China and America – financially in each other’s pocket

October 29, 2013 by Timothy Beardson

China has some $3.6 trillion-worth of foreign exchange reserves invested in different instruments in various countries and currencies. At the same time it has an almost broadly balancing amount of domestic currency debt which enabled those foreign reserves to be acquired.

Any significant rise in China’s currency (the yuan) exchange rate implies a loss on the value of its overseas reserves. For example a 10% rise in the yuan against major foreign currencies loses 10% – or over $300bn – on the value of its foreign reserves.

Similarly, the low interest rates received by China on instruments such as United States Treasuries are way below those China pays on its domestic borrowing to finance those foreign reserves. It has been estimated that the running loss to Beijing could be $66bn annually.

Several major countries, such as the US, Britain and Japan, are struggling to keep their currencies weak – partly for economic reasons. Washington believes the Chinese currency is undervalued. The IMF feels it is “moderately” undervalued. Each of these factors suggests the Chinese yuan could rise further against other major currencies.

Despite receiving lower interest rates on its overseas assets than it pays on its local debt, Beijing is often criticised by academics for “financial repression”. This means the policy of maintaining a mandatory low interest rate structure for depositors in the interests of those who would borrow for capital investment purposes. The market is not encouraged to play a role in setting domestic interest rates.

The impact of a rising Chinese currency would be to increase the losses on its portfolio of foreign reserves. While other major countries manipulate their interest rates as low as possible and China is advised even to increase its domestic interest rate structure, its annual losses on interest rate differentials are likely to mount.

This situation places Beijing in the invidious position of having a vulnerable, leveraged and continually deteriorating foreign reserve exposure. At some point it is quite likely that China will decide this situation cannot simply be rolled over and ignored. However, how easy will it be to wind down those holdings of foreign assets and repay that domestic debt?

Since the Western financial crisis of 2008, the United States has intervened in its debt markets through the Federal Reserve Bank acquiring a large part of each year’s public debt offerings from the US Treasury. For example in 2011, the Federal Reserve bought 77% of all US Treasuries sold. It is estimated that the Federal Reserve now holds $3.3 trillion of “publicly-held” US federal debt. This is 20% of all such US federal debt.

The Federal Reserve rebates to the Treasury the interest on the debt it acquires. As such, the US gets a substantial free ride on one fifth of its entire public debt.

This debt is purchased through money which is created – or “printed” – for this express purpose and thus in excess of normal monetary requirements. Economists would usually suggest that such excess money creation will lead to inflationary consequences. However, proponents of this measure argue that America is not facing inflation; indeed it is facing deflation and thus the strategy does not incur the normal risks.

This situation of governments buying in their own debt is not believed, even by the Federal Reserve, to be a sustainable long term strategy. It is an extreme measure for extreme times.

What is accepted by almost everyone is that in future these debt instruments temporarily held by the Federal Reserve will need to be removed from the balance sheet and sold to the public. However, such a move will have many consequences.

One clear consequence is that the authorities may be selling over $3 trillion of debt instruments at a time when normal public debt issuance is also continuing. It would be optimistic to assume that recent $1 trillion budget deficits will be dramatically reduced in the next few years. This creates two large simultaneous official sources of supply. If we assume that such sales will only happen when the US economy is finally judged to be recovering, then the corporate bond markets might also be hungry for funding.

A further consequence of this selling down is that it will certainly be the case that those acquiring the possibly $3 trillion of instruments to be sold by the Federal Reserve will not be minded to rebate the interest so there will be a substantial increase in US government interest costs. This could be of the order of 25%.

This is regardless of the separate issue of how much higher interest rates will go when the Federal Reserve’s downward market manipulation of rates ceases, when there are more offerors of debt and when the economy is recovering.

There must be also the risk of “crowding out” the private sector borrower given conventional assumptions of the greater security in holding public sector debt and the fact that it should be widely available.

The likely timing for unwinding would seem to be unpropitious for orderly US capital markets.

So, it seems that both China and America have massive financial positions – of very similar magnitude – to unwind without any historic guidance available. Both exercises incur the risk of substantial collateral damage. Financial policy-makers will be swimming in the dark. Perhaps the risks might encourage closer Sino-American cooperation?

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