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What if the Chinese Sell Treasuries?
By: Dr. Charles Lieberman
Date: 6/15/2009
Investors remain nervous that foreign investors, particularly the Chinese, might stop buying Treasury debt and even worse, could sell off some of their huge holdings. If this were to occur, U.S. interest rates could rise sharply, the dollar would likely sell off, credit flows might be disrupted, and the economy might weaken, setting off another recession before we have recovered from the current one. Public statements by Chinese government officials suggesting concern over U.S. macro policy and willingness to explore other ways to hold their foreign exchange reserves keeps adding fuel to this question. Even so, the Chinese do not really have viable alternatives to the dollar without undermining their quest to develop their economy and keep improving the living standards of their citizens. The Chinese have no viable option to continued buying of dollar assets that do not hurt China's economic interests.
Perhaps the best way to start any discussion over Chinese purchases of Treasuries is to point out that they do so out of their own interest, not because it helps finance our fiscal stimulus package. If they were to sell off dollar assets, the dollar would decline, but more importantly, the Chinese renminbi would rise, undermining China's competitiveness in the global markets. This point can be made quite vividly by recalling there was a period not long ago when our Treasury Secretary and members of our Congress were encouraging the Chinese to do precisely this. We suggested, cajoled, demanded, and requested, sometimes privately, sometimes very publicly, they buy fewer dollars to allow their currency value to rise. Only after substantial pressure and many explicit and implicit threats did the Chinese allow the renminbi to rise in a controlled upward float.
Weakness in the dollar costs foreign investors, including the Chinese, huge losses. That's been the pattern for some time, interrupted only by the credit crisis, which drove global investors into dollar assets as a safe haven and a clear reminder that the dollar remains the premier global currency. This was just a brief respite for the Chinese. With about $2 trillion in foreign reserves, a mere 10% fall in the dollar costs the Chinese $200 billion. So, it's hardly surprising they would like to insulate themselves somehow from such further falls in the dollar. That's wishful thinking. So if we wanted the Chinese to buy fewer Treasuries, why do they still buy?
The dollar is weak partly because of China's policies. As did the Japanese, Koreans, Taiwanese and others in Asia before them, China used a cheap currency to make their goods inexpensive globally. That's a powerful driver of exports, which creates jobs, income and wealth in China. With living standards still well below those enjoyed in developed countries and a huge underemployed workforce, China wants and needs to sustain rapid growth for many years to come. It's an effective and sensible growth strategy with important domestic political benefits. But it doesn't come without some costs. Until China's middle class grows large enough to take over as the locomotive for development and growth, that leadership role falls on exports, which implies that China must maintain large trade surpluses and must accumulate more foreign exchange, even if those asset holdings lose value over time.
Interestingly, China has recently become a major importer of raw materials, above what it seems to need for current production including coal, aluminum, oil, copper, and other commodities. It seems part of the strategy is to store value in commodities that China will need to buy anyway, instead of holding Treasury bonds. This does help minimize their accumulation of dollar assets without driving up the value of the renminbi, even if the capacity to hold huge amounts of raw materials is somewhat limited. Moreover, such holdings entail their own cost. Treasury bonds pay interest, albeit low rates today. However, investing in commodities earns no interest income whatsoever and entails substantial inventory costs. The net difference is substantial. So buying commodities instead of dollar assets has been costly to China, too.
Chinese officials have asked for guarantees that their investments in dollar assets will be protected by the U.S. government, without specifying in public the nature of the guarantees being sought. They already have the guarantee of repayment, since the Treasuries they bought are full faith and credit bonds. The U.S. is committed to paying them when they mature. If the Chinese seek guarantees that we will not permit inflation to erode the value of their bonds, they could buy TIPs instead. Nor do U.S. policy makers wish to unleash inflation. If the Chinese want Special Drawing Rights (SDRs) as an investment not dependent on the dollar, then is the guarantee of the IMF any better than a U.S. bond, particularly since the U.S. is the largest contributor to the IMF? Hardly. In fact, the Chinese lack a solution to their own demands.
Like it or not, the Chinese are stuck with a simple and stark investment choice, accumulate dollar assets or allow their own currency to appreciate to reduce the trade surplus that is helping their economy develop. They can play around the edges and buy some euro-denominated assets or commodities to deploy some of their surplus, but those options are fairly limited. The rhetorical question, what will we do if the Chinese stop buying Treasuries is best answered by the conclusion that the Chinese have nowhere else to go unless they are willing to allow a much slower pace of development of their domestic economy. Given that Hobson's choice, they will continue to buy dollar assets, even if they object to it periodically. And they do this strictly out of their own self interest, not out of compassion or sympathy for U.S. policy needs.
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