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Pity the Chinese




The Chinese own about $1 trillion worth of Treasury securities, whose average yield is now probably in the range of 1-1.5%, and they are being forced to take a beating on those holdings. They are in a real bind, because they are being pressured to appreciate their currency by U.S. politicians who are sadly ignorant of how global trade and capital flows work, and by the Federal Reserve, the architect of the ongoing loss of the dollar's value. In the past four months, China's central bank has allowed the yuan to appreciate over 8% against the dollar in an attempt to alleviate those pressures.

China's reasons for doing this are twofold: to appease U.S. policymakers who are arguing for a much more dramatic appreciation of the yuan, and to minimize the inflationary impact of being tied to a weak and falling dollar. Pegging its currency to the dollar is the cornerstone of China's monetary policy, and if the dollar weakens, then the yuan also weakens, and this is equivalent to a monetary ease which will sooner or later show up as higher Chinese inflation. In fact, China's CPI has already risen, on a year over year basis, from a low of -1.8% in July '09 to 3.5% as of August '10. The weakening of the dollar, which has carried the yuan down with it, is the proximate cause of this reflation.

Revaluing one's currency doesn't come cheap, however, especially when the currency you are revaluing against is also the currency in which the majority of your reserve assets are denominated. The appreciation of the yuan over the past four months has effectively wiped out a little over 3 year's worth of interest on their dollar security holdings. Further yuan appreciation, which seems likely, will wipe out even more of the value of China's foreign bond holdings. They are truly caught between a rock and a hard place.

This reminds me of the massive losses that Japan suffered as result of the appreciation of the yen, which rose from 250/$ in 1985 to 80/$ at its peak in 1995. This 200% yuan appreciation destroyed fully two-thirds of the value of the countless billions of dollar assets that Japanese savers had accumulated. Recall that Japan was a major export engine at the time, its aging population had a high savings rate, and the destination of choice for those savings—which were larger than could be accommodated by Japan's own economy—was the U.S.

Remember the book "Rising Sun," by Michael Crichton? His thesis was that the U.S. was monumentally stupid to allow the Japanese to buy so much of our real estate and so much of our industry. As a resident of Los Angeles, I recall that Japan's purchases of a number of downtown office towers occurred almost precisely at the peak of real estate prices in the early 1990s. Prices then proceeded to drop by one-third, at the same time the dollar fell from 130 yen to the low 80s—real estate bought in the early 1990s lost over one-half its value when translated back into yen. Japan's savers lost a fortune, thanks to the Bank of Japan's extremely tight monetary policy. And as it turns out, Japan never acquired the nefarious control over U.S. industry that Crichton warned about in his book. On the contrary, we took them to the cleaners. We bought their cheap cars and cheap electronics; they invested their export earnings in the U.S., only to see a huge portion of those savings wiped out by the weak dollar/strong yen.

And so it is with the Chinese. They sell us mountains of cheap goods, then turn around and invest most of the proceeds (equivalent to our trade deficit with China) in U.S. Treasury securities. We get the goods, and we get to keep the money. Then we devalue the dollar, and they lose on their investment. Why we would want them to stop doing this is beyond me, though if I were a Chinese citizen, I would be furious with my government for directing such massive quantities of my country's export earnings to Treasuries. The central bank of China has no need to further increase its already-massive reserves; instead, the government should be relaxing capital constraints, allowing Chinese citizens more freedom to save and invest abroad in the types of vehicles with which they feel most comfortable. China's workforce is aging daily, and like Japan a few decades ago, China's economy cannot accommodate all the savings of the Chinese people—they are essentially forced to save overseas.

Contrary to what you read in the press—which mistakenly believes that our large trade deficit with China is something we need to worry about—China is the one that needs to worry, not us.

UPDATE: I highly recommend John Cochrane's WSJ article, "Geithner's Global Central Planning." Key quote: "The Chinese government's accumulation of U.S. debt represents a tragic investment decision, not a currency-manipulation effort." The article is an elegant ridicule of all those who think they can spot and treat a global trade or currency "imbalance." It should be required reading for all students of economics.

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