It reflects what seems to be a widespread sense inside China that US treasuries aren’t a good investment

TO BE NOTED: From Follow The Money:

“We hate you guys … but there is nothing much we can do”

Posted on Sunday, May 17th, 2009

By bsetser

That – now famous — quote by Luo Peng isn’t really true. China’s government choose to peg its currency to the dollar. More importantly, China’s government choose to peg to the dollar at a rate that can only be sustained – in most states of the world – only if China’s government intervenes heavily in the foreign exchange market. If China didn’t peg to the dollar at the current rate, it wouldn’t need to intervene as heavily in the market — and thus wouldn’t need to accumulate quite so many dollars.

To be sure, the pace of China’s dollar reserve accumulation slowed when “hot money” moved out of China in q4 2008 and q1 2009 (see this graph). But there are some (tentative) signs that reserve growth is starting to pick back up – we will know when China releases its reserves data for q2.

And there certainly is no shortage of evidence that China’s public complaints about the safety of US financial assets haven’t kept it from buying US Treasuries.

The TIC data for March was quite extraordinary. Foreign investors bought — gulp – over $100 billion of Treasuries in March: $55.3 billion in longer-term notes and another $47.9b in short-term bills. Indeed, over the 12ms of data – a period framed on one end by Bear’s collapse and at the other end by the stress tests, with Lehman’s failure punctuating the middle – foreign investors have bought a stunning $800 billion of Treasuries. $300 billion of longer-term bonds and $500 billion of short-term bills.

In March, China – according to the TIC data — bought $14.85b of longer-term bonds and $14.5 billion of bills. Talk about not putting your money where your mouth is. As a result, China’s Treasury portfolio – shown here disaggregated between bills and bonds – continues to rise.

Over the last 12ms, China has bought around $270 billion in Treasuries — $173b of bills and $98b of longer-term notes. That surge came even as Chinese reserve growth slowed. China, in effect, stopped buying all US assets other than Treasuries. Agencies especially.

The shift in China’s portfolio during the crisis – described in more detail in an updated paper that I have done with Arpana Pandey of the Council on Foreign Relations — mirror the global data almost perfectly. China wasn’t the only foreign investor that shifted out of Agencies and into Treasuries – or, for that matter, the only investor who stopped buying US equities and corporate bonds.

Russia sold its Agencies to buy short-term Treasury bills. Its holdings of non-Treasury short-term securities have gone from $97 billion at the end of 1997 to $1 billion at the end of March 09 while its holdings of Treasury bills rose from next to nothing to $73 billion. A host of smaller central banks did something similar. And private investors abroad – including, I suspect, European banks – wanted more bills too.

A plot of total foreign demand for Treasuries (short-term and long-term) against total foreign demand for Agencies (short-term and long-term) makes this shift brutally clear:

The fact that key foreign investors didn’t lose faith in Treasuries when they lost confidence in the debt of the Agencies, private US financial institutions and issuers of asset-backed securities helps to explain the dollar’s resilience during this crisis.

There frankly isn’t much more to say about the TIC data these days. Foreigners are consistently buying only one type of US asset. Ok, there was a bit more foreign interest in US equities in March too. But the scale of the inflow into equities was dwarfed by the inflow into Treasuries.

I understand the logic of this flow.

The crisis reminded central bank reserve managers that they cannot take much credit risk. They cannot – politically – afford to take visible losses. And as long as they report their reserves in dollars, holding Treasuries is the one safe choice. Some central banks and sovereign funds also underestimated their needs for liquidity. Kuwait and Abu Dhabi, for example, have had to draw heavily on their foreign assets to finance domestic bailouts.

At the same time, China’s increasingly rhetoric isn’t an accident. It reflects what seems to be a widespread sense inside China that US treasuries aren’t a good investment.** Private Chinese savers presumably wouldn’t want to buy Treasuries at current rates. But China’s current exchange rate regime compels China to buy dollars when private Chinese investors don’t want them.*** The result: a strange world where China’s government ends up buying an asset that China’s people currently do not want …

That is one of many ironies of the Bretton Woods 2 system. Its stability hinges on the willingness of central banks in the key surplus countries to buy dollars when private investors in their countries won’t.

