Will China lose its ability to finance U.S. spending?
I have seen my share of ugly charts lately and the one on Chinese exports is right up there with the best of them. We're getting a lot of mixed signals out of China right no, like the increase in its purchasing managers' index last month (see article: A sign of hope for China's economy?), but most of the news from there is still fairly bad. According to the wise folks at Stratfor (which is a fascinating site BTW), Chinese exports fell by a whopping 25.7% year-over-year in Feb. This is even worse than the 17.5% drop in exports that it reported a month earlier.
Clearly the main driver of Chinese exports, American consumers...or over-consumers one could say, is slowing. Despite calls by many analysts that the world is decoupling as late as a year ago, clearly the old axiom "When the U.S. sneezes, the rest of the world catches a cold." is true. With consumer confidence low, savings rates rising, and scared Baby Boomers reducing their level of spending...perhaps permanently, the U.S. consumer may not be riding to the rescue any time soon.
So how can China turn around its economy? It needs to wean itself off of its reliance upon exports, they currently account for approximately 40% of Chinese GDP, and stimulate domestic demand. It needs to do so ASAP to avoid possible civil unrest amongst its migrant workers. The Chinese government certainly seems to be trying. It rolled out a massive 4 trillion yuan ($586 billion) stimulus package well before we did so here in the United States.
So what does all of this mean for U.S. investors? Obviously, anyone here can purchase Chinese stocks. While I have been optimistic for some time that Chinese stocks would outperform the U.S. markets in 2009, as of right now I see very little evidence of an economic recovery in China. Focusing on the purchasing manager's index while ignoring the elephant in the room, a massive drop in exports, seems foolish to me. Doing so is like the U.S. investors who have been focusing on the better than expected (perhaps less worse is a better, yet grammatically incorrect description) retail sales numbers and boosting U.S. stocks over the past several days.
Less obvious than its impact upon Chinese companies and their stock prices, the country's massive drop in exports could ultimately affect its appetite for U.S. Treasuries. The Chinese government has generated large trade surpluses and built up massive and reserves over the past several years. It has been using much of this money to buy Treasuries. Without China's massive appetite for our debt, interest rates would likely have to head much higher.
China prefers to use its trade surplus to buy bonds rather than tapping into its reserves to do so. If its exports, and in turn its trade surplus, continue to fall it will have less money to buy our debt. Its February trade surplus fell to a paltry $4.84 billion, down from $39.1 billion in January. This is definitely a number to keep an eye on. The lower it gets, the more difficult it will be for China to finance U.S. spending.
For now, the demand for U.S. Treasures continues to be robust (see article: Investors are still gobbling up Treasuries). There is absolutely no physical evidence that China will stop buying Treasuries, but it continues to make threats that it might do so in the future. Just yesterday Chinese Premier Wen Jiabao said "We have made a huge amount of loans to the United States. Of course we are concerned about the safety of our assets. To be honest, I'm a little bit worried. I would like to call on the United States to honor its words, stay a credible nation and ensure the safety of Chinese assets."
The amount of our debt that China holds gives it a lot of power. Analysts estimate that China currently holds approximately $1 trillion in U.S. Treasuries and similar notes issued by government-affiliated agencies. If it becomes apparent that the Chinese are unwilling or unable to continue buying Treasuries at the current rate, interest rates would likely begin to rise, something that we can ill afford during an economic downturn.
I see China doing a whole lot of talking and not a lot of walking on this front right now. I suspect that it will continue to buy massive amounts of Treasures for as long as it can, well into 2010. Fixed income investors definitely need to keep an eye on China. It is probably best to avoid super long-term debt at this point and to instead focus on issues that will mature over the next several years. I'm not worried about a spike in interest rates in the near term, but long-term it is going to be difficult for the U.S. continue to issue debt at this rate and expect foreigners to keep gobbling it up.