June 29, 2005

It’s Japan Not China.  The other day I was having a friendly chat with an engineering friend of mine.  The discussion, naturally, turned to global economics.  Peering over his reading glasses he commented, “You know Michael; I am very worried about the Chinese buying so many U.S. government bonds.”  He continued, “What if the Renmimbi appreciates significantly, say by 10%, wouldn’t that have a horrible effect on the U.S. economy?”  I sipped on my diet Coke, thought about it for a moment, shrugged my shoulders and said, “I doubt it.  China represents what, about 10% of our trade, and trade represents about 10% of our economy.  So…a 10% change would mean ten percent of one percent of our economy. Not very much.”  But then always being paranoid of being wrong I finished with “but I’m not sure.”

Turns out that my engineering friend is not the only one asking that question.  David Rosenberg and the economics team at Merrill Lynch have been asking the very same question.  They estimate that a 10% revaluation of the Renmimbi would have a +0.1% impact on GDP growth for a year, +0.1% to inflation and -0.1% to the current account/GDP ratio.  Basically, not that big of an impact.

In fact when you look at the issue more closely, you see that China shouldn’t be our main concern in terms of Treasuries, it should be Japan.  Rosenberg estimates that China owns $197 billion of U.S. Treasury securities.  This amount has increased by $75 billion over the last two years.  That seems like a lot.  But remember, the first lesson of economics is:  everything is relative.

Japan, on the other hand, owns $702 billion of Treasuries and this is up some $311 billion in two years!  This is 3.5 times what China owns.  But even then, foreign central banks only hold about 12% of their reserves in long-term bonds Rosenberg estimates, so even a big intervention probably won’t have that big of an impact on long term Treasury yields.  Keep in mind the U.S. Treasury market is about $4 Trillion so China’s holdings are less than 5%.

So while everyone in the U.S. seems to be wringing their hands over what the Chinese will do, it is probably a better idea to make sure we keep the Japanese on our side.  Given the recent increase in tensions between China and Japan it should be clear which side the U.S. should take in these disputes.

All the best,

MBrandl