FYI | Jun 20 2007
By Greg Peel
There is a general fear across global financial markets that the world will withdraw its support for the US dollar. Since the greenback replaced gold as the global reserve currency in 1971, the preferred safe haven for central bankers and private investors alike has been in US dollar investments, particularly government-issued Treasury bonds. However, the US has been building, year upon year, a significant current account deficit. This means the US is the world’s largest net debtor. The US has then used its debt to support its consumption, which is aided by a dollar with sufficient purchasing power.
While the two largest offsets to the US deficit are Germany and Japan, China has been the rapidly rising contributor. The US has lapped up cheap imports from China, while China has balanced its receipts by investing them into US Treasuries. The result is that US bond yields have remained low through strong demand, and the US dollar has held its ground.
The problem is that China has enjoyed a booming export economy because it is providing the finance to do so. It is akin to lending a customer the money to buy goods, and then lending more money to buy more goods, until it is clear that turning off the credit tap would only mean losing the most valuable customer. It would be an internecine decision.
Both the US and Europe are putting China under pressure to allow its currency to revalue to a level that better reflects China’s booming economic growth. To do so, however, would mean Chinese exports would be more expensive, thus reducing demand, and China’s holding of US dollar assets would be worth less. This is a lose-lose that China clearly would like to avoid, but to carry on regardless while US debt steadily builds is only to face an inevitable swift and destructive correction some time in the future.
China recognises that its fortunes are heavily dependent on its overweighting in US dollar assets. Hence it has decided this year to begin quietly diversifying away from US Treasuries in order to both diversify its risk and to obtain greater returns from other currencies and asset classes. When this was announced there was an initial scare that US bond prices would collapse (yields shoot up) as China withdrew its support, but these fears were unfounded as China was only ever going to adopt a softly-softly approach.
US bond yields have, however, jumped markedly this month, putting somewhat of a frightener through markets. What was the cause? The most popular reason is expectations of growing global inflation. With food prices pushing higher, oil prices pushing higher, and commodity prices soaring ever higher, it stands to reason that China, and other producers, must at some point pass those price rises on, resulting in higher inflation. But even the most recent US evidence suggests inflation is well under control.
Another potential reason is the withdrawal of support for US Treasuries. China is not the only nation overtly diversifying away from the US dollar and into the euro, gold, other commodities or equity markets. In the case of China, however, it seemed for a long time there was a lot of talk and little action.
The US Treasury last week released its Treasury International Capital (TIC) flow data. This measures longer term movements into and out of US dollar assets. Because of the long term nature, the latest figures were only those for April, now a month and a half old. While US bond yields have been ticking up for a while, it was only earlier this month when the real jump came as rates broke through 5%.
Nevertheless, the data showed that China had indeed become net sellers of US Treasuries for the first time since October 2005. China net sold a value of US$5.8 billion, which brought the extent of its holdings down to US$414 billion. This doesn’t seem like much, but as the consultants at GaveKal point out this does not mean it is insignificant.
Firstly, given bond price movements in May-June it is fair to assume China has continued to be a net seller. Secondly, China does not only hold US Treasury bonds but also US thirty-year mortgage bonds. These have also jumped 60 basis points in yield in the last three weeks, so perhaps China is also divesting of these assets as well. Thirdly, the data finally show that China is making good on its intentions to commit US$200-300 billion to higher risk/higher return investments.
Both China and Europe have been pushing China to revalue its currency more rapidly. As a result of an artificially low renminbi, export industries across the globe are finding it hard to compete, threatening their own economies. It may well be, suggests GaveKal, that China is letting the world know that a sharp revaluation of the renminbi will surely result in sharply higher US bond yields, and that’s no good for anyone. Softly-softly however is a safer approach.
GaveKal believes we have “turned a corner on [global] interest rates”. However, the encouraging news is that world stock markets have held up. The strength of the bull market is “very impressive”, particularly in Asia.
The release of the TIC data, and the revelation that China has become at net seller, should have put the wind up financial markets once more, but it didn’t. It didn’t because despite Chinese movements, foreign flows into US dollar assets in April were nevertheless net positive – to the tune of US$84.1 billion, up from US$58.5 billion in March. A total of US$97.4 billion of foreign money flowed into the US, while a total of only US$13.3 billion flowed out of the US into foreign investments.
Thus there appears little to worry about. The US dollar is being supported globally and bond yields have now fallen back to as low as 5.09% last night from their peak of 5.30% last week. Stock markets have reacted accordingly.
Morgan Stanley suggests that the data confirms the rise in US bond yields is not just about a “buyers’ strike” of US Treasury investors (although we’re yet to learn about May and June). Given inflation fears have been somewhat muted by recent CPI data, this is supposedly no reason to be selling bonds either.
Morgan Stanley also makes the observation that while foreigners may be investing more in the US than the US is investing offshore, thus making the US a net debtor, the US is accruing much better returns on their foreign investments (11.5%) than vice versa (6.4%). Thus the US continues to record a surplus on net investment income.
Add this to the argument from GaveKal that there is little to worry in regards to the US deficit while it is US companies receiving all the profits from their foreign outsourcing, and it seems that ongoing fears about the US current account deficit will remain as just that – fears – for a while yet.
