Monday, March 22, 2010

Foreign Demand For U.S. Treasurys - The Chinese Version

Some popular media are obsessed with China’s economic stronghold over the U.S. economy, namely in the form of a massive accumulation of Treasurys. Although “experts” and government bureaucrats extol the virtues of an independent Federal Reserve, the fact of the matter is that this is a moot point—particularly in light of excessive dollar reserves (in US debt) held by China. Dumping a large portion of its dollar-based portfolio would send the financial markets into a tailspin: interest rates would immediately rise, default prospects of the U.S. government would become quite evident, and an avalanche of fear would no doubt engulf the markets.

Having said that, let me address one point that is not well understood these days: China discontinuing to (or slowing the) purchases of U.S. Treasurys. China will not do this until it completely abandons its fixed exchange rate policy. Consider this graph of the China/USD foreign exchange rate.

Ever since June 2008, the People’s Bank of China (PBOC) has maintained a fixed value of conversion between the Yuan and the U.S. Dollar. This means that the monetary policy of China is the same as the one exercised by the Federal Reserve Bank. For example, when the FED prints money, the Chinese have to print money. This is because the value of any currency vs. another is strictly determined by supply and demand. A loose monetary policy increases the supply of money, thereby reducing its value in relation to other currencies.

From a Chinese perspective, a loose monetary policy by the FED causes its domestic supply of money to increase. In other words, when the FED prints money, the Yuan appreciates. In order to maintain a fixed exchange rate, the PBOC must purchase the sufficient amount of currency in the foreign exchange market in order to keep its currency within its predetermined target. The PBOC may try to sterilize the excess supply of Yuan by selling Yuan-denominated bonds in its domestic market, but such policy is rarely successful.

Let’s look closely the behavior of the Yuan/Dollar FX rate over the last 10 years.

From 2000 to late 2005 the exchange rate was fixed at approximately 8.30 CNY per $. From late 2006 to May 2008, the Chinese floated its currency, hence the appreciation. And since June 2008 the CNY has been fixed at rate approximately 6.82.

Against this background, let’s see what happened to Chinas’ US Dollar exchange reserves (in billions): [Foreign reserves data was obtained from here].

January 2000 to December 2005: up from $165 to $818

January 2006 to May 2008: up from $845 to $1,797

June 2008 to December 2009: up from $1,808 to $2,399

In short, US dollar reserves in the hands of the PBOC have ballooned. This is no surprised, given the fall of the U.S. dollar in international markets for most of the first decade of the 2000s: a depreciating currency forces a fixed exchange rate country to a loose monetary policy in order to maintain parity in the currency. When market participants expect continuous exchange depreciation in the anchored currency (i.e. the US dollar), capital inflow occurs in the fixed currency economy (i.e. China). It was under this scenario that China found itself with no other credible option than to revalue its currency after late 2005. The U.S. dollar continued to depreciate and hence China’s reserve continued to skyrocket.

Until China freely floats its currency in relation to the U.S. dollar, all talks about the PBOC sobering its purchase of Treasurys is tabloid journalism.

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