Not surprisingly, this talk of a nuclear threat (see entry below) has caused a lot of concern. How credible is it? Not at all, in my opinion. In fact the whole thing is a little silly, for at least thee reasons, and I don't think any of the financial authorities in China believe otherwise (although if it helps to frighten US congressmen from behaving too irrationally on the trade front it is probably a good thing).
1. It overestimates the importance of PBoC reserves relative to the overall market. $1.4 trillion are a lot of reserves for any central bank, but the total amount of liquid securities in the US is many times that number and even weekly turnover dwarfs that number. Every year the US trade deficit, which is roughly half that number, gets financed with absolutely no difficulty.
If there were a sudden major sale. what would it look like? The last time there was a massive fire sale of US assets was probably during the start of WWI when, in order to finance the war effort, European belligerents dumped an amount of US securities equal to a greater share of total US securities than the amount China currently holds -- and this in a much less mature financial system.
The impacts on the US markets were not nearly as dramatic as one might have at first expected. There was a brief panic and the NYSE was closed for a short time, but my understanding is that this had more to do with US Treasury fears of a short-term gold outflow than with the ability of the market to absorb the sales.
At any rate the net impact turned out to be a major transfer of wealth from Europe to the US as American investors snapped up years of carefully invested European savings at bargain prices. A fire sale of PBoC assets would almost certainly result in a similar transfer of hard-earned Chinese savings to US and non-US bargain hunters.
2. It ignores the likelihood that a massive sale of US assets by the PBoC would immediately trigger large offsetting purchases. Remember that any decision by the PBoC to sell dollar assets is also automatically a decision to buy other non-Chinese assets. What could they buy? Almost certainly only euros, yen, sterling, and a few other currencies (even purchasing commodities would simply imply a recycling of PBoC dollars into dollars, euros, yen, etc. by the commodity sellers).
Any attempt to do so, of course, would cause these currencies to shoot up against the dollar. It is hard to imagine that other central banks would stand idly by and watch this happen (with the attendant trade implications) without themselves intervening to support the dollar. Throw in the foreign bargain hunters looking to buy up cheap US companies and US institutions who hold vast amounts of money offshore, who would be more than happy to bring it back home to buy cheap US assets, and there is plenty of buying power to set off against PBoC sales.
This is not to say that the market would immediately stabilize, nor that we wouldn't have some very scary moments, but rather that the disruption would be of relatively short duration, and would probably have a limited impact on the country's underlying economic health.
3. Finally, let's assume a worst case scenario: the dumping of US dollars by the PBoC causes a sharp and damaging rise in US interest rates and a significant slowing down in the US economy. For the reasons described above it would also cause a similar impact on most other major economies.
How would China benefit? There would be a nearly immediate collapse in world trade as the US deficit shrunk to zero (remember, if no one finances it, it must be zero). The economic impact on each country would depend largely on how flexible its financial system was in absorbing shocks and where global savings would flow. In both cases it seems pretty safe to bet that the US would suffer least of any major country. It has an astonishingly flexible financial system that has allowed it to withstand a whole series of financial shocks over the past several decades with almost no spillover into the real economy, and in times of trouble there is plenty of evidence to suggest that money will fly to the US as a safe haven.
China, on the other hand, would find it extremely hard to escape the consequences. Not only is its financial system rigid and poor at processing information and capital, but its economy is highly dependent on the export sector.
Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is a member of the board of directors of ABC-CA Fund Management Co., a Sino-French joint venture based in Shanghai.
Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. He has also worked as a partner in a merchant banking boutique that specialized in securitizing Latin American assets and at Credit Suisse First Boston, where he headed the emerging markets trading team. Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt.
Pettis is a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. He is the author of several books, including The Volatility Machine: Emerging Economies and the Threat of Financial Collapse (Oxford University Press, 2001). He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University.
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November, 2007
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