China’s ‘Impossible Trinity’

--In Friday’s Daily Reckoning, I mentioned I would discuss China’s dumping of US treasuries in more detail. It’s shaping up to be a very big issue. That’s because you’re seeing the reversal of a dominant macroeconomic trend that has shaped global economics for the past 15 years. 

--Karen Maley is onto it in the afr.com:

‘…one of the most surprising aspects of last week's market turmoil was investors' marked refusal to treat US bonds as a "safe haven". Usually, a bout of sharemarket volatility causes investors seek refuge in bonds, which has the effect of pushing up bond prices and sending bond yields sharply lower.

‘But last week a different pattern emerged. After tumbling below 2 per cent on Monday, bond yields then spiked, with US bonds suffering their biggest weekly price drop in two months.’

--Wow. So in a torrid week for the equity market, the US bond market actually fell. Treasury bonds are the world’s premier ‘risk-free’ asset, aren’t they? That may still be the case, but there is a shift taking place. 

--To understand how big a deal this could be, let’s back up a bit…

--China has pegged its currency, the yuan, to the US dollar since 1994. It removed the peg in 2005 to allow for a one-off revaluation, but has more or less tried to manage the exchange rate to favour its export sector. 

--That’s why China has such a huge trade surplus and why, at the peak, it had accumulated foreign exchange reserves of nearly US$4 trillion…the largest such hoard in modern history.

--What many people don’t understand is that to maintain the pegged value of the currency, the central bank must ‘print’ yuan to swap for dollars.

--When this happens on a massive scale, the central bank ends up printing a huge amount of yuan to maintain the pegged exchange rate. If they didn’t, the yuan would rise against the US dollar (thanks to excess US dollars flowing into the economy) and China’s exporters would lose competitiveness.

--A simple way to think of it is like this: The more foreign exchange that piles up, the more yuan printing that must take place to maintain the exchange rate peg. 

--Given the centrally planned nature of the economy, the central bank can do a number of things to curb the inflationary nature of maintaining the currency peg.

--They can ‘sterilise’ (or soak up) the newly created yuan by issuing notes and bonds of varying maturities. They can also increase banks’ reserve requirements. Over the years, China did both of these things and more to contain the inflationary effects of managing the exchange rate.

--On the other side of the coin, China invested its surplus dollars into US treasury bonds and the bonds of housing finance companies Fannie Mae and Freddie Mac, which had an implicit US government guarantee. 

--This had the effect of pushing US interest rates down, which caused a consumption and house price boom…and a spectacular bust in 2008. 

--Such is the distortionary effect of a fixed exchange rate…

--The bust in the West had devastating consequences for China. Its economic structure was entirely geared towards manufacturing for western consumption. 

--So it launched a stimulus and credit boom that, in conjunction with the west’s massive reflationary attempts, encouraged speculative flows to continue in their pre-2008 pattern. 

--China’s foreign exchange reserves began to grow again and speculative capital flowed into China, in the expectation that the authorities would actually revalue the yuan higher. QE and US interest rates at zero encouraged hedge funds to borrow US dollars cheaply and buy yuan, taking advantage of higher Chinese interest rates and the lack of currency risk because of the pegged exchange rate. 

--In short, the post-2008 Chinese economy became a casino. Something had to give. 

--Now, before I go any further, I want to tell you about something called the ‘Impossible Trinity’. It states that a country cannot maintain a fixed exchange rate, have a free flow of capital AND set interest rates independently. You can have two of those things, but not all three. 

--For years, China had a closed capital account. That is, the authorities placed restrictions on capital coming into and going out of the country. This allowed them to maintain the exchange rate peg and set monetary policy independently. 

--But in the past few years, capital controls in China have ceased to be effective. This is in part due to deliberate attempts to liberalise capital flows, and in part because people find a way around them. 

--Look at all the Chinese capital flowing into Australian property and other property markets around the world. That wouldn’t happen if China had a closed capital account. 

--This increasingly free flow of capital means the exchange rate peg has to give. Ever since China’s economy began to slow from around 2012/13 and the US went from QE to an interest rate tightening path, the speculative flow of capital has reversed. 

--Instead of China having to buy billions worth of US dollars (and buy treasuries with the proceeds) to maintain the exchange rate, it now must sell. 

--While China still brings in dollars via a trade surplus, the outflow of speculative capital is overwhelming. As the punters sell yuan and buy back dollars, the People’s Bank of China must sell US treasuries to satisfy the demand for dollars. 

--This unwinding of speculative flows is self-reinforcing. While China has plenty of scope to fight it, running down foreign exchange reserves reduces liquidity in the Chinese economy too. This is not what China needs when its economy is already slowing sharply. 

--If this trend continues, you could see a situation where US treasury yields rise in the face of a slowing global economy. That’s bad news and you have to wonder whether the Fed would go through with an interest rate rise in such a scenario. 

--The bigger picture implications are enormous. If China no longer buys US treasuries, then who will finance excess US consumption? The Fed via QE4?

--For Australia, the risks are even greater. If China continues to slow and heads towards a recession, we won’t be far behind. It will be the end of Australia’s 24 year run of uninterrupted economic growth. It will be the end of Australia as you know it. 

Regards,

Greg Canavan
Editor, The Daily Reckoning