Chinese Financing of the United States

1
Chinese Financing of the United States

• Brad Setser
• Roubini Global Economics and the Global Economic
  Governance Programme, University College, Oxford

2
Global balance of payments

• Big US current account deficit an estimated
  900b in 2006
• Offsetting surpluses found overwhelming in the
  emerging world
• China _at_ 220b (maybe more)
• Oil exporters _at_500b (Middle East/ Russia over
  400b)
• Europe small (but growing) deficit also financed
  by emerging world
• Japan significant (but stable) surplus that helps
  finance the US/ Europe
• US deficits of 900 to 1 trillion likely for
  some time, even if trade deficit begins to trend
  down
• Interest payments on US external debt stock set
  to rise

3
Global current account balance
4
Chinese financing of the US

• Overwhelmingly done by the central bank
• Reserves managed by State Administration of
  Foreign Exchange (SAFE)
• Reserve growth in 2006 likely to top 250b
• Reserves growth from
• Current account surplus (Rising)
• Net inflows of FDI (China trying to offset with
  outflows)
• Hot money inflows (Falling)
• Most think around 70 of reserves invested in
  dollars, 20 in euros, 10 in other currencies

5
Chinas reserves
6
What we know

• China held 530b in US assets in June of 2005 (v
  710b in reserves and 770 b in augmented
  reserves (counting the 60b transferred to 3
  Chinese banks)
• China has added over 230b to its reserves
  between June 05 and June 06.
• By end of q3, reserves likely will reach 1000b,
  augmented reserves will reach 1070b
• Recorded inflows since June of 2005 are around
  110b, implying a bit under 640b of total
  Chinese holdings of US securities
• Two ways of measuring Chinese holdings flows
  (how much US residents report selling to China)
  and stock (how much the Chinese report holding in
  the US annual survey)
• For complicated reasons, the increase in the
  survey data has tended to exceed the increase
  implied by the flow data.
• Likely Chinese holdings of US debt now total
  around 700b i.e. 70 of total reserves
• Chinese deposits in international banking system
  are relatively small most Chinese reserves seem
  to be invested in securities.

7
Chinese purchases flow v stock data
8
It is not just Treasuries

• China holds a relatively diverse portfolio
• Lots of agency bonds
• Other mortgage backed securities as well
• The trend has been for more purchases of
  agencies, corporate debt, and the
  dollar-denominated debt of emerging economies
• China will likely set up a government investment
  corporation at some point to make more
  aggressive investments PBoC manages a very
  significant share of Chinas national wealth.

9
Chinese holdings Survey data through mid-2005
2006 estimate
10
Misconceptions

• Argument China could sell its treasury
  portfolio, roiling US markets
• Maybe, but it does not have to sell to influence
  US markets. All it has to do is stop buying.
• Right now markets used to 150b or so in annual
  Chinese purchases. Net increase in Chinese
  holdings from June 04 to June 05 185b.
• Conservative estimate is Chinese purchases lower
  US rates by around 30bp (Warnock and Warnock,
  2005)
• Treasury market most liquid, Chinese sales of
  agencies/ MBS/ corporate bonds would have a
  bigger impact
• China will never sell if it sells, it would
  move the market against it.
• True.
• But China will take losses no matter what
  Philip Swagel has argued that since China over
  paid for its US bonds, large losses are already
  baked in.
• China can choose time/ place when it realizes
  those baked in losses
• If China cared only about financial losses, it
  should just stop buying treasuries now and let
  the RMB appreciate.
• The real constraint for China isnt financial
  losses. It is that selling would antagonize its
  key customers the US and Europe. US would be
  less able to buy Chinese goods. And Europe
  wouldnt be happy if Chinese actions pushed the
  euro to 1.5 or above and drove the RMB down
  against the euro.
• Other risk for China is a US freeze on Chinese
  assets held in the US A big share of Chinas
  financial wealth at least 25 of Chinas GDP --
  now invested in US.

11
Scenarios -- speculative

• Chinese options
• Shift Chinese funds into London/ Singapore
  custodial accounts (still in dollars)
• Have the head of SAFE give speech extolling the
  reserve management of Russia and India (both have
  far smaller dollar allocations)
• Stop (or slow) purchases of US securities buy
  more European securities.
• Stop (or slow) purchases of US securities buy
  more oil/ strategic commodities
• Sell US securities from custodial accounts in
  London
• Sell Chinese positions in less liquid markets to
  maximize the market impact
• Quietly take derivative positions before making
  noisy sales
• Do nothing. Let the market fret

12
Scenarios -- Speculative

• US options
• Borrow Euros that the US sells to buy dollars
• Borrow from the markets (Issue euro-denominated
  Treasury bonds)
• Borrow from other governments
• Encourage others to buy dollars. Europe might
  intervene to keep euro from going to 2
• Sell oil if China is buying oil
• Freeze Chinese assets but China would likely
  seize US investment in China

13
Conclusions

• Chinese leverage comes from the potential
  withdrawal of the financial subsidy it currently
  provides the US by overpaying for US debt.
• This financial subsidy benefits Chinese
  exporters. So withdrawing the subsidy also has a
  current cost to China.
• Realistic options fall short of the extreme
  options
• Reducing purchases rather than outright sales
• Markets would try to anticipate any Chinese move
  generating economic/ financial costs in the
  event of a serious rise in US/ Chinese tensions
  
• Threat of using leverage is often more valuable
  than actual use
• China opposed Iraq war in UN. It then helped
  finance it
• It isnt just China. Saudi Arabia/ Russia now
  have around 500b in reserves, and their reserves
  are increasing by 200b a year