It was on Christmas Eve that China chose to launch what
appeared to be a simple new trade scheme to start using
renminbi, rather than US dollars or euros, in deals with eight
neighbouring economies. Worries about both dollar volatility
for exporters and the impact of a dollar slump on the
countrys $2tr foreign currency holdings presumably led to
the announcement being pitched softly over Christmas for fear
of what it might do to the US currency.
If the new scheme to use
renminbi for international trade works, the experiment could
herald the start of the renminbis global ascent, as China
inches closer to making its currency convertible and paves the
way to becoming an international reserve currency a goal
Chinas top economic policy-makers now confirm
theyre actively pursuing. At root, the move may represent
an attempt, however provisional, to decouple Asian currencies
from the US dollar.
If and when China makes its
capital account convertible, importing countries will need
reserves of renminbi. To get them, central banks around the
world will have to sell US assets and Treasury bills.
More worryingly for
international finance, this comes at a time when Chinas
appetite for US debt, apparent in recent comments from Chinese
policy-makers, is on the wane. As the global downturn has
intensified, Beijing is starting to keep more of its money at
So far, despite all the talk
coming out of China, Beijing has yet to lose its near-term
appetite for either dollars or Treasuries. Over the last 12
months, Chinas official US Treasury purchases have hit a
record $190 billion. Most of the rise has come in the past few
months of data.
But whats becoming
increasingly clear is that the impact of the global downturn on
Chinas finances has been severe. Its also having an
effect on what the government does with its money: Beijing is
looking to pay for its own $600 billion stimulus just as
tax revenue is falling sharply as the Chinese economy slows.
Meanwhile banks are being ordered to lend more money to small
and medium-sized firms, many of which are buckling under lower
export orders, and to local governments to invest in new roads
and other projects.
Looking ahead, Chinas
official purchases of US debt are bound to fall from their
current level as the rate of foreign exchange accumulation
slows. This will become especially acute as Chinas huge
trade surpluses fall back to earth. The share of Chinas
reserves held in dollars and the proportion invested in
Treasuries may also shift downward. Fitch, the credit rating
agency, forecasts that Chinas total foreign currency
reserves will increase by $177 billion this year down
sharply from an estimated $415 billion last year.
Nevertheless, increasingly many
global investors are, for now, piling into dollar assets, even
though yields on 10 year US Treasuries have fallen to 2.4%.
Despite the Treasury markets rally at the end of last
year, many investors still see value in US bonds, especially in
the five and ten year sectors.
Treasury yields have fallen in
both absolute terms and, markedly, in relative terms to the
yields on private instruments, as investors flee global
economic uncertainty for the perceived stability of US
Of course, if this extent of
economic calamity had hit an emerging markets government whose
financial institutions were in as deep disarray as those of the
US, investors would have run a mile cutting off the
offending nation from global capital markets. But for the US,
just the opposite has happened.
The reasons for this are well
known: potential capital losses on existing stocks keep foreign
investors locked into US government securities, helping explain
why global investors have, in effect, been rushing into a
burning building at the first sign of smoke.
But reduced Chinese enthusiasm
for buying US bonds will complicate matters not least
for US interest rates. Chinas insatiable demand for
American bonds has helped keep interest rates low for borrowers
ranging from the federal government to home buyers. As Beijing
pulls back, the result will be a decrease in this dampening
effect on rates.
Yet as of today, this scenario
represents a sharp break with consensus. Worldwide, the
possibility of deflation has boosted demand for sovereign
paper. Indeed todays commonplace analogy for the US
economy is of Japans lost decade, when bond
yields kept falling as a deflationary spiral took hold.
But this view is potentially
wrong. For a start, the US Federal Reserve will not wait for
years to hit the printing press. On the contrary, monetary
expansion has already begun in earnest. And if China becomes a
net seller of US treasury bonds, the Fed and other central
banks will move swiftly to monetize their ever-growing national
deficits. As this happens, markets will quickly forget about
deflation. Instead, attention will shift to the fact that the
Fed is boosting its balance sheet nearly four-fold, from $800
billion to $3 trillion. Bond markets could be in for a
surprise, as yields rise sharply whatever happens to
economic growth. Economic history is littered with examples of
falling production and rising inflation.
Of course this is a problem not
just for the US but for the UK and eurozone economies too. It
also presents a profound conundrum for bond markets in the year
ahead all the more so given the record amount of
sovereign debt set to be issued.
For now, one can only hope that
Chinas surprise Christmas initiative takes place
gradually, lest it torpedoes the value of American bonds
not to mention dollar assets globally.
But given the risks, take
nothing for granted.