Why China will resist dumping US Treasuries in retaliation

Ditching debt would unleash financial instability in Washington but likely backfire on Beijing

Michael Mackenzie

China is the largest foreign holder of US Treasury debt with $1.1tn worth of holdings © FT montage; AP/AFP/Getty

Occupying a prominent place in the bilateral trade and economic relationship between the US and China is the $16tn Treasury bond market. As the world’s two biggest economies escalate their rivalry, anxiety over whether China will abruptly use its $1.1tn holdings of US Treasuries as a trade war weapon is rippling through the bond market.

Rather like President Donald Trump’s numerous tweets extolling the benefits of tariffs for the US economy, the idea that China will undertake a major liquidation of its Treasury debt portfolio as a weapon does not stack up.

Liquidating its Treasury portfolio may appear a compelling threat on paper. China’s stake along with other foreign buyers, comprising 40 per cent of the market, has down the years helped contain US interest rates, enabling Washington to spend and push the federal deficit ever higher.

In practice, a draconian response from China runs the risk of unleashing a bout of financial instability that resonates globally. But the effect would be shortlived and wind up damaging China more than the US at a time when Beijing already faces the challenge of rebalancing a slowing and highly indebted economy.

That will not halt conjecture about China’s intentions. The latest official Treasury data released this week revealed further selling by the market’s largest foreign holder and during a time when a trade deal between Washington and Beijing appeared on track. While the drop in Treasury notes and bonds held by China in March was the largest in a year, half of the $20bn in sales was recycled back into short-dated bills.

This fits a pattern seen in recent years where China has been in maintenance mode with its Treasury portfolio as holdings peaked at $1.316tn in November 2013. China surpassed Japan as the largest foreign holder of Treasury debt in 2008, and has comfortably owned in excess of $1tn since 2010. Years of trade surpluses generated hefty foreign exchange reserves that peaked in 2014. In turn, this has helped manage the level of the renminbi, a currency that is weakening as the trade dispute intensifies.

Beijing is ready to sell Treasuries in order to moderate any decline in the currency given the often-stated desire for financial stability after a bruising 2015 devaluation of the renminbi. With more foreign investment funds buying mainland shares and bonds, a sudden drop in the currency would only impair China’s efforts to open up its markets to the rest of the world.

Supporting the renminbi in this way should not, however, be seen as an escalation by China towards actively liquidating its Treasury portfolio. Indeed, several factors limit Beijing from abruptly exiting the Treasury market.

There is a good reason why a chunk of China’s reserves sit in the world’s largest government bond market: it is deep, liquid and pays a positive yield. The two main rivals to Treasuries are Japanese government bonds and German Bunds. Both markets not only lack the depth and variety of Treasuries, they are also negative-yielding through to their respective 10-year benchmarks.

True, China’s central bank has been buying more gold lately, but as Marc Chandler at Bannockburn Global Forex points out, Beijing’s Treasury holdings are “worth around five years of gold production”.

Beyond trying to find an asset that can effectively replace US debt, there is the risk of China moving the Treasury market too sharply against it. Once any market senses a whale is selling, the cost of doing so rises sharply and China’s unsold holdings would devalue.

There are also reasonable grounds for thinking the bond market would recover from a temporary bout of indigestion that pushes yields sharply higher. In a $16tn market, China has some influence, but there are limits and for every seller there is a buyer.

This is particularly true given the current outlook flagged by the US bond market. Expectations for economic growth and inflation are the ultimate drivers of bonds. A two-year Treasury yield of 2.20 per cent sits below the Federal Reserve’s current overnight borrowing rate range. This late-cycle view of the US economy suggests Treasury prices will head higher over time. So it hardly makes sense for China to dump its holdings because it would only present a buying opportunity for others who hold a less reassuring macro view.

These are all aspects of Treasury trading that China understands. Despite the speculation over a dramatic exit trade, Beijing will stick to a long game. Treasury yields will trend lower as the economic cycle ebbs and the clamour among other investors for owning government bonds means China can exit near the top in price terms and smoothly pivot away from the US more broadly and focus on rebalancing its economy.

Germany’s economic model is not the problem

Political leadership in addressing regional inequality and social polarisation is lacking

Marcel Fratzscher

Cars under construction at the Porsche factory in Leipzig. Germany’s export companies are increasingly investing abroad and less at home, threatening the country’s attractiveness as an investment hub © Bloomberg

The German economic model has received some unusually harsh criticism of late, notably from French president Emmanuel Macron, who said in April that it “has perhaps run its course”. Yet the problem for Germany today is not its economic model, but rather inadequate economic policies and two deep-seated illusions.

