For the sake of argument, let's assume that the headline is true -- local governments have taken on more debt than they can service in a slowing economy.
What's the endgame? Here are some possibilities, would love to see some economic modeling to quantify some scenarios.
1) Central government gradually inflates the currency to monetize the debt with a few defaults along the way. Damage is funded by Chinese creditors (defaults) and Chinese citizens (inflation), and it takes 20 years to fully play out.
2) Central government bails out bad loans by selling a portion of their $3T in foreign reserves, including $1T of US government debt. Chinese creditors, investors and citizens are made whole. Foreign bond prices fall and interest rates rise, causing recession and financial crisis in the US.
3) Central government bails out a few well connected players, but mostly allows market forces to run their course. Shadow banks and local government financing vehicles go bankrupt, causing a cascade of bankruptcies in the real economy, and economic growth is 200 basis points under potential until 2022.
> 2) Central government bails out bad loans by selling a portion of their $3T in foreign reserves, including $1T of US government debt. Chinese creditors, investors and citizens are made whole. Foreign bond prices fall and interest rates rise, causing recession and financial crisis in the US.
That is unlikely to be the result. The US national debt is over $21T now. $1T is <5%. Dumping that much on the market at once would certainly affect interest rates, but not at a catastrophe-inducing level, and all of the normal tools used to control interest rates remain available.
By comparison, the US deficit this year is ~$0.8T, i.e. the US itself is dumping nearly that amount into the market. The Quantitative Easing program after the housing crisis was $3.5T over a few years.
It's also unlikely that they would dump the entire amount at once, because causing a sudden short-term rise in interest rates is not to their advantage (they would take a bath on bond prices). But if they divested something like $100B/year, the effect on the market would be minimized.
Russia recently dumped the majority of its UST, widely believed to cause the treasury rate to hit 3%. Some commentators speculated the reason for this was
1) to avoid future potential sanctions
2) a trial-run to gauge how the market would react to a similar move by China.
At its peak Russia held less than $0.2T, Russia liquidated approx $50B per month for 3 months. If China dumped $75B per month for 6 months, there would be pain that would likely spread into corporate bonds.
Did Russia liquidate their Treasurys or just move them offshore?
The Kremlin may be trying to pull off a balancing act by mostly shifting its cache offshore, rather than selling outright.
Analysts at the Council of Foreign Relations this week found that holdings of American bonds in Belgium and the Cayman Islands increased by about $45 billion in the same period that Russia was reducing its U.S.-based hoard, meaning it may have been an attempt to protect against seizure.
I'd bet on a combination of 1) and 3), more of 3), to be honest, the Chinese Central Government is known as picking losers and winners (which can be seen from the outside as "market forces running their course") and the subdued economic growth can be easily masked with aggressive foreign policy rhetoric, like building some new islets in the South China Sea. Choosing 2) will most probably escalate the dangers of a military confrontation with the US, I don't see the Chinese going that route, war it's bad for business (in most cases, anyway).
> war it's bad for business (in most cases, anyway).
Most wars are great for business actually, even world wars! Let's not forget that WW2 was mostly responsible for dragging the US out of the great depression.
I think 4) Since this is local government debt, local governments start selling off their principal assets, land. And as land prices hit rock bottom, there begins a massive transfer of ownership of local public owned land to private individuals and companies. Initially there may be a flight of Chinese capital out of the country as land prices begin falling off a cliff. Then once they stabilize, there will be a big whooshing sound as money is repatriated and people start snapping up choice holdings?
I think a large amount of bitcoin prices are attributed to western banks explaining to wealthy chinese how to transfer money out of the country on a large scale.
Bitcoins don’t work for that. If you want to buy bitcoins with Currency X you need to find somone that wants to sell bitcoins for Currency X. Similarly if you want to sell bitcoins for Currency Y you need somone to buy them in Currency Y. Net result you can’t get large net cash flows unless people can exchange currency X for Currency Y.
PS: Bitcoin mining is another story, but it’s little different than building anything in China and selling abroad.
Sincerely asking: Are you serious? Do you have sources, good or otherwise (even rumors or talk of this topic)?
What exactly is it that you think is happening, if I may ask? Does a Chinese citizen, perhaps vacationing in the US, walk into BoA or WF and ask a wealth management advisor how to move money to their newly opened account there?
Possible that the central government is more exposed to this than anyone thinks due to creative accounting practices? Result might be central government is unable to conduct its policies at the same level of robustness as before? Doomsday here being that social programs, belt and road, etc might suffer. Potential downstream impacts would include dissatisfaction with leadership and a change there? Or, you know, just straight up war as a distraction of we’re talking real downsides.
