Note: The author updated this blog post in May 2019. The updated version can be accessed here.
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The furor over recent comments by Chinese officials that they may reduce their purchases of U.S. Treasury bonds show just how poorly the world understands the balance of payments. Here is what Bloomberg had to say:
Senior government officials in Beijing reviewing the nation’s foreign-exchange holdings have recommended slowing or halting purchases of U.S. Treasuries, according to people familiar with the matter. The news comes as global debt markets were already selling off amid signs that central banks are starting to step back after years of bond-buying stimulus. Yields on 10-year Treasuries rose for a fifth day, touching the highest since March.
China holds the world’s largest foreign-exchange reserves, at $3.1 trillion, and regularly assesses its strategy for investing them. It isn’t clear whether the officials’ recommendations have been adopted. The market for U.S. government bonds is becoming less attractive relative to other assets, and trade tensions with the U.S. may provide a reason to slow or stop buying American debt, the thinking of these officials goes, according to the people, who asked not to be named as they aren’t allowed to discuss the matter publicly. China’s State Administration of Foreign Exchange didn’t immediately reply to a fax seeking comment on the matter.
Why would China reduce its purchases of U.S. government bonds? In a January 2018 Financial Times article, ING’s Asia chief economist and head of research, Rob Carnell, was quoted as saying that the Chinese decision may be in reaction to U.S. President Donald Trump’s trade rhetoric:
The most likely explanation, aside from a mistake, in this author’s opinion, is to demonstrate that China is unlikely to passively accept tariffs on steel, aluminum, and solar panels—industries the U.S. Trade authorities are looking to penalise shortly for unfair trade practices.
If China is indeed threatening to retaliate against any U.S. trade action by reducing its purchases of U.S. government bonds, not only would this be a pretty hollow threat, but in fact it would be exactly what Washington wants. To see why, let’s consider all the ways in which Beijing can reduce its purchases of U.S. government bonds.
- Beijing could buy fewer U.S. government bonds and more of other U.S. assets, so that net capital flows from China to the United States would remain unchanged.
- Beijing could buy fewer U.S. government and other U.S. assets, but other Chinese entities could then in turn buy more U.S. assets, so that net capital flows from China to the United States would stay unchanged.
- Beijing and other Chinese entities could buy fewer U.S. assets and replace them with an equivalently larger amount of assets from other developed countries, so that net capital flows from China to the United States would be reduced, and net capital flows from China to other developed countries would increase by the same amount.
- Beijing and other Chinese entities could buy fewer U.S. assets and replace them with an equivalently larger amount of assets from other developing countries, so that net capital flows from China to the United States would be reduced, and net capital flows from China to other developing countries would increase by the same amount.
- Beijing and other Chinese entities could buy fewer U.S. assets and not replace them by purchasing an equivalently larger amount of assets from other countries, so that net capital flows from China to the United States and to the world would be reduced.
These five paths cover every possible way Beijing can reduce official purchases of U.S. government bonds. As I will explain, the first two ways would change nothing for either China or the United States. The second two ways would change nothing for China but would cause the U.S. trade deficit to decline, either in ways that would reduce U.S. unemployment or that would reduce U.S. debt. Finally, the fifth way would cause the U.S. trade deficit to decline in ways that would likely either reduce U.S. unemployment or reduce U.S. debt; this fifth way would also cause the Chinese trade surplus to decline in ways that would likely either increase Chinese unemployment or increase Chinese debt.
By purchasing fewer U.S. government bonds, in other words, Beijing would leave the United States either unchanged or better off, while doing so would also leave China either unchanged or worse off. This doesn’t strike me as a policy Beijing is likely to pursue hotly, and Washington would certainly not be opposed to it. Let’s consider each possibility in turn.
1) Beijing could buy fewer U.S. government bonds and more of other U.S. assets, so that net capital flows from China to the United States would remain unchanged.
This would be a non-event. Basically, it means that Beijing would redirect its purchases from U.S. government bonds to other U.S. assets. Of course, the seller of those other assets would now be forced to deploy the proceeds of the sales elsewhere, so that directly or eventually the proceeds would be used to buy U.S. government bonds. The only thing that would change, in this case, is that Beijing would have swapped its ownership of U.S. assets from one form to another.