The German economy has slowed sharply, its dependence on industry is high and its automotive sector is slow to embrace new technologies. Germany’s dependence on exports makes it vulnerable to a slowdown in global growth.

Yet the problem is not the country’s economic model, which has been key to its success since the end of the second world war. The openness of the German economy and high degree of geographic and sectoral diversification of German exports which helped it to prosper for decades will be even more important for income growth and stability as the population ages and emerging markets catch up.

Mr Macron’s criticism of the German model for not being compatible with his vision of a social Europe is misplaced. A particular strength of that model is the Mittelstand — midsized, often family-run companies, with hundreds of unsung champions. These are often flexible, highly innovative and specialised firms with solid balance sheets and stable global market shares.

Another traditional strength has been the social partnership between employers and unions and a strong social welfare state.

The real problem for Germany is that its political elite is in the grip of two dangerous illusions. The first is the widespread assumption that it is not Germany that needs to change, but other European countries who need to follow the virtuous German path. But Germany has implemented hardly any meaningful economic reforms during the past decade, despite mounting imbalances and vulnerabilities.

Low levels of public and private investment contribute to anaemic productivity in the non-tradable sectors and a current account surplus of 8 per cent of gross domestic product in 2017. Germany’s export companies are increasingly investing abroad and less at home, threatening the country’s attractiveness as an investment hub.

Low productivity and weakening social partnerships have contributed to the enormous expansion of the low-wage sector. Meanwhile, instead of implementing reforms — such as lowering labour taxes, simplifying the tax code, deregulating services, modernising an inefficient bureaucracy and raising public investment in infrastructure, education and innovation — the past three governments have tried to appease vested interests through misguided handouts.

Popular frustration with the political elite and the rise of the far-right Alternative for Germany party are not the result of economic weakness, the migrant crisis or an overreaching EU, but of a political failure to address some legitimate concerns about rising regional inequality and social polarisation. Germany failed to use the boom years to renew its economic model.

The second illusion is that Germany does not need Europe and that the EU and eurozone are effectively a transfer union with a German paymaster. This attitude explains why many Germans are deeply suspicious of Mr Macron’s proposals for reforming the eurozone. Ironically, however, Germany would be one of the greatest beneficiaries of some of the changes Mr Macron envisages: the completion of monetary union and the strengthening of European institutions. Yet for years, Berlin resisted such reforms. Worse, it is showing increasingly protectionist tendencies, with proposals for the state to intervene much more directly in the economy and pursue the creation of “national champions”.

Global trade tension and rising nationalism in the US and elsewhere mean the continued success of Germany’s economic and social model will hinge on its ability to help create a strong, united Europe. The extent of political support in Berlin for further EU integration will be crucial in determining whether Europe can be a third partner at the geopolitical table alongside the US and China.

So it is not Germany’s economic model, but the reluctance of its political elite to pursue economic and social reforms, domestically and in the EU, that is the main risk that Europe faces today. But it is not too late to change course — Germany’s economic and political strengths mean it still has a chance to bring about change together with its European partners.

The writer is president of DIW Berlin, a think-tank, and professor of macroeconomics and finance at Humboldt-University Berlin


American life is improving for the lowest paid

Come back capitalism, all is forgiven

BRAD HOOPER quit his previous job at a grocery in Madison because his boss was “a little crazy”. The manager threatened to sack him and other cashiers for refusing orders to work longer than their agreed hours. Not long ago, Mr Hooper’s decision to walk out might have looked foolhardy. A long-haired navy veteran, he suffers from recurrent ill-health, including insomnia. He has no education beyond high school. Early this decade he was jobless for a year and recalls how back then, there were “a thousand people applying for every McDonald’s job”.

This time he struck lucky, finding much better work. Today he sells tobacco and cigarettes in a chain store for 32 hours a week. That leaves plenty of time for his passion, reading science fiction. And after years of low earnings he collects $13.90 an hour, almost double the state’s minimum rate and better than the grocer’s pay. His new employer has already bumped up his wages twice in 18 months. “It’s pretty good,” he says with a grin. What’s really rare, he adds, is his annual week of paid holiday. The firm also offers help with health insurance.

