Although investors hang on every comment by
Federal Reserve Chairwoman Janet Yellen to get insight on the direction of
interest rates and what it means for the economy and asset prices, the real
power to determine U.S. interest rates may be in the hands of China, according
to Lombard Street Research. Facing an overvalued currency that is
hurting corporate profits and slowing growth, China appears ready to dump its
$1.3 trillion in U.S. Treasury bonds to drive U.S. interest rates up and
strengthen the dollar.
The secret to China’s spectacular growth beginning in the
early 1990s was devaluing its currency to the U.S. dollar from 2.8 Chinese yuan
to 8.7 yuan. The devaluation cut the cost of Chinese labor by 68% and launched
the cheap labor manufacturing boom. Exports as a percent of GDP grew from about
13% in 1994 to 39% of GDP in 2007.
With the export boom causing huge labor demand,
approximately 200 million rural Chinese moved to cities from to 2000
to 2007. During the period, China’s Shanghai Stock Index vaulted 330%,
while the U.S. S&P Index was only up 11%. However, since 2006, the Federal
Reserve and both the Bush and Obama administrations have pursued weak-dollar
policies by pushing interest rates down. This caused the exchange rate of
the dollar to weaken and the yuan to strengthen from 8.3 yuan to 6 yuan to
the dollar.
China tried to slow the fall of the dollar by increasing its
holdings in U.S. Treasury bonds from $400 billion in 2007 to $1.33
trillion at the end of 2013. Despite spending almost a trillion dollars on
U.S. Treasury purchases, the weak-dollar policy caused the Shanghai Index to
fall by 38%. During the same period the U.S. S&P Index rose 199%.
China’s $1.3 trillion of U.S. Treasury bonds sounds like 7%
of the $17.7 trillion U.S. federal debt outstanding, but a third of
the debt was supposedly “purchased” by the U.S. government to back Social
Security and other purposes. Of the net U.S. public debt outstanding, China
owns about one in every seven dollars of U.S. Treasury Bonds.
The People’s Bank of China in November of 2013 announced it
was ending its purchase of U.S. Treasury bonds. When China sold $48
billion in Treasuries in January, the yuan weakened by 5% to 6.3 yuan to
the dollar. China has recently been intervening in the foreign exchange market
to prevent the yuan from strengthening.
Although the International Monetary Fund estimates that the
yuan is still 5-10% undervalued, Lombard believes that China’s currency is
15-25% overvalued to the U.S. dollar.
A smooth sale of its U.S. Treasury bond portfolio by China
would push up U.S. 10-year Treasury bond yields by up to ½% and U.S.
interest rates by about 1%. The People’s Bank of China could intervene in the
currency markets to smooth the yuan’s decline.
However, yuan devaluation and higher U.S. rates would be a
lethal combination for the Eurozone competitiveness. A much weaker yuan and
higher U.S. interest rates would devastate peripheral European economies that
compete with China for lower value-added manufacturing.
The weakening of the U.S. dollar that began in 2007 may have
precipitated the 2008 global financial crisis. China would prefer to not start
another international currency crisis. However, desperate to weaken the yuan to
restart growth and support employment, China will soon start dumping U.S.
Treasury bonds.
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