Report On Money And Banking Animation Essay

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An unprecedented number of bank failures and mortgage defaults have occurred in the United States during the current recession that has spanned the end of the first decade of the young century. Surviving banks have the U.S government to thank; TARP money has enabled these institutions to keep toxic assets from overrunning their balance sheets. An enormous stimulus bill has been cited as being the force that has brought the U.S. economy back from the brink of depression. Some observers have stated that the stimulus, sized at $787 billion, is not large enough (Cowan 2009). Moreover, the U.S. is preparing to overhaul its health care system which will place an even larger financial burden on the federal government. Even though the dollar is one of the most stable stores of wealth in the world, countries that have large quantities of U.S treasury bills may view this increase in U.S. spending as a threat to their assets. The largest of these countries, China, has developed its merchandise and commodities market to be largely dependent on U.S. investment (Rivoli 2005). The Chinese government has no choice but to continue its purchase of US debt in the face of a depreciating dollar and a possible interest rate increase in the aftermath of the United States economic stimulus and health care reform.

In order to better understand the intricacies of the economic relationship between the United States and China, it is necessary to comment on the liberalization of Chinese enterprises and the reasons underlying China's pursuit of US debt.

Before the early 1980's, the Chinese government exerted strict controls over most of the economy. Enterprises were ordered to report to the central government, profits were given up, and the interests of the central authority decided the salaries of laborers. In 1979, after some political unrest and economic disorder due to deteriorating economic conditions, a new communist party leader began his renovation of China's economy. Deng Xiaoping recognized the need to reform the nationalized economic system after periods of decreased productivity (Gabriel 2007). Top officials in the Chinese government attacked this problem vigorously. The transformation to a socialistic market economy (which enabled foreign direct investment) and the realization that state-owned enterprises (SOE's) were hurting economic performance foreshadowed China's economic progress into the 21st century. By 2001, 86% of SOE's had been restructured, and 70% of those had been privatized. The number of SOE's fell from 64,737 in 1998 to 27,477 in 2005 (Woetzel 2009). Concurrently, industrial output increased.

Liberalization forced Chinese businesses to produce goods that other nations demanded. Within the last ten years, trade has increased to 70% of GDP (Fig 2). This ratio-the percentage of merchandise trade compared to overall GDP-represents the importance of goods traded in the national economy. From Figure 2, it can be deduced that, compared to ten years ago, international merchandise trade has become a more vital part of China's economy. Of the primary GDP sectors (agriculture, mining, manufacturing), manufacturing plays the largest role. As China's industry restructured, its manufacturing sector experienced a rapid surge in development and trade (Fig 3). This suggests that as manufacturing production increased, China's merchandise trade along with overall GDP increased. China's economic strength is in its textiles. The boom in trade came from the increased trade of manufactured exports.

Co-analyzing Figure 4 and Figure 1, it is evident that when FDI increases, China's industry expands. The direct relationship between Figure 1 and Figure 4 is important; FDI is the key to the improvement of China's export market and thus, it is the key to improving the economy.

How does the U.S. factor into China's merchandise niche? The reorganized Chinese economy is fueled by FDI. Over the past three decades, China and the United States have developed a special economic relationship that benefits both nations (Morrison 2009). The massive influx of FDI from the U.S. into China gives Chinese businesses open access to one of the wealthiest consumer markets in the world. This not only gives China huge trade profits, but it also increases (or maintains) Chinese employment. China then turns around and invests its profits in US treasury bills. This process allows China to accomplish these goals:

Why Does China Invest in U.S. Securities?
  1. To store balance of payments surpluses
  2. To acquire valuable assets
  3. To maximize returns and increase the pile (Scissors 2009)

The article proceeds to analyze possible interest rate movements in light of health care reform and what this means for U.S. treasury bills. Next, I will evaluate theoretical arguments supporting the notion that exchange rate movements that make the RMB more valuable relative to the dollar are detrimental to Chinese investments. I will then discuss how these movements affect Chinese assets. In order to determine the effect on possible Chinese exit strategies, I look at how China can maneuver its holdings of U.S. debt to minimize its risk of interest rates increases. Finally, a discussion of the long term relationship between China and U.S debt securities is presented.

