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China's Risky Play in the U.S. Debt Market

July 31, 2014 in Economics

By James A. Dorn

James A. Dorn

The rally in U.S. Treasuries this year is due in large part to China’s continued appetite for longer-term U.S. government debt. In the first five months of this year, China bought US$ 107 billion of Treasury debt maturing in more than one year, up from US$ 81 billion for all of 2013. That pace is the fastest on record and has put downward pressure on yields even in the face of the Federal Reserve’s decision to end quantitative easing by October.

The 10-year U.S. Treasury note has fallen from 3 percent at year-end 2013 to 2.54 percent, a decline few expected. The corresponding rise in bond prices, however, is unlikely to continue once the U.S. economy heats up, QE ends and the Fed begins to increase its benchmark rate. Fed Chairwoman Janet Yellen is in no hurry to increase rates, but the longer she waits, the more costly will be the final adjustment process.

Keeping rates too low for too long helped produce the Great Recession. Doing so again risks another crisis. As Kansas City Fed President Esther George warned in a recent speech: “Waiting too long (to increase rates) may allow certain risks to build that, if realized, could harm economic activity.”

China has picked up the pace of its purchase of Treasuries, but both it and the United States would be better off if it relied less on the accompanying investment and export-led model.”

China’s willingness to support U.S. Treasury prices and help keep yields low stems from a desire to stimulate export growth and protect state-owned enterprises. Instead of allowing market forces to determine the exchange rate, the authorities peg the yuan-dollar rate while allowing some variation to frustrate one-way speculation.

Most experts expect the long-run real exchange rate to appreciate, which would help rebalance China’s economy. But this year the yuan has been declining, exports expanding and foreign exchange reserves accumulating. A large part of those reserves are invested in U.S. Treasuries. Moreover, the carry trade (incentivized by the Fed’s zero interest rate policy) has led to an inflow of dollars that ultimately end up at the People’s Bank of China (PBOC). Under a floating rate system, those inflows would increase the yuan’s nominal exchange rate. However, under the pegged system, the PBOC supplies base money to prevent appreciation of the yuan, and then sells bills to absorb the newly created base money and …read more

Source: OP-EDS

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