Understanding Sovereign Bonds- Foreign Financing of Fiscal Deficits

The rise of Neo-Mercantilism’s export-led growth in countries such as China and Japan has brought a host of Balance of Payments (BoP) and Sovereign Debt problems to the fore. These problems are paramount to the international economy, but experts and policymakers alike demonstrate ignorance of the mechanisms behind the BoP through counterproductive proposals.

Sovereign Debt Markets and the Balance of Payments are one of the most counterintuitive and complex themes that policymakers face, fallacies are therefore riddled throughout the public debate. Not even the US Secretary of State Hillary Clinton is immune to frequent blunders when engaging in the sphere of international macroeconomics. In February, 2009 for example she made a famous imploration to China that they continue their purchases of US treasuries. This simple (and fallacious) request to the Jintao administration received almost no academic criticism; despite the detrimental effect that the Secretary of State’s policy goals would have on the US economy. An analysis of Chinese purchases of US dollar-assets is therefore required in order to address the unforeseen issues associated with foreign financing of sovereign bonds.

There are two main problems with Clinton’s imploration to the Chinese- namely the nondiscretionary nature the Bank of China’s treasury purchases, and the manner in which these purchases fail to alleviate fiscal deficit serviceability.

Firstly, the Bank of China (BoC), and Chinese Sovereign Wealth Funds do not simply decide to purchase huge quantities of US dollar-assets (in the form of bonds for now) based on whimsical choices of investment hubs. The decisions are not arbitrary; they are natural. The Bank of China’s decision to keep the RMB devalued means that they acquire huge foreign exchange reserves primarily in the form of US dollars. These dollars must be invested somewhere, and the only two markets large enough to absorb this influx of liquidity are the Eurozone and the US. Of these two options the US financial sector’s development and reputation of a safer investment location makes it the obvious choice.

Even if the Chinese decided to shift their exchange reserves to the Eurozone, they would have to undergo huge and costly transactions changing their accumulated dollars to Euros, in the process making huge losses in arbitrage as the dollars were devalued. It is clear with this in mind that Clinton’s beggary to the Chinese was completely ineffectual. The only way the Secretary of State could get her wish of increased foreign purchases of dollar-assets would be through the BoC devaluing the RMB even more, acquiring more reserves, before shoving them back into the bloated US treasuries market.

This leads us to the second (and far more important) fallacy underlying the Secretary of State’s understanding of foreign financing. The only way for China to unilaterally increase its purchase of US bonds would be to increase the volume of its capital exports to the US, thereby forcing a larger current account surplus as well (By definition the quantity of capital that is imported or exported is equal to the quantity of goods that are imported or exported respectively). The influx of demand for dollars would inflate the value of the currency, increasing the trade deficit by an even larger amount, and consumption on imports would boom leading to an even more indebted household sector.

In addition, interest rates on bonds would be largely unaffected and the government’s debt would become no more serviceable than before. This is due to the fact that with an appreciation of the dollar, many tradable sector firms would be adversely affected, and workers would be made redundant quite quickly. As a consequence, the US fiscal deficit would rise in a quantity roughly equal to the initial influx of Chinese bond purchases which caused the appreciation or by contrast the US would have endure higher levels of unemployment (The change in the capital deficit will be exactly equal to the trade deficit).

The point is that the Obama administration would have to issue an amount of bonds roughly equal to or in excess (A few economists have tried to calculate the exact relationship with little success) of the amount purchased by the Chinese. The influx of supply would equal the influx of demand, and the price (in the form of interest) would have no net effect. The difference for the American economy would be that both the current account deficit and the fiscal deficit would have grown. Americans, in essence, would be forced into an even larger imbalance between consumption and production.

Hillary Clinton’s imploration to the Chinese in this light is clearly opposed to American interests, and yet the entire economics profession remained largely apathetic to her announcements. Today, the profession continues to be mute when confronted by similar policies that flout textbook macroeconomics.

http://www.telegraph.co.uk/finance/financialcrisis/4782755/Hillary-Clinton-pleads-with-China-to-buy-US-Treasuries-as-Japan-looks-on.html

Leave a Reply