Tuesday, October 19, 2010

Pity the Chinese

The Chinese own about $1 trillion worth of Treasury securities, whose average yield is now probably in the range of 1-1.5%, and they are being forced to take a beating on those holdings. They are in a real bind, because they are being pressured to appreciate their currency by U.S. politicians who are sadly ignorant of how global trade and capital flows work, and by the Federal Reserve, the architect of the ongoing loss of the dollar's value. In the past four months, China's central bank has allowed the yuan to appreciate over 8% against the dollar in an attempt to alleviate those pressures.

China's reasons for doing this are twofold: to appease U.S. policymakers who are arguing for a much more dramatic appreciation of the yuan, and to minimize the inflationary impact of being tied to a weak and falling dollar. Pegging its currency to the dollar is the cornerstone of China's monetary policy, and if the dollar weakens, then the yuan also weakens, and this is equivalent to a monetary ease which will sooner or later show up as higher Chinese inflation. In fact, China's CPI has already risen, on a year over year basis, from a low of -1.8% in July '09 to 3.5% as of August '10. The weakening of the dollar, which has carried the yuan down with it, is the proximate cause of this reflation.

Revaluing one's currency doesn't come cheap, however, especially when the currency you are revaluing against is also the currency in which the majority of your reserve assets are denominated. The appreciation of the yuan over the past four months has effectively wiped out a little over 3 year's worth of interest on their dollar security holdings. Further yuan appreciation, which seems likely, will wipe out even more of the value of China's foreign bond holdings. They are truly caught between a rock and a hard place.

This reminds me of the massive losses that Japan suffered as result of the appreciation of the yen, which rose from 250/$ in 1985 to 80/$ at its peak in 1995. This 200% yuan appreciation destroyed fully two-thirds of the value of the countless billions of dollar assets that Japanese savers had accumulated. Recall that Japan was a major export engine at the time, its aging population had a high savings rate, and the destination of choice for those savings—which were larger than could be accommodated by Japan's own economy—was the U.S.

Remember the book "Rising Sun," by Michael Crichton? His thesis was that the U.S. was monumentally stupid to allow the Japanese to buy so much of our real estate and so much of our industry. As a resident of Los Angeles, I recall that Japan's purchases of a number of downtown office towers occurred almost precisely at the peak of real estate prices in the early 1990s. Prices then proceeded to drop by one-third, at the same time the dollar fell from 130 yen to the low 80s—real estate bought in the early 1990s lost over one-half its value when translated back into yen. Japan's savers lost a fortune, thanks to the Bank of Japan's extremely tight monetary policy. And as it turns out, Japan never acquired the nefarious control over U.S. industry that Crichton warned about in his book. On the contrary, we took them to the cleaners. We bought their cheap cars and cheap electronics; they invested their export earnings in the U.S., only to see a huge portion of those savings wiped out by the weak dollar/strong yen.

And so it is with the Chinese. They sell us mountains of cheap goods, then turn around and invest most of the proceeds (equivalent to our trade deficit with China) in U.S. Treasury securities. We get the goods, and we get to keep the money. Then we devalue the dollar, and they lose on their investment. Why we would want them to stop doing this is beyond me, though if I were a Chinese citizen, I would be furious with my government for directing such massive quantities of my country's export earnings to Treasuries. The central bank of China has no need to further increase its already-massive reserves; instead, the government should be relaxing capital constraints, allowing Chinese citizens more freedom to save and invest abroad in the types of vehicles with which they feel most comfortable. China's workforce is aging daily, and like Japan a few decades ago, China's economy cannot accommodate all the savings of the Chinese people—they are essentially forced to save overseas.

Contrary to what you read in the press—which mistakenly believes that our large trade deficit with China is something we need to worry about—China is the one that needs to worry, not us.

UPDATE: I highly recommend John Cochrane's WSJ article, "Geithner's Global Central Planning." Key quote: "The Chinese government's accumulation of U.S. debt represents a tragic investment decision, not a currency-manipulation effort." The article is an elegant ridicule of all those who think they can spot and treat a global trade or currency "imbalance." It should be required reading for all students of economics.


Anonymous said...
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Anonymous said...

I believe China is very well aware of the problem encountered by Japan after Plaza Accord in 1985, and Chinese officials are trying very hard to avoid following the footstep of Japan. Unfortunately, as time goes by, they are unintentionally following the footstep.

Also sprach Analyst

Bill said...

Excellent piece. I cant understand why people object to foreign investment in the US. When foreigners buy an office tower here, we get the money and the tower stays here. The Japanese did not ship Rockefeller Center to Tokyo. Foreign investment is a sign of confidence in America, not American weakness.

Market Factors said...

The US needs to worry because of all the jobs that have been shipped overseas. We buy crap from them that we should be making in the US. We have 9.5% or 17% or 22% unemployment depending on who you believe and we have 45 million people on food stamps. Is it better for the US population to be fully employed or is it better for 75% of the population to be able to get a cheap new ipod every year, or 10 pairs of shoes every year? Near 20% unemployment is a BIG deal.

