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November 30, 2004

The Yongding Factor
by Brady Willett

Overnight Fears

On Friday November 26, 2004 the Shanghai-based China Business News quoted monetary policy committee member, Yu Yongding, as saying that China had cut its stake in U.S. Treasuries to $180 Billion (USD). Immediately following this announcement U.S. Treasuries declined sharply, the dollar traded lower, and gold rallied. Volatility in these markets - not to mention a sharp decline in U.S. equity futures - generated fears that there would be a mini crash when Wall Street opened.

Morning Calm

A few hours after the Yongding story broke - and well before the major U.S. financial markets opened for business - Yongding said that his comments had been 'misinterpreted'. Reverting to statistics current as of September Yongding pointed out that while China's U.S. Treasury stake as percentage of total foreign exchange holdings had decreased, China's total investment in U.S. Treasuries had 'actually increased'. Seemingly contradicting his 'misinterpreted' insights into the amount of U.S. Treasury Securities China currently owns Yongding added, "I have no knowledge of what action the State Administration of Foreign Exchange has taken or is about to take on foreign exchange reserves". The financial markets stabilized following Yongding's clarification.

Why Fear?

The U.S. needs to attract approximately $1.8 billion a day in to fund its current account deficit. Accordingly, and to overly simplify things, if $1.7 billion or less in foreign capital flows into America tomorrow the value of the U.S. dollar declines, and if $1.9 billion or more flows into America tomorrow the dollar's value increases.

Keeping this in mind, the fear is not that China will reduce its Treasury holdings per se. Rather, that any tremors in the currency markets resulting from Chinese capital shifts will reverberate in the fixed exchange market. Again to overly simplify things, $1.7 billion or less in foreign capital into America per day decreases the value of U.S. dollar, but a continued string of sub $1.8 billion daily tallies would, eventually, mean that U.S. interest rates would be forced higher (until enough capital to make up the shortfall is attracted).

In short, any hint that China is reducing its $174 billion stake in U.S. Treasury Securities is alarming; not only because of the negative implications for the U.S. dollar, but also because the U.S. could potentially lose its seemingly omnipotent grip on interest rates. Yongding sent alarm bells off last Friday morning, if only for a moment.

China Has Become A Less Important U.S. Debt Player

That China is losing its penchant for U.S. debt is not as startling as it first sounds. Rather, the statistics - along with incessant speculation from analysts and unnamed insiders - have been suggesting for some time that China was shifting more of its reserves into gold and Euros while paying less attention to U.S. dollar backed assets.

To put the numbers into perspective, China has increased its holdings of U.S. Treasuries by $27.7 billion over the last 12-months. Notwithstanding the limitations of these statistics, $27.7 billion equals a $0.076 billion per day average over the last year (or 4.2% of the U.S.'s current daily capital requirements). While certainly noteworthy, China U.S. Treasury purchases pale in comparison to Japan. Indeed, Japan has purchased more than $229 billion in Treasury Securities over the last 12-months; an amount that equates to 34.9% of the U.S.'s current daily funding needs.

Not only is China playing second fiddle to Japan - China's Treasury Securities stake is matched only by Japan's $720.4 billion position - but the importance of China's capital flows have recently been tuned out by other nations. To be sure, over the last 12-months the UK has purchased more than twice the amount of Treasuries than China, and Caribbean Banking Centers have purchased 1.78-times more Treasuries than China.

Although China is a still a crucially important U.S. Treasury owner, the country has quickly become a significantly less active U.S. Treasury player. Accordingly, and paying no attention to the Yuan revaluation situation, you could argue that fears over China not buying U.S. Treasuries has become overstated. Assuming, of course, that you believe China will never become a net seller of U.S. Treasuries.

Yongding Statements And Other Anti-Dollar Factors

How can we be so sure that Yongding was misinterpreted by China Business News given that the conspiratorially mind can easily conjure up visions of irate U.S. officials making threatening phone calls to Chinese policy makers demanding that Yongding recant? Because the original story said that China reduced its U.S. Treasury position to $180 billion. China - at least according to U.S. statistics - has never owned as much $180 billion in U.S. Treasuries.

* Ironically, if the original Yongding story had been true - which would only be possible if China had dramatically increased its Treasury position and then reduced it - it would have meant that China wad actually adding to its net U.S. Treasury position at a faster pace than seen during the last 12-months. In other words, the original misquotes from Yongding should have eased investor concern that foreign central banks were readying to flee the dollar. Instead the story caused a brief period of chaos in the financial markets.

The illogical reaction in the financial markets following the Yongding story was the direct result of building tensions/fears in the currency markets. To be sure, leading into last Friday countless Central bankers had already begun to offer rhetoric laced with interventionist plans. Moreover, rumors were emerging on what seemed like a daily basis that China, Japan, and others were losing their appetite for U.S. debt. Lastly, there were currency policy/reserve shifts from countries like Russia - as well as the economically unmentionable Cuba - that suggested the U.S. dollar's reserve currency status was in jeopardy. The Yongding story highlighted that China was worried about the U.S. dollar's decline enough to switch more reserves to Euros...the Yongding story - ignoring that actual statistics contained within - further exposed just how extremely reliant the U.S. is on foreign capital.

Yongding No Hashimoto

As suggested last year in 'The Hashimoto Factor' - well before current investor/media fascination with the U.S. current account began to bubble - "The U.S. economy and the bubbles inherent to its financial markets are only sustainable so long as foreign capital (and those who control it) is placated." Nothing has changed since last year. In fact, the U.S. has become even more reliant on foreign capital and even more complacent about how the unsustainable U.S. current account deficit can be remedied. For example, Fed Chairman Greenspan - who at every turn since 2001 has served to facilitate and implore consumers and businesses to leverage, borrow, and spend - actually had the audacity to recently suggest that increased savings is the correct course of action (to help remedy the CA). As was the case during the stock market bubble years (today's market included), Greenspan helps create the imbalance and then he says 'act rationally' to correct it.

"Policy success, of course, requires that domestic saving must rise relative to domestic investment..." Greenspan

Although the recently appointed Yongding is not nearly as memorable an instigator as Hashimoto, he is nonetheless probably the lowest ranking Chinese official to ever have such a dramatic, albeit brief, impact on the global financial markets. What Yongding's words did was bring investor fears to the surface. The dormant fear now threatening to explode is that the end result of unsustainable deficits - as Greenspan recently suggested - is that foreign investors eventually demand more of a return on their investment.

The original and revised Yongding story does not represent any new threat or policy shift out of China. Rather, Yongding's statements simply pointed out that foreign central banks have, and will, opt to increase non-U.S. dollar reserves. This is the cost associated with the unabated printing of dollars. The cost America is likely to become increasingly more familiar with in the future.

"Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost..." Bernanke. Nov 2002

Brady Willett
FallStreet.com

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