When Wen Talks...You Must Listen
If China's Portfolio Sneezes...
...Yours Could Get Sick
Dear A-Letter Reader,
Enquiring minds are keeping a close eye on China. They have been for years now.
After all, it really seems like things are starting to come together in the Middle Kingdom.
Home to the world's largest population, the world's largest war-chest of foreign currency reserves, and some of the fastest GDP growth on the planet, China is the apple of many-a bull's eye.
And a number of economists, pundits and politicians openly espouse the belief that this crisis will ultimately lead to China's rise to power, much like the Long Depression and the Great Depression served to hoist the United States into the ranks of global economic hegemony.
So can we get a timeline here?
I mean...the rise of China is something that's fascinated reporters, analysts and investors for years now. But despite all the enthusiastic lip service and the years of emerging market hullaballoo, no one seems to have actually scheduled this whole event.
Quite an oversight if you ask me.
But no matter. Let's look at some pictures to get an idea of when this whole thing might actually go down...
Partners in Crime
So you already know that one of China's biggest trading partners is the U.S. They send us toys painted with lead-laced paint, and we send them dollars in exchange. A match made in heaven for the two stereotypes - the "hard-working" Chinese and the hyper consuming American - living on either side of the pond.
But you might not know about the whole "second half" of that process.
It can't just end there. If it did, then it would be a direct transfer of wealth from us to the Chinese. You might think that's the kind of thing they're looking for in the long run, but not in the short-term.
See, for us to keep buying Chinese products, they have to be cheap. Hey, who's going to pay US$1,000 for a dorm-room refrigerator?
For the products to stay cheap, China's currency has to remain relatively cheap - at least relative to the currencies of China's trading partners. That's what everyone's talking about when you hear "competitive devaluations" or "devaluation leads to heightened export-competitiveness."
While some countries are now hoping to resort to competitive devaluations in order to boost their exports in times of crisis, it's actually a standing policy in the People's Republic of China.
And Treasuries are how they make that happen.
So...Who Owns the U.S. Treasury?
It should be coming together for you now...the concern about China as a Treasury buyer (and owner of roughly 1/3rd of the securities outstanding)...China issuing concerns about their Treasury stock...and rumblings of a new "world reserve currency system"...
So China needs to buy Treasuries in order to keep their currency cheap and the exports flowing. But that's not the only thing they get from the U.S. Treasury. They get interest payments...which offset inflation and preserve the value of their investment. The Chinese might be looking to hold their currency down, but they're not trying to fall on their sword.
Now historically, China has purchased all over the yield curve. They'd buy short-term T-Bills, longer-dated U.S. securities...anything that fit a gap in their portfolio. But according to BCA Research, there's been a marked change in the Chinese appetite lately...
China's Finger on the Trigger?
Okay...you're looking at a few data points on China's Treasury portfolio.
Up top are the total foreign exchange holdings vs. U.S. dollar holdings. Notice the gap that's developed in the last few years? That means other currencies - like euro - are stepping up to play a more significant role in China's portfolio. And that's the least concerning of these data points.
The second chart shows the unsettling downtrend in U.S. Assets (Treasuries, etc.) as a % of China's total foreign currency reserves.
But the third and bottom chart shows the most unsettling development here; China's preference for short-term vs. long-term Treasury investments. As you can see, China's appetite for short-term instruments like T-Bills has exploded in just the last year...while Chinese holdings of U.S. Assets was actually diminishing!
China's Packing a 'Chute
So what does it all mean?
Well, first, it could mean that the Chinese government is wary of inflation. 30-year Treasury Bonds bought with a 3.6% yield will offer little consolation if we hit an inflation rate of 10%+ in the next three decades. Moreover, inflation could wipe out a portion of their initial investment...and nobody likes that.
But second, you could liken the change in China's Treasury appetite to "packing a parachute." No matter what happens, China's keeping a huge chunk of cash within arm's reach...instead of parking it in long-dated Treasury securities, where the future outlook is questionable at best.