A temporary 4% drop in the S&P 500 (based on closing prices) is hardly a mini-crash. If you check the historical price charts over the past several decades, movements of that size are common. And analysts make up all sorts of explanations after the fact for the fluctuations just so that they have something to talk about on TV. The reality is that we don't know why; maybe it was interest rates, maybe it was something else.
The problem is we haven't seen a 4% drop for years, from a predictive of recent decades, many who wasn't in the Stock market during 2008, a 4% drop is a mini crash.
Of coz for those of us who are in it for multiple decades.... 4% drop doesn't surprise us.
The Fed manipulates interest rates in an attempt to stabilize the economy. The strategy goes something like this: slowly raise interest rates while the economy is humming along, and when a downturn comes along they quickly lower them in an attempt to boost the economy [0].
One of the dangers inherent in this strategy comes in the timing of the rate manipulations. Be too aggressive with raising rates and you may lose large amounts of economic momentum. Be too slow to raise rates and you may have nothing to lower in the event of a recession.
So if China sold off a ton of US debt and it negatively affected the world economy, the Fed would likely cut interest rates in an attempt to counter the downturn.
When you say "manipulate" you need to be clear about the mechanism.
The Fed doesn't just dictate interest rates, because who would listen to them? Instead, interest rates are set by the market.
If the Fed wants higher interest rates, they sell bonds in the market. If they want lower interest rates, they buy bonds in the market.
So if China sold a ton of US debt, that would reduce bond prices and increase interest rates. If the Fed wanted lower interest rates, it would need to buy a lot of that additional supply that China dumped on the market.
Aye, mostly. It's important to remember that the Federal Govt. has the ability to manipulate the money supply by printing money and the ability to nearly indefinitely borrow whenever they get into trouble. Note that borrowing implies issuing bonds, which will lower interest rates.
So the Fed cannot simply dictate interest rates, but if it wants to manipulate the rates there is not a whole lot stopping them. In a recession scenario I imagine they would not have much trouble justifying more borrowing to the American public.
With regard to the effect a Chinese selloff would have on the market (both the US bond market and the wider global economy) I don't know enough to comment. However, I am fairly confident that if such a selloff resulted in a major economic downturn the Fed would try to lower rates to stimulate the economy.
Whoops! You're exactly correct. Issuing more bonds increases the risk of the issuer not being able to repay the debt and thus the debtors will demand higher rates to offset this increased risk.
Although, unlike other bond issuers, the Fed has other tools in it's arsenal that would allow it to manipulate the yield curve.
Also, you can't magically liquidate Treasuries to dollars. China would have to find a buyer for it's $1T in bonds. And I don't know who has that kind of money. They wouldn't get full price.
The rates are better for newly issued bonds. Existing bonds become devalued. The point (IIUC) is that unwinding is a tricky proposition and dependent on the mix of maturities.
AFAIU, the Social Security Trust Fund will stop soaking up deficits some time in 2019 as it transitions to a net outflow of cash. I can't find the numbers but presumably this means (and has meant for several years, now) that the public (non-intragovernmental) share of yearly deficit funding has been steadily growing and will really take off next year. That in turns means foreign buyers will have increasingly more leverage to effect interest rates.
Forget about the share of outstanding debt. That's money under the bridge. Think about the year-over-year change in the share of deficit spending funded by foreign buyers. Considering how explosive deficit spending will be over the next decade because of the tax cuts, compounded by higher interest rates, we could be in for a very bumpy ride.
What once were irrelevant swings in interest rates, current account deficits, domestic savings rates, etc, could quickly come to dominate the trajectory of the economy.
Sure, the Federal Reserve could soak up the deficit. But that would be much more likely lead to inflation than in previous periods.[1] Higher inflation means foreign buyers pull out, which leads to greater inflation and less capacity to purchase the imported goods that we're completely dependent on. It also means less profit on the international market for the high-margin services and industrial products we specialize in. Europe is doing a much better job than the U.S. at controlling deficit spending, and the Euro could easily become the new reserve currency.
[1] And don't forget, the Federal Reserve's mandate is low inflation and low unemployment. Congress may need to step in to change their mandate to de-prioritize low inflation, which would send a very nasty message to investors. Decades of easy money because of our current account deficit (aka trade imbalance) and strong domestic savings (via Social Security) has left people with a twisted perception of the consequences of budget deficits and inflationary monetary policy.