U.S. interest rates: There would be no net impact on overall U.S. interest rates and a very small impact on relative interest rates. Because this outcome represents nothing more than a swap by Beijing out of lower-risk assets into higher-risk assets, with no net change in demand for U.S. assets, the result might be at most a small rise in yields on riskless assets matched by an equivalent tightening of credit spreads.
U.S. investment: There would be no change in overall U.S. investment except to the extent that tightening credit spreads would cause a small rise in risky U.S. investments.
U.S. trade deficit: Beijing’s decision would leave the U.S. capital account surplus unchanged, so it could not have an impact on the U.S. current account or trade deficits.
Chinese trade surplus: Beijing’s decision would leave the Chinese capital account deficit unchanged, so it could not have an impact on the Chinese current account or trade surpluses.
2) Beijing could buy fewer U.S. government and other U.S. assets, but other Chinese entities could then in turn buy more U.S. assets, so that net capital flows from China to the United States would stay unchanged.
Again, this would largely be a non-event. The volume of Chinese capital flows to the United States would be unaffected, but there would be minor changes in the composition of assets to which the flows are directed.
U.S. interest rates: There would be no net impact on overall U.S. interest rates and a very small impact on relative interest rates. Again, the result might be at most a small rise in yields on riskless assets matched by an equivalent tightening of credit spreads.
U.S. investment: There would be no change in overall U.S. investment, except to the extent that tightening credit spreads cause a small rise in risky U.S. investments.
U.S. trade deficit: Beijing’s decision would leave the U.S. capital account surplus unchanged, so it could not have any impact on the U.S. current account or trade deficits.
Chinese trade surplus: Beijing’s decision would leave the Chinese capital account deficit unchanged, so it could not have any impact on the Chinese current account or trade surpluses.
3) Beijing and other Chinese entities could buy fewer U.S. assets and replace them with an equivalently larger amount of assets from other developed countries, so that net capital flows from China to the United States would be reduced, and net capital flows from China to other developed countries would increase by the same amount.
In this case, China’s overall capital account deficit and current account surplus would remain unchanged, but there would be a reduction in its bilateral capital account deficit and current account surplus with the United States, and an increase in its capital account deficits and current account surpluses with the rest of the developed world. The reduction in the U.S. current account deficit would mean a reduction in the excess of U.S. investment over U.S. savings. If U.S. investment were constrained by an inability to access savings, this reduction would occur in the form of lower U.S. investment. Because that is not the case, it would occur in the form of higher U.S. savings.
Savings can be forced up in many different ways, almost always involving either less debt or lower unemployment. For example, a reduction in capital inflows can deflate asset bubbles and so discourage consumption through wealth effects, or such a reduction can lower consumption by raising interest rates on consumer credit, or even by encouraging stronger consumer lending standards. A reduction in capital inflows can also increase savings by reducing unemployment. One way or another, in economies like the United States that do not suffer from weak access to capital, a reduction in foreign capital inflows automatically increases domestic savings.
It may be harder than we think for China to redirect capital flows from the United States to other developed economies. Continental Europe, Japan, and the UK are the only developed economies large enough to absorb a significant change in the volume of capital inflows, but none of them are eager to absorb the current account implications. Some economists, misunderstanding the nature of the account identity that ties net capital inflows to the gap between investment and savings, will undoubtedly argue that these inflows would cause investment in Europe, Japan, and the UK to rise, but this is wrong. That would only be true if investment in these economies had previously been constrained by scarce savings, but because this is clearly not the case in today’s environment, the impact of higher capital inflows into developed economies could only be to reduce domestic savings.
For developed economies, in other words, significantly higher capital inflows from abroad would either cause savings to decline as the inflows strengthen their currencies and reduce exports—causing either unemployment or consumption to rise—or, if their central banks act to sterilize the inflows, to increase imports by increasing consumer debt. If continental Europe, Japan, and the UK are unwilling to accept higher unemployment or higher debt, they would be unwilling to allow unlimited Chinese access to domestic investment and may quickly take steps to retaliate.
U.S. interest rates: Contrary to popular perception, a reduction of Chinese capital flows to the United States would not cause U.S. interest rates to rise except to the extent that it would cause U.S. economic growth to pick up. Because the reduction of the U.S. capital account surplus would result in an increase in U.S. savings, this would fully match the reduction in Chinese savings that had previously been imported by the United States.
U.S. investment: There would be no change in overall U.S. investment and an increase in U.S. savings, the latter driven either by lower unemployment or a reduction in consumer debt.
