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Will China lose its ability to finance U.S. spending?

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March 13, 2009 – Comments (6)

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.

Deej

6 Comments – Post Your Own

#1) On March 13, 2009 at 9:51 AM, EHoyle80 (< 20) wrote:

AP reports that China’s trade surplus has almost evaporated. (See here) This was despite a 24% drop in imports in February (year over year), as exports dropped 25.7% to US$64.8 billion. China’s trade surplus was only US$4.8 billion in February, down from US$39.1 billion in January.

Via Stock Research Portal 

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#2) On March 13, 2009 at 10:59 AM, CycleFreak7 (22.66) wrote:

Well-written and informative post, Deej.  Thank you.  Where's that rec button? ... Ah, there we go :).

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#3) On March 13, 2009 at 11:08 AM, outoffocus (23.66) wrote:

Check this article:

China "worried" about US Treasury holdings

Even if they could buy our treasuries, I dont think they want to.

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#4) On March 13, 2009 at 11:33 AM, tdoodler (23.91) wrote:

Great post.  I dont think they will lose their ability (As Americans are showing the world - that you can do whatever you want,  you just have to print more money) - but more importantly, they may lose their desire to buy our treasuries.

 

Watch the TBT.  If demand for treasuries stars to fall, rates will have to rise - and that would be devastating to the world.  (I thought I read something about a slowing treasury demand in IBD - but I cant find it).   The Chinese have made a great return on their money over the last 10 years. But now, China is in a catch 22 as they (presumably) hope and believe that the American consumer will come back.  However, as a society (ie for most Americans), these recent economic events were an unwelcome and devastating surprise.  Americans have lost a lot of their wealth at a time when they are getting closer to retirement and need (and now will want ) less things.  As Warren Buffet recently said, the American consumer has changed forever.

So China will attempt (and ultimately succeed - but not for a long time) to change their export driven economy to their own consumer driven econmy.  In theory, then China will have less of a need to buy our Treasuries (and less of a want - particularly in a rising rate environment).  At the same time, American baby boomers will retire - and start drawing on social security  as they earn less income and hence pay less in tax.  Our deficit will be out of sight.

Rates will rise precipitously as our government will have to inflate their way out of the tremendous debt and the only way to get others to buy our debt will be through higher rates.

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#5) On March 13, 2009 at 11:40 AM, Option1307 (29.97) wrote:

Another great post Deej...

Question for you/others. I realize that there will be a day when the other coutnries stop buying our treasuries and thus stop funding our addiction to debt. This obviously will be bad scenario and we will be inclined to raise our interest rates, etc.I'm aligned with you there. However, as you mention, China is our largest treasury holder, yet the only hold 1 Trillion dollars worth. Yes, this is a large amount of money, but realistically its just a drop in the bucket comapred to what we've spent/pledged this recession (>10 Trillion) and doesn't even make a dent on our total deficit including future obligations (see medicare/SS,etc.) which is >50 Trillion.

So in essentially, do we even care if they stop buying treasuires from us? I know this is a tad oversimplified, but you get my point. Curious to hear your take on the matter...

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#6) On March 14, 2009 at 5:43 AM, uclayoda87 (29.46) wrote:

I think we care because when China, Japan and Saudi Arabia stop wanting out debt, interest rates will go up and the buying power of the US Dollar will likely fall dramatically.  This will result in a significant fall in the US standard of living.

Medicare and Social Security are the ultimate Ponzi schemes.  We don't like to talk about them because we know we can't really fix them.  We just lie to ourselves about reforms, but what we are actually doing is passing this burden to some future generation.  If we are not "saved" by some horrific natural disaster or war, then these program will eventually default, resulting in millions of Americans being left to fend for themselves.  Not a pretty picture either way, which is why no career politician really wants to deal with these problems.

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