It is a frequent theme of foreign exchange and bond market commentaries that Asian central banks play a crucial role in financing the giant twin deficits of the US and that if they were to suspend their intervention in currency markets, both the US dollar and US fixed-rate bonds would tumble. Fortunately for the stability of the global economy, there is little basis to these concerns, except in one particular risk scenario – that of global deflation. And even in that scenario it is the dollar, not US fixed-rate assets, which would be highly sensitive to the intervention tactics of the Asian central banks.
A first point to realize is that it is the overall savings surplus in East Asian countries and the currency preferences of investors there which matters to the overall stability of the global economy and market – not whether the surplus savings are invested by the public sector (central banks and governments) or the private sector. In fact, this point is well demonstrated by recent Japanese experience. Since March 2004, the Bank of Japan has undertaken virtually no intervention in the foreign exchange markets. Private capital outflows from Japan have gained considerable momentum, and Japanese investors have continued to show preference for the dollar (albeit not to the same extent as the government of Japan).
A strong stream of private capital flows from Japan into dollar fixed-rate or money assets has as much if not more of an influence in holding down US rates and holding up the US dollar as Bank of Japan intervention. There may at the margin be some influence on spreads between Treasury bonds and other fixed-rate assets in so far as private Japanese investors might not show the same taste for government paper as the Bank of Japan. And in so far as Japanese investors concentrate on dollar cash rather than fixed-rate assets, there might be an influence on the yield curve (long-maturity fixed rates rising relative to money rates). But these spread effects are likely to be very small given the small size of flows concerned relative to the outstanding stocks of the given assets.
The government of China is the biggest remaining accumulator of foreign exchange reserves in the region. But as such it is one player in a huge round trip. The Chinese private sector is a massive borrower of US dollars, as it positions itself (by replacing yuan with dollar liabilities) to profit from an eventual appreciation of the Chinese currency. Direct investment inflows into China run at around 5% of GDP and are largely financed by US dollar borrowing or out of US dollar resources. These two large inflows are matched by Chinese official foreign exchange purchases and also some portfolio outflows by private Chinese investors – in so far as these are possible within the constraints of an exchange control system still largely in place. The net outflow of capital from China to the rest of the world (mainly into US assets) is a comparatively small $45 billion (the size of the US current account deficit).
Far cry?
One day – probably in the more distant future than many expect – the yuan will float and Chinese government buying of dollar assets will shrink or even go into reverse. But that will not be a traumatic event for US asset markets, because at the same time as Chinese official demand for US assets falls, the Chinese private sector will be stepping up its export of capital into dollars – either via the purchase of US assets or in the form of repaying dollar borrowing. (Repayment of dollar borrowing by non-US residents is a form of capital inflow to the US.) After all, there is a huge amount of speculative borrowing of dollars to repay.
The crucial long-run issue in assessing the importance of China to US asset markets is how large will be the outflow of private capital on a sustained basis. (The assumption is made that a floating of the yuan will be accompanied by the lifting of most exchange controls in China.) Some economists argue that as the Chinese investment bubble bursts, and private savings driven by the need to provide for old age remain very large, China will evolve into a massive capital exporter. The fragile condition of the Chinese banking system is in itself a factor likely to promote private capital outflows. An OECD simulation has China as the largest international creditor by 2035.
Outside China and Japan, the most important capital outflows are from the group of small advanced economies in the region –Taiwan, Singapore, South Korea and Hong Kong. They are (with the probable exception of South Korea) in large structural savings surplus. At times the government sector is important in buying foreign assets; at other times, the outflow of capital is mainly private sector in origin. Again, the private sectors in principle might have less of a bias in favour of dollars than the public sector. In practice, however, experience suggests that US assets are favoured. And that preference for the dollar would likely survive a floating of the yuan. The euro is a risky and low yield alternative, and in any case, a floating yuan is likely to move closer to the US dollar than the euro.
So, is the issue of official intervention by Asian central banks largely an irrelevance? Consider the following special case where in fact their operations could assume global importance. Suppose the US economy were to slide into a new recession and money market rates there again reach historic lows. In principle the equilibrium level of interest rates in the Asian savings surplus countries would drop to negative levels, but that cannot happen in conventional monetary systems, so rates fall to zero and stay there. Under those conditions the outflow of private capital from Asia would seize up, and central bank intervention would be essential to avoiding an upward spiralling of their currencies and downward spiral of the US dollar. It is this deflationary special case which needs to be focused upon by G7 contingency planners – if they are to be found anywhere!
Brendan Brown is author of Euro on trial and The Yo-yo yen and director/head of research at Mitsubishi Securities International in London
A floating yuan is likely to move closer to the US dollar than the euro [pq]