an end to Chinese financing of the world, or even necessarily a fall in China’s reserves. Let me see if I can explain why.
Suppose China’s economy slows sharply — a not-impossible development given the rather starling fall in the OECD’s leading indicators for China. How would that impact China’s balance of payments?
The first impact is rather obvious. China would import less. It would buy less. And since the rise in Chinese demand helped push the price of various commodities up, it stands to reason that a fall in Chinese demand would push prices down. It probably already has. That implies a big fall in China’s import bill, and a larger trade surplus. A slowing global economy would hurt China’s exports, but in this scenario China would slow more than the world. That means China’s imports would fall more than its exports. China’s trade surplus would rise.( GOOD POINT )
But, you might say, the current account surplus is determined by the gap between savings and investment. Why would that change in a slowdown? Simple. China’s slowdown reflects a fall in investment (especially in new buildings and the like). Less investment and the same level of savings means a bigger current account surplus. In practice, though, savings would also likely fall a bit — as a slowdown would cut into business profits and thus business savings. It possible that China’s households would reduce their saving rate to keep consumption up as their income fell. But it is also possible that Chinese households might worry more about the future and save more( MY VIEW ). My best guess though is that the fall in investment would exceed the fall in savings, freeing up more of China’s savings to lend to the world. That surplus savings has gone into Treasuries and Agencies in the past.( I AGREE )
The second impact is harder to assess. A big fall in output might lead China’s savers to lose confidence in China, or rather to lose confidence in the RMB bank accounts as a stable store of value. The big fall in output might, for example, create expectations that China would devalue the RMB v the dollar — and Chinese households, anticipating the devaluation, would have a strong incentive to hold dollars. That likely means a rise in capital outflows.
Since reserve growth is a function of both the current account balance and capital outflows, it is possible that the rise in capital outflows could overwhelm the rise in the current account surplus. That seems to be what happened in q4.
In the absence of such outflows, though, the rise in China’s current account surplus would imply that China almost certainly would continue to add to its Treasury holdings. And even if there are large outflows — so large that the outflows exceed China’s current account surplus and China’s government has to dip into its reserves to meet the surge in Chinese demand for dollars — China would still be financing the rest of the world. The accumulation of foreign assets by private Chinese savers would substitute for the accumulation of foreign assets by the central bank, but money would still be flowing out of China. And some of that outflow likely would still make its way into Treasuries. Private Chinese demand for bank deposits would rise, and the world’s banks might decide to play the yield curve and increase their Treasury holdings. And if say Hong Kong intervened to keep a big inflow of funds into the the Hong Kong dollar from pushing the Hong Kong dollar up, the rise in Hong Kong’s reserves might increase the HKMA’s purchases of Treasuries.
The key point is that as long as China runs a current account surplus someone in China will be adding to their stockpile of foreign assets. It just may not be the government.( A GOOD POINT )
As importantly, the raison d’etre for China’s foreign exchange reserves isn’t “as a sterilization mechanism to dampen inflation.” Rather the opposite. The raison d’etre for China’s reserves is that China didn’t want the RMB to rise against the dollar, or at least not to rise by all that much( TRUE. FOR EXPORT PURPOSES. ). For most of the past six years, that has required the purchase of dollars by China’s government, as private demand for dollars fell far short of the private supply of dollars at the prevailing exchange rate.
The rise in China’s reserves, in turn, threatened to push inflation up. When the PBoC buys dollars, it sells RMB and thus in the first instance increases the amount of money in circulation. Since the PBoC wanted to avoid a rise in inflation, it then sold sterilization bills to remove the currency it printed to buy dollars from circulation. The net result is that the PBoC is left with a bigger balance sheet, one where it has more foreign assets and more domestic liabilities (the sterilization bills).
But China wasn’t buying dollars to hold inflation down. It was buying dollars to hold the RMB down. To keep the weak RMB and the expansion of the PBoC’s balance sheet from stroking inflation, the government had to “sterilize” the growth in its reserves and to run a tighter fiscal policy than otherwise would have been the case.
Think of it this way. A central bank that is buying reserves is growing its balance sheet — as it is adding to its assets. Some central banks expand their balance sheet by buying domestic assets (the Fed, for example). Others expand by buying foreign assets (the PBoC). The rise in the asset side of the central banks balance sheet is offset by a rise in its liabilities. If it doesn’t sterilize, the amount of cash outstanding increases. Cash, remember, is a central bank liability. If it does sterilize, the amount of sterilization bills rises. The PBoC was sterilizing because its balance sheet was growing faster than the economy’s need for new money, and it didn’t its balance sheet expansion to lead to a rise in inflation.
Now, as Michael Pettis observes, China potentially faces the opposite problem. Money is flowing out, reserves are no longer growing, deflation is a bigger threat than inflation and banks may no longer want to lend. I wouldn’t worry too much though about the risk that the money supply will shrink just because China’s reserves aren’t growing. Growing reserves can lead to money creation. But so can the same stock of reserves and less sterilization. And the PBoC has enormous scope to reduce the scope of its sterilization operations. The recent cut in the reserve requirement is an obvious example. Moreover, if the PBoC wants to expand its balance sheet, it always could start buying domestic Chinese bonds. The real challenge — as the US and UK are discovering — is getting the banks to lend in a shrinking economy!
