Thursday, February 18, 2010

Of Docks and Dollars

I shot this lad collecting parking fees in the Lao capital of Vientiane. Note his vest, which says JIAOTONG, apparently Chinese. Most consumer goods in Laos come from China, as do many of the merchants.

Tom Holland in the SCMP blistered those feeling the forex fears from China after military leaders blustered earlier this month. News this week says that China has slipped to number 2 holder of US debt after dumping a bit in December. Holland, in a piece entitled Fat-headed generals wrong to see forex reserves as a weapon, argues:
Given that China's US$2.4 trillion pot of foreign reserves is by far the world's largest (see first chart), and that it is held mostly in US-dollar-denominated assets, Luo's threat sounds devastating.

Coupled with the news late on Tuesday that Beijing's direct holdings of US Treasury debt fell by US$43.5 billion over the last two months of 2009 (see second chart), his bellicose words added fuel to the fires of a dozen internet conspiracy theories.

Believe the theorists and you would have little doubt that a fatally weakened US economy now lies at the mercy of a small band of unhinged Beijing warmongers just itching for an opportunity to destroy the value of the US dollar and bankrupt the US government by abruptly selling down their holdings of Treasury bonds.

Certainly the US military establishment takes the prospect seriously. In late 2008, Colonel Jeffrey Haymond, vice-commander of the space development test wing at Kirtland Air Force Base in New Mexico, published an article in the journal of the US Air Force's research institute entitled "The economics of a Chinese currency attack".

In Haymond's scenario, Washington dispatches two aircraft carrier battle fleets to the region following a Taiwanese independence vote. Suddenly, global financial markets go haywire, with massive selling of US Treasury notes. Long-term interest rates jump by a full percentage point in a single day and the US dollar falls 5 per cent.

It becomes obvious that China is dumping its foreign exchange reserves. US stocks fall 30 per cent while the US dollar drops 20 per cent against the euro. Slammed by the volatility, banks and investment funds begin to fail and the US economy is brought to its knees. A Chinese currency attack on the US, Haymond concludes, would be "a viable tool of economic statecraft". Luo and his comrades in the PLA clearly think so, too. The trouble is that they, the internet conspiracy theorists and Haymond are all wrong. The whole idea that Beijing could use its foreign exchange reserves as an weapon against the US is nonsense. It simply wouldn't work.

To see why, just imagine what would happen if China really did try and dump its holdings of US Treasury bonds. Once word got around the market that Beijing was on the offer, every financial institution in the world would run for cover. Bids would vanish and all liquidity would evaporate. With no buyers in sight, Beijing would not be able to sell its debt.

Trying to sell the US currency in the foreign exchange market wouldn't work either. The only buyers likely to emerge would be the central banks of Europe and Japan, who could sell their own currencies in unlimited quantities in order to stabilise their exchange rates against the US dollar. As a result, the most visible consequence of the Chinese action would be that the yuan's exchange rate against other major currencies would soar, crippling China's export sector.

And contrary to common expectations, a Chinese attempt to dump Treasury bonds wouldn't ruin the US government's finances. Yields would rise initially (although Federal Reserve purchases would soon push them down again). However, it would rapidly become apparent that Washington is not reliant on Beijing to fund its budget gap. Over recent months, Chinese purchases of Treasury debt as a proportion of the federal deficit have shrunk almost to zero without precipitating a crisis.
Note how unrealistic the whole scenario above is (for starters, why on earth would Washington defend Taiwan if it voted to declare independence, when it has clearly indicated Taipei would be on its own if that occurred?). Holland could have added much more -- a rising Yuan against the dollar would dramatically spike China's imports, while a falling dollar would give fresh impetus to the ailing US export machine (and other exporting nations, like hated Taipei and distant Europe). Too, once those US securities were dumped, they would cease to be leverage over the US. That would give Washington a lot more room to manuever. Is that really what Beijing wants? To give up secure leverage for an uncertain future? Not to mention all that lovely interest from the US treasury.....