Interest Rate Movements

Interest rates are influenced by a variety of factors including the length of the term to maturity and the creditworthiness of the issuer. Long-term bonds will carry higher interest rates, for it is difficult to predict market conditions far into the future. If the issuer of a bond defaults, the buyer will lose some or all of his original investment. Therefore, if an issuer of a bond is in financial trouble or has a less-than-stellar balance sheet, he or she will have to increase the interest rate on his or her bond in order to find buyers. Buyers expect to be compensated for this risk.

Now, the United States needs to spend in order for its health care overhaul to take place. With budget deficits mounting, the United States needs China to finance its debt at low interest rates. The interest rate at which China has been purchasing U.S. treasuries in the past can be seen in Figure 5. Within the past decade, China's interest rate on its treasuries has decreased from a high of 7% to its current rate of 3.87%. To maintain this low rate, the U.S. government needs to keep the dollar healthy and continually remind its investors of its creditworthiness.

A rise in interest rates would hurt Chinese assets. For example, suppose the U.S. government sells Treasury bonds when existing market interest rates are at 9%. A bond with a face value of $1,000 on issue would pay $90 a year in. But if market interest rates were to rise to 10%, then who would want to buy such a bond? One could just as easily purchase the bond with the higher interest rate. Therefore, the market price of the bond would have to fall to a level where that fixed $90 annual payment has the equivalent of a 10% annual yield. In this case, the price would have to fall to $900 so that the annual $90 payment would equal 10% of the purchase price of the bond.

The United States Treasury may be forced to increase T-bill rates in order to finance the stimulus and health care reform. Large deficits from massive spending may test the trust that investors have in the dollar. Nicholas R. Lardy, a scholar at the Peterson Institute for International Economics, states:

"The United States government is going to have to sell a huge amount of paper, and the market may react by demanding a higher interest rate...This will force down the price of outstanding treasuries, imposing large paper losses on the Chinese." (Wines 2009)

Exchange Rate Movements (Falling Dollar)

Empirical evidence is available on the correlation between deficit spending and inflation (Mishkin 2009). From 1960 to1980, the conclusion that inflation is a monetary phenomenon is given much support. Figure 6 documents the rising inflation during these years.

The rise in inflation over this period can be attributed to the rise in the money growth rate during these years. Particularly high peaks in the graph represent supply shocks. Recall that temporary upward bursts of inflation during those years can be contributed to oil and food price increases that occurred in 1974 and 1980.

What is the underlying cause of the increased rate of money growth from 1960 to 1980? There are two possible sources of inflationary monetary policy: government adherence to a high employment target and deficit spending (Mishkin 2009). The U.S. government is currently spending more than ever, causing an increase in the already-burgeoning federal deficit. Increased deficit spending may cause the ratio of government debt to GDP to rise. This will put upward pressure on interest rates because the public will be asked to hold onto more government bonds relative to their capacity to buy them. To remedy this, the Fed may attempt to purchase treasuries or print money; both will expand the monetary base and therefore, inflation.

Purchasing power parity theory (PPP) can explain changes in exchange rates in response to changes in inflation. To illustrate this, consider two fictional countries: Tylerland and Alexville. Suppose that on January 1st, 2010, the prices on every good in each country are identical. A $20 soccer ball in Tylerland costs ¥2000 in Alexville, meaning that the exchange rate is $1 to ¥100. If PPP holds, then the dollar must have equal value in Tylerland and Alexville-otherwise it would be possible to make a risk-free profit by buying soccer balls in one market and selling them in the other. Now, suppose that Alexville has 50% inflation, whereas Tylerland has no inflation. If inflation impacts every good in Alexville, then the price of soccer balls in Alexville will be ¥3000, but the price in Tylerland will still be $20. If PPP holds and it is not possible to make money from buying soccer balls in one country and selling in another, then ¥150 must now be worth $1. In other words, it takes ¥150 to purchase $1. The value of Yen has fallen. Investors will then prefer dollars to Yen-decreasing the Yen exchange rate while increasing the dollar rate.

