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Monday, November 10, 2008


china: sudden stop, hit the stimulus

paul kedrosky notes what is becoming more apparent: things have gone from bad in china to worse.

and that has a lot to do with the $600bn chinese fiscal stimulus package announced today. some skepticism may be appropriate -- per macro man, the plan is spread oer two years and includes much that was already announced or going to be spent anyway -- but the desperation appears genuine. questions about the efficacy of keynesian stimulus are to be put aside. more from brad setser.

of considerable concern to the united states -- where is the money coming from? a lot of it, one would think, will be redirected from what would have been american treasury bond purchases.

UPDATE: via ft -- more thoughts on the sourcing of massive chinese spending, with peter schiff noting the sensibility (from the chinese perspective) of liquidating as much agency and treasury debt as is needed.

UPDATE: via barrons:

It may finally be catching up with Uncle Sam. That's what the yield curve may be whispering. But some economists are too deaf, or dumb, to get it.

The Treasury yield curve -- from two to 10 years, which is how the bond market tracks it -- has rarely been steeper. The spread is up to 250 basis points (2.5 percentage points, a level matched only in the past quarter century in 2002 and 1992, at the trough of economic cycles. ...

The steepening of the Treasury yield curve has been accompanied by an increase in the cost of insuring against default by the U.S. Treasury. It may come as a shock, but there are credit default swaps on the U.S. government and they have become more expensive -- in tandem with an increase in the spread between two- and 10-year notes.

This link has been brought to light by Tim Backshall, the chief analyst of Credit Derivatives Research. The attraction of investors to the short end of the Treasury market is "juxtaposed with the massive oversupply and inflationary expectations of the longer end," he writes.

... [Scott] Minerd doubts that private savings in the U.S. and foreign purchases of Treasury debt will be sufficient to meet those government cash. That leaves the Fed to take up the slack; that is, monetization of the debt.

However it comes about, Backshall's charts of the yield curve and the spread on U.S. Treasury CDS paint a dramatic picture. Both the yield spread and the cost of insuring debt moved up sharply together starting in September.

Cutting through the technical jargon, the yield curve and the credit-default swaps market both indicate the markets are exacting a greater cost to lend to Uncle Sam. And it's not because of anticipated recovery, which would reduce, not increase, the cost of insuring Treasury debt against default.

All of which suggests America's credit line has its limits.

UPDATE: more and more important from brad setser, who argues that domestic RmB stimulus cannot be effectively financed from reserves -- leaving the stimulus largely dollar-indifferent. only in the event that china's current account surplus were to reduce would one see a reduction in china's demand for foreign assets -- and setser (though this is a major concern) sees this as unlikely, at least for the time being, unless china's economy slows much more than currently thought. meanwhile, in the united states he sees growing government indebtedness as being offset by its opposite in corporate and consumer debt -- meaning no large surge in overall american financing needs, with contraction indeed possible.

the danger to the dollar, he feels, is not in the stimulus package but in executive decisions taken by china's leadership to divert its reserve accumulation away from treasuries, with effects similiar to that seen earlier this year in china's abandonment of agencies.

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of considerable concern to the united states -- where is the money coming from? a lot of it, one would think, will be redirected from what would have been american treasury bond purchases.

I'm still having trouble with the whole "what happens if foreigners stop buying our bonds" concept. If China wants to invest its dollars domestically rather than in US treasuries, won't it first exchange them to yuan? That action would depress the dollar -- but because of the exchange peg they will print more yuan at the same time to maintain the peg (lessening the amount they need to exchange to obtain the yuan to spend). But the big unexplained mechanism for me is what happens to the dollars that the Chinese exchanged for yuan -- whoever bought those dollars is almost as likely to invest them in treasuries as the Chinese would have been. What am I missing?

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hey hbl -- i think implicit in the action would have to be a strengthening of the yuan -- it operates on a dirty float as opposed to a peg, and there is a policy debate ongoing within china as to how that float should be managed.

as to where the dollars go, they may well get recycled into treasuries -- but it may take significantly higher interest rates to make that happen.

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So it sounds like the key to this extremely common argument is that foreign central banks have an irrationally large preference for government treasury bonds over other assets (or are not allowed to buy other assets?) I suppose that could be true but I can't help but think the tendency of those recycled dollars to go back to treasury bonds is higher than most assume, given that they have to be invested in something (I guess the cash default is t-bills but yield is low). So far such bonds have been one of the smartest investments out there... (Though I understand the concerns over future sovereign default, etc, could change that -- yet in Japan didn't they remain the best domestic investment?).

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yeh, that's essentially right in my view hbl -- FCB are rate insensitive, as they are not investing with return as a primary objective but rather mercantilism. they've engineered the yuan to facilitate an export-driven model (and take under much of the developed world's manufacturing capacity as well).

other parties may both buy dollars and sink them into treasuries -- but it would not be enticing to do so without a much weaker dollar (so as to close most of america's current account deficit, limiting supply) and significantly higher interest rates on treasuries.

should that happen, the united states would be faced with trying to finance its treasury borrowing domestically -- either forcing a much higher savings rate and inviting consumer depression, or monetizing the debt by printing.

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The majority already seem to be expecting monetization of US debt (you have mentioned it also, and it's famously part of Bernanke's 2002 "how to defeat deflation" speech). That would both increase demand and reduce supply, making treasuries at least a more logical asset choice than they would be without monetization. I guess the big debate is whether to expect engineered high inflation...

I don't mean to stray too far though -- thanks for the response.

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Unfortunately, this is most likely the next screw to be removed from our economic chair leg; an increase in long term interest rates and tanking of long bonds. So far the fed has been taking on massive debt, but that has not been inflationary because it is only replacing evaporating assets that would be deflation if they were not replaced. So the credits are only being transferred from the private to the public sector at this point. Later when the dust settles, we will either have to pay this off for real by higher growth or taxes or just print money to pay for it. Politics being what it is, I think we know which way that one will fall. When the world gets wise to that, it will not be so easy to convince them that our paper is worth the paper it's written on. Also, governments around the world are finding increasing uses for their funds at home, namely trying to reflate their own deflating assets. Another trend moving in that direction is that our trade deficit will start moving toward zero pretty quickly. That means that our vendor financing ponzi scam will wind down as well as we are providing less dollars to the world that they will have to repatriate by buying our t-bills. This is probably a gross over-simplification, but so far our best hope has been that the rest of the world is more screwed up than we are, monetarily speaking. Will that continue? Stay tuned for next week's epispode.

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