Dollar concerns prompt China’s Christmas surprise
China’s discreet moves to promote the renminbi as an international reserve currency could spell disaster for the US Treasury market and further exacerbate the structural weaknesses of the dollar
It was on Christmas Eve that China chose to launch what appeared to be a simple new trade scheme to start using renminbi, rather than US dollars or euros, in deals with eight neighbouring economies. Worries about both dollar volatility for exporters and the impact of a dollar slump on the country’s $2tr foreign currency holdings presumably led to the announcement being pitched softly over Christmas for fear of what it might do to the US currency.
If the new scheme to use renminbi for international trade works, the experiment could herald the start of the renminbi’s global ascent, as China inches closer to making its currency convertible and paves the way to becoming an international reserve currency — a goal China’s top economic policy-makers now confirm they’re actively pursuing. At root, the move may represent an attempt, however provisional, to decouple Asian currencies from the US dollar.
If and when China makes its capital account convertible, importing countries will need reserves of renminbi. To get them, central banks around the world will have to sell US assets and Treasury bills.
More worryingly for international finance, this comes at a time when China’s appetite for US debt, apparent in recent comments from Chinese policy-makers, is on the wane. As the global downturn has intensified, Beijing is starting to keep more of its money at home.
So far, despite all the talk coming out of China, Beijing has yet to lose its near-term appetite for either dollars or Treasuries. Over the last 12 months, China’s official US Treasury purchases have hit a record $190 billion. Most of the rise has come in the past few months of data.
But what’s becoming increasingly clear is that the impact of the global downturn on China’s finances has been severe. It’s also having an effect on what the government does with its money: Beijing is looking to pay for its own $600 billion stimulus — just as tax revenue is falling sharply as the Chinese economy slows. Meanwhile banks are being ordered to lend more money to small and medium-sized firms, many of which are buckling under lower export orders, and to local governments to invest in new roads and other projects.
Looking ahead, China’s official purchases of US debt are bound to fall from their current level as the rate of foreign exchange accumulation slows. This will become especially acute as China’s huge trade surpluses fall back to earth. The share of China’s reserves held in dollars and the proportion invested in Treasuries may also shift downward. Fitch, the credit rating agency, forecasts that China’s total foreign currency reserves will increase by $177 billion this year — down sharply from an estimated $415 billion last year.
Nevertheless, increasingly many global investors are, for now, piling into dollar assets, even though yields on 10 year US Treasuries have fallen to 2.4%. Despite the Treasury market’s rally at the end of last year, many investors still see value in US bonds, especially in the five and ten year sectors.
Treasury yields have fallen in both absolute terms and, markedly, in relative terms to the yields on private instruments, as investors flee global economic uncertainty for the perceived stability of US government debt.
Of course, if this extent of economic calamity had hit an emerging markets government whose financial institutions were in as deep disarray as those of the US, investors would have run a mile — cutting off the offending nation from global capital markets. But for the US, just the opposite has happened.
The reasons for this are well known: potential capital losses on existing stocks keep foreign investors locked into US government securities, helping explain why global investors have, in effect, been rushing into a burning building at the first sign of smoke.
But reduced Chinese enthusiasm for buying US bonds will complicate matters — not least for US interest rates. China’s insatiable demand for American bonds has helped keep interest rates low for borrowers ranging from the federal government to home buyers. As Beijing pulls back, the result will be a decrease in this dampening effect on rates.
Yet as of today, this scenario represents a sharp break with consensus. Worldwide, the possibility of deflation has boosted demand for sovereign paper. Indeed today’s commonplace analogy for the US economy is of Japan’s ‘lost decade’, when bond yields kept falling as a deflationary spiral took hold.
But this view is potentially wrong. For a start, the US Federal Reserve will not wait for years to hit the printing press. On the contrary, monetary expansion has already begun in earnest. And if China becomes a net seller of US treasury bonds, the Fed and other central banks will move swiftly to monetize their ever-growing national deficits. As this happens, markets will quickly forget about deflation. Instead, attention will shift to the fact that the Fed is boosting its balance sheet nearly four-fold, from $800 billion to $3 trillion. Bond markets could be in for a surprise, as yields rise sharply — whatever happens to economic growth. Economic history is littered with examples of falling production and rising inflation.
Of course this is a problem not just for the US but for the UK and eurozone economies too. It also presents a profound conundrum for bond markets in the year ahead — all the more so given the record amount of sovereign debt set to be issued.
For now, one can only hope that China’s surprise Christmas initiative takes place gradually, lest it torpedoes the value of American bonds — not to mention dollar assets globally.
But given the risks, take nothing for granted.