China flexes its muscles ahead of G20
Chinese Premier Wen Jiabao’s expressed concern over the safety of US treasuries has generated a fair few column inches in recent days.
The whole issue as to what China will do with its holding of US treasuries is a red herring, although it is always surprising the noise such comments can generate. I would see it largely as saber-rattling ahead of the upcoming G20 meeting on 2 April 2009. The Chinese must enjoy putting the jitters through the US bond market.
The reason China has purchased a large amount of US treasuries in recent years is to prevent its currency appreciating meaningfully against the US dollar. If the Chinese decided to stop purchasing US dollar assets it would be because they were happy to let their currency strengthen. The US dollar is just about the strongest currency of the past 12 months, so it is unlikely that the Chinese would now like to see their own currency strengthen further against the competition by allowing it to strengthen against the dollar. This is especially true at a time when Chinese exports are weak and deflationary risks elevated.
So in order to prevent currency appreciation against the dollar, the Chinese have to purchase US assets of some description. Compared to their previous forays into the likes of Blackstone or Morgan Stanley, US treasuries have been a good bet. The Chinese will also be well aware that further reassurances from the US government on debt which it already guarantees are meaningless.
Implications for the dollar and US treasuries are minimal.
These sorts of comments can create some noise and fear over a few days but should not have any sustained impact.
Regardless of China’s actions, unless you think the US is going down the same path as Japan, the medium-term investment case for US treasuries is unattractive. As and when risk aversion recedes and once a recovery appears to be taking place, we can expect higher yields (say 4% on the US 10-year treasury). But while perceptions of risk are elevated and the US economy weak, a sustained sell-off in US treasuries is unlikely. And should it occur, there are good odds that the Fed will step in and purchase US treasuries directly to contain yields, or at least try to talk them lower. (Note though that these are reasons unrelated to direct Chinese actions).
Can such comments contribute to broad-based dollar weakness? On a short-term basis it is possible (as we saw during the dollar bear market when similar rumours surfaced) and such comments can increase the perceived riskiness of the dollar especially after a strong run. But fundamentally, they should not since Chinese purchases of US treasuries relate to the renminbi - dollar exchange rate, not the value of the dollar against other major currencies such as the euro or sterling.
The bear case on the US dollar over the past few years focused on the twin deficits (budget and current account). While the budget deficit is clearly deteriorating (as it is everywhere), the tendency of the current account deficit is to improve from here. Since the current account balance is identically equal to domestic savings less investment, a higher household savings rate is supportive of an improved current account position (although the government’s efforts to fill the gap left by the consumer will cloud the net result). So over the next 12 months, the US current account deficit will gradually become a non-issue (as has been happening over the past 12 months).
A legitimate bear case on the dollar relates to aggressive money creation by the Federal Reserve. There is a lot of confusion as to whether Fed policies will be inflationary (dollar negative) in the long run, but it is plausible that the Fed will be able to reduce the narrow money supply without too much trouble once a recovery is well underway. The market will probably worry otherwise at some point though. The other issue is that currencies are a relative price and if central banks around the world are printing money, then this particular bear argument for the dollar becomes less compelling.
