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ByCharles Engel

Treasury bonds that they might have to sell some day.  The trap that they have fallen into, the experts say, is that they have assets whose price may now fall.  If only they had followed my investment strategy: investing in equities and bonds from around the world, with only a small fraction of my portfolio in U.S. government bonds.  I am so happy today, because the value of my portfolio might increase!

Here is a chart to remind us how the dollar has done against some major currencies in the past year:

Here is another chart that shows how the dollar has done against currencies of some Asian and Pacific currencies:

The foreign currency value of those U.S. Treasuries being held by China has risen almost across the board (with a slight dip only relative to the Japanese yen and a few other currencies.)  And, actually, the dollar value of the Treasuries rose as well – the yield on a 10-year Treasury note has declined from 3.76% in early April 2008 to 2.66% at the beginning of this month.

I understand the perils of blogging and offering public opinions on difficult economic issues.  I’m chicken, and have done very little of that.  (My only previous posting here was last May, when I argued that there was an economically sound case – despite what some commentators said – for the position that there was a bubble in oil prices.)  But in this community, nobody ever has to admit they are wrong.  What am I referring to?  (Not oil prices, though I haven’t seen many commentators admitting they were wrong on that one either.)  Back in 2008 and earlier, we heard over and over again what a mistake it was for the Chinese to be acquiring U.S. Treasuries.  There was going to be a huge reversal of the U.S. current account deficit, and the dollar would plunge.  As China was forced to unwind its position in Treasuries, U.S. interest rates would soar.  But for some reason, the opposite happened to foreign exchange prices and interest rates.  But the commentators weren’t wrong.  No, now the Chinese are really in a trap!  Now if they sell their Treasuries, the dollar and the price of Treasuries really, really will go down. 

Let me be clear what I am saying and what I am not saying.  I think it might be right that the dollar will weaken, and the price of Treasuries will go down.  That event may well be accentuated by a market impact effect – the Chinese holdings of Treasuries are so large that the mere act of unwinding their position may exacerbate the fall in the dollar and the increase in U.S. interest rates.  I’m reluctant to predict that will happen.  I know from experience, both in my academic work and in my own remarkably bad investment choices (the best advice I can give anyone on investment is to watch me and do the opposite), that it is very hard to predict the change in asset prices.  But it certainly is plausible that these asset prices will move in the direction, at least temporarily, of a weaker dollar and weaker Treasuries as the commentators say.

But even if that happens, it does not vindicate the assertions that have been made for years that China is following obviously misguided policy by buying U.S. Treasury assets to keep the yuan from rising to its market-determined level.  The whole issue is a complex one, and over the next few weeks or months I will take the plunge and discuss in this space some of the pros and cons of that policy.  In this posting, my main objective is to get across the point that while it may not have been an intentional investment strategy on the part of the Chinese, going long in U.S. Treasury bonds has, so far, had a great return.  (Cutting through my smart-alecky remarks, that was the point of the charts above.)

It is helpful, I think, to break down the issue step by step.  One criticism of the Chinese takes as given the policy to maintain the value of the currency, but questions the portfolio the Chinese chose to hold.  Instead of acquiring mostly dollars, the argument goes that the Chinese should have held a more diversified portfolio of government bonds from the Eurozone and other countries.  In general, I believe diversification is a good thing.  That’s why my own portfolio held such a small share of U.S. Treasuries.  But whether by design or by luck, the Chinese portfolio has done really well compared to most.  U.S. Treasuries have been the winner during this crisis. 

By the way, it may not have been entirely luck.  A few years ago, some – notably Ben Bernanke – made the argument that China and other Asian central banks were acquiring U.S. bonds as a cushion in the event of a future financial crisis.  In this one, it seems, only the Chinese seem to have acquired a big enough war chest to scare off speculators and prevent a steep drop in their currency.

I have contrasted the Chinese portfolio choice with my own, but of course there is a big difference in the wealth of the Chinese central bank and my own or that of other individual investors.  Unlike us, if China makes significant changes in its portfolio, it will probably impact asset prices.  This may be a temporary liquidity effect or it may be a more permanent effect by influencing the risk premia the market requires to hold certain assets.  That is, if the Chinese start selling Treasuries, it might push down their price even if the fundamental value of Treasuries is not influenced by this action, because there are not enough buyers in the short run to sop up all the Treasuries that would flood the market.  Or it might have a more permanent effect depressing the price if the rest of the market (the non-Chinese part) requires a larger risk premium to be induced to hold U.S. government bonds.

The claim that rebalancing the Chinese portfolio will depress U.S. Treasury prices or the value of the dollar is, however, not straightforward.  I would like to see the empirical evidence that supports this claim.  The market for U.S. Treasury bonds is very deep and very liquid, so it is not patently obvious that even large sales by China will have huge consequences for asset prices.  But even if the claim turns out to be true, there is another issue.  If the Chinese should have been diversifying their portfolio all along, wouldn’t large purchases of Eurozone, U.K. and Japanese bonds have pushed up the prices of those bonds and their currencies?  And wouldn’t the missing purchases of U.S. bonds have pushed down the dollar and the prices of U.S. government bonds?  In other words, if diversification is going to have this effect on the level of asset prices, what difference does it make if the Chinese do it sooner or later?  Indeed, it seems like it makes sense to wait until the dollar is strong before you start diversifying (if you are lucky or wise enough to foresee an increase in the value of the dollar.)  The argument for doing it earlier must rely on some sort of non-linear effect – that the market impact effect is going to be larger if the Chinese start unwinding their big pile of Treasuries now instead of having done it all along.  Maybe that story is right, but again I would like to see the evidence.

Indeed, as the Chinese have acquired their stash of Treasuries over the past seven or eight years, the dollar weakened, not strengthened, against most currencies (though not, of course, the yuan.)  To be sure, that was part of the case against the Chinese policy – that they were acquiring an asset that was losing value.  Instead they could be investing in U.S. real estate and other high-yielding investments. 

It is hard to make the case, in other words, that the Chinese have done a bad job investing their assets.  The real case must be that they should not have been acquiring so many assets in the first place.  That is, if China had not been actively engaged in buying U.S. Treasuries in exchange for yuan, then the yuan would have strengthened and Chinese national saving would have been lower.  It would have been better to have consumed than to acquire so many assets, even assets that have performed as well as U.S. Treasury bonds.  I feel that way a little bit myself – if only I had spent my money on a fancy sports car and a Caribbean vacation instead of saving for my kids’ college tuition, I would be so much happier now.  I may have already mentioned that my investment strategy wasn’t quite as good as the China’s.  But maybe there is still something to the argument – there surely might have been room for the Chinese to consume more.

In future blogs I will address the following three issues, among others: (1)  Would letting the yuan float really have led to a large increase in Chinese spending?  (2)  Even if it did, do we omniscient American economists know how much the Chinese should be saving or is it really obvious that Chinese saving is the root of a financial collapse that some now say will be with us for years to come?  (3)  Are there good reasons for the Chinese to have tried to offset the market forces in favor of buying the yuan, or are we always better to let the wisdom of the market determine the exchange rate?