U.S. trade deficit: Because Beijing’s decision would reduce the overall U.S. capital account surplus, it would also reduce the U.S. current account and trade deficits.
Chinese trade surplus: Because Beijing’s decision would leave the Chinese capital account deficit unchanged, it would have no impact on the Chinese current account or trade surpluses.
4) Beijing and other Chinese entities could buy fewer U.S. assets and replace them with an equivalently larger amount of assets from other developing countries, so that net capital flows from China to the United States would be reduced, and net capital flows from China to other developing countries would increase by the same amount.
In this case, China’s overall capital account deficit and current account surplus would remain unchanged, but there would be a reduction in its bilateral capital account deficit and current account surplus with the United States and an increase in its capital account deficits and current account surpluses with the developing world. As explained above, the reduction in the U.S. current account deficit would occur through an increase in U.S. savings.
Because investment in developing countries is often constrained by difficulty accessing global savings, a redirection of Chinese capital from the United States to developing countries would boost investment in those countries. The problem is that China has had a very bad experience with its investments in developing countries and may not be eager to raise them significantly more than it has already planned.
U.S. interest rates: Again, and contrary to popular perception, a reduction of Chinese capital flows to the United States would not cause U.S. interest rates to rise except to the extent that it would cause U.S. economic growth to pick up.
U.S. investment: There would be no change in overall U.S. investment and an increase in U.S. savings, the latter driven either by lower unemployment or a reduction in consumer debt.
U.S. trade deficit: Because Beijing’s decision would reduce the overall U.S. capital account surplus, it would also reduce the U.S. current account and trade deficits.
Chinese trade surplus: Because Beijing’s decision would leave the Chinese capital account deficit unchanged, it would have no impact on the Chinese current account or trade surpluses.
5) Beijing and other Chinese entities could buy fewer U.S. assets and not replace them by purchasing an equivalently larger amount of assets from other countries, so that net capital flows from China to the United States and to the world would be reduced.
Finally, China could reduce its overall capital account deficit by reducing the amount of capital directed to the United States and not replacing it with capital directed elsewhere. This would mean that China must either reduce domestic savings or increase domestic investment. This would also mean, of course, that it must run lower current account and trade surpluses.
One way savings can decline quickly is if a drop in exports causes unemployment to rise. The only other way is if there is a surge in consumer debt. For investment to rise quickly, there almost certainly has to be either a rise in unsold inventory as exports drop or a rise in nonproductive investment into infrastructure. In either case, this would mean a rising debt burden.
U.S. interest rates: Again, and contrary to popular perception, a reduction of Chinese capital flows to the United States would not cause U.S. interest rates to rise except to the extent that it would cause U.S. economic growth to pick up.
U.S. investment: There would be no change in overall U.S. investment and an increase in U.S. savings, the latter driven either by lower unemployment or a reduction in consumer debt.
U.S. trade deficit: Because Beijing’s decision would reduce the overall U.S. capital account surplus, it would also reduce the U.S. current account and trade deficits.
Chinese trade surplus: Because Beijing’s decision would reduce the Chinese capital account deficit, it would necessarily also result in a reduction in the Chinese current account or trade surpluses.
Conclusion
Even if Beijing forced institutions like the People’s Bank of China to purchase fewer U.S. government bonds, such a step cannot credibly be seen as meaningful retaliation against rising trade protectionism in the United States. As I have tried to show, Beijing’s decision would either have no impact at all on the U.S. balance of payments, or it would have a positive impact. It would have almost no impact on U.S. interest rates, except to the extent perhaps of a slight narrowing of credit spreads to balance a slight increase in riskless rates.
It would also have no impact on the Chinese balance of payments in the case that it leaves the U.S. balance of payments unaffected. To the extent that it would result in a narrower U.S. deficit, there are only three possible ways this might affect the Chinese balance.
First, China could export more capital to developed countries, in which case the decision would have no immediate impact on China’s overall balance of payments, but it would run the risk of angering its trade partners and inviting retaliation. Second, China could export more capital to developing countries, in which case the decision would have no immediate impact on China’s overall balance of payments, but it would run the risk of increasing its investment losses abroad. And third, China could simply reduce its capital exports abroad, in which case it would be forced into a lower trade surplus, which could only be countered, in China’s case, with higher unemployment or a much faster increase in debt.
