Geithner and China: Who Are You Fooling?
Treasury Secretary Tim Geithner's trip to Asia has been heralded as a sales trip aimed at convincing the Chinese to keep buying U.S. Treasuries and thereby finance U.S. deficits. Such headlines are, in my humble opinion, an insult to the Chinese. Over and over again, we fall victim of the temptation to believe that Chinese leaders act in a vacuum, dictating policies out of a closet. Chinese leaders know very well the state of the Chinese, the U.S., and the world economy; they don't need a sales pitch. So what's the purpose of Geithner's trip then?
There's a saying that when you owe the bank a dollar, it is your problem. But if you owe the bank a million dollars, it's the bank's problem. Well, the U.S. owes China $767.9 billion worth of U.S. Treasury securities (Chinese holdings as of March 2009; see table) in addition to agency and other securities; in total, China owns about $1.4 trillion in U.S. assets. This is definitely China's problem. If this is a case of "The Emperor Wears No Clothes" then the Chinese and the U.S. are in the same boat in trying to convince the world to buy U.S. Treasuries.
At times, however, it may be better for the world to see the challenges as they are and talk plainly about them. Maybe it takes a bodybuilder as emperor to have the courage to admit that clothes are long gone, such as is the case with California's finances. In California, with its dysfunctional state government, the governor is at least trying to rein in spending. Contrast that with New York where the solution to every financial crisis seems to be tax increases. The federal level, however, beats them all: the Federal Reserve's (Fed's) printing press attempts to keep up the illusion of prosperity. Printing money, however, only works when there are takers. That's where Treasury Secretary Geithner comes in. However, Geithner is no bodybuilder but has a lot of heavy lifting to do if he is to make U.S. debt appear attractive.
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Unfortunately, the situation is far too serious to talk in puns. While the U.S. government and China are the most prominent figures in this drama, all of us are participants. Indeed, while we ponder whether the Chinese may continue to finance U.S. deficits, we should also be concerned about all other potential buyers, including domestic buyers. One of the new growth areas in U.S. finance is to offer services to U.S. institutional investors to hedge their U.S. dollar risk. It's virtually unheard of that institutions in the developed world hedge their domestic currency risk. Yet this is a very real consequence of present market interventions. It doesn't matter whether Americans or foreigners sell the dollar: a dollar sold is a dollar sold. If the Fed prints too much money and/or artificially lowers the yield on U.S. Bonds, Americans and foreigners alike may flee the currency.
Not surprisingly, Geithner assures China - and with it the rest of the world -U.S. deficits will be brought under control once the economy recovers. Trouble is: a) the shape of the recovery is far from certain: trillions may be wasted through inefficiently applied programs that prop up a broken system rather than providing incentives for a sustainable recovery; and b) considering all the Administration's ambitions, it is difficult to imagine just how the looming deficits are going to be tackled even with the most optimistic of assumptions. Aside from the long-term challenges, the U.S. may need to raise about $3 trillion of new money in the debt markets this year; this could weigh heavily on the bond market at a time when a fragile recovery may depend on a strong bond market.
In addition to the photo-ops, a good deal of Geithner's time is likely to focus on discussing the "exit strategy." A crisis is too good an opportunity to miss. Unfortunately, U.S. policies have so far sorely lacked in reform to promote a more sustainable future. Rather than encourage an economy more focused on savings and investments, there was no incentive for businesses to invest in the so-called stimulus bill. On the contrary, all efforts were aimed at getting consumers to keep up their borrowing. The U.S. savings rate is slowly moving upward, but more out of consumer desperation than a new vision for a more prosperous future being embraced. This may bode badly for a sustainable recovery in the U.S.
For China, the stakes are high, but China's massive reserves give the country room to maneuver. In particular, China has to decide whether to try to build its recovery on a fragile U.S. consumer or to find ways to achieve a more balanced economy. The former implies more of the same: buying Treasuries, finding ways to jumpstart exports, keeping the yuan pegged to the dollar. There are many problems with that policy, including:
- Exports to the U.S. may not recover as much as desired; any recovery may not be sustainable as long as U.S. consumers continue to have very high debt levels.
- In a best-case scenario, China may face the same challenges it has today down the road once again. Except that China's finances may not be in as good shape as they are today and China may have less room to maneuver.
- Current policies pursued may be highly inflationary; loans have grown at an annual rate of 50% in recent months.
China needs to create a more balanced domestic economy. More balanced does not mean giving its citizens credit cards so that they fall into the American debt spiral. More balanced means more sustainable growth by fostering a growing and stable middle class. In our assessment, policy makers can achieve this by providing its citizens a vision of the type of country China wants to be. A vision that includes a strong private sector, supported by a tax and regulatory framework that encourages private sector investment, may unleash tremendous power. Some argue China should privatize many of its state run enterprises; that may help to jump start investments, but we believe setting the path for new investments by domestic entrepreneurs would benefit China most in the long run. China needs to streamline regulations and enforcement of regulations to provide a more stable environment that fosters investment and innovation. Merely privatizing state run institutions may not be enough to weed out overly bureaucratic structures where necessary.
Allowing the yuan to appreciate may be the most effective tool in combating the headwinds of inflation that, in our view, may impact China before too long. We already see commodity prices soaring as a result of global reflationary efforts. China's industry has done well by shifting more towards products at the higher-end of the value chain where there is more pricing power. We have seen the manufacture of low end products increasingly move to lower cost countries.
A stronger yuan increases China's purchasing power. However, given China's massive holdings of U.S. debt, it doesn't want to erode the purchasing power of these assets. China has already indicated that it wants to deploy its foreign exchange reserves by buying assets abroad; it may only be a question of when, not if, China diversifies out of U.S. Treasuries. China has in the past shown to be very sensitive to the markets; just as China is reluctant to dump its Treasuries, China has been very careful in not rocking the markets when building its gold reserves. Despite this, market forces may force China to accelerate its transitions; change is painful, but the more it is postponed, the more disruptive it may be.
China has taken many important steps to have a more flexible exchange rate, including allowing trade in local currency with neighboring countries. Most recently, China and Brazil agreed to settle trades in local currency - an agreement that may still take years to implement, but shows the direction China is heading in. For the time being, China and the U.S. are putting on a show to tell the world the U.S. dollar is strong; China may be well advised to use this opportunity to put steps in motion for a sustainable recovery that does not depend on a strong dollar - the term "strong dollar" increasingly seems an oxymoron in light of the policies pursued in the U.S.
We manage the Merk Hard and Asian Currency Funds, no-load mutual funds seeking to protect against a decline in the dollar by investing in baskets of hard and Asian currencies, respectively. To learn more about the Funds, or to subscribe to our free newsletter, please visit www.merkfund.com.