The rally in U.S. Treasuries this year is due in large part to China’s continued appetite for longer-term U.S. government debt. In the first five months of this year, China bought US$ 107 billion of Treasury debt maturing in more than one year, up from US$ 81 billion for all of 2013. That pace is the fastest on record and has put downward pressure on yields even in the face of the Federal Reserve’s decision to end quantitative easing by October.
The 10-year U.S. Treasury note has fallen from 3 percent at year-end 2013 to 2.54 percent, a decline few expected. The corresponding rise in bond prices, however, is unlikely to continue once the U.S. economy heats up, QE ends and the Fed begins to increase its benchmark rate. Fed Chairwoman Janet Yellen is in no hurry to increase rates, but the longer she waits, the more costly will be the final adjustment process.
Keeping rates too low for too long helped produce the Great Recession. Doing so again risks another crisis. As Kansas City Fed President Esther George warned in a recent speech: “Waiting too long (to increase rates) may allow certain risks to build that, if realized, could harm economic activity.”
“China has picked up the pace of its purchase of Treasuries, but both it and the United States would be better off if it relied less on the accompanying investment and export-led model.”
China’s willingness to support U.S. Treasury prices and help keep yields low stems from a desire to stimulate export growth and protect state-owned enterprises. Instead of allowing market forces to determine the exchange rate, the authorities peg the yuan-dollar rate while allowing some variation to frustrate one-way speculation.
Most experts expect the long-run real exchange rate to appreciate, which would help rebalance China’s economy. But this year the yuan has been declining, exports expanding and foreign exchange reserves accumulating. A large part of those reserves are invested in U.S. Treasuries. Moreover, the carry trade (incentivized by the Fed’s zero interest rate policy) has led to an inflow of dollars that ultimately end up at the People’s Bank of China (PBOC). Under a floating rate system, those inflows would increase the yuan’s nominal exchange rate. However, under the pegged system, the PBOC supplies base money to prevent appreciation of the yuan, and then sells bills to absorb the newly created base money and prevent inflation.
Financial repression in China and in the United States (with negative real interest rates) distorts the global allocation of capital. China, as a capital-poor country, should not be a net exporter of capital. By controlling capital flows, suppressing interest rates and pegging the exchange rate, China continues to rely on investment and export-led development.
That model of development, with the central role of state-owned banks and enterprises, is not sustainable, as China’s leaders have noted. By failing to allow a greater play of market forces in determining relative prices, including the yuan-dollar exchange rate, China is running the risk of a balance sheet crisis when U.S. interest rates rise, as they must.
Loan demand in the United States is picking up. As it does, banks will begin to lend out their excess reserves, and the money multiplier will increase. As overall money growth accelerates, so will inflation. Ultimately, markets will dictate higher rates and asset prices will fall, both in the United States and China.
The risk of capital losses on Treasuries is something China has to be concerned about. In addition to the interest rate risk, there is the risk of a falling dollar as inflation winds start blowing. There is also the risk of a downgrade of U.S. government debt, although that risk is less likely than the first two.
It is in China’s long-run interest to downsize its holding of U.S. debt by ending financial repression and allowing a greater play of market forces. A virtuous outcome would be to deny the U.S. government the means to over-leverage and overspend, while invigorating China’s non-state sector by releasing scarce capital for private investment.
Finally, if Beijing were to create real capital markets, based on private ownership and the rule of law, both domestic and foreign investors would find many attractive investment opportunities. The real exchange rate would appreciate, the balance of payments would normalize and there would be no need to hold vast amounts of foreign exchange reserves that are wasted on buying U.S. government debt.
Reform in China would put pressure on Washington to get its house in order. Congress could no longer depend on China to keep interest rates low and finance excess spending (most of which goes to special interests). The 2008–09 financial crisis was a balance sheet crisis: households, banks, corporations and governments were over leveraged. We have learned that monetary policy is no panacea; it cannot create real growth or reduce unemployment (except for very brief periods).
The Fed’s ultra-low interest rate policy and QE have laid the basis for asset bubbles: stock prices are increasing much faster than real incomes, while productivity is severely lagging. The solution is to remove barriers to entrepreneurship, lower marginal tax rates, and adopt fiscal, regulatory and monetary policies that favor markets. Both China and the United States would benefit from freer trade in goods, services, capital and ideas.
Reducing debt and increasing equity is a sound policy for future growth. China cannot hold the world economy on its shoulders, nor can America. But if both respect the rule of law and adhere to sound economic principles, everyone would be better off.
China cannot pull out of the U.S. debt market overnight, but it can signal that market forces will play a greater role in the allocation of capital and in price formation – in an effort to rebalance the economy. If investors are confident in China’s promise to liberalize and protect property rights, the positive effects will quickly set in.
Meanwhile, the United States should welcome Chinese investors who want to build the stock of private capital, rather than lend to an over-leveraged federal government that has failed to generate economic growth.