“Voldemort runs out of money” –MacroMan

“Voldemort” is the name MacroMan has given to the Central Bank of China, which has been doing its best to recycle dollars earned from imports into US Treasuries in order to prevent the yuan from rising.

Now, Keith Bradsher of the NYT says the Central Bank of China is in a bind. It has bought $1T in Treasury bonds and Agencies from Fannie and Freddie. Now, the Agencies are collapsing in value, and dollar weakness is eating at the value of all of those bonds. And the Central Bank doesn’t have large enough capital reserves to make its books balance.

The consequences are likely to be drastic, though it takes some explanation to understand how all the sloshing of money is likely to come out. See Brad Setser for a professional’s take on the situation plus interesting discussion. Here’s is mine:

A low yuan is desirable from the standpoint of keeping exports high and thereby keeping Chinese employed, which is probably the government’s primary concern However, it carries with it the problem of inflation.

To keep the yuan low, the government has to keep buying US securities. It probably won’t buy Agencies without ironclad guarantees. Treasuries are also kind of iffy, since the rates are so low. Therefore, it will probably buy stocks and corporate bonds. In this case, look for the US stock market to rise.

Problem: they are short on capital. As Bradsher says

The central bank has gone to great lengths to maintain its foreign purchases. The money to buy foreign bonds has come from the reserves required that commercial banks must deposit with the central bank. In effect, China’s commercial banks have been lending the central bank more than $1 trillion at an interest rate of less than 2 percent.

Therefore, there is a finite chance that the strategy will fail and threaten to put the Central Bank in default. If it does, the Chinese will be forced to dump their dollar holdings, driving the dollar down and pressuring US interest rates to rise.

The US can respond in two ways. It can raise interest rates, plunging the US into deep recession. Or, it can allow the dollar to fall, exacerbating inflation. More likely, we can expect a combination of both.

My prediction has been that the Chinese would decide to lower their dollar holdings and let the yuan rise. This would dampen inflation at some cost to employment, but there is still so much infrastructure development to be done that at a modest cost they could compensate that way.

So far, they have not done so. If Bradsher and MacroMan are right, then we could be about to see another financial shock.

There’s one more interesting sidelight. A lot of Chinese politics is based (not entirely unreasonably) on xenophobia. So, there is a lot of anger at the US, and consequently a higher than usual likelihood that they are going to generate the financial shock in a manner that is most painful to the US. If they do so, it could trigger a broader panic, as other US dollar holders react. Bradsher:

Victor Shih, a specialist in Chinese central banking at Northwestern University, said that when he visited the People’s Bank of China for a series of meetings this summer, he was surprised by how many officials resented the institution’s losses.

He said the officials blamed the United States and believed the controversial assertions set forth in the book “Currency War,” a Chinese best seller published a year ago. The book suggests that the United States deliberately lured China into buying its securities knowing that they would later plunge in value.

“A lot of policy makers in China, at least midlevel policy makers, believe this,” Mr. Shih said.