Not that you'll necessarily wake up one day to find that China's divested itself of all its U.S. assets. Remember that it was U.S. consumer dollars that helped drive China's meteoric growth over the years. Scorning U.S. consumers could be just as bad for Chinese producers as it would be for dollar inflation.
But when it comes to fiscal spending in China, and the kind of stimulus China might need to make it through this crisis, trade relations with the U.S. will be secondary. Preserving order and looking out for her people will be China's main concern here.
And China's portfolio of U.S. Treasuries could turn out to be a driving force when it comes to inflation in the near future.
So think of China's prime minister Wen Jiabao as a modern day E.F. Hutton. When he talks...you should be listening.
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Global Financial Crisis to Hasten China's Rise
"The balance of economic power is shifting," says Investment Director Eric Roseman.
"China will emerge as the pre-eminent economic giant over the next several years because it has the money to spend to grow its way out of an economic slowdown, unlike most foreign powers, particularly the United States."
"The rise of China's economic prowess will be hastened by this financial crisis. For investors, tapping into this new world economic reality should yield substantial profits once the financial system finally stabilizes."
"Some of the more obvious choices for speculation include leading Chinese oil companies, supported by lower tax rates compared to Western energy companies and the country's most liquid markets - notably in Hong Kong, where China's largest companies (H shares) are publicly-traded. Also, though still tiny, Chinese and other Asian convertible bonds might emerge as dynamic securities offering companies and investors alike an alternative to traditional and volatile sources of financing."
"If the United States dominated the 20th century then it's probably fair to predict that China will lead the global economy in the 21st century as America's explosive debt burdens result in a lower standard of living while China's continues to improve."
"Unlike the United States, China is a net creditor nation in 2009. The country holds more than $1.9 trillion dollars of foreign exchange reserves and has been aggressively buying depressed commodities recently, including financing big natural resource deals as it increases its stake in oil and gas projects around the world. The Asian giant has in recent months deployed more than $50 billion dollars acquiring oil and gas and industrial metals at a discount following a collapse of raw materials prices last July."
"Last week, China publicly questioned whether it should continue to aggressively purchase Treasury debt - the largest single buyer of such securities - in the wake of monster sized U.S. deficits to bailout the banking sector. After years of a mutual understanding predicated and supported by trade, the United States and China might be heading into a collision course as the Asian powerhouse grows increasingly reluctant to finance America's current account."
"Previous economic shocks to the financial system have resulted in the transition and acceleration of the balance of economic power from one leading power to the next emerging giant. This last occurred in the late 19th century as Germany and the United States challenged Great Britain, as the latter gradually withdrew from colonial imperialism as its finances crumbled. By the end of WW I, Great Britain was relegated to a secondary power, virtually broke, relinquishing that title to Germany, Japan and the United States."
"The United States, of course, won't drop to secondary power status overnight. Its markets remain among the most liquid in the world and it is still the largest economy by far. The United States also maintains the world's most powerful military complex and that status won't be challenged for a long time. Yet there's little doubt that we are now at the cusp of another monumental shift in economic power this century as China overtakes the United States as the pre-eminent center of modern capitalism."
"Importantly, while the United States is about to introduce all sorts of new regulations to tame capitalism, similar to the 1930s, the Chinese are likely to become a bastion of free markets enforced by fewer domestic constraints on financing, leverage and, increasingly, laissez-faire economics."
"History, however, has not been kind to secular shifts in economic power. The last shift in the global balance of power earlier in the 20th century resulted in two World Wars and the near destruction of capitalism in the 1930s. Let's hope the United States will engage China more constructively ahead of the next major showdown among economic powers, hastened by the credit crash and the ensuing New World Order."
As we trudge on into a new and uncertain future, Currency Analyst Sean Hyman looks at some of the best investments for re-building your retirement account in today's Special Comment...
MATTHEW COLLINS, A-Letter Editor
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