One of the most fascinating sub-plots in the global economic drama over the next few months would be over how the Chinese government manages its foreign exchange reserves, especially its investments in dollar denominated assets and US Treasuries. Over the past few months the Chinese accumulation of forex reserves has slowed, thanks to the decline in global trade, but its purchases of US Treasuries (though not of agency debt like the fixed income securities issued by US government backed entities) have continued to grow, though at a much slower rate than the ballooning borrowing needs of the US Treasury. It has been estimated that 82% of China's foreign reserves are in dollar denominated assets.
The global de-leveraging has resulted in a massive flight of capital, from both American and from other country financial institutions, to dollar denominated assets and the US Treasuries. At a time when the global markets have been paralyzed by deep uncertainties about counter-party risks, the US Treasuries have offered the attraction of safety and liquidity, despite their low yields.
But there have been interesting shifts in recent months. First, the Chinese have been selling the debt of US government-sponsored enterprises like Fannie Mae and Freddie Mac and substituting the same with US Treasuries. This has created the impression that the Chinese are continuing to finance the major share of US borrowings, despite the fact that it has effectively stopped putting fresh money into dollar assets. Second, as concerns mount about the soaring US deficits, the Chinese government has also been swapping its investments in long term Treasury Bonds for short-term T-Bills. As NYT writes, "This gives China the option of cashing out its positions in a hurry, by not rolling over its investments into new Treasury bills as they come due should inflation in the United States start rising and make Treasury securities less attractive."
There are two contrasting opinions on the impact of possible movements of Chinese reserves. The view that burgeoning US deficits could unleash inflationary pressures and frighten Chinese investors away from US Treasuries and into other currency bonds and thereby force up US interest rates is nicely articulated by David Leonhardt. All this would in turn prolong the recession.
Paul Krugman takes issue with this and argues that when faced with a liquidity trap, which means "an incipient excess supply of savings even at a zero interest rate" or "too large a supply of desired savings". Further, the declining trade and current account deficits and upward shift in domestic household savings will keep this supply of savings coming for some time to come. He argues that if China draws down these surplus reserves (or its accumulation of reserves slows down) to spend more, it will only boost the global aggregate demand and increase trade and thereby help the US economy. If it only shifts these reserves to other currencies, it will only weaken the dollar and boost US exports. Either way, it will not be doomsday scenario as predicted by many. And in any case, if the Chinese do start pulling out of US Treasuries, it will only drive down the Treasuries, thereby forcing them to take big hits on their investments, which presently earn nearly $50 bn in income every year.
In the final analysis, global macroeconomic imbalances triggered off by the global "savings glut" can be eliminated only if the US moves from being a consumption nation to saving more, and the emerging economies, especially China, saving less and consuming more. As David Leonhardt writes, "Americans became hooked on cheap goods and cheap money, and China came to depend on the income from selling those goods." Now to remedy the imbalance, China must become hedonistic and Americans thrifty! However, the trends are not encouraging with the Chinese consumer spending declining to 35% in 2009, down from 40% in 2004 and almost 50% in the early 1990s. By comparison, the share is 54% in India, 57% in Europe and 70% in the United States.