China’s morbid dependency

In the lead up to Standard and Poors’ (S&P) downgrade of US Government debt, the largest holder of US Treasuries – China – had stepped-up its warnings and condemnation of the US Government’s fiscal mis-management and its deteriorating debt repayment capability.

In November 2010, China’s Dagong Global Credit Rating Co. reduced its credit rating for the US to A+ from AA, citing a deteriorating intent and ability to repay debt obligations after the Federal Reserve announced more monetary easing (‘Quantitative Easing’). At this point in time, Dagong’s US credit rating was four notches below the global credit ratings agencies: S&P, Moodys and Fitch.

And in the month prior to the S&P downgrade, senior Chinese officials expressed strong disdain at the US’ economic mis-management to Stephen Roach, Morgan Stanley’s Executive Chairman of Asia:

The Chinese have long admired America’s economic dynamism. But they have lost confidence in America’s government and its dysfunctional economic stewardship. That message came through loud and clear in my recent travels to Beijing, Shanghai, Chongqing, and Hong Kong.

Coming so shortly on the heels of the subprime crisis, the debate over the debt ceiling and the budget deficit is the last straw. Senior Chinese officials are appalled at how the United States allows politics to trump financial stability. One high-ranking policymaker noted in mid-July, “This is truly shocking… We understand politics, but your government’s continued recklessness is astonishing.”

Then, in the days prior to the S&P downgrade, Dagong again reduced its US sovereign debt rating to A from A+, placing the US five notches below AAA and on par with Russian sovereign debt.

And following the S&P downgrade, the Chinese Government blasted the US Government’s debt addiction, demanding that the US live within its means and cut its military and social security spending in order to ensure the safety of China’s US dollar assets, as well as advocating the creation of a new reserve currency:

China, the largest foreign holder of U.S. debt, demanded Saturday that the United States tighten its belt and confront its “addiction to debts” in the wake of Standard & Poor’s decision to downgrade the U.S. credit rating.

China currently owns $1.2 trillion of U.S. Treasury debt, the largest stake of any central bank. The commentary carried by the state-run Xinhua News Agency was China’s first official response to the S&P decision.

“The U.S. government has to come to terms with the painful fact that the good old days when it could just borrow its way out of messes of its own making are finally gone,” Xinhua said.

It said the rating cut would be followed by more “devastating credit rating cuts” and global financial turbulence if the U.S. fails to learn to “live within its means.”

“China, the largest creditor of the world’s sole superpower, has every right now to demand the United States to address its structural debt problems and ensure the safety of China’s dollar assets,” it said.

Xinhua said the U.S. must slash its “gigantic military expenditure and bloated social welfare costs” and accept international supervision over U.S. dollar issues.

Last month, China’s top general, Chen Bingde, also linked America’s financial woes to its military budget and asked whether paring back on defense spending wouldn’t be the best thing for U.S. taxpayers.

Such comments reflect China’s desire that the United States reduce its military presence in Asia. The U.S., rattled by China’s military buildup, also routinely chides China for its fast-growing defense spending.

Xinhua also suggested a new global reserve currency might be necessary to replace the dollar, a position China has frequently advocated.

“Mounting debts and ridiculous political wrestling in Washington have damaged America’s image abroad,” Xinhua said. “To cure its addiction to debts, the United States has to re-establish the common sense principle that one should live within its means.”

China’s concern about the US Government’s ability to repay its creditors is understandable, given it holds around $1.2 trillion of US Treasuries, equating to nearly 30% of total outstanding US Treasuries as at end-2009 (see below US Treasury chart):

The acceleration of China’s US Treasury holdings – from 5% in 1994 to around 28% as at end-2009 – coincided with the 50% devaluation of the Yuan against the USD in early 1994 (denoted by the black vertical line).

This devaluation of the yuan represented a deliberate policy action undertaken by the Chinese authorities in the wake of the mid-1990s Asian Financial Crisis in order to both promote export-led growth and insulate China’s financial system from future external shocks by accumulating large foreign-exchange reserves. The Chinese Government achieved this devaluation by ‘sterilising’ its trade surpluses via selling the Chinese yuan and buying USD denominated assets, including Treasury Bonds.