*The methodology that Arpana Pandey and I use to estimate China’s purchases actually suggests a somewhat smaller number for China’s March purchases, as we attribute some purchases through London to China. In March the UK was a net seller of Treasures, which mechanically reduces our estimate of China’s total holdings a bit. The different though is truly trivial.
** These arguments tend to put more emphasis on the (growing) US fiscal deficit and less emphasis on the (shrinking) US trade deficit than I would. And they ignore the fact that dollars never were a good investment for China, as China was buying dollars precisely because there was market pressure for the dollar to fall and the renminbi to rise. For the sake of simplicity, I am ignoring those periods when private money was moving out of China, as I suspect the current bout of optimism about China’s growth prospects has reduced those flows.
*** China could then sell those dollars for other foreign currencies. But if those sales drove the dollar down, they would also drive China’s currency down so long China pegs tightly to the dollar. That would not please many of China’s trading partners."

I was surprised by how conservative China was in the immediate aftermath of the crisis.

TO BE NOTED: From Follow The Money:

"Creditors generally do like to lend in their own currency …

Posted on Tuesday, March 31st, 2009

By bsetser

China may not be an exception after all.

A creditor than lends in its own currency doesn’t have to worry all that much about the risk that it its lending is denominated in a currency that will depreciate. The borrower assumes the risk its currency will depreciate against the currency of its creditor as a condition for getting financing.

That is good for the creditor, and not so good for the borrower.

Back its days as a large creditor, the US (both the US government and private US creditors) generally lent in dollars. That meant that if a Latin currency depreciated against the dollar, the borrower had to find the dollars it needed to repay the US – or default and accept the consequences. Latin countries couldn’t allow their currencies to fall against the dollar and, in the process, reduce the real value of their foreign debts.

China is now a major creditor. But its foreign assets though are denominated in dollars, euros and yen – not RMB. That means that if the dollar depreciates against the RMB, it is China’s problem, not the United States’ problem. The amount of dollars the US has to pay China doesn’t change. But the amount of RMB that China gets for each dollar will fall

China’s willingness to take on this risk in some sense part was a core part of the Bretton Woods 2 system where reserve growth in emerging countries like China financed the United States external deficit. Had the United States external debt not been denominated in dollars, Dr. Roubini and I would have been even more worried by the size of the United States external debt than we were back in 2004. If United States debt structure hadn’t been as favorable, the dollar’s slide from 2002 on would have generated much, much larger problems.

China seems to have woken up, belatedly, to the fact that lending to the United States – or any other country – in its borrowers currency is risky. It probably should have started to worry some time ago, before it had $1.6 trillion or so of dollar-denominated claims. As the FT noted in a recent leader, “The People’s Republic has, however, over-exposed itself to the US, piling up dollar-denominated securities.” China is currently struggling with a problem that is very much of its own making.

China could, in theory, address this problem by ending its accumulation of dollar and euro and yen denominated reserves and instead making RMB denominated loans to the rest of the world.

Internationalizing the RMB poses two problems though.

First, most debtors, including the US, currently do not issue any RMB denominated debt – and I would strongly argue that they shouldn’t start. The countries able to borrow in their own currency at low rates should do so. And countries that have to pay more to borrow to borrow in their own currency also should generally do so, to avoid dangerous currency mismatches. Brazil has benefited immensely in the recent crisis from the fact that most of its debt is now denominated in real.

Second, expanding the “international use” of the RMB is rather hard when China doesn’t want foreign investors to hold RMB denominated assets. If say Argentina had RMB denominated debts, it also might want to hold some RMB denominated reserves as well.

And that would mean allowing foreigners to buy some of the RMB debt that China’s government issues and to hold it as part of there reserves.

That is the rub. Remember, buying RMB debt is also a way of speculating on the RMB.

If China made the RMB fully convertible, anyone could buy long-term RMB denominated debt and benefit if the RMB rose over time. That isn’t something China that has wanted. Remember all the complaints about speculative capital inflows a year ago?

Still, China’s willingness to provide RMB credit to Argentina suggests that China is beginning to recalibrate its definition of its interests.

It is further evidence that China is defining its interest as a creditor – not just as an exporter willing to accept losses on the “vendor financing” it supplies on subsidized terms to those it hopes to encourage to buy its goods.

I was surprised by how conservative China was in the immediate aftermath of the crisis.

It seemed to be concerned almost exclusively with the need to minimize the credit risk in its reserve portfolio. That meant turning down requests from countries like Pakistan for bilateral financing – as well as selling Agencies and buying Treasuries. Now it seems that China has concluded that it has reduced the credit risk in its reserve portfolio to an acceptable level and is turning its eye toward reducing its currency risk.

That though may be a tougher nut to crack.

Perhaps the state council was spooked by a memo the PBoC sent up the food chain laying out all of the risks that remained in China’s portfolio. If the rumors that China’s leaders were surprised to discover the extent of their exposure to Fanny and Freddie are true, the PBoC has every incentive now to make sure that China’s top leaders aren’t surprised by any future currency losses on China’s reserves.

