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Made in China - Part I

Posted:September 12, 2024

Categories: China, Federal Reserve, Monetary Policy

The United States and China are clear leaders in today’s global economy. They account for around 43% of the world's gross domestic product (GDP). The actions of the central banks, the U.S. Federal Reserve, and the People’s Bank of China have the most impact on capital markets. The following article will discuss the background of the U.S. and China relationship over the past 30 years. The second article will examine a dataset of various economic and financial data to compare these two superpowers. My goal is to shed light on this important economic relationship and how it impacts capital markets and monetary policy moving forward.

1994 to 2024

Before diving into the details, it’s important to take a step back and review the economic relationship between these two countries. 30 years ago, China made a major decision when it massively devalued its exchange rate relative to the U.S. dollar. The Chinese Yuan went from around 5.80 to the dollar to 8.70 and stayed around this range for many years. You can see this change in Figure 1 below. This wasn’t a huge deal at the time as China’s economy was small relative to the rest of the world. What many could not foresee was the massive shift undertaken by the government in China to move millions of people from rural areas to the cities and into factories.

Figure 1: USD/CNY Historical Currency Pair (1990 - 2024)

Source: Macrotrends

The term “Made in China” was a product of this decision and economic circumstances. When one currency is “cheap” relative to another, this makes that country's exports incredibly attractive. In this case, the United States began importing goods from China at a tremendous pace in 2000. Furthermore, when a country devalues its currency and fixes it to another currency, they are essentially exporting deflation. What occurred, as a result, was that China exported goods to the United States and in return received U.S. dollars. China then recycled those dollars into United States Treasuries (debt). Figure 2 below shows the rise of U.S. Treasury securities held by China since 2000. Keep in mind this chart shows the market value which takes into the drop in the value of treasuries as interest rates have risen since 2020. China currently owns $780 billion as of June 2024.

Figure 2: China Holdings of US Treasury Securities

Source: Apollo

Consequences for the United States

The rise of “Made in China” allowed the U.S. to print lots of money, and sell lots of debt, which in turn kept interest rates low. Higher amounts of leverage occurred in the United States with the Fed having to maintain a 2% inflation target and a ready and willing buyer of U.S. Treasury securities. Debt was cheap. Low interest rates fueled the technology bubble in the early 2000s and were a major factor in the 2007/2008 global financial crisis. Figure 3 below shows the level of U.S. Government debt (blue line, right scale) and the 10-year U.S. Treasury interest rate (purple line, left scale). Federal debt grew from roughly $600 billion to $34 trillion while the 10-year treasury rate dropped from a high of 15% in the early 1980s to under 1% in 2020. It’s important to point out that some of the consequences turned out to be very positive for the U.S. outside of recessionary times. GDP growth has been robust, our housing market has boomed, and the S&P 500 is up 500% since the turn of the 21st century.

Figure 3: U.S. Federal Debt & U.S. 10-Year Treasury since 1970

Source: TradingView

Consequences for China

For China, this meant massive capital account and current account surpluses as far as the eye could see. Dollars kept flowing and they kept buying U.S. Treasury bonds. Bank reserves increased allowing ample collateral to fuel massive lending and capital investment. State-owned and managed commercial banks turned on the credit spigots and growth took off. What resulted was overinvestment in capital and the mother of all speculative real estate bubbles. Some estimate the size of China’s real estate market hit USD 50 trillion, roughly twice the size of the entire U.S. economy. 

Figure 4 below shows the rapid rise of China’s residential real estate market since 2005. Prices have gone sideways since 2018. According to Kenneth Rogoff, China’s homeownership rate is over 90% in urban households, the highest of any country in the world. For context, the U.S. sits at around 60%. A massive drop in real estate, a declining population, and over-indebted citizens, companies, and government have directly impacted growth in China. This comes at a time when this 30-year marriage between the United States and China is changing. Globalization is declining, and non-Chinese investors are pulling capital from China due to the lack of a rule of law. 

Figure 4: Residential Property Prices for China since 2004

Source: St. Louis Fed

Much of this article owes to the great work and research of Russell Napier. He points out the following about countries craving control. He says a country can’t control all three of the following at once:

1. Price of Money - Raising and lowering interest rates (the “Discount Rate”)

2. Quantity of Money - Adding or subtracting money from the economy (think “Quantitative Easing”)

3. Exchange Rate

With a flood of capital coming from the West, China was able to control the price of money, and quantity of money, and peg its exchange rate to the U.S. dollar. This allowed them to have large capital account surpluses and flood their country with high levels of reserves, leading to high levels of debt. This is all now changing with capital flowing out of China. Growth in bank reserves has gone nowhere in 10 years which has negatively affected the economy due to their real estate troubles and less capital flowing from the West. This has forced China to grow debt via “non-bank” channels. Furthermore, to keep their exchange rate fixed, they must intervene, which means selling reserves.

Devalue, Deflate, or Do Nothing

All of this leaves China’s President Xi Jinping at a crossroads. Do they devalue the yuan, let their economy deflate, or stick with the current policies and hope for things to turn around? 

Devalue - Should they allow the exchange rate to freely float, the CCP would be giving up control. Further, the exchange rate would most likely drop hurting the purchasing power of the yuan. This directly impacts their citizens as China has strict capital controls. 

Deflate - This is certainly not an option as no government would openly choose to allow their economy to decline. Let alone a government that has so much control. I just don’t see this happening.

Do Nothing (with a fixed exchange rate) - If China chooses to ease via a loose monetary policy such as lowering interest rates, adding to bank reserves, and increasing money creation, they may find themselves in a pickle. With low capital inflows and foreign direct investment, this would increase imports and decrease their capital account. This would certainly increase GDP growth but also put pressure on their exchange rate. This would require China to intervene to manage the exchange rate forcing them to sell U.S. Treasury bonds and deplete bank reserves, which would tighten monetary policy at a time when they are trying to ease monetary policy. Thus, they enter a doom loop of sorts.

The 30-year “Made in China” marriage is not ending, but rather, shifting gears. This has major implications for the U.S. bond and stock markets, but also emerging market stocks as China makes up roughly 25% of the emerging market stock index. This also has major implications for gold as many Chinese citizens have been turning to gold as a store of value as they see a deleveraging real estate market and a dropping stock market. Having this context is important as in my next article, I plan to show a dataset comparing the United States to China to see how these superpowers match up.

References

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