Can Beijing’s sale of dollar reserves actually be a positive for America’s economy?
- By Patrick ChovanecPatrick Chovanec is chief strategist and managing director at Silvercrest Asset Management and is an adjunct professor at Columbia University’s School of International and Public Affairs.
China owns more U.S. Treasury securities than anyone but the U.S. government itself. So when China’s foreign exchange reserves — after piling up steadily, year after year, to an astounding $4 trillion — fell by $153 billion in the second half of 2014, some people grew worried. They fear that if China starts selling off U.S. Treasurys, the market for them could collapse, driving U.S. interest rates up and the nation into a recession.
These fears are misplaced. To the contrary, China drawing down its reserves won’t tank the Treasury market, and is actually very positive for the American economy.
That might seem counterintuitive — after all, if China sells Treasurys, you would think their price should go down (and their yield up), since so much demand will drop out of the market. But it depends on what happens to the proceeds. If I sell a Treasury bond and use the money to buy a house, and the homeowner uses that money to buy a Treasury bond, basically we’ve just done an asset swap. Demand for Treasurys and houses remains the same, as do prices. On the other hand, if the homeowner goes and buys another house, preferences have actually shifted, and the price of Treasury bonds will fall. The point is, you can’t just look at one side of the equation, as though the dollars China receives from selling Treasury bonds just disappear.
So what does happen to with the money China receives from unloading U.S. Treasurys? A common misconception is that China is using the proceeds from selling U.S. Treasurys to prop up its own slowing economy — by funding infrastructure projects, for instance, or bailing out troubled banks. It’s true that after Japan’s bubble burst in the early 1990s, many Japanese companies sold off overseas assets and brought the money back to plug holes in their balance sheets. But selling private assets and selling central bank assets are two entirely different things. If a Chinese company sells a building it owns the United States, it trades the dollars it receives with China’s central bank (the People’s Bank of China, or PBOC) for yuan. By issuing more yuan, the PBOC adds to China’s money supply and credit.
But when the PBOC sells U.S. Treasurys, the opposite occurs. It can’t spend the dollars it receives in the Chinese economy, and if it exchanges them for yuan, it’s in effect taking money out of the Chinese economy. The PBOC can counter this tightening effect by injecting more yuan, on its own, but selling U.S. Treasurys does nothing to channel more funds into the domestic Chinese economy. Quite the contrary — it is buying reserves that expands a country’s money supply and credit; selling those reserves is (other things being equal) contractionary.
Then what good are the dollars the PBOC gets when it sells U.S. Treasurys? Though accepted around the world, U.S. dollars are fundamentally a claim on goods and services, and assets, in the U.S. economy. When China draws down its reserves, it means money wants to flow out of the Chinese economy, to purchase those goods, services, and assets from abroad.
When Chinese companies change their yuan for dollars (from the PBOC) to import goods or buy services from the United States, those dollars are earned back into the U.S. economy. When they buy existing assets (like a home or a factory) in the United States, the American seller gets the dollars. When they invest in new assets (like opening a new factory), the dollars go to pay contractors, suppliers, and workers, creating new demand in the United States. In each case, the dollars that exit U.S. Treasurys don’t disappear, they just change hands.
The impact on the U.S. Treasury market depends on what the new recipients choose to do with their dollars. If they are as cautious as China’s central bankers — and given today’s jittery markets, they may well be — they might hold it in money market accounts that invest in U.S. Treasurys. In that case, virtually nothing has changed; total demand for Treasurys remains the same, as do interest rates. (They could divert them into another “safe harbor,” like gold — but are they really more likely to do this than the PBOC, which has more dollars than it knows what to do with?)
If Americans don’t put those dollars from China back into the Treasury market, they may choose to spend them or invest them in ways they hope will earn a higher return. Then, assuming the Federal Reserve refrains from replacing those dollars by injecting more into the economy, U.S. interest rates will tend to rise — but for good reasons, not bad.
Today, U.S. interest rates are low because people are afraid to spend and invest. The “opportunity cost” — the benefits of doing something other than stashing money in low-yielding Treasurys — is too low. If demand for Treasurys falls and interest rates rise because the opportunity cost is rising, that’s good news; it means the economy is generating more profitable investments. (This is why, when U.S. officials go to Beijing, they don’t beg the Chinese to accumulate more reserves to buy Treasurys — they beg them to spend or invest the dollars they earn instead.)
But what if the Chinese don’t want to buy from or invest in the United States? They might be able to sell Treasurys and pay in dollars elsewhere, too. The Saudis, for instance, will gladly sell them oil for dollars. But then the Saudis would have more dollars in their sovereign wealth fund, which they will then invest in … well, you know. In all likelihood, their options, and preferences, don’t differ that much from the PBOC’s.
Critics will object that, after World War II, many countries held huge reserves of British pounds that they had no desire to spend or invest in Britain. When they eventually sold off these reserves, the British suffered repeated currency crises and a great deal of economic pain. But that was because Britain, under the Bretton Woods system then in place, had to maintain a fixed exchange rate. Under a flexible exchange rate, like the United States has now, the sale of dollars would cause the trade balance to adjust, bringing dollars back to American shores without forcing the Fed to raise interest rates. A shrinking trade deficit could mean merely that Americans can’t afford to buy as many imports, that — like post-war Britain — our quality of life has deteriorated. But with $4 trillion in Chinese savings sitting on the sidelines, waiting to be spent or invested to raise Chinese living standards, the more likely effect of Beijing drawing on its reserves is a win-win for both Chinese households and the U.S. economy.
So don’t worry about Beijing selling U.S. Treasurys — the dollars don’t disappear; they go into someone else’s pocket. And if they don’t go back into Treasuries, but into real economic growth instead, that’s a welcome development indeed. In that event, rising interest rates reflect not a collapse, but a rebound in America’s economic prospects.
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