Note: This is an updated version of a previously published January 2018 blog post. The original version can be accessed here.
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Suggestions by some 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 a recent Financial Times article had to say:
It was an unnerving piece of data for investors last week, buried halfway down an esoteric spreadsheet released by the US government that tracks how many Treasuries foreign investors buy and sell. China, the largest foreign creditor to the US government with total Treasury holdings in excess of $1.2tn, sold $20bn of securities with a maturity exceeding one year in March, according to US government data. The sales amounted to China’s largest retreat from the market in more than two years.
The article then goes on to suggest that China’s reduced holdings of U.S. Treasury bonds may reflect a strategic response to the escalating trade conflict between Beijing and Washington:
The data reignited fears that Beijing may weaponise its holdings as part of the trade war, wreaking havoc with the biggest bond market in the world, pushing interest rates higher and increasing the US government’s cost of borrowing.
“If China starts dumping its Treasuries, it would cause huge financial instability,” said Mark Sobel, a former Treasury department official who spent nearly four decades at the agency, adding that he considered this an unlikely scenario.
In January 2018, I explained on this blog why China cannot “weaponize” its holdings of U.S. government bonds. It is not because, as many observers seem to think, that selling off the bonds would cause havoc in the market and in doing so would undermine the value of China’s own holdings. This is very unlikely. First of all, the Federal Reserve could easily act to overcome any temporary volatility. Second, as another article in the same issue of the Financial Times points out, rising uncertainty is causing investors to increase their purchases of U.S. government bonds:
US Treasury yields plunged to their lowest level since 2017 and shares fell more than 1 per cent on Thursday as the deepening trade dispute between the US and China raised concerns about global economic growth.
The rush to the relative safety of government debt pushed the yield on 10-year US Treasury bonds to roughly the same level as when the Federal Reserve began raising interest rates in 2015. Longer-term rates fell below shorter-term ones, a yield curve inversion that is seen by many traders as an indication of an impending economic downturn.
I thought it would make sense to revisit and update my January 2018 post. As I explained in that entry, the real reason China cannot sell off its holdings of U.S. government bonds is because Chinese purchases were not made to accommodate U.S. needs. Rather, China made these purchases to accommodate a domestic demand deficiency in China: Chinese capital exports are simply the flip side of the country’s current account surplus, and without the former, they could not hold down the currency enough to permit the latter.
To see why any Chinese threat to retaliate against U.S. trade intervention would actually undermine China’s own position in the trade negotiations, 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 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: China can buy other U.S. assets, other developed-country assets, other developing-country assets, or domestic assets. No other option is possible.
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 in ways that would reduce U.S. debt. Finally, the fifth way would also cause the U.S. trade deficit to decline in ways that would likely either reduce U.S. unemployment or reduce U.S. debt; but this would come at the expense of causing the Chinese trade surplus to decline in ways that would 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 other U.S. assets, so that net capital flows from China to the United States would remain unchanged.
This would be a non-event. Beijing would in effect simply redirect its purchases from U.S. government bonds to other U.S. assets. Of course, the seller of those other assets would then be forced to deploy the proceeds of the sales elsewhere, so that directly or eventually the proceeds would be used to buy the U.S. government bonds that Beijing sold. The only thing that would change, in this case, is that Beijing would have swapped riskless U.S. assets for risky U.S. assets.
In that case, 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.
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. What is more, 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. Finally, 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. As in the previous case, 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.
Again, as in the previous case, 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. Beijing’s decision would also leave the U.S. capital account surplus unchanged, so it could not have any impact on the U.S. current account or trade deficits. Finally, 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 this is not the case. Given that U.S. businesses have easy access to as much capital as they need to fund investment, the adjustment 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, such a reduction can lower consumption by raising interest rates on consumer credit, or this reduction could even take place 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 will automatically increase 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. It 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 either to retaliate or to redirect the flows to the United States.
In the latter case, of course, it would again be a non-event. To the extent that developed countries do not redirect Chinese capital inflows to the United States, however, Chinese sales of U.S. government bonds would affect the U.S. economy, but largely in positive ways. First of all, 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. 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. This is just the logical consequence of the balance of payments constraints.
