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What’s Driving China’s US Treasury Sell-Off?
It’s natural that some Americans see in the market’s recent convulsions evidence of a deliberate Chinese plan to crash the US economy. Economic warfare was, after all, a favored and often successful tactic of the Soviet Union. But the Soviets always calculated their risks and took logical measures: They moved when they had more to gain than lose. I’m thus more inclined to see in China’s precipitous stock-market decline the folly of attempting to circumvent the laws of economics.
In the past decade, alarmists have warned that China was poised to overtake the US. These warnings are reminiscent of those about Japan in the 1980s and 1990s. Some now believe China owns the US by virtue of its $4 trillion-plus foreign debt holdings. They survey China’s apparently rapid economic growth and conclude that China’s a major, unstoppable economic force.
China had logical economic reasons for accumulating US Treasuries. Despite the destructive economic policies of successive US governments, particularly this one, US Treasuries are still considered the world’s best credit risk. Although the dollar is a sorrowful currency investment, American debt instruments carry little-to-no risk of default. For nations such as China, which during the 1990s was barely credit-worthy and seeking to undertake major development projects with few cash reserves, leverage is the only viable alternative. But obtaining foreign capital investment requires collateral. China had none, save weapons; like the former Soviet Union, it relied upon arms sales to prop up its annual income. Creditors need to know that their investments are reasonably guaranteed in the event of insolvency. A loan backed by US Treasuries is a relatively secure investment.
Investors, particularly developers, were initially drawn to China because Beijing opened the door to capital appreciation. China had precious few regulations of the kind that strangle economic progress in the West, and offered a tacit promise to indemnify investors against capital loss. No wonder many so-called capitalists flocked to the Empire of the Sun. Incentives matter, and those are very attractive ones indeed. Thus began a major economic development program. China became the most favored location of those who sought to garner huge returns with little exposure.
Of course, China remained a communist dictatorship. That kind of power comes in handy. To fill demand for blue-collar labor, the central government relocated people who had only known life in rural villages to newly-reinvigorated metropolises. The PRC could easily supply unskilled workers in abundance, but lacked people skilled in business, science, engineering, communications, and technology. Employment opportunities in those areas became scarce in Hong Kong after the British withdrawal, so the skill went where it was needed: Residents of the former British Colony flocked to the mainland, despite their unmasked distaste for the PRC; the lure of huge salaries and low cost-of-living was irresistible. The economic growth their influx prompted encouraged similarly skilled people from other nations to rush there, too.
Naturally, to the casual observer it appeared that China was on the right path. Many who would otherwise fear and loathe communism found this communist nation quite agreeable. Some even speculated it was moving toward real market capitalism.
But this betrays a fatal misunderstanding of free markets.
Free enterprise, synonymous with sustainable economic growth, requires full exposure to profit and loss. A real market system needs profits: These create incentives to take risk, also known as investment. It also needs loss: This creates incentives to behave prudently. Attempts to control either part – profit or loss – ultimately condemn the entire system to failure.
China created a system where profits could be made easily and relatively painlessly. But it doomed itself by protecting investors from loss. The economy was driven by political expediency, not economic reality. Like US real estate, the Chinese miracle was a bubble, and bubbles pop.
Recently, physical structures in China have collapsed so often one might lose count. That’s what happens when you put up complex buildings, bridges, and infrastructure in haste. The cost in wasted capital and natural resources are nothing compared to the cost in human lives. These things were designed and built because they had immediate potential for capital appreciation, not because they were meant to be viable in the long term. Such is the nature of all get-rich-quick schemes.
With one investment after another crumbling down to its constituent parts, international investors are cashing in their chips. In a report for the Congressional Research Service, Wayne Morrison, Specialist in Asian Trade and Finance, notes:
[T]he Chinese economy has slowed in recent years. Real GDP fell from 10.4% in 2010 to 7.8% in 2012, to 7.4% in 2014. The IMF projects that over the next six years China’s real annual GDP growth will average 5.9%.
