China might slow purchases of US government debt - Rabobank

Analysts at Rabobank note that Chinese officials have hinted that they might slow purchases of US government debt, according to Bloomberg news.

Key Quotes

“Congrats to Bloomberg for the scoop – but anybody who panics at that story doesn’t understand much about the actual China-US economic and financial dynamic.”

“After all, China is forced to buy foreign assets by virtue of the fact that it runs such ridiculously large trade surpluses – themselves the product of an “I-can’t-believe-it’s-not-mercantilism” trade policy that even the French have had to point out to Beijing on their recent state visit. True, the total current account surplus is far smaller, at just 1.0% of GDP. Nonetheless, that’s still a whole lot of money when you are a giant economy like China, and what comes in on the current side has to go out on the capital side of the balance sheet.”

“As such, China is always stuck with the dilemma of what to buy with its FX reserve pile. If it doesn’t want to purchase US Treasuries, where the 10-year yields 2.55% this morning, perhaps they would like a 10-year Bund that it will have to fight the ECB for (and yielding 0.54%)? Or a JGB it will have to fight the BOJ for (yielding 0.08%)? Thought not. Or perhaps they’d like some volatile equities? Good luck with marking those to market, PBOC, and hoping the company doesn’t collapse. Or maybe they’d choose some housing-related bonds: didn’t that all end well in 2008 in similar circumstances? Or maybe it’s time for some hard commodities like oil, gold, etc. Perhaps, but prices there are also volatile; moreover, China would effectively be selling its goods for gold or oil, not USD. What’s the point of that when you can use USD to buy old and oil and other things too, whereas gold is just gold, and oil is just oil? You see, China is stuck with buying something, and there are few better choices than liquid and high-yielding US Treasuries.”

“Now, there is one key argument for China scaling back Treasury purchases: that the country’s FX pile has been static around the ‘magic’ USD3.0 trillion level (according to the staggeringly-convenient monthly official data) for quite some time. As such, there isn’t much more to invest every month anyway. Surely those quoted Chinese officials know all this – or one would hope so!”

“As such, perhaps what we have to understand is that this is a coded message to the US as President Trump builds up to making what chatter has as a fateful decision to openly confront China economically in his end-January State of the Union address, following which we might get serious tariffs put in place. Indeed, if you consider that this week also saw the removal of the “we do whatever we like with our currency, thanks counter-cyclical adjustment factor” by the PBOC, it’s not hard to join the dots to see China is whispering that if we get serious US protectionism, it will no longer feel bound to prop up its currency or to buy US assets. That’s entirely logical – and deeply threatening to the Goldilocks scenario we are currently enjoying; it would be more like the Three Bears treating markets like Leonardo DiCaprio in The Revenant. It would mean much lower equities and bond yields – something we’ve already seen briefly when threatened before (in August 2015 and early 2016, for example). But it isn’t the story that has being reported so far.”

“Indeed, if we don’t see the US drop ‘da tariff bomb’, what is China going to do? Stop buying something that makes it more money than the available alternatives? And would it really sell its Treasuries? If so, US yields might go higher for a while, but that would wipe out the value of the remaining USD1.2 trillion of Treasuries China holds, and strengthen the USD, so CNY would come under far greater downwards pressure. In short, China would destabilise itself, not the US by unilaterally doing what it is apparently suggesting.”

“Moreover, if China really tried to decouple itself from the US entirely for political reasons, the Fed would no doubt step in immediately. China would then be left with a much smaller trade surplus to cushion it from the serious economic issues it has to deal with. How stable would CNY look with its fiscal deficit of over 13% of GDP and no trade surplus to back it up? Exactly. As such, if China thinks it is in any way ready to supplant the USD at this stage via these kind of veiled threats, then perhaps it’s time to stop gargling the bong water and look at CNY’s share of global SWIFT transactions as a refresher: it is almost irrelevant, and until it’s China doing all the net global importing, that is not going to change.”