Is China Losing Its Taste for US Debt?

International Herald Tribune
U.S. debt is losing its appeal in China
By Keith Bradsher
Thursday, January 8, 2009

HONG KONG: China has bought more than $1 trillion in American debt, but as the global downturn has intensified, Beijing is starting to keep more of its money at home - a shift that could pose some challenges to the U.S. government in the near future but eventually may even produce salutary effects on the world economy.

At first glance, the declining Chinese appetite for U.S. debt - apparent in a series of hints from Chinese policy makers over the past two weeks, with official statistics due for release in the next few days - comes at an inopportune time. On Tuesday, the U.S. president-elect, Barack Obama, said Americans should get used to the prospect of "trillion-dollar deficits for years to come" as he seeks to finance an $800 billion economic stimulus package.

Normally, China would be the most avid taker of the debt required to pay for those deficits, mainly short-term Treasury securities. In the past five years, China has spent as much as one-seventh of its entire economic output on the purchase of foreign debt - largely U.S. Treasury bonds and American mortgage-backed securities.

But now, Beijing is seeking to pay for its own $600 billion economic stimulus - just as tax revenue falls sharply as the Chinese economy slows. Regulators have ordered banks to lend more money to small and midsize enterprises, many of which are struggling with slower exports, and Chinese bankers say they are being instructed to lend more to local governments to allow them to build new roads and other projects as part of the stimulus program.

"All the key drivers of China's Treasury purchases are disappearing," said Ben Simpfendorfer, an economist in the Hong Kong office of the Royal Bank of Scotland. "There's a waning appetite for dollars and a waning appetite for Treasuries. And that complicates the outlook for interest rates." (The reason that China has been buying Treasuries is to sterilize the impact of their dollar trade surplus and to support their industrial exports policy. These are not 'investment.' - Jesse)

Fitch Ratings, the credit rating agency, forecasts that China's foreign reserves will increase by $177 billion this year - a large number, but down sharply from an estimated $415 billion last year.

In the United States, China's voracious demand for American bonds has helped keep interest rates low for borrowers ranging from the government to home buyers. Reduced Chinese enthusiasm for buying those bonds takes away some of this dampening effect. (And China will be under increasing pressue to maintain the peg of the yuan to the dollar at an artificially low rate despite their currency controls - Jesse)

But with U.S. interest rates still at very low levels after recent cuts to stimulate the economy, it is quite cheap for the U.S. Treasury to raise capital now. And there seem to be no shortage of buyers for Treasury bonds and other debt instruments: Prices for U.S. debt have soared as yields have declined. (Buying of the debt is heavily concentrated in safe haven buying domestically and a small number of foreign central banks. It is vulnerable at these prices - Jesse)

The long-term effects of this shift in capital flows - with China keeping more of its money home and the U.S. economy becoming less dependent on one lender - are unclear, but the phenomenon is something economists have said is long overdue. (The result will be few Chinese exports to the US and a stronger renminbi - Jesse)

What is clear is that the effect of the global downturn on China's finances has been drastic. As recently as 2007, tax revenue soared 32 percent, as factories across China ran flat out. But by November, government revenue had actually dropped 3 percent from a year earlier. That prompted Finance Minister Xie Xuren to warn Monday that 2009 would be "a difficult fiscal year." (China must stimulate their domestic economy and raise the median wage to encourage consumption of their own production - Jesse)

A senior central bank official mentioned last month that China's $1.9 trillion in foreign exchange reserves had actually begun to shrink. The reserves - mainly bonds issued by the U.S. Treasury and by Fannie Mae and Freddie Mac, the mortgage finance companies - had been rising quickly ever since the Asian financial crisis in 1998. (There was a massive dumping of Agency debt by the foreign central banks, but a parabolic increase in Treasury purchases as we have previously documents - Jesse)

The strength of the dollar against the euro in the fourth quarter of last year contributed to slower growth in China's foreign reserves, said Fan Gang, an academic adviser to China's central bank, at a conference in Beijing on Tuesday. The central bank keeps track of the total value of its reserves in dollars and a weaker euro means that euro-denominated assets in those reserves are worth less in dollars, decreasing the total value of the reserves.

But the pace of China's accumulation of reserves began slowing in the third quarter along with the slowing of the Chinese economy, and appears to reflect much broader shifts.

