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					Chinese Financing of the
     United States
             Brad Setser
  Roubini Global Economics and the
    Global Economic Governance
Programme, University College, Oxford
    Global balance of payments
• Big US current account deficit – an estimated $900b in
• Offsetting surpluses found overwhelming in the emerging
   – China @ $220b (maybe more)
   – Oil exporters @$500b (Middle East/ Russia = over $400b)
• Europe small (but growing) deficit also financed by
  emerging world
• Japan significant (but stable) surplus that helps finance
  the US/ Europe
• US deficits of $900 to $1 trillion likely for some time,
  even if trade deficit begins to trend down
   – Interest payments on US external debt stock set to rise
Global current account balance
   Chinese financing of the US
• Overwhelmingly done by the central bank
  – Reserves managed by State Administration of
    Foreign Exchange (SAFE)
• Reserve growth in 2006 likely to top $250b
• Reserves growth from:
  – Current account surplus (Rising)
  – Net inflows of FDI (China trying to offset with
  – Hot money inflows (Falling)
• Most think around 70% of reserves invested in
  dollars, 20% in euros, 10% in other currencies
                       China’s reserves
                                Reserves and Reserves/ GDP (1998-2006)

         1200                                                                                          60%

         1000                                                                                          50%

          800                                                                                          40%
USD bn

          600                                                                                          30%

          400                                                                                          20%

          200                                                                                          10%

           0                                                                                           0%
                1998   1999   2000      2001          2002          2003    2004   2005   2006 (est)

                                           Reserves          Reserves/GDP
                        What we know
•   China held $530b in US assets in June of 2005 (v $710b in reserves and
    $770 b in augmented reserves (counting the $60b transferred to 3 Chinese
•   China has added over $230b to its reserves between June 05 and June 06.
     – By end of q3, reserves likely will reach $1000b, augmented reserves will reach
•   Recorded inflows since June of 2005 are around $110b, implying a bit
    under $640b of total Chinese holdings of US securities
•   Two ways of measuring Chinese holdings – flows (how much US residents
    report selling to China) and stock (how much the Chinese report holding in
    the US annual survey)
•   For complicated reasons, the increase in the survey data has tended to
    exceed the increase implied by the flow data.
     – Likely Chinese holdings of US debt now total around $700b – i.e. 70% of total
•   Chinese deposits in international banking system are relatively small; most
    Chinese reserves seem to be invested in securities.
                         Chinese purchases –
                          flow v stock data
               The change in Chinese holdings in the annual Survey is far larger
                 than the sum of Chinese purchases in the monthly flow data



USD bn




                   June 02 to June 03              June 03 to June 04              June 04 to June 05

               Flows of Purchases (TIC)   Change in Stocks of Purchases (Survey)   Change in Reserves
        It is not just Treasuries
• China holds a relatively diverse portfolio
   – Lots of agency bonds
   – Other mortgage backed securities as well
• The trend has been for more purchases of
  agencies, corporate debt, and the dollar-
  denominated debt of emerging economies
• China will likely set up a “government investment
  corporation” at some point to make more
  aggressive investments; PBoC manages a very
  significant share of China’s national wealth.
Chinese holdings – Survey data through
      mid-2005; 2006= estimate
                                       Chinese Holdings of US Securities
                     Data from the Treasury's annual survey, with an estimated $146b in additional purchases
                                                  from June 2005 to June 2006




  USD bn





           End June 2003                   End June 2004                    End June 2005                      End June 2006

                                               Treasuries    Agencies     Corporates
•   Argument: China could sell its treasury portfolio, roiling US markets …
     –   Maybe, but it does not have to sell to influence US markets. All it has to do is stop buying.
     –   Right now markets used to $150b or so in annual Chinese purchases. Net increase in
         Chinese holdings from June 04 to June 05 = $185b.
     –   Conservative estimate is Chinese purchases lower US rates by around 30bp (Warnock and
         Warnock, 2005)
     –   Treasury market = most liquid, Chinese sales of agencies/ MBS/ corporate bonds would
         have a bigger impact
•   China will never sell – if it sells, it would move the market against it.
     –   True.
     –   But China will take losses no matter what … Philip Swagel has argued that since China over
         paid for its US bonds, large losses are already “baked in.”
     –   China can choose time/ place when it realizes those baked in losses
     –   If China cared only about financial losses, it should just stop buying treasuries now and let
         the RMB appreciate.
     –   The real constraint for China isn’t financial losses. It is that selling would antagonize its key
         customers … the US and Europe. US would be less able to buy Chinese goods. And
         Europe wouldn’t be happy if Chinese actions pushed the euro to 1.5 or above … and drove
         the RMB down against the euro.
     –   Other risk for China is a US freeze on Chinese assets held in the US … A big share of
         China’s financial wealth – at least 25% of China’s GDP -- now invested in US.
       Scenarios -- speculative
• Chinese options
   – Shift Chinese funds into London/ Singapore custodial accounts
     (still in dollars)
   – Have the head of SAFE give speech extolling the reserve
     management of Russia and India (both have far smaller dollar
     allocations) …
   – Stop (or slow) purchases of US securities … buy more European
   – Stop (or slow) purchases of US securities … buy more oil/
     strategic commodities
   – Sell US securities from custodial accounts in London
   – Sell Chinese positions in less liquid markets to maximize the
     market impact …
   – Quietly take derivative positions before making noisy sales
   – Do nothing. Let the market fret …
     Scenarios -- Speculative
• US options
  – Borrow Euros that the US sells to buy dollars …
     • Borrow from the markets (Issue euro-denominated Treasury
     • Borrow from other governments
  – Encourage others to buy dollars. Europe might
    intervene to keep euro from going to 2 …
  – Sell oil if China is buying oil …
  – Freeze Chinese assets … but China would likely
    seize US investment in China
• Chinese leverage comes from the potential withdrawal of the
  financial subsidy it currently provides the US by “overpaying” for US
• This financial subsidy benefits Chinese exporters. So withdrawing
  the subsidy also has a current cost to China.
• Realistic options fall short of the extreme options –
    – Reducing purchases rather than outright sales
• Markets would try to anticipate any Chinese move – generating
  economic/ financial costs in the event of a serious rise in US/
  Chinese tensions …
• Threat of using leverage is often more valuable than actual use
    – China opposed Iraq war in UN. It then helped finance it …
• It isn’t just China. Saudi Arabia/ Russia now have around $500b in
  reserves, and their reserves are increasing by $200b a year …