Observations on Holland:
  1. China has already stopped purchasing US treasuries in significant amounts.
  2. The amount sold in December was a tiny fraction of all Chinese holdings, around 2%. No earthquake there.
  3. While Beijing's chorus in the US blamed Taiwan, or the US military, or anything but Beijing for deciding to dump a few US treasuries -- in a permanent state of victimhood, poor Beijing is always the passive recipient of someone else's actions -- the sell-off dropped China below Japan, so that it is no longer the leading holder of US treasuries. Looks to me like the whole thing was a PR exercise -- Beijing decided to sell just enough bonds to become #2, and take some of the focus off its holdings of US debt. This may be because a stealth sell-off is in the works, or perhaps just because it didn't like everyone watching its financial arrangements.Whatever the case, congrats to the PR boys in Beijing who once again got the Usual Suspects out there flacking for it.
The media is really confusing me. Are tensions rising or falling between Beijing and Washington? Should I go with the BBC's Nimitz docks in Hong Kong despite China tensions or with the AP's U.S. Warship In Hong Kong In Sign Of Easing Tension? China hasn't really taken any of the actions it threatened to, as several reports have noted -- which also suggests that the whole We're Tough! exercise was aimed at its domestic front.

Interesting times, indeed.
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20 comments:

Thomas said...

An Apple Daily editorial I read earlier also made an interesting point. If China becomes the No. 2 debt-holder, won't China already lose leverage? How many times have the media gurus obsessed about Japan's holdings of US debt in the last few years? Very few. Why? Because Japan was not No. 1.

If China is no longer the No. 1 debt-holder, than much of the media discourse about fearing China's economic leverage could slowly dissipate. This might result in a public and media that are less fearful of China.

Michael Turton said...

Yeah, that's kinda what I'm thinking. The sum was so tiny it was made for PR/internal reasons.

Michael

Arty said...

You guys do know we, the USA or Federal Reserve to be exact, is the largest US debt holder by far. Also, you should know that we can default on debts to other country with little consequences, but we can't default of on our retirees.

There is no tension between China and US. Both sides talk tough, but making love in the back room. Now, if you are Taiwan, what do you think will be the Taiwan's future?

Thomas said...

"There is no tension between China and US."

This is a naive statement. Arty, I have no doubt that the current "tensions" are overhyped. However, I remind you that, even if on a government-to-government level there were no tensions at all, the perceptions of the populations in the respective countries would eventually demand responses from the parties in power. This has been true in the US for a very long time and is increasingly true in China.

When policymaking is affected, you can't just brush such "tensions" under the rug so easily.

This aside, I don't think you are so naive as to believe that there is no tension on a government-to-government basis. Case in point: If there were no tension, then China and the US would have seen eye-to-eye in Copenhagen and we would now have a real climate accord. Tension exists where there are disagreements. Are you saying that there are no disagreements between the US and China?

Arty said...

This aside, I don't think you are so naive as to believe that there is no tension on a government-to-government basis. Case in point: If there were no tension, then China and the US would have seen eye-to-eye in Copenhagen and we would now have a real climate accord. Tension exists where there are disagreements. Are you saying that there are no disagreements between the US and China?

Well, of course, there are disagreement between China and the US. However, it is not to the point of I would call tension and it is much hyped. Just like in life, I can have disagreement with my friends, however, it does not mean there are tensions amongst us. If you're married, and you have disagreement with your wife, are you going to have so call tension to the point of physical violence? No, you work out the disagreement.

P.S. Copenhagen is a joke (by the way do you really think US want it). There are better ways to solve globe warming than forcing people to cut back without incentive. Also, if I told you the largest green house gas is actually water in the air would you believe me (sounds a lot less sexy right)?

Michael Turton said...