Ultimately, the national security of the US is at stake if the currency continues to lose value. The US must currently import over half it's oil, if the world is no longer willing to accept dollars for oil, or the price goes too high, US society will be hit with a shock which will compound our misery.

NormanB said...

The Chinese don't have to wait for devaluation to lose money on their Treasury purchases because due to the undervalued yuan, which helps sell their goods, they are and have been paying more for the Treasuries than its worth to them. This is why and undervalued currency doesn't work. What you gain in one sphere you lose in the other. Why all the brilliant economists and people that call up all of these 'Accords', 'Steralizations', etc have their heads up their asses. Its a simple matter.

Charles said...

China is a developing country with a brutal population policy, a limited safety net and a mercantilist economic policy. Instead of investing in the next generation, Chinese are forced to save by acquiring assets. This policy throws the whole world off balance and will have catastrophic consequences for the Chinese over the next two generations. The Chinese should spend on the children they want to have rather than buying treasuries through their government.

septizoniom said...

excellent post

Frozen in the North said...

I would suggest that the Chinese government drivers are very different than those of "capitalists", what Chinese leader worry about are riots, and social breakdown.

Creating a society where consumption accounts for less then 1/3 of GDP (vs 2/3 for America) tells you something about their priorities. Full employment and not profitability are core elements of China's economic policy.

I also doubt that China's yield on US bonds is around 1.5%, simply because China has largely stopped buying US government bonds over the past two years, and the great bulk they did buy were long dated, when interest rates were higher.

China's inflation rate is north of 3.5% (if you exclude housing costs) as such their currency (which has not changed in value for the past 3 years), is deeply undervalued.

The issue is always the same, it takes two to tango, Americans are consuming too much (consumption is 70% of GDP), and Chinese are consuming too little. part of the problem is that the Feds still think that pushing consumption is a good idea.

America needs to consume less, save more and Chinese need to consume more and save less.

Cabodog said...

And in related news, China lobbed trial balloons regarding the suspension of rare earth mineral exports. China produces 97% of rare earth minerals, which are essential to high-tech manufacturing.

Benjamin Cole said...

The Chinese should let the free market determine the exchange rate of the yuan.

Unknown said...

It would be helpful to know what you regularly read as well as some of your 'top' books.
Enjoy your posts!

Unknown said...

It would be helpful to know what you regularly read as well as some of your 'top' books.
Enjoy your posts!

The Dude said...

Excellent post, as always. On a related note, during Bernanke's reappointment, there was some concern about the Fed's independence from political influence and Ben gave some token reassurance. Now we know. Substitute total monetary policy for fiscal policy, fire up the presses and monetize the debt. Hello inflation. The 5yr 5yr forward measure of inflation (the Fed's favorite)has moved up about 76 bps (16%)since the first of September.

Instant said...

Market Factors,
Even if Chinese appreciates yuan, jobs will never go back to the U.S. There are many places which can manufacture stuff cheaper than the U.S. How about India, Pakistan, Vietnam, Mexico, Cambodia, Indonesia, Philippine...

Instant said...

Benjamin, yes Chinese should not interference the Yuan exchange rate and so does the dollar!

Benjamin Cole said...


You may be surprised.

Manufacturing platforms in other countries are often not reliable and corrupt. Just try doing anything in Mexico. Electricity can cut out--and needs a bribe. Deliveries mysteriously disappear.

Most Third World nations are poor due to corruption, graft and massive laziness or indifference.

Hard work and (relatively) good government define China and Japan. That's why they climbed out of poverty so quickly.

In a rare bit of good news, a cabinet importer in Los Angeles I know has been bringing in stuff from China. At first the minimum order was 6 units. Then 20. They just got told the minimum order is 50.

China is going the way of Japan in 10-20 years, and there will be no more huge, efficient low-cost manufacturing platforms left on the planet.

India is there, but stifled by culture and government. You really think you can make cars in Pakistan? Want some opium with that?

Public Library said...

In one sentence you highlight the Japanese experience for buying US property while simultaneously getting slammed on fx, and in another recommend the Chinese government allow their populous to buy foreign assets to their liking, which in this case, will simply be US assets. Again, while their currency appreciates against the dollar. How do you reconcile this view?

China should raise interest rates so people can save less by earning more and stop diverting every penny into manufacturing and exports through subsidies of all sorts. This would spark domestic consumption. The transition is always bumpy but the destination is far more optimal.

I think what Scott will never understand because of his unwavering belief in comparative advantage is a necessary + healthy balance in all aspects of life. Every equilibrium is not created equally. The ripple effects of unsustainable behavior are felt by all peoples, albeit to differing degrees.

The US is now financially depriving massive segments of the population via disincentives to save similar to Japan and China. Whether through tax structures benefiting debt or zirp interest rate policies. There is a very real and unhealthy balance and if left unfettered, all economies will come down hard when the next equilibrium evolves.