There would be no direct change in overall U.S. investment, and there would be an increase in U.S. savings, driven by either lower unemployment or a reduction in consumer debt. There might be an indirect change in U.S. investment eventually as the American trade deficit declines. Remember that because Beijing’s decision would reduce the overall U.S. capital account surplus, it would also automatically reduce the U.S. current account and trade deficits, for reasons that I discuss in an earlier blog entry. Finally, 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, as in the previous, 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.
There is no difference between this case and the previous one as far as its impact on the United States or on China. Interest rates in either country would remain unchanged, the U.S. trade deficit would decline, and China’s trade surplus would remain unchanged.
There is one important difference to the global economy, however. 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. This would increase global growth and would benefit both developed economies and developing economies, including the United States. But the reason this is unlikely to happen to any large extent 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.
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. China, in other words, would export less capital abroad. This would mean, by definition, that China must either reduce domestic savings or increase domestic investment. This would also mean, of course, that Beijing 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 in infrastructure. In either case, this would mean a rising debt burden.
As in the previous two cases, there would be no direct change in overall U.S. investment, and there would be an increase in U.S. savings, the latter driven either by lower unemployment or a reduction in consumer debt. There might be an indirect change in U.S. investment eventually as the American trade deficit declines. This is because as Beijing’s decision reduces the overall U.S. capital account surplus, it also would automatically reduce the U.S. current account and trade deficits. Most importantly for China, Beijing’s decision would reduce the Chinese capital account deficit and so 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 showed, Beijing’s decision would 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. trade 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 very high risk of increasing its investment losses abroad. Or third, China could simply reduce its capital exports abroad, in which case it would be forced into running a lower trade surplus, which could only be countered, in China’s case, with higher unemployment or a much faster increase in debt.
Comments(31)
Have you been working on your book?
Indeed, have been waiting for your book!
Thanks. The book is done and the first draft at the publishers (Yale) undergoing the peer-review process. It will be sent back soon enough with questions and suggestions for changes and I hope all of that is done by the summer. I don't have a publication date but I am told to expect it early in 2020.
Professor Pettis, does the trade war create any tension for you in Beijing? Surely, some of the University community and many in government don't agree with your policy analysis.
I try to keep my analysis as logical as possible and focussed on accounting identities, Philip. At any rate I have been under no pressure at all so far and free to write and teach as I think appropriate.
Dear Mr. Pettis, I like this article in particular as it answers a central question. I have a few questions regarding "Trade Wars": Did anyone think about the existence of a "war crime" in the context of a trade war? Would a massive patent infringement qualify? Do patents related to central infrastructure technologies (Internet has become one)make sense in case of political trade bans ? When do we get the equivalent of a Hague convention here? Maybe a bit off your diret expertise, but your opinion would be of interest if it does not endanger your stay in China.
Calling it trade war is useful journalism, Lars, but I don't think intervention in trade has anything truly war-like about it and consists most of countries invoking their sovereign privilege to affect interest rates and exchange rates, subsidize businesses they think important, tax imports, and so on. I don't think the US, China, or any other major economy would ever give up its right to control its domestic economy.
You make good points. One option you haven't considered is if the Chinese convince (easily at this point, I would argue) the world to do away with the US Dollar as the reserve currency. Last I checked, our bellicose foreign policy is not only creating more enemies, but also alienating our longstanding allies. Should this continue, enemies and allies alike could make a cogent argument for changing this. If that happens, the entire argument is moot. We are a debtor nation. If we failed to fix our infrastructure and deal with the unsustainable health care costs during zero interest rates, imagine what will happen when we start paying credit card interest for our expenses. We will be ruined. Damn shame so many ignorant folks continue to think we are exceptional--given our policy actions. What a sad end to a great experiment.
It's nearly impossible for the Chinese to give up using the dollar, CT, let alone convincing the world to do so. It has to be Washington that forces the issue and makes it more difficult for foreigners to use the dollar as a safe haven in which to dump excess savings.
CT. My thinking tells me there's nothing to worry about concerning US Govt debt, or interest on that debt. If you read through some of Mike's old papers, he'll tell you that there isn't a country out there looking to become the reserve currency. We've taken that position so that through the World Bank and the IMF, we dominate global finance and can break down foreign economies, do regime change and such. As long as we share the wealth, we won't find opposition among other world powers.
