Riptide

A story we've been returning to with some regularity, the U.S. Treasury bond market & U.S.-China economic relations, and especially currency valuation, returned to the headlines this week. And, for the first time, it was one of the top headlines both in the U.S. and in China. The proximate cause was Tim Geithner's statement to the Senate Finance Committee that President Obama thinks China has been “manipulating” its currency. Personally, I'm not sure what this means. Certainly, China has been managing the value of the RMB. Is that manipulating its value? At any rate, what's really at issue is the desire of many in the developed world for the RMB to be freely tradeable and for its relative value to be set by the market. The assumption in the West (and great swatches of the East as well, no doubt) is that the RMB will rise against the US Dollar, the Japanese Yen, the Euro, the Pound (if, indeed, the Pound could go much lower). This is desirable, from a US policy perspective, because it would make exports to China cheaper. Cheaper goods from the US means more sales to China, or so the reasoning goes. But it also means less Foreign Direct Investment (FDI) coming into China, as well as (in relative terms) cheaper investments in the US by China. In other words, The RMB, having hypothetically gone up in value against the Dollar, will buy more New York real estate, more government bonds, etc. It also means a few other things, of great concern to the Chinese: US Dollar holdings by the China Investment Corporation (China's Sovereign Wealth Fund) will go down. They've already gone down a bunch and further declines will bring more criticism from within China and, paradoxically, make further Chinese investment in the U.S. less politically attractive. In addition, current Chinese holdings of U.S. Treasuries will be cheaper in RMB terms or, stated differently but with the same essential financial meaning, interest rates will need to go up, as we've predicted, only more so. Already, since 2008 Year End, Treasury yields have risen. They bumped up a bit more this Friday after Geithner's remarks were made public. And Chinese newspapers led with the story meaning, at the very least, that China took notice.

There's nothing really new in this issue. China's friends as well as her critics in the U.S. have been warning for years -- and by that I mean at least since 1998 -- that the issue of currency values and the U.S. trade deficit with China would be an issue someday. Every year, it has seemed, those who have been doing the warning have looked like a combination of Chicken Little (of "The Sky is falling! The Sky is falling!" fame) and the Boy Who Cried Wolf. You can only warn so many times without the danger arriving before you're ignored and even perceived as a bit of a naive idiot. As the Chinese would say, if the weren't being polite, "Er Bai Wu" -- the Village Idiot! If, as the Chinese may fear, the era of the gentlemanly "Go Along to Get Along" policies of the Bush Administration are over, things will get interesting pretty quickly.

The irony for both parties is that they need each other in innumerable ways. Both China & the U.S. have serious economic problems and need to work together as allies to effectively deal with those problems. This requires both candor & practicality. The problems are real. To be genuinely and effectively dealt with, both sides will have to put sensitivities aside and grapple with the real-world issues. The Bush Administration made the "Global War on Terror" the measure of all things. This was not to the benefit of either China or the U.S. A more nuanced & honest relationship would be better for both.

The Great Uncoupling

There have been a number of intriguing developments in the last week that have potentially big implications for U.S.-China commercial, financial & trade relations.

Keen observers of China's banking scene may remember that a number of big western financial institutions, including Bank of America, Citigroup, UBS, Goldman Sachs, American Express and Royal Bank of Scotland have invested in various big Chinese banks a few years ago, primarily before those Chinese banks went public in western and/or the Hong Kong stock exchanges. At the time, these investments made plenty of sense for both sides. The western investors, of course, got to jump into -- even if a bit passively -- the Chinese banking markets. Those markets had been largely closed to their significant participation before China's accession to the WTO. After China became a member of the WTO, altho the banking market technically was partially opened, only a few foreign banks hopped over the border. Not that the Chinese government exactly made it particularly easy, but that's a story for another day. The one avenue where the gates swung wide open, altho the gatekeepers were still on duty, was equity investments in Chinese banks. With the prospects of the big four (Industrial & Commercial Bank of China, China Construction Bank, Bank of China, and Agricultural Bank of China) going public in the near future, the chance to jump in before the expected stampede for public shares was irresistible. For the Chinese side, there were big advantages. Looking forward to impending IPO's, the Chinese banks got a bit of legitimacy. If Bank of America buys shares in a bank, it must be a good investment. Or so the reasoning went at the time.
In addition, the then badly managed Chinese banks, in their rush towards legitimacy, could rightly claim that they had not only dumped a lot of their bad loans but they also were getting operational advice & counsel from their western brethren. In hindsight, we can all hope that they didn't learn too much.

Since those days in the not too distant past, the banking world has turned topsy-turvy. Those western pillars of the banking world turned out to have been infinitely more poorly managed than the big four Chinese banks. After the events of the last few months and the effective partial nationalization of many, if not all of those western banks, the scene has become truly surreal. Follow the logic. The big U.S. banks, with their significant ownership in major Chinese banks, are now largely owned by the U.S. Treasury. That means that the U.S. Government owns a chunk of the Big Four Chinese banks. Since the Big 4 are partially owned by the Chinese Governmentas well as the investing public, it means that the Chinese & U.S. Governments are, effectively, co-investors in the banking business. Mao Zedong & Ronald Reagan must both be squirming around in their graves, wondering what on earth could have happened.

But that's not the story. Now, in an effort to raise badly needed funds, Bank of America has sold off some of its Chinese bank stock for approx. $2.8 billion (for a profit of a bit more than $1.1 billion -- we're glad something has worked out for them, by the way). Analysts expect that B of A will be selling more stock (and they've got plenty left). In addition, other western banks are expected to begin to sell some of their Chinese bank holdings as well over the next few months as restrictions on stock sales expire.

So that's the first part of the story: Western banks begin divesting Chinese bank stocks.

The second and also intriguing development is this story, reported in the New York Times, among others:

China has bought more than $1 trillion of American debt, but as the global downturn has intensified, Beijing is starting to keep more of its money at home, a move that could have painful effects for American borrowers.

The declining Chinese appetite for United States debt, apparent in a series of hints from Chinese policy makers over the last two weeks, with official statistics due for release in the next few days, comes at an inconvenient time . . .

In the last five years, China has spent as much as one-seventh of its entire economic output buying foreign debt, mostly American. In September, it surpassed Japan as the largest overseas holder of Treasuries.

But now Beijing is seeking to pay for its own $600 billion stimulus — just as tax revenue is falling sharply as the Chinese economy slows. Regulators have ordered banks to lend more money to small and medium-size enterprises, many of which are struggling with lower exports, and to local governments to build new roads and other projects.

While this is not, in itself, striking news (it follows reports last year of China's national sovereign fund, The China Investment Corporation, coming under popular criticism in China after some of its less-than-stellar western investments began showing the strains of the times), it comes, as The Times notes, at a rather inconvenient time for the U.S. As mentioned previously in this blog and numerous other places, there's a lot of U.S. Treasury debt that must be rolled over soon and a big bill to be paid, financed by soon to be issued, crisp new Treasuries, for the first & second phases of the Big American Rescue Plan. That will mean that, in order to attract investors to the Treasury auctions, interest rates will need to be higher than they are now. Interest rates going up means Treasury prices go down. And the current Chinese holdings aren't immune to those market forces. It doesn't mean, of course, that Chinese bond buyers will entirely sit out upcoming U.S. Government bond auctions, but they can expect to demand higher returns. And we wouldn't be surprised if they bought less than they have in the past. And you can't blame them; you'd do the same thing.

Let the Great Uncoupling Begin!