Now that foreign investment has ebbed, the Yuan is taking a pounding in the currency market. One way China might redress the issue is to follow the path of the Federal Reserve and inflate its currency. Instead, it’s selling foreign debt instruments. This does not automatically mean bad news for the US.
The revenue received from cashing in the US Treasuries has to go somewhere. Some of it will circle back to the US market in exchange for goods and services. China will also reinvest a sizable sum in its US enterprises. Moreover, those seeking to hedge might return a good portion of it to Treasuries. So what many see as a major divestment may in fact be no more than an asset swap.
The downside, of course, is that the Federal Reserve may act impetuously, as it has in recent years, and inflate the dollar before the market has had an opportunity to clear. This could be very bad for investors everywhere. We’ll see.
Naturally, everyone wonders if China, and more importantly, world markets, will weather this storm. Although we’ve all just taken a serious financial hit, I don’t see it as a fatal collapse. We’re nearing that day, but that’s another subject. In the near term, China will recover, although it will have to look more realistically at its economic policies.
They’d be well-advised to invest a bit of their hard revenue in a few economists of the Austrian persuasion.
Published in General
I didn’t totally understand all of this, but I hope your conclusion is correct! We live in worrisome times. Thanks for the analysis.
You have the heart of a teacher. Thank you!
We have been assured that fears of a Chinese sell-off are unfounded, so I have no choice but to reject your so-called “news” as false.
Like this stuff. Keep it coming, if you don’t mind that your readers only understand about 1/2 of it – on a good day.
Thanks.
It sounds like a plausible explanation. Thanks.
If you could tell me that expiration date in advance, that would be handy information to have! It’s OK if you’re off by a day or two. :-)
I’m confused by this:
Are you referring to China in 1980 with its initial opening or today or some point in between?
I’d also appreciate some clarificaton regarding this point:
While the real estate bubble popped in the U.S. it meant prices in many places reverted to those of a few years prior. When you refer to popping of the Chinese bubble do you mean that its economy is set back a few years or that the entire history of economic change since Deng’s opening in the early 80s is a bubble?
I noticed your location as Cowley. Do you teach/work at Oxford? (I lived down the road in Stanmore.)
We need more of this analysis Tom.
If PRC stays on path to continue moving their currency lower wouldn’t that lead to other regional countries depreciating their own currencies? And wouldn’t a currency war be a net positive for U.S. ($) assets?
If you are Randy Webster, yes. STRONG DOLLAR! But if you export, then no — your goods are too expensive for your foreign customers. Ask Cat.
Genuinely curious: who is talking this way?
Most commentary I read suggests people believe that U.S. markets have been driven to precarious heights by our zero interest-rate policy (which nobody knows how to gracefully unwind).
I don’t know anyone who thinks the Chinese are crashing their own economy to crash the U.S.
I’m referring to the period in the early 1990’s when China made the decision to expand into world markets. China’s leading export at the time was weapons. Figures regarding GDP were at best, specious. They had no major marketable goods and services in those days save arms.
I’m speaking only about the period of her economic growth and particularly the moment she became attractive to foreign investors. Again, this is the 1990’s although it never really took off until about 10 yeas ago. China’s economy is suffering the effects of a decades long attempt to ignore market realities. Now that the bottom has fallen out, her economy will shrink to a more realistic level of growth. Foreign investors will of course be more difficult to attract.
I’m in the US currently but that’s likely to change soon. A teaching post at Oxford would be nice but given the ideological leaning of most of the faculty, I don’t think they’d have me.
It would only be positive for the US if the Federal Reserve does not do likewise. If history is any indication, the Fed I expect them to institute another round of “quantitative easing.”
Editor’s note: First, thanks for another terrific piece, Tom. I found this fascinating and I agree with you; in fact, I’ve been saying this for a while, as many of my bored dinner-guests will attest. Second, I edited this to incorporate the clarification you offered in the comments. If anyone’s confused by the back-in-forth in the comments, that’s why.
