Foreign capital, go home!

By Michael Pettis

Is the PBoC going to stop buying USG bonds? Once again we are hearing very worried noises from various sectors about the possibility of a reduction in Chinese purchases of USG bonds. Here is what an article the South China Morning Post said:

China will press ahead with diversification of its US$3.2 trillion in foreign exchange reserves, the State Administration of Foreign Exchange (SAFE) said on Thursday, adding 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 per cent of which are now in US dollar assets, according to analysts’ estimates – but the process has been gradual.

“We will continue to diversify the asset allocation of our reserve assets and continue to optimise the holdings based on market conditions,” the foreign exchange regulator said in a statement, responding to questions about its reserve management from the public. It did not mention the US debt debacle. Top Republicans and Democrats worked behind the scenes on Wednesday on a compromise to avert a crippling US default and potential credit rating downgrade.

Xia Bin, an adviser to the central bank, told reporters earlier this month that China should speed up reserve diversification away from dollars to hedge against risks of the US currency’s possible long-term decline.

It sounds like this time the PBoC might be pretty serious about diversifying their risk away from USG bonds, right? Let’s leave aside the fact that every six months we have heard the same thing for the past several years, and nothing has happened, shouldn’t we nonetheless be worried? Won’t reduced PBoC purchases be hugely disruptive to the US economy and to the US Treasury markets?

No, they won’t. There is so much nonsense still being said about this, even by economist who should know better, that I thought I would try to address what it would mean if the PBoC were actually serious and not simply making noises aimed at domestic political constituents.

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 actually a net importer of capital, the PBoC must export huge amounts of capital in order to maintain China’s trade surplus. In order the keep the RMB from appreciating, the PBoC must be willing to purchase 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 – and this is the crucial point – whose economy is willing and able to run a large enough trade deficit.

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 financial markets, and the ability and willingness to run large trade deficits – which is why the PBoC owns huge amounts of USG bonds.

If the PBoC decides that it no longer wants to hold USG bonds, it must do something pretty drastic. There are only four possible paths that the PBoC can follow if it decides to purchase fewer USG bonds.

1. The PBoC can buy fewer USG bonds and purchase more USD assets.
2. The PBoC can buy fewer USG bonds and purchase more non-US dollar assets, most likely foreign government bonds.
3. The PBoC can buy fewer USG bonds and purchase more hard commodities.
4. The PBoC can buy fewer USG bonds by intervening less in the currency, in which case it does not need to buy anything else.

We can go through each of these scenarios to see what would happen and what the impact might be on China, the US, and the world. To make the explanation easier, let’s simply assume that the PBoC sells $100 of USG bonds.

The PBoC can sell $100 of USG bonds and purchase $100 of other USD assets. In this case basically nothing would happen. The pool of US dollar savings available to buy USG bonds would remain unchanged (the seller of USD assets to China would now have $100 which he would have to invest, directly or indirectly, in USG bonds), China’s trade surplus would remain unchanged, and the US trade deficit would remain unchanged. The only difference might be that the yields on USG bonds will be higher by a tiny amount while credit spreads on risky assets would be lower by the same amount.

The PBoC can sell $100 of USG bonds and purchase $100 of non-US dollar assets, most likely foreign government bonds. Since in principle the only market big enough is Europe, let’s just assume that the only alternative is to buy $100 equivalent of euro bonds issued by European governments.

There are two ways the Europeans can respond to the Chinese switch from USG bonds to European bonds. On the one hand they can turn around and purchase $100 of USD assets. In this case there is no difference to the USG bond market, except that now Europeans instead of Chinese own the bonds. What’s more, the US trade deficit will remain unchanged and the Chinese trade surplus also unchanged.

But Europe might be unhappy with this strategy. Since there is no reason for Europeans to buy an additional $100 of US assets simply because China bought euro bonds, the purchase will probably occur through the ECB, in which case Europe will be forced to accept an unwanted $100 increase in its money supply (the ECB must create euros to buy the dollars).

On the other hand, and for this reason, the Europeans might decide not to purchase $100 of US assets. In that case there must be an additional impact. The amount of capital the US is importing must go down by $100 and the amount that Europe is importing must go up.

Will this reduction in US capital imports make it more difficult to fund the US deficit? Not at all. On the contrary – it might make it easier. Why? Because if US capital imports drop by $100, by definition the US current account deficit will also drop by $100, almost certainly because of a $100 contraction in the trade deficit.

A contraction in the US trade deficit is of course expansionary for the economy. Since the purpose of the US fiscal deficit is to create jobs, and a $100 contraction in the trade deficit will create jobs, the US fiscal deficit will contract by $100 for the same level of job creation – perhaps even more if you believe, as most of us do, that increased trade is a more efficient creator of productive jobs than increased government spending.