Of couse water vapor is a greenhouse gas. Everyone knows that, and the excellent Wiki page on greenhouse gases has a good explanation of it.

http://en.wikipedia.org/wiki/Greenhouse_gas

Thomas said...

"If you're married, and you have disagreement with your wife, are you going to have so call tension to the point of physical violence? No, you work out the disagreement."

Arty, I don't know what point you are trying to make. Does your definition of tension mean that violence has to be involved? The appropriate definition of the word tension by dictionary.com is "a strained relationship between individuals, groups, nations, etc." The desire to inflict violence is not a prerequisite.

Disagreements strain relationships, thus causing tension.

This is a pointless symantic exercise. You can call the tension in question a "hot dog" if you want. My questioning of your line of thinking is really more about your absolute negation, which doesn't really make much sense unless you engage in creative symantics to prove your point.

Anonymous said...

'Federal Reserve to be exact, is the largest US debt holder by far. Also, you should know that we can default on debts to other country with little consequences, but we can't default of on our retirees.'

Actually, I wouldn't be surprised if the financial wizards like Madoff and Bernanke figured out a way to default on America's retirees.

What exactly would stop them?

Anonymous said...

No Tension? Are you crazy? The Chinese gov't is America's #1 enemy.* Why do you think we are in PakAF? War will come between CN/US, by proxy first, but it will come.

Also, China isn't really buying less T's. It's been speculated that in actuality, they are continuing buying T's through their UK businesses. Just look at the latest FED TIC report. How does the bankrupt UK have money to buy more Treasuries?

http://www.ustreas.gov/tic/mfh.txt

The hammer is going to come down on China. The KMT is foolish to put all their eggs in the CCP basket.

(ok, its a toss-up between the Wall St. Bankers/FED and the Chinese as to who is the biggest enemy...).

Robert R. said...

Michael,

Holland's contention that buyers would dry up if China floods the market is exactly what would make their stragety work. If you have a lot of sellers and no (or nearly none) buyers, that'll tank the price of the dollar. If Holland's correct, then China would be able to cause us that damage while not taking as big of a financial hit, since you'd probably expect the dollar to recover to some extent after the "conflict" ends.

Your opposite contention that once China uses all of their dollar reserves they'd lose that leverage. That's like saying once I use my nuclear bomb on you, I'll no longer have that threat. While true, the damage is done. The only issue is how much. And, as I understand it, the interest on treasuries is relatively low compared to other (non-Yen) currencies.

True point, however, on the export situation, and it'll probably do bad things to their export economy.

Robert R. said...

As for being 1st or 2nd, I think that's silly talk. The reason people aren't obsessed about Japan's large dollar holdings is because they're not batshit crazy to use it as a weapon, but rather as a financial instrument. Not so true for the new #2.

Robert R. said...

Arty, we can default on our debt with little effect? I've heard little of that. Aside from the precipitous drop in the exchange rate and our inability to raise further debt at any reasonable interest rates. Now, if we were an isolated economy, that wouldn't be a huge problem. But hey, hellooooo hyper inflation! (OK, I'm not sure about that last one)

Michael Turton said...

Fair comments. The way I see it, a nuke is a reliable weapon. But the very uncertainty of the financial bomb makes it more useful as a threat than a reality. No one can really predict what would happen, least of all the people in Beijing.

Anonymous said...

Perhaps the secondary effect of the theoretical Chinese action would be more important - panic in all markets. A huge shock to the system. Not sure how that helps China.

One problem with the analysis mentioned is the idea that "the yuan would skyrocket against the dollar." The Yuan not a free-trading currency. The Chinese government can set it by fiat. Now, because it does not float really freely it creates other problems for them, but again it doesn't have to skyrocket against the dollar in response to market forces.

I think the old saying "If you owe the bank a thousand dollars, that's your problem. If you owe the bank a million dollars, that's their problem" applies to this situation as well.