The current equilibrium is neither healthy nor sustainable.

Instant said...

Think back 20-30 years ago, Ben could you ever imagine China will be such a big huge, efficient low-cost manufacturing platforms?

Sorry I didn't. Then why you think other nations cannot repeat what China's miracle? History repeat themselves. After the ww2, nobody believe japan could develop into such a modern country too.

Ask your friends to find another manufacturer. There are many of them around. If this manufacturer do not want to do business with you because of the size of the order, find another one.

Importers are smart enough to find the cheapest cost for importing stuff from other countries to the U.S. Non conventional cost are also part of the total cost. The importers have already put these "extra" costs into account; otherwise, they would have got broke long time ago.

Benjamin Cole said...


Yes, I do not see another nation with the resources of China replacing China once China becomes too expensive.

India is hidebound with culture and bureaucrats, lawyers and corruption. Sheesh, they still have castes in India. Africa is hopeless, and Latin America nearly so.

I suspect manufacturing will migrate back to America in the next 20 years.

Indeed, I see a long, long global boom, if only we solve some debt issues. Leave equity tax-free and tax debt. Something like that.

piefarmer said...

It is not the government's job to encourage (or discourage) savings. There will always be ants and grasshoppers. The government's role is to be neutral and let folks decide their own path. In the realm of monetary policy, neutrality means price stability. That should be the government's only role.
Instability is harmful for major economies like ours, but it is deadly to emerging economies. It makes perfect sense for emerging economies to peg their currencies to ours, or at least it did historically when the US monetary policy was stable. Floating exchange rates won't help China, it will only open them up to manipulation by large currency traders. They need more stability, not less. Raising interest rates won't help China, because it is contractionary. The best thing for China is also the best thing for America: a stable currency. China needs to gradually ease their peg to counterbalance our weak dollar policy. But if we practiced price stability, China could keep their peg fixed and realize stability as well.

dyarchy said...

did you read martin wolf in FT
10/12/2010 "why america is going to
win the global currency battle".
hope you get a chance to write about it.

Joseph N. said...

Thank you for writing this. I have been saying this for years, but to no avail. How can I compete with the "sky is falling" screams coming from our chicken little media?

The economics of it is so simple: the PRC has been buying trillions of dollar assets to keep the dollar high, but in doing so they have amassed a pile of dollars that remains valuable only so long as they keep buying more, and eventually the supply _always_ becomes too great to purchase.

Frankly, the PRC dollar purchases remind me of Bunky Hunt and his attempt to push up the price of silver. The more he bought, the more silver appeared for sale on the market. Hunt went bankrupt.

Instant said...

China has no choice. What can they do with the large sum of money coming every month?

They do want to buy some assets, like the U.S. government not letting them.

They learn the lesson from Japan. There is no way they will make the same mistake.

Anonymous said...

It is foolish for other countries to support the value of the dollar by buying treasuries when the US is printing so many dollars and the value will be going down. In effect the US is collecting an inflation tax on the whole world. When the world wises up and stops this, the dollar will crash and America will be very poor.


Charles said...

India has three huge long term advantages over China: English, democracy and children. India represents the future of Asia and not China.

Demography is at the heart of China's problems and China is big enough to destabilize the world economy.

Buddy R Pacifico said...

The U.S. should worry very much. The Output Gap for the U.S. is worrisome and anemic growth of less then 2% will widen the Gap substantially.

When manufacturing moves away from the U.S. it is much more then manufacturing plants. There are all the associated sub-contracters such as machine shops and engineering firms. The U.S. has lost much critical mass, or key clusters, in manufacturing .

These Clusters are now thrivinng in China. Clusters take a lot of time, investment and training to establish. There is smugness and arrogance towards manufacturing but it is really against the whole of design/build on many levels -- resulting enormous loss of prosperity.

Scott Grannis said...

The perception of a great loss of jobs to China is much worse than the reality. We've been losing manufacturing jobs for many decades, yet manufacturing output has been steadily rising because of strong manufacturing productivity growth. The U.S. remains by far the biggest manufacturer in the world.

Buddy R Pacifico said...

The perception of what constitutes U.S. manufacturing figures is probably flawed because of the lack of tracking of foreign inputs.

Richard O'Neill said...

Having lived very closely to the Japan-to-US investment epoch, and seeing the bath the Japanese took on so many fronts, it seems the analogy with China is pretty apt. Good analysis Scott. By my lights, seeking a long cycle perspective, the changes are tolerable to the extent that China is marching out of poverty; as recently as 1958, tens of millions starved to death under the Marxist doctrines that held China down. The emergence of the world from poverty never seems to be linear, pretty, or readily reducible to a robust hypothesis. But long term we may "get by" and be able hand off enough capital for future generations to build upon.

Scott Grannis said...

Richard: I appreciate your comment, and I think it makes sense that rising living standards almost everywhere serve to insulate us to some extent against public policy mistakes.