For over a decade China’s policies achieved their goal, with China’s holdings of US Treasuries offsetting declining holdings by US households, thereby enabling higher levels of US consumption – much of which was spent on imports from China (see below US Treasury chart):

But in being so reliant on financing from China to help promote growth and fund its budget deficits, the US has handed China considerable political leverage.

With the US Government now monetising its debts (via ‘Quantitative Easing’), there is the risk that China might decide to offload a large share of its Treasury holdings, which could, other things equal, eventually lead to a sharp depreciation of the USD and force the US to raise interest rates in order to attract capital from other investors.

However, the likelihood of this scenario playing out is slim since a large sell-off by China could:

  1. decrease the value of China’s remaining dollar-denominated assets, leading to large investment losses;
  2. diminish US demand for Chinese imports, either through a rise in the value of the yuan against the USD or a reduction in US economic growth via higher interest rates; or
  3. provoke protectionist measures in the US against China.

At the end of the day, China and the US are caught in a morbid dependency whereby China sells its goods to the US and the US borrows money from the Chinese to pay for these goods. Like it or not, both nations are inextricably linked, despite the often-heard claim that China has de-coupled.

Which brings me to a related dilemma arising from the current market ructions: assuming the US and European economies experience another protracted slowdown, can China maintain its current growth trajectory?

To help answer this question, lets first examine the statistics.

First, China’s exports by destination:

As you can see, the US and EU account for around 35% of China’s exports.

Second, the composition of China’s GDP:

This chart illustrates two important points. First, in 2009, the last time Western nations were in recession, declining exports lopped almost 3% from China’s GDP. There is no “decoupling”.

Second, China’s GDP growth has become increasingly dependent upon fixed asset investment, which peaked at a whopping 90% of GDP in 2009, and has surpassed the peak levels reached by both Korea and Japan during their industrialisation.

This increase in fixed asset investment arose after the Chinese government embarked on a massive fiscal and monetary stimulus program in the latter half of 2008 to counter the aftershocks of the global financial crisis.

The maintenance of artificially low interest rates at China’s state-owned banks – which punishes the country’s savers (households) and encourages over-investment (speculation) in housing, as well as over-investment by state-owned enterprises that are able to borrow at subsidised rates from China’s banks – has also contributed to the fixed asset boom.

As has been well documented on this blog (most recently here), much of this investment appears to have been channelled into unproductive ventures, which raises the prospect of China’s banking system (read depositors) being saddled with a significant amount of non-performing loans.

Another worrying trend for China, as evident in the above chart, is private consumption’s declining share of GDP growth, as well as both labour income and personal disposable income falling as a share of national income and GDP (see below charts):

In the event that the US and European economies do enter a protracted downturn that crimps imports from China, the Chinese authorities will have to engineer one (or a mix) of the following outcomes in order to maintain current rates of GDP growth:

  1. maintain high levels of fixed asset investment;
  2. shift GDP growth towards domestic consumption; or
  3. increase exports to other nations.

Maintaining China’s recent rate of fixed asset investment appears unsustainable. There is only so much infrastructure, buildings and factories that can be built before overcapacity is reached (if it is not already).

Shifting GDP growth away from fixed asset investment and exports towards domestic consumption is the authorities’ end goal. However, as shown by the above charts, the trend is currently moving in the wrong direction with consumption’s share of GDP falling, suggesting that this outcome is not achievable any time soon.

Finally, increasing exports to other nations (e.g. Asia) to offset declining exports to the US and EU would likely be difficult, as protracted slowdowns in the US and EU would likely adversely affect growth in China’s other trading partners, affecting their demand for Chinese goods.

Ultimately, any hard landing in the US and EU is likely to adversely affect China’s growth prospects one way or another, although the extent and timing is uncertain.