His improving fortunes reflect recent gains for many of America’s lowest-paid. Handwritten “help wanted” signs adorn windows of many cafés and shops in Madison. A few steps on from the cigarette shop is the city’s job centre, where a manager with little else to do points to a screen that tallies 98,678 unfilled vacancies across Wisconsin. In five years, he says, he has never seen such demand for labour. He says some employers now recruit from a vocational training centre for the disabled. Others tour prisons, signing up inmates to work immediately on their release.

Unemployment in Wisconsin is below 3%, which is a record. Across America it was last this low, at 3.6%, half a century ago. A tight labour market has been pushing up median pay for some time. Fewer unauthorised immigrants arriving in America may contribute to the squeeze, though this is disputed. Official figures show average hourly earnings rising by 3.2% on an annual basis. “Right now, part time, it seems like everyone is hiring. Every American who wants a job right now can get a job,” says another shop worker in Merrillville, in northern Indiana.

In any economic upturn the last group of workers to prosper are typically the poorest earners, such as low-skilled shopstaff, food preparers, care-givers and temps. Their pay was walloped in the Great Recession a decade ago, and the recovery since has been unusually slow. Pay has leapt recently—with the lowest-paid enjoying faster gains than the better-off.

The benefits are not equally spread. In Wisconsin, as in much of the country, more jobs are being created in urban areas and in services. Laura Dresser, a labour economist, points to a “very big racial inequality among workers”. Wages have been rising fastest for African-Americans, but poorer blacks, especially those with felony convictions, are also likelier to have fallen out of the formal labour market, so are not counted in unemployment figures.

The wage recovery is not only about markets. Policy matters too. Some states, typically Republican-run, have been reluctant to lift minimum wages above the federal level of $7.25 an hour. In Merrillville, a worker in a petshop carries a Husky puppy to be inspected by a group of teenage girls. Staff are paid “a dollar or two above the minimum wage”, says his manager. Despite his 13 years’ employment, and over 40 hours’ toil each week, his pay and benefits amount to little. He calls occasional bonuses a “carrot at the end of the road”.

He could munch on bigger carrots in other states. Lawmakers in some states are more willing to lift minimum wages. Where they do, the incomes of the lowest-paid rise particularly fast. Thirteen states and the District of Columbia raised the minimum wage last year. (Some cities, like Chicago and New York, occasionally raise it too). Elise Gould of the Economic Policy Institute told Congress in March that, in states which put up minimum wages at least once in the five years to 2018, incomes for the poorest rose by an average of 13%. In the remaining states, by contrast, the poorest got a rise of 8.6% over the same period.

In neither case, however, do the increases amount to much better long-term prospects for the worst-off. By last year, the poorest 10% were still earning only a miserly 4.1% more per hour than they did (in real wages) 40 years ago. Median hourly pay for America’s workers was up a little more, by 14%.

One study in Wisconsin suggests that caretakers, for example, took home over $12 an hour by last year, so were only just getting back to their (real) average earnings achieved in 2010. Expansion at the bottom of the labour market “is finally pulling some wages up. But it’s certainly been much slower in this boom than any other,” argues Tim Smeeding, a poverty expert at the University of Wisconsin, in Madison. He describes “capital winning over labour” for several decades, and expects the trend to continue, given weak unions, more automation and other trends.

The poorest get some hard-to-measure benefits in addition to higher hourly pay. Mr Hooper is not alone in daring to walk away from an exploitative boss. More of the low-paid get a bit more say on how and when they toil. Many crave a reduction in the income volatility that afflicts them, since sudden swings in earnings are associated with poor mental health, high stress and worry over losing access to financial assistance or food stamps.

One study of 7,000 households, by Pew, found in 2015 that 92% of them would opt for lower average incomes, if earnings were predictable. Follow-up research late last year suggested the same trends are still present. Low- and middle-income households remain anxious about volatile earnings. Most have almost no savings. Many would struggle with a financial shock of just a few hundred dollars.

Lots of jobs that are being created are in or near flourishing cities like Madison, where low-paid workers are squeezed by high housing costs. Pew has estimated that 38% of all tenant households spend at least 30% of their income on rent. Living in more affordable places, such as Janesville, an hour south of Madison, may be an option for the lower-paid. But that means commuting to the city, or taking local jobs with less pay and fewer benefits. Few workers earning less than $12 an hour get health insurance from their employer, whereas most do so above that threshold.