China manages its reserves with considerable secrecy, but economists believe about 70 percent is in dollar-denominated assets and most of the rest in euros. The country has bankrolled its huge reserves by effectively requiring its entire banking sector, which is state-controlled, to hand nearly one-fifth of its deposits over to the central bank. The central bank, in turn, has used the money to buy foreign bonds.

Now the central bank is rapidly reducing this requirement and pushing banks to lend more money instead. (Good this is what they must do to encourage real capital investment that does not flee at the first whiff of a crisis - Jesse)

At the same time, three new trends mean that fewer dollars are pouring into China - and as fewer dollars flow into China, the government has fewer dollars to buy American bonds and help finance the U.S. trade and budget deficits.

The first, little-noticed trend is that the monthly pace of foreign direct investment in China has fallen by more than a third since the summer. Multinational companies are hoarding their cash and cutting back on the construction of factories. (FDI cuts and runs quickly in a crisis - Jesse)

The second trend is that the combination of a housing bust and a two-thirds fall in the mainland Chinese stock markets over the past year has resulted in moves by many overseas investors - and even some Chinese - to get money quietly out of the country. They are doing so despite China's fairly stringent currency controls, prompting the director of the State Administration of Foreign Exchange, Hu Xiaolian, to warn in a statement Tuesday of "abnormal" capital flows across China's borders; she provided no statistics.

China's most porous border in terms of money flows is with Hong Kong, a semi-autonomous Chinese territory that has its own internationally convertible currency. So much Chinese money has poured into Hong Kong and been converted into Hong Kong dollars that the territory has had to issue billions of dollars' worth of extra currency in the past two months to meet the demand, shattering its previous records for such issuance.

A third trend that may further slow the flow of dollars into China is the reduction of its huge trade surpluses.

China's trade surplus set another record in November, at $40.1 billion. But because prices of Chinese imports like oil are starting to recover while demand remains weak for Chinese exports like consumer electronics, most economists expect China to run trade surpluses closer to $30 billion a month.

That would give China a sizable sum to invest abroad. But it would be considerably less than $50 billion a month that it poured into international financial markets - mainly U.S. bond markets - during the first half of 2008.

"The pace of foreign currency flows into China has to slow," and therefore the pace of China's reinvestment of that currency in foreign bonds will also slow, said Dariusz Kowalczyk, the chief investment officer at SJS Markets, a Hong Kong securities firm.

For a combination of financial and political reasons, the decline in China's purchases of dollar-denominated assets may be less steep than the overall decline in its purchases of foreign assets. (Their industrial policy of export to the US is the reason - Jesse)

Many mainland Chinese companies are keeping more of their dollar revenues overseas instead of bringing them home and converting them into yuan for deposit in Chinese banks. In essence, they would not show up on the central bank's books. So, overall Chinese demand for dollars would not be falling as much as the government's demand for dollars, said Sherman Chan, an economist in the Sydney office of Moody's Economy.com.

Treasury data from Washington suggest the Chinese government might be allocating a higher proportion of its foreign currency to the dollar in recent weeks and less to the euro. The data also suggest China is buying more Treasuries and fewer bonds from Fannie Mae or Freddie Mac.

Figures from the U.S. Federal Reserve and the Treasury point to a sharp increase in Chinese holdings of Treasury bonds in October. China passed Japan in September as the largest overseas holder of Treasuries, and took a commanding lead in October, with $652.9 billion compared to $585.5 billion for Japan.

But specialists in international money flows caution against relying too heavily on these statistics. They mostly count bonds that the Chinese government has bought directly, and exclude purchases made through banks in London and Hong Kong; with the financial crisis weakening many banks, the Chinese government has a strong incentive to buy more of its bonds directly.

The overall pace of foreign reserve accumulation in China seems to have slowed so much that even if all the remaining purchases were U.S. Treasuries, the Chinese government's overall purchases of dollar-denominated assets will have fallen, economists said.

But China's leadership is likely to avoid any complete halt to purchases of Treasuries for fear of looking like it is torpedoing the chances for a U.S. economic recovery at a vulnerable time, said Paul Tang, the chief economist at the Bank of East Asia here.

"This is a political decision," he said. "This is not purely an investment decision."