What if the Chinese Stop buying US$??

Published on Author Mike

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.

One Response to What if the Chinese Stop buying US$??

  1. Other than buying Japanese bonds for the safe-haven aspect, I see little logic to holding Japanese debt over Japanese equities. The equity point is for a different discussion, but since early April when Haruhiko Kuroda emphatically increased the amount of easing the BoJ planned on providing over the coming years, as well as providing a 2 percent inflation target, Japanese debt, yielding less than a percent does not appear to hold the relative value benefit. Historically, Japan has been embattled with deflation, struggling to circumvent its zero-bound issue. Yet, as Professor Smitka points out, the real cost of borrowing was always positive, since deflation was present and interest rates were hitting a bottom. This negative real interest rate due to deflation, fostered an environment threatened by bank deleveraging, delayed consumption, and reduced investment, catalyzing Japan’s nearly two decades of stagnation.

    Thus, through a combination of forward guidance, QE, pension reform, tax reform, and free trade agreements, Abenomics has, at the very least, temporarily generated above trend growth for Japan. Wary of money neutrality, the core CPI has been increasing since Kuroda’s monetary stimulus. Providing asset purchases at roughly twice the size of QE3 relative to the two economies, as well as promising to double the monetary base, Kuroda has maintained low interest rates across the JGB’s term structure and began to elevate inflation…making a JGB a worse investment and less of a safe-haven. Moreover, the Yen has depreciated 25% since Shinzo Abe was poised to become the next Prime Minister. However, compared to the typical safe-haven security—US Treasury—America’s self-inflicted political headwinds, tepid growth, and ballooning debt (also a prominent Japanese issue) makes our typical image as “secure” seem ever so slightly less secure. Providing a reason for China to look elsewhere for bond purchases.

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