Bottom line: A big fall in activity in China will tend to drive China’s trade surplus up. It thus would tend to increase — not reduce — China’s (net) purchases of foreign assets. Someone in China will still buying foreign assets — and likely providing indirect support for the Treasury market — even if it is not China’s central bank. A big fall in activity also means less Chinese demand for the world’s products — as well as less Chinese demand for China’s products, which frees up capacity to export. That adds to the deflationary forces in the world economy.
And right now, the risk of a shortfall in global demand strikes me as the bigger risk than a shortfall in demand for Treasuries. The last thing the US should want is a larger Chinese current account surplus, even if a larger suplus would increase China’s capacity to finance the US deficit( TRUE ).
What then should China do if the OECD’s indicators prove accurate?
David Dollar’s suggestions seem pretty good to me."
"Considering China's options in weakening global economy
The December export numbers for China showed a 2.8 percent decline from the year before. This was the worst showing in a decade, but better than the 4-5 percent decline expected by the business press. There is still plenty of cause for worry, as economist and blogger Brad Setser wrote in a recent post, "This really doesn’t look good". While Setser is talking about the breath-taking drop in Korean and Taiwanese exports in December, some of those exports normally would be on their way to China for further processing and re-export. So, the grim news from those economies in December probably presages more tough times ahead for China's exports.
In this deteriorating global environment, the Ministry of Finance and the World Bank's Beijing office last week held a seminar with some very good international and Chinese economists to discuss China’s macroeconomic policy options. While the economists had a wide range of views, I took away a pretty strong consensus from them on three things: (1) preference for stimulating domestic demand over external demand( GOOD ); (2) preference for social spending over infrastructure in the stimulus package( NEED TO ); and (3) given that there will inevitably be some infrastructure spending, a preference for projects that improve urban quality of life over those that merely expand economic capacity( NEED TO ).
China has slowed down because it experienced a large drop in domestic demand (in the real estate sector) as well as in external demand for its products. In theory, the country could try to compensate for this either by stimulating domestic demand or by trying to induce greater external demand through devaluation or export promotion. The latter approach is not likely to work for two reasons. First, the external slowdown is so serious that efforts to gin up external demand are not likely to have much effect. Second, such efforts would definitely be viewed as "anti-social," especially by other developing countries. In this crisis, there are many developing countries that now face large external deficits and do not have big international reserves. They have no choice but to devalue. China still has a large trade surplus and massive reserves, so China does have a choice.( YES. ALTHOUGH THEY DO WANT TO KEEP THIS ARRANGEMENT IN PLACE. )
The domestic stimulus option is also attractive because China has huge fiscal space to do so. It has little public debt relative to GDP and has run budget surpluses during the boom years. Hence China can easily afford a large fiscal stimulus, even beyond the fiscal package that has already been announced.
A second area of broad agreement among the economists was that the stimulus plans announced so far mostly focus on infrastructure. These may take some time to get going and will not help the large numbers of workers losing their jobs in the export sectors. China has made a lot of progress in setting up a structure of safety net programs: urban and rural minimum income support; rural medical cooperative scheme plus medical assistance for the poor; central transfers to expand rural education. The central government could afford to expand all of these programs quickly. In general they are administered at the local level, but often lack sufficient local funding to make them fully effective. Central transfers to fully fund and expand these programs would be effective stimulus that would also address social needs. Money to support laid-off workers will be spent quickly, whereas some of the proposed infrastructure projects will inevitably take months to get off the ground.
A third interesting point was about the kinds of infrastructure projects that should be included in the stimulus. China stimulated the economy in 1997 through infrastructure projects that also set the stage for long-term growth by addressing bottlenecks. This is a nice idea that is still relevant. In 1997, there were bottlenecks in highways, power, sea ports, and airports. It is important to recognize, however, that today the bottlenecks are different. Many provincial airports are seriously under-utilized and the highway system is already well-developed, as is power and seaports. Hence there is a danger in this situation of "fighting the last war" – expanding the same infrastructure that is now basically excellent.
On the other hand, there are obvious infrastructure needs. There is not enough low-cost housing for migrants to move permanently to cities with their families; not enough schools and social services for these migrants; not enough capacity in wastewater treatment and environmental protection. The railway system is under-developed compared to highways or airports. So, there are lots of good opportunities for infrastructure investments that improve the quality of life. The challenge is to choose projects that actually address current bottlenecks.
Adjusting to the global crisis provides a "win-win-win" opportunity for China. It could stimulate domestic demand in a way that keeps the growth rate high, addresses important social gaps, and makes the development path more environmentally friendly.
Image credit: uzvards at Flickr under a Creative Commons license."
These seems to me like good points. However, I would assume that the main reason for social safety net spending and quality of life spending is to avoid social disruptions and dislocations. For the time being, they can hedge their bets and afford to be patient with exports. For the time being.
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