China ends her exchange rate peg and the implications for the US Treasury Bond market

Last week ended rather quietly on world markets although there was quickly a statement of significance from the Chinese Central Bank. For those who do not follow the situation closely it has been considered for a while internationally and by the US administration that the Chinese Yuan is undervalued (estimates vary between 25 and 40%) and that this is one of the reasons for China’s Balance of Payments surplus and  a contributor to the American deficit. The fact that the Chinese Yuan has been pegged to the US $ at an exchange rate of 6.83 Yuan to the dollar has only reinforced the importance of the issue to the United States. Late on Friday the Chinese Peoples Bank of China put a statement on its website from which I which quote below.

In view of the recent economic situation and financial market developments at home and abroad, and the balance of payments (BOP) situation in China, the People´s Bank of China has decided to proceed further with reform of the renminbi (Yuan) exchange rate regime and to enhance the renminbi (Yuan) exchange rate flexibility. 

The global economy is gradually recovering. The recovery and upturn of the Chinese economy has become more solid with the enhanced economic stability. It is desirable to proceed further with reform of the renminbi exchange rate regime and increase the renminbi (Yuan) exchange rate flexibility.

In further proceeding with reform of the renminbi (Yuan) exchange rate regime, continued emphasis would be placed to reflecting market supply and demand with reference to a basket of currencies. 

China’s external trade is steadily becoming more balanced. The ratio of current account surplus to Gross Domestic Product, after a notable reduction in 2009, has been declining since the beginning of 2010. With the Balance Of Payments account moving closer to equilibrium, the basis for large-scale appreciation of the renminbi (Yuan) exchange rate does not exist.

What does this mean?

This means that we can now expect the Chinese currency to begin to appreciate gradually over the next weeks and days. I would not expect any great move in the short term as the last paragraph I quote is quite explicit on this front. The daily trading range for the Yuan mentioned above is 0.5% of its value and one can now expect it to drift upwards within such ranges. I think that today the People’s Bank of China has reinforced my view on its strategy by announcing that todays trading range will be centred on an exchange rate of 6.8275 to the US $. When the currency was last allowed to rise back in 2005 then it rose by 21% over 3 years until the peg to the US $ was reinstated in July 2008 but I expect China to resist moves on any such scale by currency intervention (although my recent article on the Swiss experience does suggest that there are limits to such a policy, China does have the advantage of being much more powerful in terms of size of her economy). The initial move has taken the Yuan from 6.83 to 6.802 against the US $ so quite a small move in the circumstances.

One can see from the statement saying that her Balance of Payments is moving back to equilibrium that China does not entirely share the view held in the United States and internationally that she has used her exchange rate as a weapon to increase her level of exports and reduce her imports. However perhaps the fact that Chinese exports rose by 48.5% in May helped to increase pressure on China.  This meant that exports exceeded imports by $19.5 billion in May up from a $1.68 billion surplus in April and a deficit of $7.24 billion in March 2010.

The Impact of this for China and the world

As the Yuan appreciates one might hope that China’s balance of payments surplus will reduce. As it is one of the imbalances in the world that economists have described as a feature and indeed cause of current economic problems then this in itself will be a positive for the world economy. One would hope that the so-called “debtor” nations such as the US and UK might benefit. Unfortunately for us in the UK our volume of trade with China in terms of exports is low so we may only see quite small gains if at all. World equity markets have certainly taken this on board with Asian markets rising strongly and the UK FTSE 100 rising by 1.5% in early trade.

It is easy to forget that against a large trading partner the Chinese Yuan or renminbi had been appreciating over the last 6 months or so and by approximately 16% over the period. As it is pegged against the US dollar then China’s currency had been appreciating against the Euro, this is the flipside of the Euro’s recent fall. So in terms of world trade there had been exchange rate moves affecting China for a while. It remains to be seen how much she is willing to allow her exchange rate to appreciate on a more general basis and how much impact it will have for the world. Not for the first time the world will be wondering if China means what she says.

US Treasury Bonds

One of the features of the recent period has been the extraordinary size of the purchases of US Treasury Bonds made by China. This has been a function of her trade surpluses in that the money has to go somewhere and as such surpluses have been enormous then they lead a large market to go to. Of course with her large deficits and accordingly large issuance of government debt then the US Treasury Bond market is not only very large but getting larger. Thus China has become almost a “purchaser of last resort” for US government debt. I am cautious of many of the figures that are produced on this subject simply because in the past such numbers have proved unreliable (recently it looked like the UK was a large purchaser of US government debt for example which turned out to be China buying through the UK). However there is no doubt that China has purchased very large amounts of US government debt in recent years (so much that if she stopped many question America’s ability to finance herself). One clue to the size is that China’s foreign currency reserves total some US $ 2.7 trillion but of course this is a total not an investment breakdown. With the recent rally in the price of US Treasury Bonds then these investments are likely to be doing very nicely, although China could never sell them in one go.