China is blustering. Now, China may end up being like America was to Japan before, the foreign power that our politicians cite as reasons for unpopular decisions...as in "we have to cut benefit x, because China says we can't afford it, so we have no choice..." Could be interesting.

Michael Turton said...

The Yuan will skyrocket anon, because when there is upward pressure on a diktat currency, the public simply opens a black market. Yet another negative for China...

Nice comments, keep em coming.

Robert R. said...

Actually, from my understanding, there are 2 main ways to fix the price of a currency. Either move your interest rates in lock step with the US Fed, or buy up all of the surplus dollars and amass a giant dollar reserve.

(I'm sure both are much more complicated than I make it out to be).

The former causes problems with inflation when the condition of your economy doesn't match the condition in the US. This is what happened in many of the middle-eastern countries that have currency pegs. They have had times of huge inflation during the time the US kept their interest rates low for a prolonged time.

The latter, obviously, is what China's doing. In order to sell their dollar reserves on the market, they'd have to get something back in return, namely RMB. With such a dump, the RMB should rise. If China try to keep their fixed rates, they'll have trouble to find people that are willing to sell their RMB, since it's market value will be much higher.

They could try to switch all of their holdings into Euro or some such, and I have no clue how that would turn out.

For the black market, within China, I'm sure that will occur, but even with the size of the country, I don't know how that would have an impact on the international markets.

Arty said...

This is a pointless symantic exercise. You can call the tension in question a "hot dog" if you want. My questioning of your line of thinking is really more about your absolute negation, which doesn't really make much sense unless you engage in creative symantics to prove your point.

The point is that Taiwan is like a meal, that in the end she will be served on a plate to China from us. That is if people of Taiwan think we will actually fight a nuclear power for them while clearly not listening to us (i.e. trying to gain independence without involvement of China. I know it is not likely China will ever let Taiwan go).

Btw, a lot of things are actually absolute i.e. if you are in a war, you either win or lose, there is no gray area like posting opinions on a blog.

Arty, we can default on our debt with little effect? I've heard little of that. Aside from the precipitous drop in the exchange rate and our inability to raise further debt at any reasonable interest rates. Now, if we were an isolated economy, that wouldn't be a huge problem. But hey, hellooooo hyper inflation! (OK, I'm not sure about that last one)

Well, in reality US can not default on its debts as of now. If you don't get it, sorry I won't take my time to explain it to you. I don't think we will have hyper inflation but I think next decade we will have higher than average inflation just to make our debt less and less expensive at the cost of debt holders. Of course, there is a way to invest and hedge that.

As for so called black market due to the fixed exchange rate and potential of hording RMB, there is also a way to get rid of it. Hint: North Korea did it. What the government has to do is to order everyone that the old physical paper RMB is outdated and need to be exchanged to the new version and limits for example 10,000 RMB per person maximum. This will in-effect make RMB circulated in black market close to worthless.

Btw, I want RMB to rise because I think you can still run a export oriented industry with a strong currency. Do not make the mistake Japanese made!

Anonymous said...

Arty doesn't know what he's talking about with economics. He made several incorrect predictions about the crash of the Taiwan stock market and had no clue about the recovery either.

China can't afford to fight the US over Taiwan. It would destroy China's economy. No one would dare use nuclear weapons which means that much of China's infrastructure is at risk, but not true of the US mainland. It would be horrible for the US, but much worse for China.

Robert R. said...

Well, in reality US can not default on its debts as of now. If you don't get it,

Well, I do get why the US can not default on it's debt, but your stated earlier that it can default "to other countries with little consequences". That's much less obvious.

Robert R. said...

Not to (seem to) defend Arty :D, but predicting the stock market has little to do with knowledge of economics. Otherwise econ professors would be much more richer.

We can, however, still rag on him for his crappy predictions (I haven't read them and I don't care to). The same for how he thinks his predictive powers in the world of finance have anything to do with the political issues he tries to discuss.