With these thoughts in mind, I will leave you with some sage advice from Michael Pettis, who believes that China can avoid a hard landing, but not an ultimate day of reckoning (via

I would argue that we urgently need to see a shift in the economy away from infrastructure, SOEs and real estate towards service industries and SMEs, especially those that are labor intensive. Until we do it is pretty meaningless to talk about a real adjustment in the engines of economic growth.

China has no choice but to adjust, but as long as it is easy to borrow – and I think we have at least four or five more years during which time debt levels can continue rising before we hit crisis levels – the adjustment problem can always be put off a little longer. That is why we are unlikely to get a real sharp slowdown in growth for at least another year or two.

But what to do about rising debt levels? This is the real problem China is facing now, and my biggest concern is that policymakers are buying into the argument that China can “grow out” of the current debt burden, just as it did after the banking crisis of a decade ago. In other words, if we keep investment levels high, we can keep growth high, in which case we can safely ignore the huge pile of debt, just as we were able to ignore the huge pile of NPLs that the banks had accumulated in the 1990s.

Contrary to popular opinion, China did not grow its way out of the previous debt crisis. What happened was very different. By keeping interests rate incredibly low, China was able to do two things.

First, very low interest rates presented a huge subsidy for borrowers, so it allowed them to borrow and invest in every conceivable project, whether of not it made economic sense. Of course all this investment created growth in the present, but because investment was misallocated, it simply meant that in future years growth would be much lower. To that extent, we didn’t have real growth – we simply overstated current growth rates in exchange for being forced to write the growth off in the future. Over the next few years we are going to pay for that misallocated investment in the form of slower growth. That means that much of the growth that allowed us to “grow” out of the debt problem simply involved pushing the real cost of the debt crisis forward.

Second, very low interest rates effectively created substantial debt forgiveness for the borrowers, so again even with the artificially high growth, China did not “grow out” of its debt. It just wrote most of the debt off, at the expense of course of depositors. This is why consumption collapsed during this period as a share of GDP.

For this reason the idea that we can “grow” out of the debt problem once again by keeping investment high is wrong. First, it would only increase capital misallocation and debt levels, and would require even lower growth in the future. We can’t keep pushing the cost off into the future, as attractive an option as that always seems. Second it would put unbearable pressure on household income and consumption, and so ensure that the one thing China needs above all – a rapid rise in household consumption – is all but impossible.

[email protected]

Leith van Onselen


  1. Jumping Jack Flash

    That chart showing the amount of US debt held by other countries is extremely interesting.

    I had no idea Japan dumped a heap of dollars starting c2004. Coincidence that bad things started happening shortly after that?

    If China follows Japan it seems it would be disastrous.

    I must do a little more research into this dumping by Japan. Very interesting.

    • Weimar Republic

      Self evidently the sky didn’t fall in when Japan reduced their holdings. In the past year they have increased their holdings by 16%.

      On the comments from China, if they view the current circumstances as a problem then they should acknowledge complicity for the situation they find themselves in, for the reasons given in the article.

      These comments (from the China bloke) seem to reflect the ongoing tension and merely an opportunity to fire back at the US after being subject to lots of criticism for their currency manipulation.

      • Weimar Republic

        and from May 08 they started steadily increasing again. as of May 2011 they owned 912 bill.

  2. Having read all that, and noted the composition of GDP charts, check out what that moron Pascoe wrote yesterday:

    What’s more, Beijing knows it has to flick the switch from exports to domestic consumption to maintain the strong economic growth it needs for social stability. That’s officially spelt out in the latest five-year plan. And, unlike the US, China is actively pursuing the required economic reform instead of just talking about it.

    China is doing no such thing.

    It has been official Chinese policy to “flick the switch to consumption” for many years, but every year the imbalances get worse. The policy response to the 2008 financial crisis — open the credit taps and build things — worsened the imbalances considerably, and if the contagion spreads to China this time the policy response is likely to be similar. Like Bernanke and the printing press, they can’t help themselves, they don’t know anything else.

    • Yes, Pascoe…….always good for a laugh. The problem is that China seems to have a never ending ability to paper over the problems it faces. How long can it last? Who knows? But in the meantime, we keep getting fed this drivel all the while being told that becoming a Hole Digging, Chinese Serf is the best thing for us and will make us the envy of the world.

