For those following world events the ongoing slowdown in the Chinese economy has been a subject of major interest. The recent volatility that we have experienced in our stock market has been attributable in large part to fears of China’s potential impact on the global economy.
One area that has received less press coverage is how changes in China may influence our interest rates.
The reason China has a potential impact on our interest rates is because in recent years they have been a major purchaser of U.S. Treasuries. Our government issues Treasuries, as a way to finance our debt, as most years we are running a budget deficit.
Our deficit was especially large during and coming out of the last recession.
The reason China was in a position to purchase U.S. Treasuries was because it was running a large trade surplus. This enabled China to build up huge foreign-exchange reserves. Because the U.S. Treasury market is extremely large and liquid it was an easy place for China to place a good portion of its reserves.
Currently China has $3.56 trillion in reserves, as of the end of August. However, this is down from a peak level of nearly $4 trillion in June of last year. Of this total Approximately $1.27 trillion is invested in U.S. Treasuries, though this figure is through June.
This figure has remained reasonably constant over the past year, even though China’s overall reserves have declined.
China’s reserves are declining, as it has been trying to prop up its currency. If this trend continues, China will most likely start to sell some of its U.S. Treasuries.
Among foreign countries China is the largest holder of U.S. government debt, with Japan a close second. These two countries constitute over 40% of the foreign ownership of U.S. Treasuries. In addition the oil exporting countries and Brazil hold close to another 10%.
Of these countries none of them are doing particularly well at the moment, though Japan is reasonably stable. The oil producing countries are hurting with the decline in oil prices, and Brazil is in a recession. While Japan will likely maintain its reserves, China, Brazil, and the oil producing countries will likely decrease their holdings.
Assuming the rest of the world does not change its ownership of U.S. Treasuries in a significant manner, foreign holdings of U.S. Treasuries will likely decline. This will presumably put some pressure on U.S. interest rates.
Fortunately, our budget deficit has been coming down. Tax revenue has been increasing in recent years, as more people are working.
Nonetheless, we are still running a deficit, and if there are less foreign purchasers Americans will need to make up the difference.
Interest rates recently have been rather stable. This is rather unique, as normally during periods of high stock market volatility interest rates have tended to decline. This is because investors tend to be attracted to the safety of U.S. Treasuries. This would imply that foreign investors, notably China, have probably been starting to sell some of their U.S. government holdings.
What this means, is that interest rates will likely begin to rise once markets start to calm down. What happens with U.S. Treasuries is important to the housing industry, because mortgage rates strongly correlate to the 10 year Treasury.
China’s economy is gradually evolving from an export led one, that will eventually become more balanced. This implies that it will no longer be a major purchaser of U.S. Treasuries, as it was in recent years. Of course this is only one factor in the determination of interest rates, and there are many other things that can influence Treasury yields.
In the short run it is very difficult to predict the direction of interest rates. However, given that rates are still at historically low levels there is a significant likelihood that they will be higher in the future, especially with China reducing its foreign-exchange reserves.