Thursday, August 11, 2011

Michael Pettis on Why China Needs to Buy United States Debt

 In Michael Pettis' private newsletter which arrived July 31, he discussed two issues: 1) why China needs to buy U.S. debt and 2) hidden debt in China.  I intend to cover why China needs economically to buy U.S. debt in this article and cover hidden debt in China in another article if time permits.

Pettis notes the growing concern over a possible U.S. default, which is unlikely, in China as political positioning since it would be a economically non-event for China.  There has been speculation on whether China would sell its U.S. bonds in Chinese media, but Pettis' is emphatic that will not happen and the speculation is based on a fundamental misunderstanding of how China's purchase of U.S. bonds is a necessary 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 (inward FDI and hot money inflows overwhelm capital flight and outward FDI), the PBoC must export huge amounts of capital in order to maintain China’s trade surplus. In order the keep the RMB from appreciating, in other words, 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."

When China buys those U.S. dollars it must put in a market large enough to absorb the money and whose economy is willing and able enough to run a 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."

 If China were to decide it no longer wants to hold U.S. government bonds, there are only four possible choices if decides to purchase fewer U.S. government bonds:
  1. "The PBoC can buy fewer USG bonds and purchase more other 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."
 Pettis then proceeds to examine each of these scenarios to demonstrate.  With respect to #1, purchasing U.S. assets rather than U.S. government bonds, "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."  There would be no change in the balance of payments and nothing would change.

With respect to #2, purchasing non-U.S. assets which would most likely be foreign government bonds, of which Europe is the only market large enough, there are only two ways the Europeans could react.  One is the Europeans would turn around and buy a similar amount of U.S. assets and the U.S. and China trade balances would remain unchanged.  Europe, however, might be unhappy with this, because it would probably be transacted through the ECB and cause an increase in the money supply, according to Pettis.  If Europe was to not purchase U.S. assets, then the U.S. imports from Europe must go down that amount while the imports to Europe must go up that amount.  This will actually improve the U.S. position and be expansionary for the U.S. economy by the creation of jobs.  "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, they are actually worrying that the US trade deficit might contract. This is something the US should welcome, not deplore."    For Europe it is another story, because as the US trade deficit declines the European trade surplus must decline while China's remains unchanged.  "This deterioration in the trade account will force Europeans either into raising their fiscal deficits to counteract the impact of fewer exports 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 anger and even trade protection."

With respect to #3, in which China buys hard commodities, the scenario is the same as above except the exporters of those hard commodities will face the same choices Europe would face.  The exporters can either buy U.S. assets or absorb the deterioration in their trading account, perhaps through a reduction in manufacturing capacity.  This scenario also has problems for China since stock piling commodities is a bad strategy since commodity prices are volatile and that volatility is inversely correlated with the needs of the Chinese economy.  It would be a good investment for China only if China grows rapidly.  This would be the wrong national economy balance sheet position any country could engineer as it would exacerbate underlying social economic conditions and increase economic volatility, which is never a good thing for the poor.

With respect to #4, in which China intervenes less in the currency and does not buy anything else, China's surplus will decline by the same amount and the U.S. trade deficit will decline by the same amount.  The net change on U.S. financing costs would be unchanged, while China's unemployment would rise unless it increases its own fiscal deficit, which is politically undesirable. 

Pettis concludes this first half of his private newsletter with "It's about trade, not capital", which is counterintuitive to many people who do not understand how the global balance of payments works, because "...countries that export capital are not doing anyone favors unless incomes in the recipient country are so low that savings are impossible or unless the capital export comes with needed technology, and countries that import capital might be doing so mainly at the expense of domestic jobs. For this reason it is absurd for Americans to worry that China might stop buying USG bonds. This is what the Chinese worry about."  Despite the U.S.-China trade dispute about China buying U.S. government bonds and the U.S. not wanting them to do so, in reality, if China's trade surplus declines then the U.S. trade deficit declines, which means China buys less U.S. government bonds and, contrary to what you may read or hear, this reduction is purchases of U.S. government bonds would not cause the U.S. interest rate to fall.  To insist otherwise is to say, if a country's trade deficit rises, its domestic interest rates decline which is patently false.  Pettis brings up a standard argumentative response to his observations on trade and capital exports writing "...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. In that case, they say, less Chinese buying of USG bonds will indeed cause an increase in US interest rates.

"No it won’t. Unless this other country steps up its capital exports to the US and replaces China – which is pretty unlikely, and which anyway would mean the same amount of foreign purchasing of USG bonds – it must cause a reduction in the US trade deficit."
The basic point is a reduction of Chinese exports to the U.S. would be matched by increase in the same amount of exports to the U.S. from a another foreign country which would then have the impact of either lowering that foreign country's exports to other countries (if it enjoyed full employment) or a rise in imports or the foreign country (if it has unemployment).  What Pettis leaves unconsidered it what would happen if there is a global contraction.

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  1. That a country with a trade surplus must have a capital account deficit and accumulate either public reserves or private investments in foreign currencies is axiomatic.

    However, China does not need to be a net accumulator of Dollars. They can use the Dollars they earn in exports to the US to pay for Dollar-based imports such as iron ore, grain, oil, etc. China's commodity imports exceed its US Dollar exports. In other words if you sum China's imports and exports by currency denomination, there is actually no reason for China to accumulate reserves in USD- instead they would accumulate reserves in other currencies (though still the same amount of reserves).

  2. Michael Pettis covers the purchase of hard commodities in scenario #3 in this discussion of how the global balance of payments between nations functions.


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