American Debt, Chinese Anxiety, Elaborated

Or, how the Tea Party is working hard to sabotage the dollar’s role in global finance.

Figure 1: Share of publicly held Treasury debt held by foreign residents (blue squares), and held by China (red triangles). Solid squares/triangles denote data from annual benchmark surveys; open squares/triangles from monthly series. Source: TIC, and St. Louis Fed FRED.From my op-ed “American Debt, Chinese Anxiety” in the International New York Times on Sunday:

Madison, Wisconsin — Last week, the United States once again walked up to the precipice of a debt default, and once again the world wonders why any country, much less the world’s largest economy, would endanger its financial reputation and thus its ability to borrow.

Though a potential global financial crisis was averted at the last minute, one notable development has been a string of warnings by Chinese officials. Prime Minister Li Keqiang told Secretary of State John Kerry that he was “highly concerned” about a possible default. Yi Gang, deputy governor of China’s central bank, warned that America “should have the wisdom to solve this problem as soon as possible.” An opinion essay in Xinhua, the state-run media agency, called “ for the befuddled world to start considering building a de-Americanized world.”

These statements, unusually blunt coming from the Chinese, show that repeated, avoidable crises threaten the privileged position of the U.S. as issuer of the world’s main reserve currency and (until now) risk-free debt.

It is unlikely that China would provoke a sudden, international financial calamity — for instance, by unloading U.S. Treasury securities and other government debt. Nonetheless, the process of repeated crises and temporary reprieves will only solidify the Chinese government’s determination to diversify its holdings away from dollar-denominated assets. …

Foreign entities — governments, companies and individuals — hold nearly half of the publicly held debt owed by the United States. Of China’s $3.6 trillion in foreign exchange reserves, about 60 percent is estimated to be held in U.S. government securities.

As foreign exchange reserves have soared over the last decade, Chinese monetary authorities have attempted to diversify away from dollar-denominated assets, with limited success. The motivation for diversification is understandable: Since July 2005, the Chinese currency has been appreciating against the U.S. dollar, so that in terms of local purchasing power, dollar-denominated holdings have been losing value.

In addition, the fiscal battles in Washington have made the Chinese authorities more anxious. The overarching problem is that over the longer term, U.S. government finances are not sustainable, in the absence of enhanced tax revenues and restrained spending.

However, Chinese policy makers have fairly limited room for maneuver. First, they are locked into a development model that relies heavily on exports as a source of growth. …

Second, most of the earnings received by Chinese exporters are in dollars, so that currency is what the People’s Bank of China accumulates. …

Third, even if the Chinese could diversify their holdings away from dollars without realizing capital losses, the question would be — as always — what is the alternative? …

Does that mean we Americans can rest easy? The answer is no.

To begin with, the fact that fiscal policy is partly in the hands of individuals who don’t believe that debt default is a serious issue understandably makes foreign investors uneasy. …

Moreover, China has been encouraging the invoicing of trade in renminbi, with some success (albeit starting from very low levels). In addition, China is loosening restrictions on renminbi-related financial transactions, with an eye to increasing the Chinese currency’s role in international finance. Eventually, this will mean a reduced demand for the dollar.

Over the longer term, both of these outcomes might be positive from China’s — and the world’s — perspective. However, if timed poorly, they would mean that demand for U.S. Treasury securities would decline at exactly the moment when interest rates on U.S. government debts rose. The resulting strain on government finances is not not be an outcome that patriotic Americans of any stripe should welcome.

I didn’t get to document and elaborate on all the points in the op-ed, so let me extend my argument.

Figure 1 demonstrates that known holdings of US Treasurys by the PRC have declined since the 2011 debt ceiling crisis. What will happen in the wake of the latest self-inflicted debacle remains to be seen.

On Friday, Paul Krugman wrote on the misguided fear that China would imminently dump dollars, provoking a spike in US interest rates. Some people (some commenters here) have taken my op-ed to be a counter to Krugman’s argument. In point of fact, we’re in close agreement; in both of our views, the danger is not an immediate flight from the dollar denominated assets. Krugman writes:

Think about it: China selling our bonds wouldn’t drive up short-term interest rates, which are set by the Fed. It’s not clear why it would drive up long-term rates, either, since these mainly reflect expected short-term rates. And even if Chinese sales somehow put a squeeze on longer maturities, the Fed could just engage in more quantitative easing and buy those bonds up.

That is an analysis perfectly appropriate for 2013, with the Fed embarked upon quantitative easing, extended guidance, and the economy with lots and lots and lots of economic slack.

My point was that an increase in default risk will induce China — and perhaps more importantly all foreign central banks and private entities — to have reduced demand for dollar assets over time, relative to what would have occurred in a world without a group of people hell-bent upon Treasury default (technical or not). If that reduction in demand shows up at a time (say five years from now) when demand for credit is rising, then interest rates will rise above what would otherwise occur. Figure 2 depicts projected Federal interest payments and ten year yields, from the February 2013 CBO Budget and Economic Outlook (data for figures).

Figure 2: CBO forecasts/projections of net interest payments as a share of GDP (blue, left scale), and ten year Treasury yields (red, right scale). Source: Budget and Economic Outlook (February 2013) data for figures, figures 1-3, 2-4.The net interest payments were projected to be 2.5% of GDP in 2018 if the ten year yield were 5.2%; compare against the 2.6% recorded on 10/18. Now, who knows how much of a default premium is built in, and how much more if the Ted Cruz faction can produce yet more debt ceiling standoffs (or an actual default).

Coming back to China, current projections from the IMF (see Article IV report from July) are for an increasing current account balance from the relatively small levels of 2012 — up to 2.7% of GDP in 2014, and 4% by 2018. By 2018, reserves will be increasing on the order of $668 billion. However, this forecast is clearly predicated on moderate progress on structural reform and a constant real exchange rate. If there is anything the Chinese government has demonstrated, it is that when the political will is summoned, it can undertake substantial changes in policy direction. The alternative, with structural reforms and continued RMB appreciation, the current account balance to GDP ratio could be as small as 1% by 2018.

Figure 3: Chinese current account to GDP ratio in the baseline (blue) and alternative scenario (red). Source: IMF, People’s Republic of China: 2013 Article IV Consultation, IMF Country Report No. 13/211, (July 2013), p.9.So, imagine a US economy close to potential GDP five years hence, with a considerably smaller demand for US Treasurys, partly because we have made US government debt less attractive. This will result in some combination of a weaker dollar and a higher long term interest rate. Not a good outcome (a weaker dollar due to from a higher exchange risk premium might not be such a bad thing, as Krugman points out). Then we might worry about crowding out, and some of that crowding out will be directly attributable to the actions of those who had no worry about Federal government default.

Background on international currencies here. For more on the RMB as an reserve currency, see here; increasing trading, here; and for a statistical analysis of the RMB as an invoicing currency, see this paper.

This piece is cross-posted from Econbrowser with permission.