Can you hear the sound of the global economy turning on its head? The Wall Street Journal and the Financial Times reported today that China is "hinting" that it might start diversifying some of its foreign exchange holdings out of U.S. Treasury bonds.
The Journal only devoted a few paragraphs to the news, which is a little surprising, because if China actually did start shunning U.S. Treasuries, the result could be, oh, just the end of the U.S. housing bubble. And the crippling of the American consumer. And maybe, just maybe, the beginning of a global downturn.
How does this work? Basically, it's like this: The U.S. government spends more than it makes. It funds the difference by selling Treasury bonds. China, right now, is the most voracious purchaser of those bonds. By the end of last September, China's foreign exchange reserves hit $769 billion. Some $247.6 billion of that was in U.S. Treasury securities. And China keeps buying, by some estimates as much as $15 billion worth a month. So, in essence, China is funding American profligacy.
Right now, that's good for China and good for the U.S. By keeping demand for the U.S. dollar high, China bolsters the value of the dollar, especially in comparison to the Chinese yuan, which helps make Chinese exports more competitive. But before you join the crowd of China critics demanding that China revalue the yuan, remember, China's purchase of U.S. bonds also helps to keep U.S. interest rates low. And that's good news for the American real estate market, and for American consumers saddled with lots of debt.
If China stopped buying bonds, so the theory goes, the laws of supply and demand would kick into action: The dollar would be worth less, and interest rates would finally start to go up. But low interest rates have been fueling the go-go housing bubble of the past few years. Money has been cheap -- it's easy to get a loan, and even easier to refinance a mortgage you might already have. All that liquidity has kept the economy humming. But what happens if the cheap money spigot gets turned off?
If the American consumer runs out of cash, then the whole world shudders. All the export capability in the world means nothing if there is no one to buy, and Americans are the world's No. 1 shoppers.
So why would China screw with the status quo? After all, without the American market, China's economy gets hit as hard or harder than anyone's.
The first answer is that it is not at all clear how drastic a move China plans, if any. China tends to move cautiously when it comes to macroeconomic policy changes. The Journal quoted Hu Xiaolian, director of the State Administration of Foreign Exchange, as saying only that China wants to "perfect management of our foreign-currency reserves and to actively explore more efficient use of our reserve assets, to improve the currency structure of our reserves, and to continue to expand the investment areas."
That's a reasonably qualified statement. But could there be a little taste of iron beneath the velvet? China is under constant pressure from American politicians who want it to reform its economy to suit domestic U.S. interests. By threatening to take its foreign exchange business elsewhere, China may be signaling that enough is enough.
I promise I will use the following quote only once in this blog, but now seems an eminently appropriate occasion. Napoleon Bonaparte is said to have remarked that "China is a sleeping giant. Let her sleep, for when she wakes she will shake the world."
China, in 2006, is awake. Now we wait to see what happens as she starts to stretch.