• China’s Chin Music

    This post originally appeared on The Finance Buff.

    Lately there has been a lot of big economic news. That’s likely to continue. Since I can’t comment on all of it, each week (time permitting) I will select the economic story from the prior week that is most significant to me. It may not always be what everyone is talking about, but it is what I am thinking about.

    Last week, my top story was Chinese Premier Wen Jiabao’s warning to the U.S. to honor its debts. In a press conference at the closing of China’s annual legislative session he said,

    “We have loaned huge amounts of money to the United States, so of course, we have to be concerned. . . . We hope the United States honors its word and ensures the safety of Chinese assets.” (As quoted by the Los Angeles Times.)

    “Huge amounts of money” in this case is $2 trillion in U.S. assets, much of it in the form of Treasury bonds.

    There are few good reasons for Wen to suggest the U.S. may not make good on its obligations. And one can hardly think of a worse time to make just such a suggestion. It certainly is not good for the U.S., which will be taking on massive debt ($11 trillion and counting) to finance an economic recovery, as well as an ambitious Obama agenda. Thanks to a global demand for financial safety the interest rate offered on new Treasuries is at an historic low. But if China and the world demand higher interest rates in compensation for a perception of credit risk, servicing this massive debt will be considerably more costly.

    Talking down the credit worthiness of the U.S. isn’t good for China either. A weakening demand for Treasuries could devalue the dollar, reducing the volume of Chinese goods we purchase. The Chinese Communist Party cannot afford for Chinese manufacturers to lose U.S. sales, particularly not now when the downward pressure is already so great. As reported by James Fallows, the party’s legitimacy relies on at least an 8 percent average GDP growth rate. Anything less could lead to widespread “discontent with Communist rule. And then anything could happen.” (China’s 2009 GDP is forecast to be well below 8 percent.)

    To be sure, for several reasons it is generally agreed by Chinese and U.S. economists and officials that the dollar must depreciate relative to the Chinese yuan. However, it is also best that this adjustment be done gradually, as China has been attempting for several years.

    If disrupting the American-Sino debt-for-growth codependency is not good for either nation right now, what might explain Wen’s overt expression of concern for the safety of Treasury bonds? One interpretation is that it was, in baseball terms, “chin music” or a “brush back,” a demonstration to the new Obama administration of China’s power. Obama is smart and surrounded by capable people so I doubt such a warning was necessary. It was certainly a dangerous way to go about it. After all, when the world is nervous and alert even a whisper can start a run.

    • Regardless of the warnings or conciliation, what will matter most in the long run is the supply/demand for U.S. Treasuries. Given the U.S. government plans to put money into all sorts of avenues, there is going to be tremendous supply of Treasuries, pushing *real* rates up. To keep real-rates from going up, the Fed will buy Treasuries. However, there’s no free-lunch. After a lag, once fear is replaced by a feeling of stagnation, inflation will kick back in, along with less “fear-demand”.

      The bottom line is this: if the U.S government spends large amounts, it will finally be reflected in a higher rate of interest. The government can choose the mix of that increase: real or inflation-adjustment. So, either way, the fundamentals — based on announced U.S. plans — indicate that China is in trouble. It makes sense that Wen would warn. Nobody is going to listen to him too carefully though.

      China would do well to be really secretive about diversifying its reserves: slowly selling some treasuries into the current fear, while secretly increasing precious metals.

    • “Obama is smart and surrounded by capable people”

      — I strongly doubt it

    • I find it slightly disturbing that China would have to make a statement like that. It’s almost scary. But I feel, however, that the US is more solid than we think, despite economic problems, and that we’ll get out of this thing soon.

    • Honestly, China scares the crap out of me financially. I am going to quit outsourcing my work to them, I am making them too powerful.