China, stop bitching !

By Michael Pettis

Mainland China's foreign reserves surged to a record US$2.13 trillion at the end June2009, confirming concerns that speculative capital is flooding into the nation to bet on rising asset prices and a quick economic recovery. Reserves rose US$178 billion in the second quarter, the biggest quarterly increase on record and up from the US$1.95 trillion yuan at the end of March. Most of the increase was driven by the very large trade surplus and smaller but still high net FDI inflows, plus of course returns on the existing portfolio. However, there is the unexplained portion of the increase in reserves, which serves as a proxy for hot money, has turned from negative in the first quarter to very positive in the second.

Hot money is pro-cyclical, and its effect will be to intensify growth in the short term, even as it increases volatility and makes monetary policy more difficult. China's central bank must recycle the net surplus on the current account and the capital account, and with the very high current account surplus, China would be creating a huge amount of domestic money just from that source. The fact that it is also running a large capital account surplus makes the central bank's monetary management that much more difficult. As long as this fiscal-stimulus-induced boom continues, hot money inflows will heat things up even more.

Does the fact that China has huge reserves mean that they will be buying loads of US Treasuries? Is China still funding the US deficit? Most people will not be differentiating between the US fiscal deficit and the US current account deficit. China is mainly funding ONE of them, not both of them altogether. When we take things and argue, we must be clear on the details because we end up revealing how shallow and little we know of the subject matter.

Goldman Sachs Group Inc. estimates that US government borrowing may total US$3.25 trillion in the year ending Sept. 30, almost four times the US$892 billion in 2008, to finance the budget deficit. Here is an example of warped thinking and a poor grasp of economics : “China’s reserves will allow the U.S. to run a higher fiscal deficit than other nations,” said Bilal Hafeez, the London-based global head of currency strategy at Deutsche Bank AG.

That is incorrect and flawed. The fact that China’s reserves have surged will in no way make it easier for the US to fund its fiscal deficit even though China has no choice but to invest these additional reserves in US Treasury bonds. Besides valuation changes and interest income, there are two reasons for the increase in the reserves – the very high trade surplus and net capital inflows into China. Take the second reason first. If money flows into China for investment purposes, it must flow out of somewhere else, and that somewhere else for the most part means the global pool of dollar savings which would anyway have been available to fund the US fiscal deficit directly or indirectly. China is acting like a unique bank that takes risk-seeking money and funnels it into low-risk assets. The USA profits from this intermediation while China runs a significant negative carry.

What about the dollars generated from the trade surplus and invested into US Treasury bonds? Won’t that help the US fund its fiscal deficit? Again the answer is no. The US government is not borrowing for abstract reasons, but rather is borrowing in order to spend locally to generate domestic employment. The amount of borrowing it needs to generate a fixed amount of domestic jobs is correlated with the US trade deficit, because it is through the trade deficit that domestic consumption “leaks out” to create jobs abroad. The higher the trade deficit, in other words, the more the US government needs to borrow to generate a fixed number of American jobs, and so the fact that China is reinvesting the dollars generated by the trade surplus with the US does not make it easier for the US to borrow since it simultaneously requires the US to borrow more. China does not fund the US fiscal deficit. It funds the US current account deficit, and it has no choice but to fund it. If the US wants China to buy US$1 trillion of new bonds every year all it has to do is ensure that the US runs a US$1 trillion trade deficit with China every year.

China may continue to bitch and scream about the Fed's printing press and the plethora of US Treasuries, but they will have to continue to buy and fund the US because the flip side of the coin does no one any good.