      I for one am tired of it. I have no interest in blowing sunshine up the butts of the miners. I work in a non-mining sector and we are on the verge of getting absolutely hammered by the fallout created by this so called boom.
      250 people just got laid off last week with no doubt plenty more to come. Try telling them that the Chines will save us

      • Maybe you should direct some of your anger at the RBA? Having the highest interest rates in the developed world creates an obvious carry trade, the current strength of the AUD isn’t all about mining. (Presuming the problems in your industry are caused by the strong AUD?)

        Of course the RBA can’t really justify dropping interest rates at the moment, but the likelihood that any drop in interest rates will be used by housing specufesters to blow an even bigger bubble is hardly the fault of the mining industry is it?

      • Delraiser, you’re a kindred spirit!

        You should post here more often and help me fend off the China Fanboys.

        Mining: They get rich, while you get laid off

  3. UC top post. The key thing for me is China’s dependence on the US/EU given percentage of the export market. Just how Swan see’s us isolated from all this is astounding.

    BTW cool USD toilet roll.

    Here’s the Gordon Brown one I got when living in the UK – it seemed very appropriate when he sold the UK’s gold, and some US guy named the event “Brown’s Bottom”

  4. Thanks,
    The notion that China switching to domestic based consumption would provide a lasting solution that maintains the current growth in GDP and steers the Chinese economy and society into calmer waters overlooks some key sociopolitical issues. The first is that the country is ruled by a communist party firmly focused on central planning and staying in power. Societies where citizens have experienced a substantial and sustained increase in the standard of living invariably demand more freedom….how is that likely to play out in China? Peacefully?
    The second problem is that China is not ethnically homogenous and there are large ethnic groups which are centred on geographical regions. If (when) the country becomes more liberal, at least some of these groups will be moved to consider independence….with the likelihood of armed conflict.
    Students of Chinese history would point to periods of long stability interrupted by decades long periods of extreme social and political upheaval, including famine and civil war.
    As a nation we are increasingly dependent on how China’s future plays out, but apparently do not consider it prudent to factor in the potential for a violent and protracted period of upheaval.

  5. Since your quoting Michael Pettis here is what he says about China selling/buying US Bonds –

    Foreign capital, go home!

    Is the PBoC going to stop buying USG bonds? Once again we are hearing worried noises from various sectors about the possibility of a reduction in Chinese purchases of USG bonds.

    The threat of a looming US default seems to be driving this renewed concern, although I am not sure that the PBoC really is worried about not getting its money back. After all if the US defaults, it will be mainly a technical default that will certainly be made good one way or the other. Since the PBoC doesn’t have to worry about mark-to-market losses, unlike mutual funds, I think for China this is largely an economic non-event (not that there isn’t good mileage in pointing to the sheer silliness of the US political process). Still, for domestic political reasons it needs to be seen huffing and puffing over American irresponsibility.

    Xia Bin, an adviser to the central bank, told reporters earlier this month that China should speed up reserve diversification away from dollars to hedge against risks of the US currency’s possible long-term decline.

    Let’s leave aside the fact that every six months we have heard the same thing for the past several years, and nothing has happened, shouldn’t we nonetheless be worried? Won’t reduced PBoC purchases be disruptive to the US economy and to the US Treasury markets?

    No, they won’t, and anyway they aren’t going to happen.

    Muddled Thinking

    There is so much muddled thinking on the issue, even from economists who should know better, that I thought I would try to address what it would mean if the PBoC were actually serious and not simply making noises aimed at domestic political constituents.

    First of all, remember that the PBoC does not purchase huge amounts of USG bonds because it has a lot of money lying around and doesn’t know what to do with it. Its purchase of USG bonds is simply a function of its trade policy.