Your thinking is completely logical but may I ask: do you see that logic carries any weight at all? It seems the same non-sensical but “established truths” prevail all the time. Non-sensical or, even better, fantastical carries a lot more weight, it seems.
Yes, DVD, but the point of the logic is not to recommend that China be logical. The point is that these are the only possible paths that can be followed. If China want's to run a current account surplus, it has no choice but to recycle the FX. If it doesn't, it will not run a current account surplus. These are opposite sides of the same coin.
DvD. Illogical and nonsensical? Only if the framework in which they are viewed is the erroneous. Try to imagine a framework in which those acts are constructive, coherent, and consistent. Psychologically it's called "chunking up." Look at phenomena, and try to find the frame which makes the assortment of data coherent.
This a well thought out explainer on trade dynamics, I enjoyed it. One follow up question I have: if China were to reduce purchases of U.S. assets, as you explained in scenarios 3-5, how would that affect both the Yuan and Dollar? My instinct is that it would make the dollar weaker, leading to a greater demand for U.S. exports, which would be another deterrent for China to reduce their U.S. asset holdings. To what extent would that be true?
It's completely logical, but the professor (didn't know he is professor before making my post below) don't see some important possibilities the Chinese have. See my post below, it's easy to harm the US. The professor is American, exceptional like all of them. ;-)
The key, Derrick, is what the PBoC does with the dollars it would have used to buy the US assets. Remember that China cannot choose whether or not it lends the money to the US. In order to maintain its trade surplus it must put into place the exchange regime that results automatically in the accumulation of foreign currency, and it must invest that foreign currency somewhere if it is to maintain the surplus.
Thanks for the insight. Is there any actions China can take that make themselves better off? If not, it explains well why US can take a tough stance on unilateral trade negotiations.
I don't think so, the professor like all in the US underestimate the leverage China has. See my post below and you will understand.
Thanks for the insight. Is there any actions China can take that make themselves better off? If not, it explains well why US can take a tough stance on unilateral trade negotiations.
Also, would you see parallel of repeating opium trade repeating? Back then, US, UK & other developed nations had great demand of tea, silks, etc. Yet, China had little appetite of foreign goods. And, so, opium was smuggled into China in order to reverse the flow of silver, which started off a great chain of events. To certain extent, we are still consequences of these events. [The China Mirage: The Hidden History of American Disaster in Asia, James Bradley]. In today's world, the equivalent of opium is probably US weapons (such as F35) -- costly but economically useless. Re-militarisation from Japan, strongarm tactics on US weapon purchases (such as Turkey). All of this dress-up under the name of 'protecting US interest', 'freedom' & 'democracy'. After all, these deals help reverse trade flow. Plus, 'nationalising' growth spot sector (such as tech in G5 / Huawei), on ground of security, can protect US firms to develope and compete. But, this will be for another topic. How do you think recent events fit into your thinking? Appreciate if you can share your thoughts. Thank you
I think there is a lack of imagination. I will give you an easy way how to weaponize the treasuries: Look for countries (or entities) which have Dollar denominated debt. Offer them to change this debt in Yuan denominated debt. If they accept the deal, sell treasuries get dollars, give that dollars to the debtor so he could pay down the dollar-debt and in the future he will pay to them not to the US. While selling the treasuries the Dollar-interest will clearly go up, give even more incentive to debtors to accept offers of Yuan denominated debt. The pay back of dollar denominated debt will bring deflation to the US financial system. Which will also bring more debtors look for alternative sources of new debt. They can offer them Yuan denominated debt to strengthen their currency and gain debtors the US will loose. The difference I see, comes from the back paying of debt from third parties against of only buying assets. That makes a difference you did not see.
Good luck with that idea. China’s credibility is lacking and has a long way to go. There’s no transparency, very little trust and low liquidity for China’s debt. The main steps for China to be considered a trustworthy global currency is to adopt the rule of law and transparent accounting standards. Currently, the world considers China a communist country with opaque finances.