That depends on the college, though. And my experience — admittedly, I long time ago — was that even the most ideologically left-wing colleges kept a few in-house conservatives around for fun. I was at Balliol (name of college turtle: Rosa Luxemburg) but some of the tutors there were nothing short of reactionary. So much so that in the Internet age, I’d hesitate to quote them to illustrate my point; they don’t need to become the objects of Twitter campaigns calling for them to be shot at sunlight over the Magdalen Bridge.
@Tom Phillips- What do you think the political fallout will be? Do you think it will lead to unrest, possibly giving the Chinese gov’t an incentive to distract via foreign confrontation or even a small war with say, Vietnam?
I imagine I may eventually end up the token conservative someday. Remembering how mischievous I was during my days at Abingdon, the universe might consider it my just reward.
And thanks for the edits Claire. Simply brilliant! It’s funny that for several years now, it seemed as if I were the only person who didn’t think fondly of the Chinese economic miracle. I’m not generally one for schadenfreude but it feels good to be vindicated.
Well, my usual Hobbesian sense of human nature would lead me to believe just that. I just don’t see it in this case however. China has far more to lose in such a scenario and as unpredictable as communists are in general, I don’t see the Chinese as the suicidal type. At present it’s still a bit too mercurial to see now the pieces will fall but we can expect a few heads to roll (figuratively) in the Chinese government.
I think that’s the first time in history that sentence has been written. I’ll let it gladden my morning. (Even if I just spotted a typo, for which I’m fully responsible. I’ve corrected it. Sorry).
I’m kicking myself for not having said so, in print, thus depriving myself of proof that I told everyone so. But I’ve said in print that India’s the real deal — and probably worth the excitement. Now all I have to do is live long enough to be proven right.
If by “market clearing”, you mean a return to an honest interest rate on U.S. government debt, we can’t possibly allow that to happen. A return to a historically normal interest rate – say 5% – would bury us in interest payments. Somebody out there better buy up those Treasuries and keep down interest rates, or the Federal Reserve is going to have to.
Thanks for a really good analysis Tom. Your analysis holds together much better than the drivel I see on CNBC or FBN. Big picture and sound principles. We need more of this.
It’s been a long time coming, which means the reckoning will be a long time unraveling. Excellent post.
“But it doomed itself by protecting investors from loss.”
An apt observance that could be applied to countless economic crisis postmortems. Of course, the loss will inevitably become manifest, but tragically it tends to fall beyond the population of investors.
Didn’t the U.S. Government just do the same thing in 2008 when they decided to “bail out” financial institutions and claimed they were “too big to fail”? I wish the company I work for would be deemed “too big to fail” and did not have to be careful about where it invests Capital.
When, in your view, did China move to an export driven economy? And to whom were they exporting weapons?
Perhaps I am misreading your sentences. Are you saying that as of 1990 China had few cash reserves, sold arms as a major source of income and then switched its strategies at that point? If that is the case, I agree as China’s arms exports shrunk by 75% from 1990 to 1998. It was the export driven economy that allowed it to build the huge reserves it has today.
This is something which causes me some serious skepticism of macroeconomics as a science rather than a religion: on one hand China is wrong to protect investors from loss, yet whatever it was that happened in 2008 prudently saved us from the Great Depression II.
I’m pretty sure that the first assertion is both prudentially and morally correct over time. The only way I can see the second assertion squaring with the first is that it was only a temporary avoidance of return to reality with the hope of a more gradual correction rather than an immediate shock or that the protection against loss wasn’t as robust as I perceive and certainly not as robust as China’s.
I totally agree. I have said this for a long time, whenever someone (including the Wall Street Journal) goes off in praise of this or that Chinese achievement. I have never been able to understand why everyone thinks so well of China. They might be the “world’s largest market”, but only until they decide to ban whatever it is. They are a perfect illustration of why and how Central Planning does NOT work.
China. Is. A. Communist. Country.
Oh, and why should anyone believe any “statistics” coming out of China?
These statistics are collected as follows:
Each village makes up a number about what they “produced” that year. Then they send it to the next level of government, who adds that village to others, and so forth.
I know a guy whose job it is to travel across China and inspect Chinese mines who report production numbers to see if they even exist. “Sometimes,” he says, “the mines are actually there.”