From Paul Krugman’s blog:
Here … is Erskine Bowles warning, in March 2011, that terrible things will happen if China stops buying our bonds:[T]his is a problem we’re going to have to face up to. It may be two years, you know, maybe a little less, maybe a little more. But if our bankers over there in Asia begin to believe that we’re not going to be solid on our debt, that we’re not going to be able to meet our obligations, just stop and think for a minute what happens if they just stop buying our debt.…
But just a few months earlier Japan was also worried about Chinese purchases of their debt — worried not that China would stop buying, but about the effects of China starting to buy:
Japan’s government said it will seek discussions with China over the nation’s record purchases of Japanese bonds as an appreciating yen threatens to undermine an economic recovery.
Japan is closely watching the transactions and will seek to maintain close contact with Chinese authorities on the issue, Vice Finance Minister Naoki Minezaki told lawmakers in Tokyo. Finance Minister Yoshihiko Noda suggested at the same hearing that it’s inappropriate for China to buy Japan’s bonds without a reciprocal ability for Japanese to invest in China’s market. Bloomberg….
Japan looks a lot like us: it’s an advanced nation that borrows in its own currency and finds monetary policy constrained by the zero lower bound.
Krugman then goes on to show that during that period, Japan’s real effective exchange rate appreciated. (Remember, an REER is a trade-weighted exchange rate index that corrects for inflation.) Why would people purchase bonds? – in the US, Japan and the EU short-term interest rates are virtually zero (in the US 2 year Treasuries only earn 31 bp). Japan, however, has deflation of 1% pa, while the EU and the US have inflation of 2%. So the “real” yield in Japan is +1% while that in the US or the EU is -2%. The reaction of financial markets to a 300 bp differential is to buy Japanese assets. [bp = “basis point” = 0.01 percentage point, used especially when referring to interest rates]
Since then, Japanese Prime Minister Abe has promised to deliver 2% inflation within two years (I don’t think he can do it, but that’s a different story). If it happens, Japanese bonds will be less attractive, so purchases should slow. And the yen has in fact depreciated, starting in late 2012, but interest rates have fallen, not risen.
So by implication, the main effect of the Chinese not buying as much US debt would be primarily a depreciation of the dollar (and thence, over time, strong exports and weaker imports), and not higher interest rates.
The second piece of the puzzle is why interest rates don’t budge – I will make that a separate post.