Katherine Cramer, who studies the long-standing causes of simmering anger among poorer, rural Americans, says “resentment is worse than before”, despite the recent better wages.

Rural folk complain that “it’s been like this for decades”, she says. A year or two catching up has not yet been enough to change their minds.

ECB faces crucial test of credibility

Markets demand forceful action from central bank which has been failed by politicians

Frederik Ducrozet

Ever since Mario Draghi took office 8 years ago, he has dealt with the consequences of other policymakers’ mistakes, incompetence or inertia © Reuters

As markets seem prepared to call the European Central Bank’s bluff, we are left with fear and hope — that Mario Draghi and his successor will rise to the challenge.

Story of his life, as they say. Ever since the ECB president took office eight years ago, he has dealt with the consequences of other policymakers’ mistakes, incompetence or inertia. As he nears the end of his term in October, we have lost count of the number of times Mr Draghi has been under pressure to act, having already done the right thing.

On his first day in office in November 2011, Mr Draghi cut interest rates in response to his predecessor’s premature tightening of monetary policy. He then followed up with the first series of long-term refinancing operations (LTRO) for banks, which proved decisive in stemming the widening in sovereign debt spreads. When the euro’s existential crisis later led to a rapid rise in the so-called redenomination term premium (a measure of euro break-up risk), Mr Draghi responded with the three most powerful words a central banker has ever said: that he was ready to do “whatever it takes”, within his mandate, to preserve the single currency.

When front-loaded, synchronised fiscal austerity led to a double-dip recession, the ECB eased again, with forward guidance in July 2013 and negative rates in June 2014. When financial fragmentation threatened the transmission of monetary policy, the ECB doubled down on credit easing, including a “targeted” LTRO. Finally, when a global slowdown and a collapse in oil prices led to deflation fears, the answer was bond purchases — quantitative easing — culminating in over €2.5tn in asset purchases by the end of 2018.

It is not the failure of its monetary stimulus that has forced the ECB to ease again and again over the past eight years. Rather, national governments continued making promises they never delivered on, while failing to move beyond their differences to make the monetary union more resilient and efficient. It is the failure of politicians to take over that has left the ECB on the hook.

Faced with “pervasive uncertainty” and persistently low inflation, the ECB stands ready to act again today. Market-based inflation expectations are falling like a stone as ECB members meet for their annual conference in Sintra this week. Crucially, Mr Draghi has ruled out nothing for the June meeting, meaning rate cuts and new asset purchases are all on the table.

For markets, the devil will be in the details of any new stimulus. Cutting rates could be the path of least resistance, especially if aggressive monetary easing from the US leads to a stronger euro and an unwarranted tightening of financial conditions in Europe. In that case, the broader market reaction would largely depend on the implementation of mitigation measures for banks, as negative policy rates get closer to levels where their counterproductive effects outweigh the benefits. An even bolder move would include a cut in the ECB’s main refinancing rate, currently set at zero per cent.

Forward guidance is likely to be adjusted again, whether the ECB cuts rates or not. A proposal from Finnish central bank chief Olli Rehn to link the timing of the first rate rise to a sustained adjustment in (core) inflation using state-contingent forward guidance may be appealing to the Governing Council, eventually.

But, in a more adverse scenario, the ECB would have to resume bond purchases to address the risk of de-anchoring inflation expectations. It could do so by either adjusting limits on purchases to 33 per cent of member countries’ debt, or by tilting debt purchases toward corporates, supranational entities and/or the most indebted governments. In the former case, German Bund yields could fall even further into negative territory; in the latter, Bund yields could jump back above zero and the yield curve would steepen.

One option could be for the ECB to engineer a form of “insurance QE” in a similar spirit as potential insurance rate cuts from the Fed. That could take the form of a front-loaded programme with no predefined quantity of monthly purchases, but a total envelope to be spread over time with greater flexibility, depending on macro and market conditions.

The bigger picture boils down to the ECB’s credibility — its greatest asset under Mr Draghi’s presidency. If conditions deteriorate sharply, markets will demand another grand statement of intent. The hope could be to talk the QE talk without walking the walk, given all the institutional, political and technical hurdles embedded in a new QE programme. Inflation expectations, equity markets and the euro will rise if, and only if, the policy response proves credible.

Credibility inevitably raises the question of Mr Draghi’s successor. The biggest challenge he or she will face may not be to ease or to normalise monetary policy, but to maintain trust in the euro’s most important institution.