    You cannot run a current account surplus unless you are also a net exporter of capital, and since the rest of China is actually a net importer of capital (inward FDI and hot money inflows overwhelm capital flight and outward FDI), the PBoC must export huge amounts of capital in order to maintain China’s trade surplus. In order the keep the RMB from appreciating, in other words, the PBoC must be willing to purchase as many dollars as the market offers at the price it sets. It pays for those dollars in RMB.

    What does the PBoC do with the dollars it purchases? Because it is such a large buyer of dollars, it must put them in a market that is large enough to absorb the money and – and this is the crucial point – whose economy is willing and able to run a large enough trade deficit.

    Simple Math

    This last point is what everyone seems to forget when discussing Chinese purchases of foreign bonds. Remember that when Country A exports huge amounts of money to Country B, Country A must run a current account surplus and Country B must run the corresponding current account deficit. In practice, only the US fulfills those two requirements – large and flexible financial markets, and the ability and willingness to run large trade deficits – which is why the PBoC owns huge amounts of USG bonds.

    If the PBoC decides that it no longer wants to hold USG bonds, it must do something else. There are only four possible paths that the PBoC can follow if it decides to purchase fewer USG bonds.

    The PBoC can buy fewer USG bonds and purchase more other USD assets.
    The PBoC can buy fewer USG bonds and purchase more non-US dollar assets, most likely foreign government bonds.
    The PBoC can buy fewer USG bonds and purchase more hard commodities.
    The PBoC can buy fewer USG bonds by intervening less in the currency, in which case it does not need to buy anything else.

    Since these are the only ways that the PBoC can reduce its purchases of USG bonds, we can go through each of these scenarios to see what would happen and what the impact might be on China, the US, and the world. We will quickly see that none of them imply calamity. On the contrary, every outcome is neutral or positive for the US.

    To make the explanation easier, let’s simply assume that the PBoC sells $100 of USG bonds. Since the balance of payments must balance, this immediately implies that there must be corresponding changes elsewhere in trade and capital flows.

    1. The PBoC can sell $100 of USG bonds and purchase $100 of other USD assets.

    In this case there has been no change in the balance of payments and basically nothing else would change. The pool of US dollar savings available to buy USG bonds would remain unchanged (the seller of USD assets to China would now have $100 which he would have to invest, directly or indirectly, in USG bonds), China’s trade surplus would remain unchanged, and the US trade deficit would remain unchanged. The only difference might be that the yields on USG bonds will be higher by a tiny amount while credit spreads on risky assets would be lower by the same amount.

    2. The PBoC can sell $100 of USG bonds and purchase $100 of non-US dollar assets, most likely foreign government bonds.

    Since in principle the only market big enough is Europe, let’s just assume that the only alternative is to buy $100 equivalent of euro bonds issued by European governments. The analysis doesn’t change if we include other smaller markets.

    There are two ways the Europeans can respond to the Chinese switch from USG bonds to European bonds. On the one hand they can turn around and purchase $100 of USD assets. In this case there is no difference to the USG bond market, except that now Europeans instead of Chinese own the bonds. What’s more, the US trade deficit will remain unchanged and the Chinese trade surplus also unchanged.

    But Europe might be unhappy with this strategy. Since there is no reason for Europeans to buy an additional $100 of US assets simply because China bought euro bonds, the purchase will probably occur through the ECB, in which case Europe will be forced to accept an unwanted $100 increase in its money supply (the ECB must create or borrow euros to buy the dollars).

    On the other hand, and for this reason, the ECB might decide not to purchase $100 of US assets. In that case there must be an additional impact. The amount of capital the US is importing must go down by $100 and the net amount that Europe is importing must go up by that amount.

    Will this reduction in US capital imports make it more difficult to fund the US deficit? Not at all. On the contrary – it might make it easier. If US capital imports drop by $100, by definition the US current account deficit will also drop by $100, almost certainly because of a $100 contraction in the trade deficit (the US dollar will decline against the euro, making US exports more competitive and European imports less competitive).

    A contraction in the US trade deficit is of course expansionary for the US economy. Since the purpose of the US fiscal deficit is to create jobs, and a $100 contraction in the trade deficit will also create jobs, the US fiscal deficit will contract by $100 for the same level of job creation – perhaps even more if you believe, as most of us do, that increased trade is a more efficient creator of productive jobs than increased government spending.