Combined Forces

The two risks that pose threats to the partnership between the United States and China are now obvious. A rise in inflation, which leads to a depreciated dollar, coupled with rising interest rates will cripple Chinese assets and distinguish any further interest in U.S. securities. However, the problem does not seem as linear as many believe it to be. Policies and factors which would precipitate such changes in the aforementioned markets may be just what China needs (Zakaria 2006).

The problem with increased U.S. spending is the rise in interest rates which will cause the value of Chinese assets to fall. To keep this from happening, the U.S. could make its stimulus programs smaller. Businesses and homes would receive less money from the government, which in turn would cause the U.S. to borrow less, thus putting downward pressure on interest rates. However, if the stimulus bill was slashed into a meager set of expenditures, the American economy would recover more slowly. There is a risk of the stimulus being too small to successfully combat ailments of the recession. Less government spending would mean less demand for Chinese goods. Less demand for Chinese goods will weaken the Chinese economy, damaging China's manufacturing niche. If China were to lose a major percentage of income from the largest consumer market it has, its economy would suffer tremendously. More specifically, it would not generate profits large enough to continue its purchase of U.S. securities. If China cannot purchase these securities, the United States government will not be able to perform the services promised to its citizens.

Just how big must the stimulus and health care reform be? Perhaps the best solution to this conundrum is one that preserves U.S. credit markets. The stimulus bill must be large enough so that banks become confident enough to allow credit to flow easily to borrowers. A healthy U.S. credit market will maintain a strong flow of goods from China into the U.S. In this case, interest rates will be kept low enough to encourage borrowers with legitimate projects to take out loans. However, the bill also needs to be small enough so that interest rate hikes do not create an adverse selection situation for banks, forcing them to lend less as borrowers have riskier projects. The best way to accomplish this would be to adopt a monetary policy which tries to slow increases in the monetary base. With such policies, the central bank would attempt to keep inflation within a certain range. Doing so would stabilize the value of the dollar, thus allowing China's assets to hold their value.

However, there is a problem with this approach. Monetary policy that targets inflation assumes that the CPI accurately represents the growth of that nation's money supply-but this is not always the case. The most important exception occurs when external factors to a national economy cause prices to increase. For example, if the Chinese government concludes that the increase in spending by the U.S. government will be detrimental enough to the dollar in the future that it decides to halt its purchase of treasuries and raise prices on all goods and services in anticipation for a devalued dollar, a monetary policy which targets inflation will be worthless. This is because interest rates, which, in this case, are set in regards to internal factors, will not solve the problem they were set to solve. This is where we see the flaw of inflation targeting: it is not based on a coherent dynamic theory, and therefore, it is not a strong enough monetary tool to combat the effects of large U.S. spending (Snooks 1998). It is possible that the monetary authorities do not yet posses a tool powerful enough to keep credit markets open in a time of increasing inflation and rising interest rates. They cannot force banks to lend. Instead, they can only try to persuade the banks to lend, and the effectiveness of this is marginal.

Exit Strategies

In January 2008, China's Premire Wen Jiabao stated that he was worried about the safety of U.S. treasuries:

"I'm worried...[about this] unsustainable model of development characterized by prolonged low savings and high consumption [in the U.S]." (Reuters 2008)

But can China do anything about it? If interest rates rise and the value of the dollar falls, China can engage in one of three strategies. It can sell its entire stake in U.S. treasuries at once, sell them off slowly, or keep the bills it owns and stop all future purchases.

The options China has to curtail its losses on its assets are all constrained to bond market supply and demand pressures. As inflationary pressures force the ratio of government debt to GDP higher, Americans will hold onto more government bonds relative to their capacity to buy them (Mishkin 2009). It would be unwise to unload securities into this environment. If China were to sell its huge stack of bills, the supply of treasuries would rise immensely. In order for demand to meet that supply, prices would have to decrease, which would lessen the value of treasuries further. China would effectively flood the treasury market and drive down the price of its securities. It indeed seems unlikely that China would do this.

