Thursday, April 15, 2010

Will the Markets Force China's Hand in Halting U.S. Treasury Securities Buying?

It is obvious that there is growing concern among top Chinese officials about the the huge quantity that China holds of U.S. Treasury securities. The reluctance to add more to the position is counter-balanced by the fact that China continues to intervene in currency markets by buying dollars to keep the yuan at a below market rate. They then buy Treasury securities with most of the dollars (Or at least, they have been). But what if the Chinese currency begins to naturally weaken against the dollar? There would be no more need to buy dollars, and thus no dollars with which to purchase additional Treasury securities.

This would not be the first time that market forces take decision making out of the hands of government officials. Indeed, here at EPJ, we continue to highlight the fact that the effective Fed Funds rate is climbing near the top end of the Fed's target range. This will force the Fed to print more money, or raise interest rates much sooner than most anticipate.

What would be behind a market forced move that would halt China's Treasury buying operations? Simple supply and demand.

In their foreign exchange manipulations, the Chinese print yuan to buy dollars. This obviously increases the Chinese money supply. Although Chinese data is notoriously unreliable, indications are that the Chinese money supply may be growing by as much as 25% annualized rate. This is huge money growth that ultimately will weaken the yuan to the extent that there will eventually be natural market forces that start pushing the yuan down against the dollar (Especially, given that Bernanke is in a no money growth, as measured by M2, mode). When this inflection, occurs, and it may not be far away, the Chinese will no longer need to provide artificial support for the dollar. There will be natural strength in the dollar.

Why do I say this inflection may be near?

In March, China recorded its first monthly trade deficit in six years. Most analysts are writing it off as a fluke. It may, however, be a sign that all the yuan floating out there are near a critical mass to the point that the yuan may start weakening on its own. A trade deficit, afterall, means that money was flowing out of the country not into it---this most certainly has a natural downward pressure on the yuan exchange rate.

1 comment:

  1. I agree completely. Under current exchange rates, China’s M2 is larger than that of the US. Though US M2 may not be comparable to Chinese M2, in a sense that the Chinese enforce strict capital controls and have no where else to put their money except for their bank accounts, this means that the Chinese in aggregate have more money that Americans do, which is somewhat hard to believe, despite their rapid growth. I should add that the Japanese also have money supply figures that are larger than that of the US, though they use some other definitions as money supply and I am not sure I should be comparing with that, and maybe that is why they are going through debt deflation, despite government efforts to inflate the economy.