Frederik Ducrozet is a global strategist with Pictet Wealth Management, based in Geneva

When commodities get hooked on derivatives

The distortions will damage the welfare of market participants and society at large

Ruslan Kharlamov and Heiner Flassbeck

Pick up marketing materials of any commodity exchange and it’s all about “risk management”. 

For many bourses, however, a real business lies elsewhere. It needs no advertising and shuns public scrutiny. 

This is the business of making markets: a licence to set prices for raw materials. As these markets went global, so did the function of their pricing and benefits for those controlling this function.

Over the years, both commodity exchanges and derivatives traded on them came a long way from their original purpose. There were three forces behind this development.

First was the wave of mergers and buyouts in the 2000s, which turned western exchanges from not for profit utilities into large corporations. Today, CME Group and Intercontinental Exchange (ICE), the two bourses reining in energy and agricultural markets, are owned by institutional investors. In 2012, London Metal Exchange was acquired by Hong Kong Exchanges and Clearing for $2.2bn.

Exchange-traded derivatives (futures, options, swaps) were invented to help supply chains mitigate market risk through harvesting and economic cycles and were largely used for this purpose since the 19th century. The situation changed in the 1990s when investment funds noticed that commodity prices moved asymmetrically to financial markets and started trading raw materials as a store of value and a source of speculative income from price fluctuations. 

The derivatives enable such trading without physical possession. This was the second factor.

For exchanges and brokers that facilitate these transactions, it was a gold mine. Commodity risk management is limited by production, trade, and consumption; speculative trading is not. 

Since revenues depend on trading volumes and services, such as clearing, the more derivatives are traded, the more money flows to investors, exchanges and brokers, creating a whole new ecosystem. In this brave new world, nobody knows the size of derivative markets and understands the interplay with their physical cousins. 

Figure 1: Oil physical and derivative markets

Finally, China. As the world’s largest consumer and producer of many commodities, it wants a say in their pricing. But how to break into exchange “franchises” that had existed for decades? 

The answer is maximum liberalisation of domestic derivative markets to boost their size and impact, largely by dint of retail investors.

In the west, even though the business model of exchanges has changed, investors still assume that a commodity future should first be used for price hedging. 

Chinese futures were ostensibly launched with a financial community in mind irrespective of industrial needs and reception. The results are startling: last year eight of the top 10 metal and agricultural futures were traded on Chinese bourses. Energy is next in line.

These forces have fuelled an unprecedented surge of speculation in commodity markets. In a race for global dominance, derivatives turn into market-making instruments for investors and governments; laissez-faire meets co-ordinated policy; and risk management becomes a Trojan horse to justify financial intermediation and speculation. While regulators don’t keep up with the pace of change, commodities are overtaking equities to become the second-most traded derivative category (Figure 2).

Figure 2: Global futures and options trading (millions of contracts)

Once a commodity is hooked on derivatives, producers lose a right to set prices — and there’s no way back.

Derivative markets are not the efficient markets from economics textbooks. Centralisation and focus on trading expectations and interpretations rather than real things make them prone to behavioural biases and manipulation. Worse, they make commodities an integral part of financial markets.

The more commodities become investable assets, the more their pricing gets intertwined with financial market dynamics and phenomena unrelated to supply and demand. This is manifested by inverted correlations between commodity prices and financial markets, among other things (Figures 3 and 4). Quantifying these effects deserves a thorough scientific study based on meaningful data.

Markets so “financialised” fail in price discovery and the efficient allocation of economic resources. Such distortions may destabilise not only markets — consider, for example, renewable energy transition — but also entire commodity-dependent nations. They damage the long-term welfare of market participants and society at large.Figure 3: Crude oil financialization

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To tackle commodities financialisation some policymakers think of curbing “excessive” speculation. This is hard to quantify and implement, especially in international markets. 

Innovation offers a better approach, shifting the onus from regulation to self-governance. By connecting suppliers, buyers and service providers directly, it will keep price formation in the real economy and enable risk management without financial intermediation.

As Milton Friedman observed: “One of the great mistakes is to judge policies by their intentions rather than results.” It’s time to follow his advice instead of financial marketing.

Ruslan Kharlamov is the chief executive of SteelHedge, and Heiner Flassbeck is an honorary professor at the University of Hamburg and a former chief economist of the United Nations Conference on Trade and Development