In other words although there is $100 less demand for USG bonds, there is also $100 less supply (or more) of USG bonds. It is of course possible that the USG ignores the employment impact of the contraction in the trade deficit, and goes ahead and spends the $100 anyway, but in that case unemployment would drop even more than expected.

This is the key point. If foreigners buy fewer USD assets, the US trade deficit must decline. This is almost certainly good for the US economy and for US employment. When analysts worry that China might buy fewer USG bonds, in other words, they are worrying that the US trade deficit might contract. This is something we should welcome, not deplore.

But the story doesn’t end there. What about Europe? Since China is still exporting the $100 by buying European government bonds instead of USG bonds, its trade surplus doesn’t change, but of course as the US trade deficit declines, the European trade surplus must decline, and even possibly go into deficit. This is because by selling dollars and buying euro, China is forcing the euro to appreciate against the dollar.

This deterioration in the trade account will force Europeans either into raising their fiscal deficits or letting domestic unemployment rise. Under these conditions it is hard to imagine they would tolerate much Chinese purchase of European assets without responding eventually with trade protection.

The PBoC can sell $100 of USG bonds and purchase $100 of hard commodities. This is no different than the above scenario except now that the exporters of those hard commodities must face the choice Europe faced above. Either they can neutralize the trade impact of Chinese purchases by buying US assets or they have to absorb the employment impact of deterioration in their trade account.

This, by the way, is a bad strategy for China but one that it seems nonetheless to be following. Commodity prices are very volatile, and unfortunately this volatility is badly correlated with Chinese needs. Since China is the largest or second largest purchaser of most commodities, stockpiling commodities is a good investment only if it continues growing rapidly, and a bad investment if its growth slows. This is the wrong kind of balance sheet position any county, especially a very poor country like China, should be engineer. It simply exacerbates underlying conditions and increases economic volatility – never a good thing, especially for a poor and undeveloped economy.

The PBoC can sell $100 of USG bonds by intervening less in the currency, in which case it does not need to buy anything else. In this case, which is the simplest of all to explain, China’s trade surplus declines by $100 and the US trade deficit declines by $100 as the RMB rises. The net impact on US financing costs is unchanged for the reasons discussed above. Chinese unemployment will rise because of the reduction in its trade surplus unless it increases the fiscal deficit.

It’s about trade, not capital

This may sound counterintuitive to all except those who understand the way the global balance of payments work, but countries that export capital are not doing anyone favors unless incomes in the recipient country are so low that savings are impossible or the capital export comes with technology, and countries that import capital might be doing so mainly at the expense of domestic jobs. For this reason it is absurd to worry that China might stop buying USG bonds.

On the contrary, the whole US-China trade dispute is indirectly about China’s insistence on purchasing USG bonds and the US insistence that they stop. Because make no mistake, if the Chinese trade surplus declines, and the US trade deficit declines too, by definition China is directly or indirectly buying fewer USG bonds, and this reduction in bond purchases will not cause US interest rate to rise at all. If it did, it would be like saying that the higher a country’s trade deficit, the lower its domestic interest rates. This statement is patently untrue.

Inevitably whenever I write about trade and capital exports someone will indignantly point out a devastating flaw in my argument. Since the US makes nothing that it imports from China, they will claim, a reduction in China’s capital exports to the US (or a reduction in China’s trade surplus) will have no impact on the US trade deficit. It will simply cause someone else’s exports to the US to rise with no corresponding change in the US trade balance.

No it won’t, unless this other country steps up its capital exports to the US and replaces China – which is pretty unlikely. Aside from the sheer idiocy of the claim that the US does not produce, or is incapable of producing, anything it imports from China, the claim is irrelevant even if it were true. Trade does not settle on a bilateral basis but must settle on a multilateral basis. If the US imports less capital its current account deficit must decline, whether because of bilateral changes in trade or not. I explain this in a blog entry early last year.

The basic point is that if reduced intervention in Chinese capital exports causes a reduction in Chinese exports to the US to be matched dollar for dollar with an increase in, say, Mexican exports to the US, the story doesn’t end there. Since Mexico’s trade balance is itself decided by the relationship between domestic investment and savings, a rise in Mexican exports will mean a rise in Mexican imports. It may very well be that lower Chinese exports to the US are matched by higher US imports from Mexico, but this will come with higher US exports to Mexico. And if it isn’t Mexico, it will be someone else.

This is an abbreviated version of the newsletter that went out two weeks ago. Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at [email protected], stating your affiliation, please. Investors who want to buy a subscription should write to me, also at that address.