Think now of the impact of a currency appreciation. All of the US Treasury Bonds that China has purchased will fall in value as measured in her own currency the Yuan as it appreciates, as they are priced in a depreciating (falling) US $. So this is another reason for China to keep the appreciation on a slow and gradual trend.

On this subject there has been a concerning trend in the US Treasury Bond market recently. Over the past couple of months the US Treasury has not been issuing as many bonds as you might have expected. It has been true for some time that the US Treasury has followed what bond watches like me call a risky strategy as in it borrows short. The average length of the bonds that it has issued to finance the debts of the United States is between 4 and 5 years which is quite short compared to her international peers. This is currently shortening as the US Treasury underfinances maturing bonds which come up.

Now this move is seductive in the short-term as if you look at short -term rates it is very cheap to do so. The danger is that if you end up borrowing on a short-dated basis any economic shock immediately becomes a big problem as you have reduced your flexibility to deal with it. You simply have to roll debts over even if you would prefer not too. Greece has been an example of how  this can be a problem over the past 6 months or so although she in fact has a longer average maturity than the US. So the American policy may well save money for now but as her debts increase it becomes in my view an increasingly risky policy.

If you look at the cost of borrowing longer-term for the United States it is in fact very cheap in my view. I know that it will cost more than using 6 or 12 month Treasury Bills but a yield of 3.23% for ten-year paper represents an opportunity to my mind. Just to put this into perspective the yield a year ago was 3.83%  andtwo years ago it was 4.15%.

Comment

The gain for the United States Treasury is that the current policy is cheap. However cheap is not always good as in this subject when you are a large borrower emphasising short -term gains is at best unwise and may turn out to be foolish. In other words it is another moral hazard where things look good for now ( it helps the US fiscal deficit) but potential problems are not only deferred but increased in size. I believe the current phrase for such behaviour is “kicking the can down the road”.

Dissension at the G20

At the end of this week the G20 group of nations will meet. There will be some satisfaction at the statement discussed above made by China which if it blooms into reality will help world trade imbalances. However we then run into  a subject which is likely to see some if not a lot of dissension. For example President Obama said on Friday.

“We must be flexible in adjusting the pace of consolidation and learn from the consequential mistakes of the past when stimulus was too quickly withdrawn,”

So he is worried about parallels with the 1930s and perhaps has concerns about recent economic figures in the United States.

Now lets us look at Europe. Germany has announced a fiscal austerity programme estimated at 80 billion Euros over the next few years, Spain and Portugal have recently announced a further tightening, the UK has an emergency budget tomorrow which will involve some considerable fiscal tightening if her new government is to be believed. Spain and Portugal announced further fiscal tightening a month ago. A French official has announced that she intends to save some 100 billion Euros over the next few years as she begins her austerity programme. Even Italy has joined in as her government recently approved a 24 billion Euro austerity package aimed at reducing the national budget deficit – which last year was 5.3% of its gross domestic product – to within the euro-zone limit of 3% by 2012. Greece has the most severe austerity package of all.

I hope that you get my point. Europe is travelling in exactly the opposite direction to that called for by President Obama. It would appear that just as there is hope for one problem we may run into another!

On this subject I intend to look at several issues and wish to raise some subjects for debate as follows.

On an individual basis austerity for many countries is a potential way out for their problems, however with some many in Europe attempting to apply it at once are they in danger of sucking each other downwards in a deflationary spiral?

Did the (Keynesian) fiscal stimulus policies applied to the “credit-crunch” inevitably lead to the austerity hangover and was it therefore yet another example of “kicking the can down the road”?

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14 thoughts on “China ends her exchange rate peg and the implications for the US Treasury Bond market

  1. Hi shaun,

    first of I would like to thank you for this blog. I myself am not an economist but very interested in (international political) economy, your contributions are always very informative, even those concerning the national UK situation (as I myself am not a UK but Belgian resident).

    Talking about China’s surplusses and US Bonds: wouldn’t it be safer for China to invest surplusses in bonds of non-Eu and non-US bonds (emerging economies?). The debt problems of the EU are evident already, but the US has its problems as well (Buffet especially mentions the finances of local authorities in the US).

    The same logic applies to me (probably others) as well: a traditional low risk investment (buying EU/US government bonds) does not seem that low risk anymore, bonds of emerging economies seem more reliable and given the weakening euro (onwards to parity with $?) currency risk for EMU investors seems low.

