Markets: A Warning From China/Japan Slowing

Something is stirring in US-China relations, and it's not nice, and it could damage the global economy.

Last week it was the Chinese using its Xinhua news agency to announce moves to support the country's four biggest banks with strategic share purchases, then the outlet announced a broad aid package for small business after reports of a credit crunch hitting businesses across the country.

This week Xinhua reported that China has sold more than $36 billion in U.S. government debt in August after the country's credit rating was cut to AA by Standard & Poor's.

That came after the U.S. Senate passed a resolution that recommended sanctions against countries (read China) thought to be guilty of manipulating their currencies).

Those sanctions would include penalty tariffs on imports from those countries into the U.S., a measure that would be illegal under World Trade Organisation rules.

Then on Thursday a more dramatic story appeared under the headline "Time for China to dump U.S. debt?".

China is America's banker, holding more U.S. government debt than any other country. Japan, South Korea and the UK are also big holders, but China's $1.137 billion outstrips those countries.

The sale in August followed $8 billion of purchases in July, according to Xinhua.

China had $3.2017 trillion of foreign reserves at the end of September, up from $3.265 trillion at the end of July and $2.9317 trillion in January.

The figures are based on U.S. Treasury department figures released earlier in the week.

These figures understate Chinese dealings and holdings (a more accurate set of figures will be released in 10 days) because they are based on geographic purchases and sales, and China quite often buys through London, as well as from Beijing.

The figures show that the UK lifted its U.S. Treasury holdings to $397.2 billion in August, a rise of 2.4 per cent compared with July. Japan's holdings rose to $936.6 billion, up from $914.8 billion in July.

So China's move stands out, and can be justified by the S&P downgrade and growing concern in China (and in the UK and Japan) that the prospect of ultra low interest rates will cost holders of U.S. debt billions of dollars.

That's why China and other countries have started buying other debt, such as Australia's and some European securities.

The sale was made before the US Senate approved the resolution calling for penalties on countries with low currencies, but the timing of the Xinhua article about the possibility of dumping the dollar came after the latest vote.

It therefore should be seen as a warning to the US Government, Congress and anyone else.

The Xinhua article stated:

"Although China trimmed its U.S. government securities in August by a hefty 36.5 billion U.S. dollars, the country remains the United States' largest foreign lender.

"The cut in August, the biggest move in at least two years, reflected concerns over safety of the Treasuries as the U.S. was stripped of its AAA credit rating, according to analysts.

"The move may suggest that policymakers in the world's fastest-growing major economy are mulling over safer ways, amid the global market turmoil and the depreciating dollar, to invest its gigantic foreign exchange reserves."

The last time China dumped U.S. Government debt was in June 2009 when it sold $25.1 billion worth of Treasury securities.

"It's a normal investing action in the market, though it's definitely related to the fluctuation caused by the S&P's downgrade on the U.S. in August," said Guo Tianyong, economics professor with the Central University of Finance and Economics, in the Xinhua report.

"Despite being a regular market move, the record drop of China's holdings of U.S. Treasuries may still add to market woes, as it revealed market concerns over the "dollar trap," economists noted.

"China has run a current account surplus and a capital account surplus uninterruptedly for more than two decades. Inevitably this has led to an accumulation of foreign reserves," Yu Yongding, an economist with the CASS, wrote in an article published recently.

"He declared that China was caught in a "dollar trap" as it had to amass the dollar-denominated assets, despite the fact that risk of a depreciating dollar kept rising.

"When China decided to slash a sizable amount of U.S. Treasuries in June 2009, the greenback had been losing value for months.

"Loaded with an excess of dollars, the world's largest exporter is facing a quandary: on the one hand, a weaker dollar could mean a big capital loss for China.

"On the other hand, the dollar is still deemed as a flight-to-safety compared with other investments. Thus the country seems stuck in the "dollar trap."

"There is no clear evident that we are reducing our holdings of the U.S. Treasuries systemically and unremittingly," said Mr Zhang.

"But whenever the dollar is depreciating, our foreign assets, with such a large portion being dollar-denominated, can hardly stay immune from the loss.

"Economists agree that as the United States' largest foreign creditor, China should contemplate ways to pull itself out of the "dollar trap," as the U.S. economy is faltering with its debt piling up and its currency on the brink to depreciate.

"China must make fuller use of the non-financial assets in its foreign reserves, as well as speed up the diversification of investing channels to resist a possible long-term weakening of the dollar, said Xia Bing, director of the Finance Research Institutes of the Development Research Center under the State Council.

"Zheng Xinli, permanent vice chairman of China Center for International Economic Exchanges, has suggested that Chinese companies boost overseas investment as a way to absorb trade surpluses and fend off the dollar risk.

