Asia/Pacific: Asia Should Sell Treasuries Now
Andy Xie (Hong Kong)
I believe Asian central banks should sell their holdings of the US treasuries now. A weakening currency should lead to higher bond yields. However, because Asian central banks hold significant amounts of US treasuries, US yields have not reflected US dollar policy. This lack of pain is encouraging the US to pursue its devaluation policy. If Asian central banks dumped their treasury holdings for short-term paper, the US government would have to balance between a weaker dollar and higher bond yields.
The US has been binging beyond its means since 1999. In 1999 and 2000, the new economy hype sucked the rest of the world into buying US tech assets. Asian portfolio investors now hold worthless NASDAQ stocks and European MNCs own many US tech companies that have heavy debts but weakening revenues.
After the tech burst, Mr. Greenspan cut interest rates aggressively, causing US treasury yields to fall to around 4% from 6%. The bond market rally sucked in foreign buyers, who supported US consumption and the dollar.
As treasury yields have bottomed out, the US now wants to devalue the dollar (which would be to the cost of foreigners who hold trillions of dollars of US financial assets) to create jobs to sustain its consumption. I see the weak dollar policy as simply another way to get foreigners to subsidize US spending.
Asia can fight back. The US uses its superpower status and the advantage of the dollar as the currency for trade pricing and central bank reserves to get foreigners to fund its outsized spending habit. Without a market signal, this US ‘shopping addiction’ won’t stop.
Asian central banks have been buying US treasuries to recycle the dollars that hedge funds take to Asia. This trade depresses US bond yields, which gave US consumers an excuse to continue their shopping spree through mortgage refinancing and the US government an excuse to run a large fiscal deficit. Now the bond yield has bottomed and the mortgage refinancing game is dead. The US is switching to a weak dollar policy. The Asian central banks do not appear to be reacting to this policy as normal investors would, which is sending the wrong signals to the US government, in my view.
If Asian central banks sell these treasuries now and keep the dollars only in cash form, it would cause the US bond yield to rise, possibly by 150 bps, in my view. That higher bond yield would stop the merry-go-round among the Fed, the hedge funds, the Asian central banks and the US consumer. With higher bond yields bringing down US consumption, the global imbalance would heal. Alternatively, the US government could raise taxes to cut the fiscal deficit, which would stabilize the dollar and the treasury yield at the same time. That would be a happy outcome for the world, I believe.
Most Asian economies have short-term interest rates lower than or at 2%. This strategy would not be financially costly. Japan, in particular, could keep the dollars that it buys locked up. With a zero short-term interest rate, Japan could do this indefinitely. It would effectively neutralize the hedge fund flows into Asia and force US bond yields to reflect fundamentals.
Higher US rates are the end-game in any case. The weak-dollar policy will not solve the US deficit problem, in my view. It would, were the dollar cheap enough for the US to start a factory-building boom. Last year, US imports were US$1,257 trillion, versus US$725 billion of exports. The deficit was US$532 billion. The US would need a great many new factories to fill this gap. The dollar index against major currencies dropped by 15% last year. However, the US deficit in the first nine months of this year was up by 19.2% (perhaps one could cite the J-curve as an explanation, although I doubt it). There is little evidence to suggest that dollar weakness will mean more factories in the US.
I believe the weak-dollar policy may work only if it triggers higher inflation in the US, forcing the Fed to raise interest rates higher and more quickly, as it did in the early 1980s, which would cause a recession in the US and decrease the US trade deficit through less domestic spending. Such a recession is necessary, in my opinion. The US should have seen a recession following the tech burst. However, it shied from this, and has since been juggling to sustain demand growth. When this juggling act falters, a recession will occur anyway.
So why take the round-about way, since the solution is higher US interest rates in the end anyway? If Asian central banks sold treasuries now, it would bring the issue to a head. If the US does not want higher treasury yields, it can cut the budget deficit, which would lead to a lower trade deficit, stabilizing the dollar.
Asia is at a crossroads. Asian governments must be strategic in dealing with the ebbs and flows in the currency markets. The hedge fund industry has become so big that short-term flows in the currency market are large and sentiment-driven. If Asian governments are swayed simply by the large flows, they risk making major mistakes as regards their economic futures.
The critical objective for Asian economies is to avoid the fate that befell Japan in the late 1980s. China and South Korea have experienced massive debt growth since the Asian financial crisis. China’s domestic credit has risen to 150% of GDP this year from 100% in 1997, mainly on business borrowings. Korea has shifted its debt to households from businesses – i.e., its debt problem that caused the crisis in 1998 has been redistributed, not solved. If their currencies appreciate substantially, these two economies could fall into the Japan-style trap of low growth, low interest rates, low inflation and a strong currency.
How China deals with the renminbi peg is the key to how the world unfolds. Many people want China to do what Japan did in the 1980s – create a large bubble to support the global economy while the US rests. ‘Currency flexibility’ is just code for drawing China down the path of mega revaluation. The Japanese yen doubled within two years after the Plaza Accord in 1985. As soon as China buckles under pressure, it could suffer the same fate, in my view.
If China goes down this slippery path of appreciating its currency under pressure, its scope for economic development will shrink sharply over time. Chinese goods suffer widespread discrimination, despite the WTO system, because Europe, Japan and the US do not recognize China as a market economy, which gives them ample room to keep out Chinese goods. Chinese goods sell because they are so cheap that businesses in these economies go to the trouble of bringing in Chinese goods for big profits. If the Chinese currency appreciates by as much as many people want, Chinese goods will cease to be irresistible and China’s exports could suffer greatly due to discrimination.
However, if Europe, Japan and the US recognize China as a market economy, China could consider some flexibility on the currency. Were China to fail to receive anything in return for currency appreciation, the market would likely view it as vulnerable to pressure – and keep pushing. That would take it down the path that Japan traveled in the 1980s.
I think the right path for China is to increase interest rates to slow down investment, which would decrease speculation. Contrary to the popular view that higher interest rates would attract more money, when China shows determination to land the economy, hot money will leave, in my view. With speculation cooling down, China could undertake currency reforms at its own pace. The renminbi’s value would be determined by the true balance between demand and supply, rather than by speculation or political pressure. |