    • Hi Bos and welcome and thanks for the compliment
      Because of the size of her surpluses China has a problem, they are simply far too large for most markets to accomodate. She has diversified a little in recent years by buying the Euro but as we stand those funds are standing at a loss because of the Euro’s fall, so this will not encourage the Chinese to do much more I would suspect. As to investing in America I would suspect her political stability and the size of her markets are the main reason. At this time Treasury Bond holdings are likely to be on a marked to market profit but China can never take a market price because of the size of funds involved…
      So as a body which sets rather than takes prices I would think that the problem for her with emerging countries is that even if she finds sufficient political stability can she get the money back out? So to my mind spreading her investments would be sensible but are the markets large enough to make a real difference?
      As to first world bond markets being no longer low risk I completely agree. I have written on here about quite a few of them but as I think through the list UK,Germany,US,Japan I can think of problems and issues for all mostly being around the fact that I think they are all too expensive….
      I will get around to Belgium when I have time as there are issues with her too, on that subject what is the current political situation ?

      • Yes, issues enough over here. A funny anecdote: the Dutch had their elections a couple of days before us, and the campaign was all about the state of the economy. Our campaign was mainly about the problems between flemish and walloons, yet our economic situation is much more problematic than that of the Dutch.

        An NVA (flemish nationalists) and PS (walloon socialists) is in the making, next to those two major parties the flemish christians, walloon christians, flemish socialists, the flemish green and walloon green will complete the majority (7 parties). The flemish liberals and walloon liberals will probably stay outside the majority as things stand.

        Bart De Wever has been appointed as informateur, he plans to work for two weeks and then the king should appoint Elio Di Rupo as formateur (= the to be prime minister).

        Last time the formation of a government took about 300 days and resulted in a very unstable political situation. The last elections were a landslide victory for the flemish nationalists (obviously only in flanders, not walloonia) and a further consolidation of power by the socialists in walloonia.

        A big (2/3) majority is needed to bring about constitutional changes, which are needed to bring stability. General opinion is we won’t be able to tackle the economic problems in a structural way before the constitutional problems (= tensions between flanders and walloonia) are solved.

        In a nutshell 😉

    • let me second that Bos. It’s a great blog. I think they should save some (tv licence) tax payers money by shutting down the economics section of the BBC and linking here 😉

  2. The thing about being a Keynesian is you have to be one all the time,not just when it suits.That means building up reserves (or least restrained borrowing) in the good times to apply stimuli in the bad.

    The objective is to use the public purse to smooth out the cyclical nature of raw unfettered capitalism.Instead Keynes was cited as a way to keep the debt fuelled party going.

    That particular economic method was the brainchild of Snr. Ponzi.

    • absolutely. It’s great to hear those shameless NuLab politicians saying how dangerous it is to reduce the deficit. Ironically Ed Balls own brother works at PIMCO and opposed Ed’s spend spend spend ideology. 😀

  3. Compare and contrast the G20 April 2009 communique which said

    “6. We are undertaking an unprecedented and concerted fiscal expansion, which will save or create millions of jobs which would otherwise have been destroyed, and that will, by the end of next year, amount to $5 trillion, raise output by 4 per cent, and accelerate the transition to a green economy. We are committed to deliver the scale of sustained fiscal effort necessary to restore growth”

    ..with the opinion of the European Economic and Social Committee on the European Economic Recovery Plan in March 2009

    “3.8 We need to start thinking now about how we can return to a long-term sustainable path after the crisis. In any case, to return to such a path, credible national strategies are needed. The urgency of this task is already highlighted by the worrying widening of spreads on certain euro area government bonds, which suggests that investors are growing increasingly doubtful about the solvency of individual national governments. Intelligent solutions are needed to stabilise public finances, which avoid the ‘kill or cure’ methods of the 1930s which were carried out at the expense of workers and the weaker members of society. At that time a combination of wage and social dumping together with protectionist measures contributed to the catastrophe.”

    So, in signing off on the stimulii the EU nations knew they would need to ensure fiscal credibility in the bond markets which were already then showing signs of stress. They also knew that the fiscal consequences of demand boosts could well be assymetrical, but sent the message out that the Stabiltiy and Growth Pact would be relaxed. Perhaps they had more faith in the Central Bank monetary boosts relieving the pressure – the QE stuff.

    Obama has the privilege / buffer of the US dollar being an international reserve currency doesnt he, so he can afford policies which others cant?

