What would happen if the Chinese pull up stakes?
China and Japan are the two largest foreign holders of U.S. Treasuries. However, the Chinese recently suggested they may diversify their foreign exchange reserves away from the U.S. dollar/Treasuries and allocate more reserves towards other assets, perhaps including U.S. corporate debt, energy and commodities, and non-U.S. dollar-denominated assets. Given the importance of Treasury sales to the U.S. economy, securities markets, the dollar and interest rates, what would be the impact of China’s decision?
Most observers believe that China’s possible move to diversify their foreign exchange reserves away from U.S. Treasuries would probably occur in such gradual increments as to soften any potential near-term repercussions. However, as China’s prominence in global economic affairs surges, any modifications in its foreign exchange policy cannot be ignored.
According to the U.S. Treasury Department, as of the end of November 2005, Japan and China together owned about $933 billion of the $2.17 trillion of Treasury securities held by foreign nations. Japan accounted for about $683 billion, while China had $250 billion. The U.K. was third at $223 billion. Though Japan’s ownership currently dwarfs China’s stake, Beijing’s rate of accumulation has been much faster. China’s total foreign exchange reserves, which amounted to nearly $800 billion at the end of 2005, are expected to reach $1 trillion this year, likely surpassing Japan’s total.
Generally speaking, says David Wyss, Standard & Poor’s chief economist, these Treasury purchases have kept the U.S. dollar high and U.S. bond yields low. “This has been good for U.S. interest rates, productivity and investment. But it’s been bad for our trade deficit, he explains. “In the long run, it has put the U.S. in an unsustainable position of having a deficit that is much too high.” For the first 11 months of 2005 the U.S. trade deficit totaled $661.8 billion, ahead of the $617.7 billion annual record set in 2004. Economists expect the U.S. trade deficit to well exceed $700-million for all of 2005. Meanwhile, China’s trade surplus with the U.S in 2005 is expected to exceed $200 billion, 25% above the record surplus posted in 2004.
Wyss noted that Treasury purchases by Japan’s central bank have decreased substantially over the past year, although private Japanese investors have more than offset that by acquiring substantial amounts of U.S. corporate bonds. “In Japan’s case, back in 2003-2004, they feared the yen would drop too much in value and they intervened heavily in the currency markets,” Wyss said. “Then, Japan ceased intervening over the last year or so — but this didn’t have much of a negative impact on U.S. markets.” In fact, the dollar rose about 14% against the yen in 2005.
The Chinese, meanwhile, have been buying Treasuries at roughly the same pace the past two years. “They have to accumulate dollars to keep the yuan down relative to the dollar,” Wyss explained. “But since China has moved to peg the yuan to a market basket of currencies, instead of just the dollar, it’s logical for them move their foreign exchange holdings to the same basket.” Indeed, last July China enacted a 2.1% revaluation of its currency by shifting from a dollar peg to a basket of currencies, potentially permitting the yuan to rise against the dollar. The yuan, in fact, rose a modest 2.6% against the dollar in 2005.
“The Chinese probably concluded they have far too much exposure to the dollar, and that the dollar has peaked for this cycle, given the Fed may be moving to a neutral position,” says Paresh Upadhyaya, portfolio manager and currency strategist at Putnam Investments in Boston. “Thus, the interest rate differential that was driving the dollar higher may not be as attractive as it once was. The risk is now the dollar may begin to depreciate. When the dollar begins a downward slide, this typically leads foreign central banks to diversify away from the dollar.”
In essence, both Japan and China are between a rock and a hard place — by holding vast amounts of dollars/Treasuries, they depress the value of their local currencies, thereby boosting their export business. But, since they own so much U.S. dollar assets, by dumping them they could hike the value of their own currencies and undermine their economic growth.
Wyss concedes that any change in China’s foreign exchange strategy would represent a reduction in demand for U.S. assets. “Other things being equal, this step by China would tend to push the dollar down and drive bond yields up. So far, this hasn’t happened since overall inflows from private bond buyers now exceeds Treasury debt purchases by foreign central banks. However, the Chinese have a lot of money invested in U.S. Treasuries and they’re probably tired of only earning only 4% on it. If they move into other dollar assets, such as corporate bonds, there would be little impact on markets. If they move into euros or other international assets, there will be.”
Higher bond yields would likely raise borrowing costs for U.S. corporations — an unpleasant scenario amidst the record budget deficit if the U.S. economy were to start to slow.
It is estimated that more than 70% of China’s foreign exchange reserves are invested in U.S. dollar assets, including Treasuries. Axel Merk, manager of the Merk Hard Currency Fund (MERKX), said if China were to stop acquiring such large amounts of dollars with its reserves — accumulating at about $15 billion every month — it could impose downward pressure on the dollar. The key to understanding the risk posed to the dollar, Merk explains, is that the U.S. current account needs to be financed daily. “Every day, foreigners need to acquire more than $2 billion in U.S. dollar denominated assets — soon $3 billion — just to keep the dollar from falling. This can be done through the purchases of U.S. bonds, or by buying assets outright.”
In the event that foreign nations, including Japan and China, lose their appetite for U.S. dollars, Merk’s Hard Currency Fund will likely “focus on currencies of countries that are less likely to manipulate their currencies.”
Merk also believes a reduction in Treasury purchases by China would lead to higher U.S. interest rates as bond prices fall. “There is disagreement on how big an impact it would have,” he said. “Fed chairman Alan Greenspan has argued that foreigners mostly purchase on the short end of the yield curve, where they have little influence on the yield.” He also noted that China buying fewer Treasuries will have negative implications for the U.S. housing market. “Lower Treasury purchases means less demand, which means bond prices fall and yields rise,” he said. “The government needs to offer a higher yield to sell its debt. Higher yield means higher mortgage rates for home buyers, and that is a weight on the housing market.”
There would also be an impact beyond the dollar itself, Merk adds. “If a foreign central bank purchases U.S. Treasuries, it is not so different from the Fed purchasing Treasury notes from regional banks,” he noted. “When that happens, banks receive cash and have increased lending power. Foreign purchases of U.S. Treasuries are directly stimulative to the U.S. economy, even before any impact on the yield curve.”