    In other words although there is $100 less demand for USG bonds, there is also $100 (or more) less supply of USG bonds, in which case there is no need for a price adjustment.

    This is the key point. If foreigners buy fewer USD assets, the US trade deficit must decline. This is almost certainly good for the US economy and for US employment. When analysts worry that China might buy fewer USG bonds, they are actually worrying that the US trade deficit might contract. This is something the US should welcome, not deplore.

    But the story doesn’t end there. What about Europe? Since China is still exporting the $100 by buying European government bonds instead of USG bonds, its trade surplus doesn’t change, but of course as the US trade deficit declines, the European trade surplus must decline, and even possibly go into deficit. This is because by selling dollars and buying euro, China is forcing the euro to appreciate against the dollar.

    This deterioration in the trade account will force Europeans either into raising their fiscal deficits to counteract the impact of fewer exports or letting domestic unemployment rise. Under these conditions it is hard to imagine they would tolerate much Chinese purchase of European assets without responding eventually with anger and even trade protection.

    3. The PBoC can sell $100 of USG bonds and purchase $100 of hard commodities.

    This is no different than the above scenario except now that the exporters of those hard commodities must face the choice Europe faced above.

    Stockpiling commodities, by the way, is a bad strategy for China but one that it seems nonetheless to be following to some extent. Commodity prices are very volatile, and unfortunately this volatility is inversely correlated with Chinese needs.

    Since China is the largest or second largest purchaser of most commodities, stockpiling commodities is a good investment only if China continues growing rapidly, and a bad investment if its growth slows. This is the wrong kind of balance sheet position any country should engineer. It simply exacerbates underlying conditions and increases economic volatility – never a good thing, especially for a very poor and undeveloped economy like China’s.

    4. The PBoC can sell $100 of USG bonds by intervening less in the currency, in which case it does not need to buy anything else.

    In this case, which is the simplest of all to explain, China’s trade surplus declines by $100 and the US trade deficit declines by $100 as the RMB rises.

    The net impact on US financing costs is unchanged for the reasons discussed above (a lower trade deficit permits a lower fiscal deficit). Chinese unemployment will rise because of the reduction in its trade surplus unless it increases its own fiscal deficit. Beijing, of course, is in no hurry to try out this scenario.

    It’s about trade, not capital

    This may sound counterintuitive to all except those who understand the way the global balance of payments work, but countries that export capital are not doing anyone favors unless incomes in the recipient country are so low that savings are impossible or unless the capital export comes with needed technology, and countries that import capital might be doing so mainly at the expense of domestic jobs.

    China’s Worry, Not US

    For this reason it is absurd for Americans to worry that China might stop buying USG bonds. This is what the Chinese worry about.

    In fact the whole US-China trade dispute is indirectly about China’s insistence on purchasing USG bonds and the US insistence that they stop. Because remember, if the Chinese trade surplus declines, and the US trade deficit declines too, by definition China is directly or indirectly buying fewer US dollar assets, which in principle means fewer USG bonds.

    And contrary to much of what you might read, this reduction in USG bond purchases will not cause US interest rate to rise at all. For those who insist that it will, it is the equivalent of saying that the higher a country’s trade deficit, the lower its domestic interest rates. This statement is patently untrue.

    • I read a similar article on the weekend, so the fear people had that China would stop buying is unfounded. Not surprising given the US has the reserve currency, and the FED can do monetary policy to keep the ponzi ball rolling. Debasing the the USD is what the FED wants.

    • Weimar Republic

      Geez it is good to read someone who is able to “get” that this is tied to trade and understands the basic accounting. Shame Pettis isn’t writing op-eds in the MSM (or more of them anyway).

  6. Great article UE.

    IMO China is a “Field of Dreams” economy, build it and they will come…

    There is a limit to unproductive building, but what that is wont be know until our economy starts to feel it. I doubt we’ll have a 10-20 year boom such as is being predicted.