Beiging () - U.S. government debt surpassed $14 trillion at the end of 2010 and headed toward a congressionally mandated debt limit, threatening a shutdown of the federal government. And as the U.S. fiscal position floundered with no improvement in sight, inflation started rearing its ugly head.
Recently, a guy in Texas was involved in a shoot-out with police, because the price of a hamburger had risen from 99 cents to $1.49.
Bearish sentiments have reappeared in U.S. government security markets. Pacific Investment Management Co., the world’s biggest bond fund, dumped all its Treasuries recently. Billionaire investor Warren Buffett is shifting to short-term debt. Investors are preparing for an end to the three-decades-long Treasury rally.
Despite shaky fundamentals, U.S. government securities are regarded as safe haven assets. Whenever there is a crisis, the value of U.S. Treasury bonds gets a boost. Indeed, Treasury bonds were among the very few assets that did not decline during the global financial crisis in 2008-09.
But the safe haven status of U.S. Treasury bonds is illusory: They are safe only in the sense that there is no one in the world who can stop the U.S. Federal Reserve from operating the printing press at full speed.
The market value of Treasury bonds depends on a wide range of factors. Now, the value of the Treasury bonds is propped up essentially by a Ponzi scheme, with the Fed’s QE2 keeping Treasury prices artificially high.
However, at end of day, market prices of Treasury bonds will fall eventually to levels dictated by American economic fundamentals. Private investors can sell short and buy long and, most importantly, get out in time after profit-taking.
China’s twin surpluses
But the People’s Bank of China is not an ordinary Treasury bonds investor.
For decades, it has been investing China’s huge surplus savings abroad, parking a portion of its funds abroad until efficiency in domestic investment allocation improves, or for some reason China has to reduce savings, or until Chinese enterprises’ ability to innovate and create have grown strong enough to capture a larger share of profitable domestic investment projects.
China mainly holds Treasury bonds to maturity and re-invests the principal. China is not so worried about variations in the book value of its foreign exchange reserves, but cares about the future real value of these reserves in terms of purchasing power when China needs to cash in and use the money to buy goods and services.
Perhaps it’s too late to do anything about the existing Treasuries in China’s portfolio without causing serious political and financial backlash. But China should at least stop continuing to build its holdings.
Needless to say, “the twin surpluses” (surplus under the current and capital accounts) represent a gross misallocation of resources. To make things worse, China has been suffering major capital losses consistently over the years and is likely to suffer even higher losses in the future. The more China stockpiles foreign exchange reserves in the form of U.S. Treasury bonds, the higher China’s potential losses will be.
In 2003, when the issue of yuan exchange rate appreciation started appearing on China’s policy agenda, China’s foreign exchange reserves totaled just above $400 billion. At the time, the price of crude oil was generally under $30 a barrel, and the price of gold was less than $400 an ounce. Now, China’s foreign exchange reserves are approaching $3 trillion, while prices for crude oil and gold are more than $120 a barrel and $1,400 an ounce, respectively.
In other words, while China’s foreign exchange reserves are seven times greater than seven years ago, their purchasing power in terms of oil and gold are just 2.8 times and 2.1 times larger, respectively. It is also worth noting that long-run dollar devaluation trends are easily recognizable: Between 1929 and 2009, the dollar’s purchasing power has fallen 94%.