> Euro could easily become the new reserve currency.
Surely you cannot be serious here. Europe is one (insert name)-exit away from total implosion. The Euro project was doomed from the very beginning: you cannot have a joint monetary policy without a unified fiscal policy (which never materialized through European consent - after failure of conquest i.e WW2)
And yet despite all the hemming and hawing the squabbling Euro area has de facto better fiscal policy than a United States firmly under the control of a single party.
The Euro area had a 2017 deficit of 0.9% of GDP, as compared to the U.S.'s 3.5%. And this is during a boom in the U.S.
The Euro isn't a better vehicle than the USD today, but it could easily become one. Not because the Euro improves but because USD will become less stable and attractive and the only realistic alternative is the Euro. Or maybe we end up with a more diversified system. Either way USD loses.
> The Euro isn't a better vehicle than the USD today, but it could easily become one.
Get back to me when Saudi Arabia starts selling oil exclusively in Euros, or better yet, once European union surpasses the US in the number of aircraft carrier strike groups. You don't seem to understand the concept of a "foreign reserve currency" if you think Euro has a chance against USD. There is more chance of physical gold replacing USD as an inter-nation trade/reserve rather than Euro!
Russia is the greatest producer of oil, or at least neck-and-neck with Saudi Arabia. Plenty of other top producers wouldn't mind switching away from a USD-denominated market, including Iran and China. Exclude the U.S. from the list of top producers and you may even have a majority of producers who would prefer a different system.
The U.S. is the world's reserve currency because everybody trades with the U.S. and the U.S. has run a current account deficit consistently since 1950, and with most of the world. That means everybody is holding USD and thus you can sell something to anybody else without needing sufficient imports from that buyer to cover the transaction. (Countries can't just buy USD willy-nilly; they need to find someone willing to trade USD for their local currency, which requires exporting some good or service.)
But that can change. Indeed, politicians are hell bent on changing it. And the global economy is exploding, meaning the U.S. won't be able to remain the center of the global commercial universe even if it wanted to.
In scenario (2), wouldn't Chinese companies be affected by the reduced demand from North America/Europe being in financial crisis? Is it understood that this would be devastating enough that China wouldn't use what is essentially a nuclear option?
This is why I'd love to see a quantitative model, there are too many players and too many variables for good intuition.
What matters for each scenario is (a) how much it costs, (b) who bears the cost, and (c) how long it takes.
If Chinese creditors, investors and citizens bear 100% of the cost in scenarios 1 and 3, but they only bear 30% of the cost in scenario 2, then scenario 2 is preferable isn't it?
But what if Chinese citizens don't have a vote, and the damage to well connected elites is lower under scenario 1? Maybe that winds up the preferred course even if total cost is greater.
Who knows without the ability to even roughly quantify the primary, secondary and tertiary effects?
That assumes you "only" have to deal with the static mass of $5.8 trillion debt. It gets even more complicated when you have to deal with the factors that have been building that debt in the first place.
Wouldn't addressing the causes of the debt build-up have an even harsher impact on the economy?
2) Central government bails out bad loans by selling a portion of their $3T in foreign reserves, including $1T of US government debt. Chinese creditors, investors and citizens are made whole. Foreign bond prices fall and interest rates rise, causing recession and financial crisis in the US.
Selling treasuries is a double edged sword. Driving up borrowing costs for the US also lowers bond prices, wiping out the Chinese government's portfolio value, right when they need the funds for a bailout. Dumping a lot of dollars on the market will drive the dollar down relative to the yuan, hurting Chinese exporters right when their economy needs it most. China has really twisted itself into a knot on this one.
Sure, defaulting on obligations is always an option.
Who would be hurt in this scenario? Who are the lenders that don't get paid back? Are they banks? Ordinary citizens saving for retirement?
When those people don't get paid back, what are the second-order consequences? Is there a cascade of defaults when they can't make good on their obligations?
1) Central government gradually inflates the currency to monetize the debt with a few defaults along the way. Damage is funded by Chinese creditors (defaults) and Chinese citizens (inflation), and it takes 20 years to fully play out.
2) Central government bails out bad loans by selling a portion of their $3T in foreign reserves, including $1T of US government debt. Chinese creditors, investors and citizens are made whole. Foreign bond prices fall and interest rates rise, causing recession and financial crisis in the US.
3) Central government bails out a few well connected players, but mostly allows market forces to run their course. Shadow banks and local government financing vehicles go bankrupt, causing a cascade of bankruptcies in the real economy, and economic growth is 200 basis points under potential until 2022.