Instead, China could try and unload its securities slowly while it moves any funds available for investment elsewhere. However, as China does this, the U.S. economy will stall. This stall will result from the United States' realization that without China, there are few borrowers to borrow from. Funding for U.S. fiscal programs will dry up. Consumer goods that were once produced in China will be produced elsewhere, possibly at higher costs. The transition from China to another area or country as the U.S.'s cheapest and largest producer would take time, and, all the while, the U.S. economy would slide further into an economic coma. As this happens, interest rates would rise, the dollar would weaken, and China's securities would be slowly milked of their value.

Finally, China could hold its treasuries and stop purchasing more. Again, the U.S. would not have a lender for its planned spending, and the economy would hemorrhage. There is no effective way for China to sell or even stop purchasing United States treasuries if it wants its own economy to continue to export to the U.S. In other words, China cannot dump its reserves without taking huge losses and drowning its own export-driven economy.

Therefore, the answer to our big question can be changed:

Why Does China Invest in U.S. Securities?

1) Because it must.

Options for China's Reserves

If China needed to invest outside the U.S., it could not (Wines 2009). If China invested its foreign currency into, for example, the EU or Japan, it would force those allies to run large trade deficits with China-deficits that neither can absorb. The rising Yen and the rising Euro would slow both economies enormously. Therefore, if other large economic powers cannot handle trading with China, the U.S. remains the only suitable investment venue. As long as China wants to keep its exports to the U.S. strong, it must recycle the trade surplus back into the U.S. It is a systemic relationship which, as discussed, is unlikely to change.

Moreover, Chinese reserves cannot be spent at home. The way that China fixes its currency, in which their central bank intervenes to set the value of the Yuan by buying dollars and selling Yuan, does not allow it to convert any of their dollars back into Yuan. If it did, reversing its role from buyer to seller of dollars would cause the currency to climb. This, in turn, would cause Chinese exports to collapse-an event that would tremendously cripple the Chinese financial system.

Short Term Locked in, But Long Term?

China has no option but to continue to purchase U.S. securities in the short term. If nothing else, there is nowhere else for their reserves to go. But what might happen if China slowly diversified out of U.S bonds? To do this, China may use derivatives contracts to try and hedge their bets on their bonds and move into other assets instead. Matthew Smith, President and Chief Investment Officer with Smith Affiliated Capital, states:

"The fear with China is they may be swapping Treasurys for commodities. So even though they still own a lot of Treasurys, you could wake up one morning and find that they don't have as much," (La Monical 2009)

China realizes the consequences of unloading their securities now, but it is possible that it is relying on a patient and insightful approach to investing so that, if need be, it will not have to rely on U.S. securities as its only safe haven for its reserves? Smith adds:

"I think China will gradually rotate into other assets. They won't be leaving the Treasury market anytime soon because they have no other choice. But over the long-term, China is going to do what's best for China. They just can't move that much money out of Treasurys quickly."

Nevertheless, for now, dumping Chinese assets reduces the value of what it owns.

A Lasting Relationship

Therefore, it is clear that the success of each nation is driven by the other-it is a circular pattern. The United States produces raw materials that it then sends to China for cheap manufacturing (Rivoli 2005). China sends the finished product back to the U.S., increasing its trade surplus. If demand falls in the U.S. for any reason, China's economy suffers. If China stops investing in the U.S., demand for Chinese goods will fall. This is evident from the comparison of Figure 4 to Figure 3. Therefore, it can be concluded that the two economic superpowers, the United States and China, must continue to support each other's economies, regardless of changes in interest rates and exchange rate fluctuations. There simply is no way for these two advanced and intertwined economies to function without each other.

To bring the article to a close, the threats and complaints of the Chinese government are hollow and empty. China, if it is to experience continued growth, must buy American debt; there is no other option. China's enormous investment will decline sharply in value if it tries to unload. Access to American goods would be cut off, and China's economy would slow. China needs FDI for capital and for access to new technologies. On the other side, the U.S. economy cannot accomplish its stimulus or engage in health care reform without China. The cycle is obvious: if China and the U.S. are to continue to be major economic powers, they will do it together.


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