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Thursday, January 22, 2009


vendor finance: pettis v setser

with the chinese economy now collapsing in spite of the government of china halting the appreciation of the renminbi against the dollar in an effort to protect its monster export capacity, the question of continued dollar financing by china of the united states government has become imperative.

it's already been determined that china has halted its purchases of private-label securitizations (the slowing and halt precipitated the bursting of the housing bubble back in 2005/2006) and further scorned agency debt (precipiating the receivership of fannie mae and freddie mac in 2008). but its purchasing of treasuries has continued at a rate more than compensating for the stoppage of these other avenues of vendor finance as the chinese current account surplus has grown.

brad setser has pointed this out in response to the worrying of the new york times, and again more recently militated against some of the implications of a piece in the financial times (previously addressed here) where a chinese economic slowdown was said to attack the driver behing chinese forex accumulation.

If the Chinese economy collapses, or even slows dramatically, then the raison d’etre for the country’s huge FX reserves - as a sterilisation measure to dampen domestic inflation - will evaporate. With that, so will China’s US Treasury holdings. Or alternatively the Chinese could devalue the yuan.

Either way, the US will be in trouble. Treasury prices could collapse (although given the current renewed banking collapse fears, not before a significant rally has occured) and if that happens, the Fed’s yield-lowering credit easing policies will be left in tatters. As will any plans for economic stimulus packages. Hypothetically that would leave just the nuclear option: devaluing the dollar.

setser counters:

I like a good China scare as much as any one. But the first concern is, I think, off. A slump in China doesn’t mean an end to Chinese financing of the world, or even necessarily a fall in China’s reserves. ...

Suppose China’s economy slows sharply — a not-impossible development given the rather starling fall in the OECD’s leading indicators for China. How would that impact China’s balance of payments?

The first impact is rather obvious. China would import less. It would buy less. And since the rise in Chinese demand helped push the price of various commodities up, it stands to reason that a fall in Chinese demand would push prices down. It probably already has. That implies a big fall in China’s import bill, and a larger trade surplus. A slowing global economy would hurt China’s exports, but in this scenario China would slow more than the world. That means China’s imports would fall more than its exports. China’s trade surplus would rise.

But, you might say, the current account surplus is determined by the gap between savings and investment. Why would that change in a slowdown? Simple. China’s slowdown reflects a fall in investment (especially in new buildings and the like). Less investment and the same level of savings means a bigger current account surplus. In practice, though, savings would also likely fall a bit — as a slowdown would cut into business profits and thus business savings. It possible that China’s households would reduce their saving rate to keep consumption up as their income fell. But it is also possible that Chinese households might worry more about the future and save more. My best guess though is that the fall in investment would exceed the fall in savings, freeing up more of China’s savings to lend to the world. That surplus savings has gone into Treasuries and Agencies in the past. ...

... [E]ven if there are large outflows — so large that the outflows exceed China’s current account surplus and China’s government has to dip into its reserves to meet the surge in Chinese demand for dollars — China would still be financing the rest of the world. The accumulation of foreign assets by private Chinese savers would substitute for the accumulation of foreign assets by the central bank, but money would still be flowing out of China. And some of that outflow likely would still make its way into Treasuries. ...

The key point is that as long as China runs a current account surplus someone in China will be adding to their stockpile of foreign assets. It just may not be the government.

pettis has argued that the chinese trade surplus is not sustainable by virtue of what enabled its creation -- a large increase in household debt.

What was unsustainable about the current global balance, in my opinion, was not the fact of a US trade deficit (although by 2006 and 2007 it had gotten too high to last very long), but rather the level of household borrowing needed to sustain it. These are not unrelated things, of course, but I would argue that if the US trade deficit had been funded by equity inflows that resulted in an increase in domestic investment, there would not be a trade-sustainability problem. If it was funded by a household borrowing binge, then trade-deficit sustainability is necessarily constrained by the household balance sheets. This is why I have argued that a program of massive fiscal spending to replace household demand is not going to solve the current problem. It simply replaces one kind of unsustainable behavior with another, and still has to be resolved at some point with massive deleveraging.

now, in his latest missive, pettis takes the argument a step further.

With international trade falling, it is probably only a question of time before China’s trade surplus begins to shrink sharply (although a number of commentators who I respect a lot, including Brad Setser, might disagree with me on this), and as I wrote last week there is mounting evidence that some of the hot money that poured into China one year ago is now starting to leave. This suggests that China may begin to see rapid contraction of foreign currency holdings and, with it, a contracting domestic money supply.

This may be the biggest unexpected risk China faces. We must remember that as long as the main task of monetary policy is to set the value of the RMB in foreign currency terms, the PBoC has limited ability to manage the domestic money supply. If net outflows are large in 2009, the PBoC may be forced to preside over a monetary contraction, and this would be exacerbated if there were problems in the banking system that caused formal and informal banks to cut lending. This would undoubtedly worsen China’s difficult economic adjustment to the problem of overcapacity. It is vitally important that Chinese policymakers recognize the monetary constraints under which they work and prepare contingency plans. China can learn a lot from the mistakes of US policy in the 1930s.

in other words, china could quickly be forced to choose between defending the renminbi-dollar peg or managing an expansion of its internal money supply. previously, as the renminbi was in demand and appreciating, these two goals were coincident -- china was in a position of having to accumulate massive forex reserves to keep the renminbi cheap, which led to domestic inflation as sterilization of that accumulation was imperfect. now, with capital actually fleeing china in flow sufficient to render an actual reduction in china's forex pile, these ends are in opposition -- and it means a choice between loosing the dogs on its exporters or facilitating a domestic debt-deflation. in truth it may be no choice at all, as either one will try to precipitate the other. again, china can be seen to be in a very bad place.

setser anticipated the point:

I wouldn’t worry too much though about the risk that the money supply will shrink just because China’s reserves aren’t growing. Growing reserves can lead to money creation. But so can the same stock of reserves and less sterilization. And the PBoC has enormous scope to reduce the scope of its sterilization operations. The recent cut in the reserve requirement is an obvious example. Moreover, if the PBoC wants to expand its balance sheet, it always could start buying domestic Chinese bonds. The real challenge — as the US and UK are discovering — is getting the banks to lend in a shrinking economy!

for example, then, the chinese government could buy renminbi in order to sell dollars to facilitate a defence of the peg as capital flees china in search of american dollars -- but also go into the domestic market to buy back sterilization bills in even greater quantity, with the net effect of pushing renminbi into the economy.

setser notes that, while this mechanism in operation would counter monetary deflationary in china, it will be deflationary for the world as a whole as a recession in china frees up yet more excess capacity for export.

the very fact of a previous episode of a trade surplus collapse coincident with a collapse in global trade in the closest historical parallel to the current china -- that being the united states in 1930 -- gives powerful weight to pettis' argument. setser has repeatedly warned that stagnating or falling demand for american treasuries is less fearsome than a decline in china's appetite for commodities and unfinished goods as an indicator of a crashing chinese economy and yet more excess capacity -- but these are probably not independent variables, as the latter will may lead to the former through the conduit of trade warfare.

in short, though i find setser's logic impeccable, i am forced to cautiously side with pettis -- the ultimate outcome is likely to be a trade war and a decline in global trade precipitous enough to force a significant decline in the chinese trade surplus in absolute terms even if it grows relative to the amount of global trade overall.

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