@laissez-faire the idea is to look for debtors (countries) who owns debt from US-creditors. If the Chinese offer these debtors to change their US-Dollar debt to Yuan debt given by Chinese banks, they can harm the US triple. And as you describe, for the debtor there will primary no risk. The Yuan seams weak therefore debt in Yuan seems to be more comfortable than debt in US-Dollar. All repaid debt works in the US like the QT (quantitative Tightening) from the FED, deflationary! Additional the US will loose debtors and the leverage they have from being their creditor. Repaying debt comes with a flow of money to the US but the same money disappears with repaying the debt. It disappears like it has created before, out of thin air. The Chinese change their dependency from US to other debtors, which have no such leverage over them like the US has. There are many debtors which on the long run are much more reliable than the US. The US interest rates will rise from selling the Treasuries. They do not have to sell all treasuries at the same time. Only making a few of such deals to punch them into the face and keep US-Interest rates high.
It certainly is imaginative, Winnie, although perhaps only because it is far too confused to make any sense. Given the extent of the confusion it is a little hard to explain all of the mistakes, and anyway I suspect that you might not understand the explanations, but to take the two most obvious problems, first, who are these countries that have chosen to borrow dollars, not RMB, who are also planning to convert their dollar debt into RMB if you ask politely? If they are willing to accept RMB debt, why didn’t they borrow in RMB? Do you know why borrowers structure liabilities in the ways they do and why few borrowers want to borrow in RMB? Second, who told you that paying back dollar-denominated debt will bring deflation to the US financial system? Try to work your way through the process and eventually you’ll figure out that this cannot possibly be true. At any rate combined with the selling if UUS governments bonds, why isn’t this simply a wash to the system? Don’t get me wrong. Imagination is a very valuable addition to the discussion, but we shouldn’t confuse being imaginative with being random.
@Michael Pettis: Thank you for answering. I did think you wouldn't do it. The structure of debt in most cases dictates the creditor. It's privilege of the US-empire that most of international debt is denominates in US-Dollar. That debt is the second pillar of US-Dollar hegemony beside the Petro-dollar. If you are a creditor you must be able to enforce repayment and the might from US-Military ensures that. Most creditors would prefer debt in their own currency but that is not what the creditor likes, for many reasons. The creditor decides that, not the debtor. Giving a credit, is creating money which before did not exist. Creating new Money is inflationary, because there is more money in circulation. While repaying a loan the money, formerly created during the valuation of the credit, disappears, means less money. Less money in circulation is deflationary. That's basic monetary theory. If the Chinese use the Dollar they get from selling their treasuries to replace loans from US-Creditors, the money created during credit valuation, will disappear. The money flows back to the US, like you wrote in the Blog post. But the money disappears in the same moment and that is deflationary. That shows there is a case to harm the US. Point.
Hi Prof Pettis, what happens if instead China sells treasuries and buys real assets instead. Stuff it needs, like Oil, Gold and uranium mines for their nuclear fleet. It seems to me, that's exactly what China is doing now. Swapping USD for real assets via gold accumulation and BRI projects.
Yes, Nick P, investing in BRI projects is a substitute for buying US Treasury bonds, and in the past China was lending pretty aggressively into BRI. At its peak, however, the amount of investment was never more than a tiny fraction of the total it had in reserves, and anyway we are past peak BRI investment. As you probably know, many of these investments went to such dodgy borrowers that they are now either being restructured or are in default, and Beijing wants to rein in as much as possible further outlays (without losing face, of course). As for gold, it cannot possibly be a substitute. Gold is less that 2% of total PBoC reserves, so that even if China decided to increase its holding by 50%, this would be negligible in the larger scheme of things, not to mention the difficulties in buying gold without causing prices to soar (and causing prices to collapse if they ever changed their minds).
Nick P. I believe that China is very limited in what it can buy and where. When it comes to great wealth and power there's not the "level playing field" and "free market" that you might imagine. Certainly we've made clear what's out of bounds here at home and elsewhere around the world; wherever we have a military presence and an economic interest.
That makes sense - as you mention - there are not many places with deep enough financial markets to absorb the size of the surpluses -
Couldn’t China also increase investment through plant and equipment of national champions rather than inventory or infrastructure?
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