But the state council has also historically been response to the concerns of China’s exporters – and the core tension between China’s interest as an exporter and its interest as a creditor remains.

Moreover, I am not exactly sure it would be a good thing for China to replace a lot of dollar lending to the world with a lot of RMB lending to the world. China would take on less currency risk to be sure, but all the problems created by China’s large surplus would remain. Actually, they would get worse — as more risk would be in the hands of the world’s big borrowers.

The FT leader again: “[China] must not just replace its mountain of dollar assets with heaps of other currencies.” Exactly right."

"As was the case in the 1930s, we also have a choice"

Martin Wolf on Keynes on the FT:

"We are all Keynesians now. When Barack Obama takes office he will propose a gigantic fiscal stimulus package. Such packages are being offered by many other governments. Even Germany is being dragged, kicking and screaming, into this race.

The ghost of John Maynard Keynes, the father of macroeconomics, has returned to haunt us. With it has come that of his most interesting disciple, Hyman Minsky. We all now know of the “Minsky moment” – the point at which a financial mania turns into panic.

Like all prophets, Keynes offered ambiguous lessons to his followers. Few still believe in the fiscal fine-tuning that his disciples propounded in the decades after the second world war ( TRUE ). But nobody believes in the monetary targeting proposed by his celebrated intellectual adversary, Milton Friedman, either( TRUE ). Now, 62 years after Keynes’ death, in another era of financial crisis and threatened economic slump, it is easier for us to understand what remains relevant( I SAY USEFUL ) in his teaching.

I see three broad lessons.

The first, which was taken forward by Minsky, is that we should not take the pretensions of financiers seriously. “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.” Not for him, then, was the notion of “efficient markets”( I AGREE ).

The second lesson is that the economy cannot be analysed in the same way as an individual business. For an individual company, it makes sense to cut costs. If the world tries to do so, it will merely shrink demand( AS A WHOLE, I CAN UNDERSTAND THIS ). An individual may not spend all his income. But the world must do so( TRY TO ).

The third and most important lesson is that one should not treat the economy( ECONOMICS IS FINE HERE ) as a morality tale( HERE I DISAGREE COMPLETELY. MORALITY IS PART OF POLITICAL ECONOMY ). In the 1930s, two opposing ideological visions( THERE WERE OTHERS, THANKFULLY DEFEATED ) were on offer: the Austrian; and the socialist. The Austrians – Ludwig von Mises and Friedrich von Hayek – argued that a purging of the excesses of the 1920s was required. Socialists argued that socialism needed to replace failed capitalism, outright. These views were grounded in alternative secular religions: the former in the view that individual self-seeking behaviour guaranteed a stable economic order(I DON'T AGREE WITH HIM HERE. VON MISES CRITIQUE OF SOCIALISM WAS MORE THAN A MORALITY TALE, AND SO WERE HAYEK'S VIEWS ABOUT THE MARKET AND THE DANGERS OF TOO MUCH STATE CONTROL); the latter in the idea that the identical motivation could lead only( IT WAS THIS MECHANISTIC APPROACH TO POLITICS AND POLITICAL ECONOMY THAT MADE MARXISM, FOR EXAMPLE, NOT SUITABLE FOR HUMAN CONSUMPTION ) to exploitation, instability and crisis.

Keynes’s genius – a very English one – was to insist we should approach an economic system not as a morality play but as a technical challenge( WRONG ). He wished to preserve as much liberty as possible( I AGREE. AS DO I. ), while recognising that the minimum state( HERE I DISAGREE ) was unacceptable to a democratic society with an urbanised economy( I CAN FORESEE A TIME OF LESS GOVERNMENT INVOLVEMENT, BUT THIS IS CURRENTLY TRUE ). He wished to preserve a market economy, without believing that laisser faire makes everything for the best in the best of all possible worlds( I WOULD SEEM TO AGREE WITH HIM ).

This same moralistic debate is with us, once again. Contemporary “liquidationists” insist that a collapse would lead to rebirth of a purified economy( COMPLETELY UNBURKEAN ). Their leftwing opponents argue that the era of markets is over. And even I wish to see the punishment of financial alchemists who claimed that ever more debt turns economic lead into gold( I WOULD LIKE TO SEE THE PUNISHMENT OF CRIMINALS ).

