Why China Affects Your Mortgage Payment
Every economist will tell you that China's surging economic growth has a direct effect on U.S. consumers. But how, exactly? Sure, cheap Chinese imports help lower our shopping bills. But Communist Party ministers in Beijing also touch the average American through more abstruse things, like what they do with foreign-exchange reserves and currency valuations.
To help explain how, Deputy Business Editor Rick Newman spoke with Jim Barth, a senior finance fellow at the Milken Institute in Los Angeles. Barth, who also teaches at Auburn University, recently led an international team that advised China's central bank on industry reform. He worked for the Reagan and first Bush administrations as a senior government economist and has been a visiting scholar at a number of agencies, including the World Bank.
So let's talk about why American consumers should care about what happens in China.
For starters, China accounts for one sixth of the world's population, and it's the fourth-largest economy in the world in terms of gross domestic product. What happens in China can affect the U.S. economy directly. That was not the case 25 years ago.
They're a huge exporter now.
That's right. U.S. consumers benefit directly from goods imported from China because they're cheaper. Wages are much lower in China than in the U.S. They have a lot of people, which leads to low wages. A lot of the goods sold through Wal-Mart come from China. Consumers don't mind that. But some U.S. firms do tend to lay off people, and at the same time some are less profitable when they have to compete against cheaper Chinese goods. They tend to complain, and that's where the political tension comes from. There are gainers and losers.
What are some examples of where that's happening now?
Textiles. It doesn't take a lot of skill to make a T-shirt anymore. And toys. About 70 percent of all toys are made in China. Some higher-skilled products are coming, too. Like electrical and power generation equipment. Perhaps automobiles soon. Keep in mind: It's not bad to lose jobs to China–if they're low-skill, low-paying jobs. We don't want young people to go into low-skill industries that may not be competitive in a global economy. Those don't require a lot of education. It's the high-skill and high-paying jobs we don't want to lose.
So losing low-skill jobs to China keeps the pressure on in the United States to continually freshen our skill base?
It's sort of like creative destruction. We want to depend more on brainpower than using low-skilled people for our economic growth.
Cheap imports benefit the U.S. economy overall, right?
Yes. They lower inflation overall in the U.S.
All the money Americans spend on Chinese products–where does it go?
The money goes to firms in China. They get it in dollars. Then they have to go to the bank to convert it to the Chinese currency, the yuan or RMB, so they can pay their employees, buy local goods. So the banks accumulate dollars. To convert them to yuan, they must go to the central bank, the People's Bank of China.
So the PBOC takes the dollars in exchange for local currency. What does the PBOC do with the dollars?
They want to invest the money, so they can make money on it. And they've been buying huge amounts of U.S. government securities. They have about $1 trillion in foreign-exchange reserves. About 70 percent of it goes into U.S. securities. About half of that is U.S. treasury securities, with other investments in things like Freddie Mac and Federal Home Loan Bank Board securities.
Why U.S. treasuries?
Because they are risk free. There is no credit risk associated with them. It's the safest investment in the world. The U.S. government can always raise taxes to make the interest and principal payments, and the Federal Reserve can also print money.
Are they long-term or short-term treasuries?
We don't really know. It's not all that clear. What we do know is that if the U.S. national debt is about $8 trillion, and that's financed through treasuries, and China holds about $350 billion worth of treasuries, then they're financing 4 to 5 percent of our national debt.
Where does the PBOC invest the other 30 percent?
Mostly assets denominated in the euro, the Japanese yen, and the Korean won.
Has China always put roughly 70 percent of its reserves into U.S. securities?
It's been that way for a while, although remember, their reserves are going up rapidly. Also, there's been concern for some time because Chinese officials have said they want to diversify, which means they might reduce their holdings of U.S. securities. But if there's a big shift coming, we haven't seen it yet.
That huge Chinese investment in the United States–how does it affect the U.S. economy?
It keeps interest rates low, because there's a broader demand for our securities. If they were only marketed in the U.S., we'd say, "Well, we don't want to buy that many, unless the interest rate goes up." Think of it this way. If the treasury has $1,000 of debt that it wants to sell, and there's only one purchaser, he's likely to say, "I only want part of it. I don't want all of it, unless you raise your interest rate." But then, if you can get more people to buy it, you don't have to raise your rate.
Does that mean that interest rates are lower than they otherwise would be, on account of China's demand for U.S. debt?
Well, in the early 1980s we had double-digit interest rates–and we didn't have China purchasing our debt. So, yes, China is helping keep our rates down.
Treasury rates are one thing, but mortgage rates, and other interest rates that consumers pay, those are different. Explain how they're related.
