Making for the exit

Once again, we are hearing worried noises about the possibility of a reduction in Chinese purchases of US government bonds. An article in the July 28 South China Morning Post quoted the State Administration of Foreign Exchange (SAFE) as saying that China would press ahead with diversification of its US$3.2 trillion in foreign exchange reserves, and that it does not intentionally pursue large-scale foreign currency holdings. “Officials have long pledged to broaden the mix of the country’s huge reserves – as much as 70% of which are now in US dollar assets, according to analysts’ estimates – but the process has been gradual,” said the article.

The threat of a looming US default seems to be driving this concern, although I’m not sure that the People’s Bank of China is really worried about getting its money back. After all if the US defaults, it will be mainly a technical default that will certainly be made good one way or the other. Since the PBoC doesn’t have to worry about mark-to-market losses, unlike mutual funds, I think for China this is largely an economic non-event (not that there isn’t good mileage in pointing to the sheer silliness of the US political process). Still, for domestic political reasons it needs to be seen huffing and puffing over American irresponsibility.

Leaving aside the fact that we have heard the same thing for the past several years, and nothing has happened, shouldn’t we nonetheless be worried? Won’t reduced purchases be disruptive to the US economy and to the US Treasury markets? No, they won’t, and anyway they aren’t going to happen. First of all, remember that the PBoC does not purchase huge amounts of USG bonds because it has a lot of money lying around and doesn’t know what to do with it. Its purchase of USG bonds is simply a function of its trade policy. You cannot run a current account surplus unless you are also a net exporter of capital, and since the rest of China is a net importer of capital, the PBoC must export huge amounts to maintain China’s trade surplus. To keep the RMB from appreciating, in other words, the PBoC must be willing to buy as many dollars as the market offers at the price it sets. It pays for those dollars in RMB. It is able to do so by borrowing RMB in the domestic markets, or by forcing banks to put up minimum reserves on deposit.

What does the PBoC do with the dollars it purchases? Because it is such a large buyer of dollars, it must put them in a market that is large enough to absorb the money and – this is the crucial point – whose economy is willing and able to run a large enough trade deficit.

This last point is what everyone seems to forget when discussing Chinese purchases of foreign bonds. Remember that when Country A exports huge amounts of money to Country B, Country A must run a current account surplus and Country B must run the corresponding current account deficit. In practice, only the US fulfills those two requirements – large and flexible financial markets, and the ability and willingness to run large trade deficits – which is why the PBoC owns huge amounts of USG bonds.

From “China Lookout – Strategy: Follow-up on our 50-100% upside call,” Wendy Liu, RBS head of China research, August 18

In the near term, we believe that markets have been overly extrapolating economic challenges in the US and EU to China. Regarding the MSCI-China, the much-feared earnings downgrades since May have so far been proven wrong; imminent issues over Chinese banks’ capital adequacy, local-government finance vehicles and fresh equity raising have failed to arise. Concerns over China’s fixed-asset investment should also be proven wrong again this year: 35% of China’s FAI is enterprise FAI, and that grew by 33% during the first half of the year. Despite much concern, private sector property FAI still grew by 36% year-on-year during the first half. At the ground level in China, people still prefer property over stocks as a store of value, based on our checks.

For the medium term, we are calling for the MSCI-China to rise 50-100% through 2012, reflecting a correction of the current mis-pricing, and the process for developed markets’ capital to flow into faster growing markets, including China.

From “The US Content of ‘Made in China,’” Galina Hale and Bart Hobijn, Federal Reserve Bank of San Francisco, August 8

Although globalization is widely recognized these days, the US economy actually remains relatively closed. The vast majority of goods and services sold in the US are produced here. In 2010, imports from China amounted to 2.5% of total GDP. A total of 88.5% of US consumer spending is on items made in the US. This is largely because services, which make up about two-thirds of spending, are mainly produced locally.

Chinese imported goods consist mainly of furniture, household equipment, other durables, clothing and shoes. Whereas goods labeled “Made in China” make up 2.7% of US consumer spending, only 1.2% actually reflects the cost of the imported goods. Thus, on average, of every dollar spent on an item labeled “Made in China,” 55 cents goes to  services produced in the United States. In other words, the US content of “Made in China” is about 55%.