By L. Randall Wray
Previously we have shown that government deficits lead to an equivalent amount of nongovernment savings. The nongovernment savings created will be held in claims on government. Normally, the nongovernment sector prefers to hold some of that savings in government IOUs that promise interest, rather than in nonearning IOUs like cash. Further, we have shown that budget deficits create an equivalent amount of reserves. And banks prefer to hold higher-earning assets than reserves that pay almost nothing (until recently, they paid zero in the USA). Hence, both savers as well as banks would rather have government bonds. We thus find that in normal times, government will offer interest earning bonds in an amount almost equal to its deficits (the difference is made up by bank accumulation of reserves and private sector accumulation of currency).
However, when government deficit spends, some of the claims on government will end up in the hands of foreigners. Does this matter? Yes, according to many. At one extreme we have many commentators worrying that the US government might run deficits but will find that the Chinese desire to “lend to” the US government is insufficient to absorb bond issues. Others argue that while Japan can run up government debt to GDP ratios equal to 200% of GDP this is only because more than 90% of all that debt is held domestically. The US, it is said, cannot run up debts that great because so much of its “borrowing” is from foreigners—who might “go on strike”. Others worry about ability of the US government (for example) to pay interest to foreigners. And what if foreigners demand more interest? And what about effects on exchange rates? This week we begin to look at such issues.
Foreign holdings of government debt. Government deficit spending creates equivalent nongovernment savings (dollar for dollar). However, some of the savings created will accumulate in the hands of foreigners, since they can also accumulate the government’s domestic currency-denominated debt.
In addition to actually holding the currency including both cash and reserves (indeed, it is possible that foreigners hold most US dollar-denominated paper currency), they can also hold government bonds. These usually just take the form of an electronic entry on the books of the central bank of the issuing government. Interest is paid on these “bonds” in the same manner, whether they are held by foreigners or by domestic residents—simply through a “keystroke” electronic entry that adds to the nominal value of the “bond” (itself an electronic entry). The foreign holder portfolio preferences will determine whether they hold bonds or reserves—with higher interest on the bonds. As discussed in previous weeks, shifting from reserves to bonds is done electronically, and is much like a transfer from a “checking account” (reserves) to a “savings account” (bonds).
There is a common belief that it makes a great deal of difference whether these electronic entries on the books of the central bank are owned by domestic residents versus foreigners. The reasoning is that domestic residents are far less likely to desire to shift to assets denominated in other currencies.
Let us presume that for some reason, foreign holders of a government’s debt decide to shift to debt denominated in some other currency. In that case, they either let the bond mature (refusing to roll over into another instrument) or they sell it. The fear is that this could have interest rate and exchange rate effects—as debt matures government might have to issue new debt at a higher interest rate, and selling pressure could cause the exchange rate to depreciate. Let us look at these two possibilities separately.
a) Interest rate pressure. Let us presume that sizable amounts of a government’s bonds are held externally, by foreigners. Assume foreigners decide they would rather hold reserves than bonds—perhaps because they are not happy with the low interest rate paid on bonds. Can they pressure the government to raise the interest rate it pays on bonds?
A shift of portfolio preferences by foreigners against this government’s bonds reduces foreign purchases. It would appear that only higher interest rates promised by the government could restore foreign demand.
However, recall from previous discussions that bonds are sold to offer an interest earning alternative to reserves that pay little or no interest. Foreigners and domestic residents buy government bonds when they are more attractive than reserves. Refusing to “roll over” maturing bonds simply means that banks taken globally will have more reserves (credits at the issuing government’s central bank) and less bonds. Selling bonds that have not yet matured simply shifts reserves about—from the buyer to the seller.
Neither of these activities will force the hand of the issuing government—there is no pressure on it to offer higher interest rates to try to find buyers of its bonds.
From the perspective of government, it is perfectly sensible to let banks hold more reserves while issuing fewer bonds. Or it could offer higher interest rates to sell more bonds (even though there is no need to do so); but this just means that keystrokes are used to credit more interest to the bond holders.
Government can always “afford” larger keystrokes, but markets cannot force the government’s hand because it can simply stop selling bonds and thereby let markets accumulate reserves instead.
b) Exchange rate pressure. The more important issue concerns the case where foreigners decide they do not want to hold either reserves or bonds denominated in some currency.
When foreign holders decide to sell off the government’s bonds, they must find willing buyers. Assume they wish to switch currencies, so they must find holders of other currency-denominated reserve credits willing to exchange these for the bonds offered for sale. It is possible that the potential buyers will purchase bonds only at a lower exchange rate (measured as the value of the currency of the government bonds that are offered for sale relative to the currency desired by the sellers).
For this reason, it is true that foreign sales of a government’s debt can affect the exchange rate. However, so long as a government is willing to let its exchange rate “float” it need not react to prevent a depreciation.
We conclude that shifting portfolio preferences of foreign holders can indeed lead to a currency depreciation. But so long as the currency is floating, the government does not have to take further action if this happens.
Current accounts and foreign accumulation of claims. Just how do foreigners get hold of reserves and bonds denominated in a government’s domestic currency?
As we have shown in previous weeks, our macroeconomic sectoral balance ensures that if the domestic private sector balance is zero, then a government budget deficit equals a current account deficit. That current account deficit will lead to foreign net accumulation of financial assets in the form of the government’s debt. This is why, for example, the US government is running deficits and issuing government debt that is accumulated in China and elsewhere.
Of course, in the case of the US, for many years (during the Clinton and Bush, jr., presidencies) the domestic private sector was also running budget deficits—so foreigners also accumulated net claims on American households and firms. The US current account deficit guarantees—by accounting identity—that dollar claims will be accumulated by foreigners.
After the crisis, the US domestic sector balanced its budget and actually started to run a surplus. However, the current account deficit remained. The US government budget deficit grew—by identity it was equal to the current account deficit plus the private sector surplus. Given that the US government became the only net source of new dollar-denominated financial assets (the US private sector was running a surplus), foreigners must—by accounting identity—have accumulated US government debt.
Some fear—as discussed earlier—that suddenly the Chinese might decide to stop accumulating US government debt. But it must be recognized that we cannot simply change one piece of the accounting identity, and we cannot ignore the stock-flow consistency that follows from it.
For the rest of the world to stop accumulating dollar-denominated assets, it must also stop running current account surpluses against the US. Hence, the other side of a Chinese decision to stop accumulating dollars must be a decision to stop net exporting to the US. It could happen—but the chances are remote.
Further, trying to run a current account surplus against the US while avoiding the accumulation of dollar-denominated assets would require that the Chinese off-load the dollars they earn by exporting to the US—trading them for other currencies. That, of course, requires that they find buyers willing to take the dollars.
This could—as feared by many commentators—lead to a depreciation of the value of the dollar. That, in turn would expose the Chinese to a possible devaluation of the value of their US dollar holdings—reserves plus Treasuries that total over $2 trillion.
Depreciation of the dollar would also increase the dollar cost of their exports, imperilling their ability to continue to export to the US. For these reasons, a sudden run by China out of the dollar is quite unlikely. A slow transition into other currencies is a possibility—and more likely if China can find alternative markets for its exports.
Next week we will look to the frequent claim that the US is “special”—while it might be able to run persistent government deficits and trade deficits, other countries cannot.
This article first appeared at New Economic Perspectives.