The lowest interest rate in the market will always be the risk-free rate. Other rates will be higher. The differential represents the risk of default. So if I'm a bank, I say, "I can invest my money in treasury securities, at the lowest possible rate, or I can make a loan to Jim. But Jim has a higher risk of defaulting, so we'll raise his rate." But if you raise the rate too much, somebody else in the market will bid you down until the rate represents the best estimate of the risk of default. If there were only one lender, there could be lots of gouging. But there's always somebody willing to shave a point or two because they think they know more about the risk of default.
So treasury rates set a floor that forms the basis for other long-term rates?
That's right. Treasuries set a floor. But keep in mind, mortgages are different from other types of loans. Credit-card rates are much higher because there's no collateral. The collateral of a home helps keep mortgage rates lower, but still, the collateral of a home is not the same as the collateral of the U.S. treasury.
Let's talk about some of the dire scenarios people worry about. What would happen if China suddenly decided to sell all of its U.S. securities?
They'd simply sell their securities in the marketplace, which means the yield would have to go up because prices would drop. It would be like a fire sale, where you have to drop the price to sell everything quickly. But that would be bad for China. If they did that, of course, they'd be getting less than they paid for the securities. That would be foolish. And the U.S. would be upset. It would be taken as a sign they are trying to harm the U.S. economy. And then, what would they do with the money? They'd have to purchase other-denominated securities. And that could be riskier for them.
If China sold all those securities, would the markets go into a tailspin?
Not necessarily. Other people would emerge to buy them, and the market would equilibrate.
Would it cause a recession?
Hard to say. It would certainly be a big enough move to get everybody's attention. And China would still have to figure out what to do with all the dollars it takes in through the exports it sells to us. What do they do with the cash?
Is there anything else China could do with its money, besides buy securities?
Sure. They could buy Wal-Mart or Citigroup. They have enough money. They could afford to purchase one of those. Now do you think the U.S. Congress would be happy about that? Do you remember what happened when they tried to buy the oil company Unocal? And think back to Japan in the 1980s. They had the biggest banks in the world and started buying all this real estate in the U.S. Then there was a crash, and they had to sell much of what they had bought.
How do exchange rates affect all of this?
On July 21, 2005, China allowed the yuan to appreciate for the first time in years, by 2.1 percent. Since then, it has appreciated another 3 percent. So that's 5.1 percent appreciation since July of '05. Most people think the yuan is still undervalued, which makes Chinese imports to the U.S. even cheaper. Sen. [Charles] Schumer's bill says it's undervalued by 28 percent, and that was before the 5.1 percent appreciation, so if he's right, the yuan is still undervalued by about 23 percent. As the value of the yuan goes up, it will make Chinese goods more expensive to Americans. And if we have to give up more dollars for the same goods, we're not going to buy some of them. So more appreciation of the yuan means China will export less, and our trade deficit with them will go down.
So Americans will buy more U.S.-made goods?
Difficult to tell. We could get other countries selling cheaper goods to the U.S. instead: Vietnam, Thailand, Cambodia.
Has the 5.1 percent appreciation led to a cutback of Chinese imports to the U.S.?
That 5.1 percent is quite small. But 23 percent could make a difference. China is reluctant, though, to allow much more appreciation. They're getting job growth right now, there's low unemployment, and they don't want to do anything that might affect jobs and cause unrest.
The U.S. trade deficit with China is more than $200 billion a year. Who's responsible for that?
Well, China would say the reason you're importing so much is that you're too consumption oriented and you don't save enough. If you saved more, you wouldn't have such a big trade deficit. In China, the household savings rate is about 25 percent. Here, it's just about zero.
How does the trade deficit factor into this?
You have to talk about both deficits–the trade deficit and the annual budget deficit. One of the biggest concerns in the U.S. is the twin deficits. We're importing a lot of capital from abroad due to the trade deficit, which means a lot of principal and interest payments are going abroad. At the same time, more U.S. treasury securities must be issued to finance the budget deficit.
Why is that a problem?
Our trade deficit, also called the current account deficit, is about 7 percent of GDP. As you take on more and more external debt relative to GDP, at some point, the amount of payments you send abroad can exceed GDP. You can't make all those payments. That means you'll have to default. But before that happens, interest rates will go up, which would help reduce the deficit. But the adjustment could be abrupt and painful.
Do you foresee that happening?
No. But the trade deficit is hitting the territory where more and more people are concerned. The first thing that will happen is the dollar will depreciate–and that has been happening.
Is there a chance that the Chinese could overspend like the Japanese did and then have to retrench?
I don't see that happening. They've done a marvelous job fixing their troubled banks, their productivity is improving, their technology and management are getting better. Nobody would have thought five years ago that China would have accomplished as much as it has.