"The dependency on the U.S. Treasuries partly revealed the country's incapability to invest overseas," Mr Zheng said. "Why did Germany and Japan not buy such a large amount of foreign bonds when they were running huge trade surpluses? That was because of their strong capability to invest overseas, which helped digest the excessive trade surpluses," Mr Zheng said.

"China has tried various measures to slow down the growth of the foreign reserves and protect the value of its existing stock. Sadly, none has worked. With large capital inflows and a current account surplus, China's foreign exchange reserves have continued to rise rapidly," Mr Yu said in his article.

"The country must adjust or even annul those macro-economic policies that result in further accumulation of foreign exchange reserves. Only by doing this can China free itself from the "dollar trap," Mr Yu said," the Xinhua article concluded.

So nothing has been concluded, but the highly sensitive issue has been dragged into the public arena as a direct reply to the U.S. Senate debate.

The Chinese government doesn't allow contrary views (to official policy) to be published on outlets like Xinhua, unless there's a reason, such as allowing a debate to reach the surface from State Council or other parts of the Party.

The U.S. debt article is a trial balloon and nothing more at this stage, unlike last week's announcements on Xinhua which were confirmations of major shifts in policy.

But there are dangers for Australia in this developing brawl between China and the U.S. We could suffer collaterall damage (to our huge trade surplus) if it worsens.

Resource companies like BHP Billiton, Rio Tinto and others would be in the firing line.

Meanwhile in Japan, more evidence that the economic rebound from the March 11 quake and tsunami is losing momentum.

Bank of Japan Governor Masaaki Shirakawa said Thursday that the central bank stands ready to take further monetary policy steps if the economy deteriorates, while committing to keep a virtually zero interest rate policy until price stability is in sight.

"The bank will continue to carefully examine the outlook for economic activity and prices, and take action in an appropriate manner," Mr Shirakawa said at the opening of the central bank's quarterly branch managers' meeting, according to newsagency report.

The BOJ chief also said that overseas economic growth is expected to be slow for the time being, although the overall trend is likely to remain firm due to solid growth in emerging economies.

His comments came after the country's cabinet office downgraded its view of the economy for the first time in six months, citing the slowdown offshore, especially in Europe, China and the U.S.

The statement said the slowdown is hitting industrial production and exports, while the strong yen was further adding downward pressure.

We have seen output and exports in Japan slow in the past couple months by more than expected by the market.

According to the latest Cabinet Office report, "the Japanese economy is still picking up although the pace has decelerated, while difficulties continue to prevail due to the March 11 earthquake and tsunami".

The report also said that production and exports were flattening and personal consumption was starting to fall again.

The Bank of Japan's policy board will meet next Tuesday to review the semiannual economic outlook and will also release its price and growth forecasts for the 2013 financial year which are expected to predict two more years of deflation.

Tokyo reports say the central bank is expected to maintain its view that the economy will return to a moderate recovery path, but will point out that risks to that growth path are increasing because of the eurozone sovereign-debt crisis.

The Bank's Regional Economic Report released on Thursday showed that slowing overseas economies already have affected some regional parts of Japan.

But five of nine regions also reported some improvement from three months earlier when the economy remained mired in the disruptions from the March 11 earthquake and tsunami.

The Japanese financial newspaper, the Nikkei, reported Thursday that the Japanese economy had not surpassed its pre-earthquake level (March 11) as of August, according to an index that uses a revised calculation method.

The paper said that the previous version of the index, used by the Cabinet office, had indicated that the economy had recovered by summer.

"Using a new method to more accurately reflect the impact of events such as the March 11 disaster and the 2008 financial crisis, the coincident index gave a reading of 90.3 for August. The previous method charted economic activity at 107.4.

"The new computational method, proposed by an expert group commissioned by the Cabinet Office, will be used in a report due out next month based on September data.

"The previous method discounted the March catastrophe's impact as an extraordinary factor, causing the August index to exceed its pre-earthquake level by 1.3 per cent.

But the new method puts the August figure 4.2 per cent below the pre-quake level, and even short of levels predating the collapse of Lehman Brothers in fall 2008.

"Under the previous method, the economy was seen to be basically recovering since March. But with the new method, the economy was still at risk of plunging into a recession until May."

The Cabinet Office said in a separate statement that nation's economy in the 13-month period through March 2009 was the 14th time since the second World War that Japan has been in recession.

According to the Cabinet Office's statement, the economic retraction in this period spanned the months prior to the Lehman Brothers Holdings Inc's crash in September 2008 and the worldwide economic slump from then on.