Jan 29

The Next Weakest Link – China


With the Obama Administration rightly proposing a major fiscal stimulus – and probably not enough – analysts are expecting well over a $1 trillion deficit in this fiscal year…and probably higher in the succeeding year.  The government can print money to fund these deficits, but it would much rather borrow (primarily from Japan and China). 

But, can we keep borrowing from the Chinese if they need to keep their savings at home to support their own troublesome economy.  How troublesome?  Below is a forecast from the OECD (not exactly a very incendiary group) and it is not pretty:

If you’re in the leadership class in China, this graph is quite scary, as economic growth below something like 7-8% probably means insufficient jobs for the hordes coming from the country to the city looking for jobs. And, history tells us that angry hordes can pose severe problems for social, economic and governmental stability.  Thus, one can make a reasonable case for China being very careful in its purchases of securities offshore. 

In fact, this has probably already happened in some fashion, as noted in the Treasury’s January 15 press release detailing November data (December data won’t be available until mid-February):  “Net foreign purchases of long-term U.S. securities were negative $56.0 billion. Of this, net purchases by private foreign investors were negative $18.9 billion, and net purchases by foreign official institutions were negative $37.1 billion.”

With apologies to economists much smarter than me, the math is really quite simple:

Large deficits = borrow or print money.

Borrowings = Domestic Savings + International Savings (i.e. Purchases of Treasuries)

If domestic savings is something we don’t want to encourage in order to recover from a recession, we must borrow from abroad.  However, if one of our largest creditors faces a large economic downturn, it will not have the desire to extend credit at current rates.  The results: (1) higher US Treasury rates in the U.S. and/or (2) dollar devaluation (express or implied) and/or (3) inflation.   Should China have the problems noted in the OECD study, we could expect some combination of one or more there.

Of course, if foreign interest in Treasuries wanes, the Fed could always buy the securities.  But isn’t that just borrowing from one pocket to pay the other?  And, to do so would most likely result in more dollars injected into the economic system (inflation).  Perhaps inflation is not so bad in an economy suffering a slight bout of deflation…but at what long term cost?