    • Hi Shireblogger
      Obama’s position I think is very difficult but I am not so sure that he realises it. America does have problems but as the cost of her debt falls as it has done (and as I write today she moves to the cheaper end of the yield curve further adding to this) then from Washington a potentially big deficit problem may start to look as if it is under control. In his quieter and more introspective moments he may smile ruefully at the idea that the improvement in his situation is because of problems in Europe leading to a “safe-haven” run into Treasury Bills and Bonds. Or more likely (he is after all a politician) he may attribute America’s good fortune to his own skill in guiding her economy and hence we may see fiscal stimulus part two and maybe even the Fed returning to printing money..
      However I think that part of his apparent ability to finance this is an illusion you see as well as her reserve currency status America has benefitted from the way events have unfolded. So should the situation of individual US states finances get (even) worse and money starts to flow out of US Treasuries then the freedom of action that President Obama thinks he has may turn out to have been an illusion.

  4. I believe this is a problem of wealth reduction in comparison to emerging economies, and a struggle to become competitive again in the longer term following a deleveraging process. The economic technique would ultimately depend on how these economies could get there. Since USA and EU (and UK) are two very different zones they’d deal with it differently in their own ways.

    Firstly, in the case of USA, with the right leaning economic policies and culture, the bigger problem so far is that of the moral hazard created by awarding high risk takers and “socialist” big-state policies caused by big government intervention (q.e., tarp etc.). I think Americans would like to ‘punish the losers as they deserve’, bear the pain, and get on with it. As a side note, for a first time (afaik), the interests of capitalism and the big capitalists are at odds with each other, and Americans will need to resolve that one, in their own ways. So, I say yes, Keynesian policies postponed the problem, perhaps helpfully, as now the public can gather whatever happened to them, and act/react in due course.

    As for Europe, big state is not a cultural problem, but an aging population and lost relative (global) economical merit will mean the well-fare state can’t survive as it is and this will potentially cause social problems. Additionally, Americans may gradually drop “the defense subsidy” they give to Europe (and lower super-power ambitions) adding additional pain. I think in this case, the austerity meausures would be sacrified to populist politics eventually and we’d see a Japanese style deflation and lost growth.

    The exception here, would be UK I guess. With its curios mix of left and right in the UK I would expect mass partial defaults by inflation (with more qe and imported inflation) and currency depreciation. That would punish the existing elite for its failures, prop up the economy while protecting the masses and lead the way in Europe by ushering them towards work.

    • Hi Burak, you write: “That would punish the existing elite for its failures, prop up the economy while protecting the masses…” Do you really think it will be the “elite” who will punished? Somehow I doubt that, since they are the ones able to take defensive measures to protect their wealth.

      I think it is likely to be the middle class provident individuals and retirees who will be punished the most, since they are less able and less inclined to take defensive action against inflation and the debauchment of their savings?

      • Hi Drf,

        Yes, inflation is harmful to many, especially the pensioners I fear. But, in this case, it’s the effective eradication of the debt principals that I refer to; for example (non-index linked) government bonds become junk, mortgage principals evaporate, so any entity who owes a lot would be better off, especially the government. Taking it the other way around, any entity who has lent a lot would be punished the most, basically investors, mostly but not exclusively rich people, ie. ‘the elite’.

        Taking it one step further, that in turn would hit investor confidence to the UK and in general to the ‘financial edifice’ (which is already happening with the gold prices going up etc).

  5. Is Bernanke a Keynesian? Maybe – at a extreme stretch – he is a Hicksian Keynesian. But usually he sounds like a monetarist. Pull a gun on him and say “Keynes or Friedman?” and clever money would be on the answer “Friedman” shooting back at you.

    I think Keynes may also paraphrase Mark and say “I am not a Keynesian”.

    Wider definition of money supply (M3) is shrinking in the USA despite M0 going off the scale and near zero interest rates. Empirically M3 expansion hasn’t following M0 expansion as the Fed’s manual says it should. The expansion of the money supply within the economy doesn’t seem to need the creation of fiat money in the first place.

    I heard someone on radio 4 on Saturday morning suggest that public sector borrowing is crowding out private sector borrowing. Alternatively you could apply the following quote to the present situation:

    “In the great booms and depressions… [there are] two dominant factors, namely over-indebtedness to start with and deflation soon after”
    – Irving Fisher

    • Hi Sean
      Your quote earlier reminded me of the discussion which went on here when I looked at money supply issues a month or so ago. It appears that in the US Ben Bernanke is considered a half or failed follower of Milton Friedman depending on what part of the spectrum they are from. In essence his supply of liquidity and QE policies agree with Friedmans view that an increase in the money supply in the period following 1929 would have helped prevent many bank failures and hence help ameliorate the worst aspects of the 1930s depression. However his pumping of money into the system hits the problem of Friedmans most famous quote “inflation is always and everywhere a monetary phenomenon” doesn’t it?

      Another example would be the M3 money supply which is now calculated by shadowstats using the Feds underlying figures, Friedman would be demanding the Fed issued and used them I think..

  6. “inflation is always and everywhere a monetary phenomenon” is always true. Inflation without money is long queues.

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