Sunday, September 16, 2007

Are China's U.S. Debt Holdings a Trump Card ?

Brad Setser | Sep 13, 2007, on his blog

[All emphasis added; RMB = renminbi, Chinese currency]
China indicated back in 2004 that it wanted to rebalance its economy, and shift away from export and investment-led growth, [but] it is increasingly clear that the policies China has adopted to try to rebalance its economy have not worked.

The World Bank’s most recent quarterly update on China’s economy report notes that net exports will contribute as much to China’s growth in the first half of 2007 as in the last half of 2006. [...]

China’s current account surplus is projected to rise to $380b (12% of China’s GDP) – even with very high oil prices. That is an increase of $300b (and 8-9% of China’s GDP) since 2004. [...]

But China’s huge external surplus isn’t just an issue for China. China’s policy choices are shaping how the global economy adjusts to the US slump. That slump – and the associated weakness in the dollar -- has already pulled down the US non-oil trade deficit a bit. But the main impact of dollar (and RMB) weakness has been an increase in China’s trade surplus. [...]

The result: China increasingly is using lending the surplus it earns selling goods to Europe to the US, not just lending the money it earns selling to the US back to the US.

On current trends, China will run a $260b or so bilateral trade surplus with the US, and a $380b global surplus. It also will likely lend the US $350b or more of its $500b in reserve growth.

China will be lending the US significantly more than it makes selling to the US for the first time.

That, I suspect, is something that is likely to continue in the future. It has a corollary as well: The gains to China from financing the US are falling, while the costs China has to bear to support the US are rising.

The standard argument that China would shoot itself in the foot, financially speaking, if it stopped lending to the US is wrong. China would certainly shoot its export sector in the foot if it stopped lending to the US. And it is true that if China stopped lending to the US, the value of the RMB would rise relative to the dollar and the value of China’s existing US assets would fall. But China would still be better off, in the purely financial sense, if it took its lumps now.

Remember, China has to buy an awful lot of dollars to keep from taking losses now. It is has to do more than hold its existing position. It has to add to its position.

And the more dollars China holds, the larger its ultimate losses.

Every time China’s government borrows in RMB to buy another dollar – a dollar that is almost sure not to hold its value relative to the RMB – it shoots another hole in its balance sheet.

No doubt, those betting that China would be willing to pay an ever-growing price to maintain stability in the US bond market have made the right call over the past few years. But those making the bet are betting that China will continue to prioritize the interests of its export sector over its own long-term financial health, and perhaps domestic macroeconomic stability as well...

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