Yet Keynes would have insisted that such approaches are foolish. Markets are neither infallible nor dispensable( TRUE. THEY ARE USEFUL. ). They are indeed the underpinnings of a productive economy and individual freedom( TRUE ). But they can also go seriously awry and so must be managed with care( TRUE ). The election of Mr Obama surely reflects a desire for just such pragmatism( TRUE ). Neither Ron Paul, the libertarian, nor Ralph Nader, on the left, got anywhere( TRUE ). So the task for this new administration is to lead the US and the world towards a pragmatic resolution of the global economic crisis we all now confront.( I AGREE )

The urgent task is to return the world economy to health.

The shorter-term challenge is to sustain aggregate demand( YES ), as Keynes would have recommended. Also important will be direct central-bank finance of borrowers( YES ). It is evident that much of the load will fall on the US, largely because the Europeans, Japanese and even the Chinese are too inert, too complacent, or too weak( TOO MUCH BEGGARING ON THEIR PART ALREADY ). Given the correction of household spending under way in the deficit countries( SPENDER COUNTRIES ), this period of high government spending is, alas, likely to last for years( BTREATHE DEEPLY MATE ). At the same time, a big effort must be made to purge the balance sheets of households and the financial system. A debt-for-equity swap is surely going to be necessary( IT WON'T NEARLY BE AS LARGE AS HE THINKS. TOO MANY PEOPLE WANT THE OLD SYSYEM BACK. IT SUITS US. ).

The longer-term challenge is to force a rebalancing of global demand. Deficit( SPENDER ) countries cannot be expected to spend their way into bankruptcy( TRUE ), while surplus ( SAVER )countries condemn as profligacy the spending from which their exporters benefit so much( THAT'S WHY THEY'RE STRUGGLING TO KEEP THIS SYSTEM ). In the necessary attempt to reconstruct the global economic order, on which the new administration must focus, this will be a central issue. It is one Keynes himself had in mind when he put forward his ideas for the postwar monetary system at the Bretton Woods conference in 1944.

No less pragmatic must be the attempt to construct a new system of global financial regulation and an approach to monetary policy that curbs credit booms and asset bubbles( WE'LL TRY ). As Minsky made clear, no permanent answer exists( TRUE ). But recognition of the systemic frailty of a complex financial system would be a good start( OK ).

As was the case in the 1930s, we also have a choice: it is to deal with these challenges co-operatively and pragmatically or let ideological blinkers and selfishness obstruct us ( I AGREE ). The objective is also clear: to preserve an open and at least reasonably stable world economy that offers opportunity to as much of humanity as possible( I AGREE ). We have done a disturbingly poor job of this in recent years. We must do better. We can do so, provided we approach the task in a spirit of humility and pragmatism, shorn of ideological blinker. ( WE GET THE POINT )

As Oscar Wilde might have said, in economics, the truth is rarely pure and never simple. That is, for me, the biggest lesson of this crisis. It is also the one Keynes himself still teaches( I AGREE )."

He gets a bit simplistic, but I generally agree with what he's saying, except for the fact that, long term, I believe that less government with a growing and balanced economy is possible. Keynes view is still too rooted in the 30s to be of major use to us undigested, and is much too pessimistic and mechanistic, as that era tended to be. Again, Political Economy and Politics are underpinned by the context and presuppositions of the time.

What Keynes offers us is a little useful wisdom and a narrative of perceived success at helping the world out of a crisis, which goes a long in times like these.

"who represent competing strains of Democratic economic thought": I'm A Sort Of Non-Competative Strand

Yesterday Free Exchange commented on the post by Robert Rubin and Jared Bernstein about interest and debt, and how they are viewed in the Democratic Party. My party. Now, you might well ask where I fit in, but I've about 600 posts now trying to answer that, so let's move on:

"ROBERT RUBIN and Jared Bernstein are two left-leaning economists (both of which have advised Barack Obama) who represent competing strains of Democratic economic thought. Mr Rubin, Treasury secretary under Bill Clinton, was known as an economic centrist—pushing free trade and fiscal responsibility. Mr Bernstein is a more progressive economist, who has emphasised international labour standards and a robust social safety net.

Today, the New York Times published an opinion column co-written by Mr Rubin and Mr Bernstein. It lays out the broad areas of agreement between the two men which, one assumes, hints at what might emerge from an Obama administration. It's not particularly scary stuff—short-term stimulus, infrastructure investment, long-term fiscal discipline, sympathetic labour policies, and a trade policy that seeks to protect workers but not jobs or industries. A change in direction, to be sure, and one that deserves vigilant oversight, but not a new social democratic state."

