Slowing export growth rates cull China's equities (Part 5 of 6)
China buys US debt
The below graph reflects China’s monthly purchases of US debt. Despite fantastic headlines surrounding the current US budget talks of sequester, you can see that China’s appetite for US debt has rebounded strongly post-2008 crisis. It will be a challenge for Speaker of the House Boehner to convince the average American that the world has limited appetite for even more US debt. Note the dramatic flight to quality into US Treasuries and out of agency mortgage-backed securities after the crisis. Yes, there’s still nothing like US Treasuries in troubled times, and China’s appetite for US debt is still quite healthy. However, as the below graph reflects, China became very worried about the fine print surrounding the US government’s “implicit guarantees” of government-sponsored agencies (or GSEs) such as Fannie Mae.
Everyone loves US Treasuries
There are rumors that the Bank of Japan would like to acquire more US Treasuries ($500 billion to $1 trillion) as a part of “Abenomics”-driven monetary policy. With such global demand for US treasuries, how can Obama resist? The major trading partners of the United States have undoubtedly renewed their wedding vows with the US Treasury post-2008. They’re looking to buy more US debt at low interest rates to keep the US recovery on track and keep their factories at home producing.
China’s appetite for agency mortgage-backed bonds is also skyrocketing to its pre-crisis highs. With Japan and China both holding about $1.25 trillion each of US treasury debt, and an additional $500 billion each of agency mortgage-backed bonds, that means that both Japan and China hold about $3 trillion in US Treasury and agency debt, and seem fairly eager to acquire another $1 trillion or more in the near term.
Where’s the crisis?
With such strong demand for US Treasuries, it’s hard for the Obama Administration to see a debt crisis. With around $12 trillion in net debt, borrowing another 10% of that amount would seem to be quite easily achieved without overwhelming the bond markets with additional supply. The world is throwing money at the United States, essentially providing the US government with a virtually unlimited credit card at 2.5%.
The Obama Administration, like the US Federal Reserve (the Fed), seems to be focused on the economic crisis of putting people back to work. With the labor force participation rate hitting a 35-year low, falling from over 67% in the year 2000 to closer to 63% today, it’s estimated that the real measure of unemployment is closer to 11% than the headline number of 7.3%. The labor participation rate hasn’t been that low since women entered the workforce and Generation X kids were introduced to the Tang breakfast and TV dinner (“Give me the Campbell life”). That’s the crisis that the Obama Administration and US Fed are focused on. With so many Americans unemployed or underemployed since 2008, it’s no wonder the real US growth rate has been languishing. And when GDP growth languishes, tax receipts suffer—every politician’s worst nightmare.
Indeed, the United States seems to be suffering from too much labor, and not enough work, as millions have dropped out of the workforce. As pointed out in a prior series, without more investment in the US economy, the US economy is likely to languish. However, it’s hard to get capital to invest in the future when the future expectations are for a lackluster economy with limited upside growth potential in consumption, with more Americans out of the workforce.
When debt becomes equity
Debt starts to turn into equity when the debtor’s cash flow declines, and the debtor finds that there’s not enough cash left over at the end of the month to make his monthly payment without canceling health insurance, food, shelter, and other essentials. The US cash flow is the government’s tax revenue, health insurance in Medicare or Obamacare or social security. Evidently, China and Japan think that the United States can tax its citizenry enough to make those payments. They seem willing to look across the valley of weak tax receipts and high debt levels to a more prosperous future of economic growth and stronger tax receipts.
China and Japan—and the rest of the world—are throwing their money at the United States and saying, “Here, take our money. We don’t care if you’re currently having a rough time. Things are still worse over here! If there’s any single country in the world that can figure out how to adapt and grow, it’s you.”
Why China and Japan don’t care
Let’s face it. US Treasury debt is not really debt. It’s a vote of confidence and an “equity stake” in global capitalism, and a vote against communism. So far, Japan and China have cast over 3 trillion votes in favor of the global economic system that the United States has forged and maintained since. Unlike corporate bonds, whose values can fluctuate widely upon fluctuating cash flows that service the monthly debt payment, the US debt marches to the beat of a different drum. The value of the US Treasury bond, as reflected in the above graph, is derived from one single hard-to-measure metric whose value is nearly impossible to derive or explain: faith.
Ye of little faith
The current sequester debate seems to be driven by the party of little faith, led by John Boehner. It’s true that debt can lose value when fiscal discipline fades, and the integrity of a country’s ability to tax its citizenry is compromised. However, bear in mind that roughly one-third of the US debt is held by overseas countries—mainly China and Japan. Evidently, they have faith in the US Treasury debt (or at least they have no better investment ideas at the moment).
Why China and Japan are patient with US “debt”
The United States spends $682 billion per year on defense, keeping the world safe for global capitalism—$718 in 2011, which was more than Medicare. Next in line is China, at $166 billion and Russia at $90 billion, and with Germany at $45 billion. The United States spends 2.5% of its GDP on defense, while Germany spends 1.4% and China 2.0%—moving up to big-boy defense status, and acquiring its first aircraft carrier. World peace and freedom are apparently not cheap. Europe and Asia have benefitted wonderfully from the United States playing “global cop” since the end of World War II.
So you can see that there’s a lot more to US debt than simple cash flow considerations. World peace has been an economic “pure public good”—like clean water or air—that the United States has provided for all. As a result, foreign purchases of US debt aren’t simply based upon the country’s future tax revenues. US creditors need to keep the country running for their own selfish purposes, and place a high economic value upon the it as the cornerstone of prosperity for global capitalism and the free market ideology. The 75% of GDP outstanding in net debt of $12 trillion can simply be seen as the present value of a small portion of the cost of world peace. It just so happens that the tab is on the account of Uncle Sam, and the rest of the world is willing to accept that “equitable” arrangement.
As a result, there seems to be significant political will around the world to continue to finance the United States through the current recession. Economist Paul Krugman points out that, despite the large amount of US debt, the US still earns more on its holdings of foreign assets than it pays on its foreign liabilities. In other words, the United States is still cash flow–positive as far as its overseas liability is concerned. As Krugman notes, “It’s not that we as a Nation have overspent and need to spend less; it’s that some people are being forced to spend less, and we have a depression because other people won’t (not can’t) spend more. This is how you need to think about debt; it’s not a burden on the Nation’s resources, because its mainly money we owe to ourselves, and it’s a problem not because we have to tighten our belt, but because debt is currently leading to spending that’s less than we need to maintain full employment.”
So perhaps the debt debate is overdone. For investors concerned about collapsing equity values, it’s possible that there’s less to worry about than the media would have us believe. China loves US debt, cherishes its trade surplus, and in fact seems to want to grow this arrangement further. While the Obama Administration might be thankful for Japan and China’s vote of confidence in US debt as sequester talks drag on, eventually the pernicious trade deficits with China and Japan that displace low-end manufacturing jobs in the United States become a political football. So appetite for US debt can be a double-edged sword: the financing rates that China and Japan offer are attractive, though the cost of the growing class of chronically long-term unemployed Americans adds up.
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.
- Japanese exports: Are we seeing an “Abenomics”-led recovery in Japan?
- “Abenomics”: A bull market for Japan’s consumers?
- Analysis: Capital investment in Japan
- U.S. consumer spending: Sustaining the unsustainable?
- U.S. investment: Have capitalists gone on strike?
- China’s exports: Is the golden age of cheap labor coming to an end?
Browse this series on Market Realist: