China’s exports: Will soaring interest rates be a curse?

Market Realist

Slowing export growth rates cull China's equities (Part 2 of 6)

(Continued from Part 1)

Foreign claims on the US dollar

The below graph reflects the dramatic increase in foreign claims on the US dollar. This graph represents foreign holdings of US debt. Total net debt in the United States equals about $12 trillion US dollars. External claims account for approximately $3.7 trillion of this amount (nearly one-third). As we’ll discuss below, this growing amount of foreign claims (dominated by China) is becoming a bubble. Unless properly managed, it could create significant problems for China.

 

QE3

Excluded from US net debt stands the US Federal Reserve Bank’s holdings of US Treasury securities, at $2.1 trillion, having stood at nearly only $500 billion as of 2009. Subsequent bond purchases during the quantitative easing (or QE3) program post-2008 crisis have grown the US Central Bank Balance sheet significantly. Of the Fed’s $85 billion per month of bond buying, $40 billion is mortgage-backed bonds. There’s speculation as to exactly when the Fed’s current $85 billion per month purchases are likely to “taper.”

QE3 began in September 2012, and after one year of buying at the $40 billion-per-month clip, the Fed’s mortgage-backed bond holdings could be approaching $500 billion USD or more. Total mortgage debt outstanding is roughly $13 trillion in the United States, with federal agencies holding a total of nearly $5 trillion, and major financial institutions holding $4.4  trillion. So the Fed holds just over 10% as many mortgage-backed securities as major financial institutions, and roughly 10% of total government holdings (including the Federal Deposit Insurance Corporation, Federal National Mortgage Association, and Federal Home Loan Mortgage Corporation.) (Source:US Federal Reserve.)

Rising rates in the United States

Should the Fed scale back its purchases of both Treasuries and mortgage-backed securities, market participants fear a rise in both government treasury interest rates and mortgage security rates. Should mortgage rates rise dramatically as the Fed withdraws its QE3 purchase program, higher mortgage rates could cool the budding US Housing recovery. Should housing prices fail to recover, or begin to decline as mortgages become harder to finance, the “wealth effect” of increasing property values could also wane, dampening consumption in the United States. This isn’t good for China’s ability to get its export growth rates back to pre-crisis levels. Recent data shows a cooling housing market, with housing starts down 13% in July versus an expected 2% decline—the lowest rate in three years. This data has market participants wondering if the US Fed will really begin tapering this fall.

Deflating emerging markets

As noted in a related Market Realist series, the US economic recovery (credited to QE3 and other fiscal stimulus) may have spelled doom for emerging markets. The budding US recovery has meant a strengthening dollar, which has caused investment flows from the low–interest rate environment in the United States to the higher–interest rate environment in emerging markets to reverse—including China. The strengthening of the US dollar is great for China’s holdings of US Treasuries, as noted above. The strengthening dollar increases the value of China’s dollar-denominated securities, though should interest rates rise more than the dollar rises, this could lead to losses on these holdings or bonds.

Of China’s nearly $3.5 trillion of foreign currency holdings, an estimated $1.25 trillion is in US Treasuries—$1.6 trillion total in public and private securities in dollars. (Source:US Treasury.) It’s important to note that China’s holdings of foreign securities grew at an annual rate of 28.7% from 2001 through 2012 from $212 billion in 2001, to $3.4 trillion as of 2012. However, from 2011 to 2012, China’s foreign reserves increased a mere 4.1%. This is a big change in a huge historical trend. Similarly, the Chinese yuan has also slowed its long-term appreciation against the US dollar—appreciating at 3% per year post–2005 liberalization of currency exchange rates, to only 1.5% in 2012. This too is a big change. Things are really slowing down—despite large government stimulus packages.

Foreign reserves bubble

Chinese foreign currency reserves as a percent of nominal GDP stood at 41% in 2012, and at 184% of merchandise imports. These are huge ratios. Some economists consider them an excessive waste of dead capital. At $3.3 trillion, China’s foreign reserve holdings are bigger than the next five holders of foreign reserves combined, including Japan ($1.2 trillion), Saudi Arabia ($656 billion), Switzerland ($476 billion), Russia ($454 billion), and Taiwan ($403 billion).

Roughly half of China’s total $3.3 trillion in foreign exchange reserves are in dollars ($1.6 trillion). Of long-term treasury holdings, Japan holds approximately $1 trillion, while China holds $1.1 trillion. Regarding US agency mortgage aecurities, Japan holds approximately $250 billion, while China holds $202 billion. Japan and China combined hold roughly $450 billion US mortgage-backed securities—just below the US Fed’s $500 billion or so in holdings. Of China’s total holdings of US Securities, roughly 72% are in Long -Term Treasuries, 13% in US agencies, 14% in US equities, and 2% in corporate and short-term debt. (Source: Congressional Research Service.)

A perfect storm for China?

So the rising dollar may be good for raising the value of China’s holdings of dollar-denominated securities, though if interest rates rise significantly as the US Fed begins to taper its QE policies, the value of these holdings could decline. Such is the curse of the King Midas touch. Having accumulated such a largesse of foreign currency reserves, China could see such a blessing of large recurring trade surpluses turn into a curse—the strengthening currency due to large trade surpluses has led to rapid wage inflation, and exports into the United States and European Union could face weakening economies there, as well as a tapped-out US consumer—three sources of a perfect storm. Yes, things are looking pretty ugly across the board in the near term. But as we saw in a related series on investment in the United States, there remains hope for a brighter future. However, the future is a ways down the road, and in the near term, for the reasons mentioned above, China’s equity markets could likely face considerable headwinds.

Outlook

For investors who think China can orchestrate a smooth deceleration in economic growth without significant disruptions to the banking system, contain inflation, enhance productivity, and grow domestic consumption, perhaps the weakness in Chinese equity prices over the past two or three years would present a more attractive price. China’s iShares FTSE China 25 Index Fund (FXI) is down roughly 15% from its November 2011 post-2008 highs. For China skeptics seeking to embrace the more recent economic trends seen in Japan and the United States, as reflected in Japan’s Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan (EWJ), as well as the USA S&P 500 via the State Street Global Advisors S&P 500 SPDR (SPY) and Blackrock’s S&P 500 Index (IVV), the US and Japanese markets may appear more attractive than China’s iShares FTSE China 25 Index Fund (FXI) and South Korea’s iShares MSCI South Korea Capped Index Fund (EWY). For further analysis as to why Chinese equities could continue to underperform Japanese equities, see Why Japanese ETFs outperform Chinese and Korean ETFs on “Abenomics.”

For related analysis, please see the following series and articles.

Continue to Part 3

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