Now, I didn't respond to this column because I also didn't see it as particularly scary or even interesting. It dealt at the level of nostrums. I'm more on Rubin's side, but I actually am concerned about Bernstein's concerns.

"What's most interesting to me are the areas where the two authors are forced to concede disagreement. One of these issues—the effect of long-run deficits on interest rates and economic growth—is one of the most contentious areas of debate for lefty economists. The authors write:

One of us (Mr. Rubin) views long-term fiscal deficits — in combination with a low national savings rate, large current account deficits and foreign portfolios that are heavily over-weighted in dollar-dominated assets — as a serious threat to long-term interest rates and our currency and, therefore, to our economic future. The other views these economic relationships as much weaker.

This is the view that shaped Clintonian deficit reduction. It also angered many Democrats, who would have preferred that increased revenues be used for a health insurance solution or public investments. Mr Rubin's position strikes me as fairly orthodox. The thing is, I'm not sure that it makes sense in light of recent events. A lot of people expected a dollar run to precipitate crisis. Instead, crisis precipitated a dollar boom."

Again, here I'm on Rubin's side. But I see the problem.

"And now, Calculated Risk is arguing that declining American deficits might result in higher long-term interest rates. Why? A reduction in the current account deficit would trim growth in foreign central bank investment in dollar-denominated assets, pushing up interest rates. In short, so long as Bretton Woods 2 held up, American deficits meant low interest rates. Only when that financial system comes apart can we expect Mr Rubin's conditions to obtain.

Mr Rubin was right about interest rates given that he was in a certain financial equilibrium, but he was wrong about which equilibrium he found himself in. Given Bretton Woods 2, and the resulting ability to borrow cheap, America should have borrowed heavily and ploughed Chinese capital into long-term domestic investments. By instead running a surplus, Mr Rubin simply made easy credit available to the private sector which, understandably, poured that credit into heavy consumption and investment in non-tradable sectors (like housing!) which weren't rendered comparatively unattractive by Chinese currency policies."

I saw the Calculated Risk post as well, and it bothered me. ( but see Setser here )

"So which should America choose moving forward? For the moment, the risk of a dollar collapse seems low, and the need for deficit spending appears high. Beyond that, we must see whether China will continue to finance American borrowing, or if China will allow domestic spending to flourish by letting the RMB appreciate. Increasingly America is learning that neither its monetary policy or its fiscal policy is as independent of international forces as it believed."

So, this really is food for thought. I agree with:

1) Risk of dollar collapse is low ( I also agree with 'seems' )

2) That's why I accept some deficit spending in the short term and a stimulus plan.

Where to go from here. Let me utter some nostrums:

1) A banking system based on Bagehot's Principles

2) Reducing government spending

3) Lower debt

4) A slight budget surplus or debt in normal times

5) Lower taxes, and fairer and more efficient taxes

I fear:

1) Inflation

But I have to admit, all these gyrations are making things hellishly complicated.

However, this post by Bob McTeer seems to echo more or less the same view, although I would disagree with him on some specifics:

"The most important near-term thing you could do to reassure financial markets and quell the turmoil is to announce early that you don't intend to eliminate President Bush's marginal tax-rate cuts. If you can't go that far, keep the adjustments as small as possible and announce your intentions to be moderate early. A little bad news early is better than great uncertainty and expecting the worse. ( I'm fine with small adjustments )

You have an education job to do. You must be able to articulate clearly how high tax rates on capital (capital gains, dividends, corporate taxes, the death tax, etc.) diminishes the demand for labor and keeps wages from rising. ( I agree )

While tax-rate increases are bad anytime, they are particularly bad in a recession. The timing couldn't be worse for a tax increase. ( I tend to agree, but the debt bothers me more )

Energy limitations must be attacked on all fronts: drill, drill, drill, nuclear, clean coal, wind, solar, and so forth. Don't push for energy independence; push for less energy dependence. ( I sort of agree, but have more environmental concerns )

Everyone knows that exports create jobs, but few focus on imports, which represent the gains from trade. Help educate people on the benefits of low prices via imports. ( I agree, basically )

Don't overdo the regulatory reaction to the current financial crisis. Another Sarbanes-Oxley is the last thing we need." ( I agree )

In other words, while things are in flux, let's stick to our general principles, while confronting reality and bending them where necessary. But like Becker and McTeer, I agree that we don't want to kill the goose that laid the golden egg.

As to Rubin and Bernstein, I'm not that bothered by either of them. I see them as sensible people. I've no fear of some massive economic shift. There will be tinkering, but tinkering can often be wise.