Chinese Financing of the United States

Brad SetserRoubini Global Economics and the

Global Economic Governance Programme, University College, Oxford

Global balance of payments

• Big US current account deficit – an estimated $900b in 2006

• Offsetting surpluses found overwhelming in the emerging world– China @ $220b (maybe more)– Oil exporters @$500b (Middle East/ Russia = over $400b)

• Europe small (but growing) deficit also financed by emerging world

• Japan significant (but stable) surplus that helps finance the US/ Europe

• US deficits of $900 to $1 trillion likely for some time, even if trade deficit begins to trend down– Interest payments on US external debt stock set to rise

Global current account balance

Emerging Asia, Japan and oil exporters finance the US

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US Eurozone J apan Emerging Asia Oil exporters

Chinese financing of the US

• Overwhelmingly done by the central bank– Reserves managed by State Administration of

Foreign Exchange (SAFE)• Reserve growth in 2006 likely to top $250b• Reserves growth from:

– Current account surplus (Rising)– Net inflows of FDI (China trying to offset with

outflows)– Hot money inflows (Falling)

• Most think around 70% of reserves invested in dollars, 20% in euros, 10% in other currencies

China’s reserves

Reserves and Reserves/ GDP (1998-2006)

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Reserves Reserves/GDP

What we know• China held $530b in US assets in June of 2005 (v $710b in reserves and

$770 b in augmented reserves (counting the $60b transferred to 3 Chinese banks)

• China has added over $230b to its reserves between June 05 and June 06.– By end of q3, reserves likely will reach $1000b, augmented reserves will reach

$1070b• Recorded inflows since June of 2005 are around $110b, implying a bit under

$640b of total Chinese holdings of US securities• Two ways of measuring Chinese holdings – flows (how much US residents

report selling to China) and stock (how much the Chinese report holding in the US annual survey)

• For complicated reasons, the increase in the survey data has tended to exceed the increase implied by the flow data.

– Likely Chinese holdings of US debt now total around $700b – i.e. 70% of total reserves

• Chinese deposits in international banking system are relatively small; most Chinese reserves seem to be invested in securities.

Chinese purchases – flow v stock data

The change in Chinese holdings in the annual Survey is far larger than the sum of Chinese purchases in the monthly flow data

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Flows of Purchases (TIC) Change in Stocks of Purchases (Survey) Change in Reserves

It is not just Treasuries

• China holds a relatively diverse portfolio– Lots of agency bonds– Other mortgage backed securities as well

• The trend has been for more purchases of agencies, corporate debt, and the dollar-denominated debt of emerging economies

• China will likely set up a “government investment corporation” at some point to make more aggressive investments; PBoC manages a very significant share of China’s national wealth.

Chinese holdings – Survey data through mid-2005; 2006= estimate

Chinese Holdings of US SecuritiesData from the Treasury's annual survey, with an estimated $146b in additional purchases

from June 2005 to June 2006

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Treasuries Agencies Corporates

Misconceptions• Argument: China could sell its treasury portfolio, roiling US markets …

– Maybe, but it does not have to sell to influence US markets. All it has to do is stop buying. – Right now markets used to $150b or so in annual Chinese purchases. Net increase in

Chinese holdings from June 04 to June 05 = $185b.– Conservative estimate is Chinese purchases lower US rates by around 30bp (Warnock and

Warnock, 2005) – Treasury market = most liquid, Chinese sales of agencies/ MBS/ corporate bonds would

have a bigger impact • China will never sell – if it sells, it would move the market against it.

– True. – But China will take losses no matter what … Philip Swagel has argued that since China

over paid for its US bonds, large losses are already “baked in.” – China can choose time/ place when it realizes those baked in losses– If China cared only about financial losses, it should just stop buying treasuries now and let

the RMB appreciate. – The real constraint for China isn’t financial losses. It is that selling would antagonize its key

customers … the US and Europe. US would be less able to buy Chinese goods. And Europe wouldn’t be happy if Chinese actions pushed the euro to 1.5 or above … and drove the RMB down against the euro.

– Other risk for China is a US freeze on Chinese assets held in the US … A big share of China’s financial wealth – at least 25% of China’s GDP -- now invested in US.

Scenarios -- speculative

• Chinese options– Shift Chinese funds into London/ Singapore custodial accounts

(still in dollars)– Have the head of SAFE give speech extolling the reserve

management of Russia and India (both have far smaller dollar allocations) …

– Stop (or slow) purchases of US securities … buy more European securities.

– Stop (or slow) purchases of US securities … buy more oil/ strategic commodities

– Sell US securities from custodial accounts in London– Sell Chinese positions in less liquid markets to maximize the

market impact …– Quietly take derivative positions before making noisy sales– Do nothing. Let the market fret …

Scenarios -- Speculative

• US options– Borrow Euros that the US sells to buy dollars …

• Borrow from the markets (Issue euro-denominated Treasury bonds)

• Borrow from other governments

– Encourage others to buy dollars. Europe might intervene to keep euro from going to 2 …

– Sell oil if China is buying oil … – Freeze Chinese assets … but China would likely

seize US investment in China

Conclusions

• Chinese leverage comes from the potential withdrawal of the financial subsidy it currently provides the US by “overpaying” for US debt.

• This financial subsidy benefits Chinese exporters. So withdrawing the subsidy also has a current cost to China.

• Realistic options fall short of the extreme options – – Reducing purchases rather than outright sales

• Markets would try to anticipate any Chinese move – generating economic/ financial costs in the event of a serious rise in US/ Chinese tensions …

• Threat of using leverage is often more valuable than actual use – China opposed Iraq war in UN. It then helped finance it …

• It isn’t just China. Saudi Arabia/ Russia now have around $500b in reserves, and their reserves are increasing by $200b a year …