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Wednesday, July 18, 2007

Big Bad China

A friend wrote the following in an email list:
What happens to the US economy if we get into a skirmish with China, between a) they make a lot of the stuff for US companies, and b) they hold a significant part of a trillion dollars in US treasury bills?
I don't think much would happen to the economy. We might have a temporary shortage of poisoned toothpaste or maybe vacuum cleaners, but the total value of trade with China is a bit over $200 billion per year which is only about 2% of the U.S. gross domestic product. Furthermore, except for poisoned toothpaste, everything China makes is also made somewhere else so those other countries could probably ramp up fairly quickly to provide the required production capacity. I think the average person in the U.S. would be unaware of any problems even if trade with China stopped completely tomorrow.

Also, in a "skirmish", China would be unable to do anything with the U.S. Treasuries they hold. We would simply put a "hold" on those Treasury instruments till the "skirmish" ended. These aren't bearer bonds and you can't transfer or redeem them without the knowledge and permission of the U.S. government (or you can "transfer" them, but the buyer is taking the risk that the U.S. decides to never redeem them).

Many people seem awfully afraid of China. I'm not. I'm more afraid for the Chinese. I think they're a very corrupt and backwards country with some very large and potentially very violent hurdles to overcome in order to become part of the 1st world. I wish them luck and I'm not at all concerned about any potential future skirmishes between China and the United States.

6 comments:

Susan's Husband said...

Yeah, I have always been mystified by the "China holding lots of T-bills is a danger to the USA" view. What that really means is that China has put a big part of its treasury under our control. How that can be good for China in a war with us is beyond my understanding.

Harry Eagar said...

Well, short of a war, if China decides to dump its US securities, the price goes through the floor, I think.

A lot of non-Chinese would be upset by that.

Bret said...

harry eagar wrote: "if China decides to dump its US securities, the price goes through the floor..."

Ummm. This sounds like a deal to me.

Let's say you're right. China starts dumping it's approximately $400 billion in treasury instruments and the price "goes through the floor" to, let's say, a price of 25 cents on the dollar.

Here are some scenario's:

(1) The Fed, which has literally an infinite number of dollars at its disposal, buys the lot for $100 billion. Those securities cost China $400 billion, we buy it back for $100 (25 cents on the dollar). Sounds good to me.

(2) The Fed doesn't do anything directly. However, it has pegged the Fed Funds rate at some level which means it's compelled to provide as much (or as little) liquidity as necessary to maintain that rate. Every bond trader in the world starts drooling at the prospect of buying U.S. bonds for 25 cents on the dollar since that implies an interest rate of several times that which can be gotten elsewhere. All private liquidity is directed towards purchasing those instruments which means the Fed Funds market is completely starved forcing the Feds to do huge open market operations of buying treasuries in order to provide enough liquidity to keep the Fed Funds rate on target. The private market buys the Chinese bonds, again for $100 billion. A good deal for private bond traders, a bad deal for the Chinese.

(3) Other governments, concerned with the stability of the dollar, intervene and buy the U.S. treasury instruments from the Chinese, again at a steep discount. Such a deal.

(4) Many other scenarios and/or some combination of the above.

No matter how you slice it, China cannot hurt the U.S. by dumping U.S. Treasury instruments. They can only hurt themselves.

Because of all the protective feedback mechanisms listed above, the price would also not go anywhere near 25 cents on a dollar. What would probably actually happen is that there would be a few day or few week long significant (but not devastating) spike up in the price of treasury instruments while the money sloshed about to a new equilibrium. The dollar would fall a bit more in the short term, but if interest rates remained higher, would probably rebound significantly.

The point is that some country dumping some securities does not mean that there are any structural problems with the United States' economy or financial situation. As a result, the markets would cope quite well with that sort of thing.

Duck said...

The problem is that the US has to issue new debt at astronomical interest rates. And all interest rate markets take their cue from the Treasury markets. Astronomical interest rates are never good for the economy.

If private buyers jump in to buy up those cheap bonds, then they are selling something else, probably stocks. So the stock market takes a nosedive.

I don't think you can make a rosy scenario out of it.

Oroborous said...

Not rosy, but definitely not apocalyptic, either.

Let us suppose that the U.S. do have to raise interest rates. That will both cause an American recession, and strengthen the relative value of the dollar.

Those two factors would probably cause the price of oil, as measured in US$, to fall by half.

Bret said...

duck wrote: "The problem is that the US has to issue new debt at astronomical interest rates."

No. The Fed sets the price of shorter term interest rates. Period. Not China.

Here's the thing. If there were a structural problem with the U.S. economy, then the Fed has to balance between higher interest rates and inflation. If not, and it's just a shenanigan by the Chinese, then interest rates will change little and the Fed can and will smooth out the markets. You're right that the interest rates will rise slightly because a significant buyer of treasury instruments will have stopped buying. But it won't be "astronomical".