February 28, 2009

An interesting dilemma for both China and the U.S.

Weekly Snapshot
• UBS replaces CEO with Oswald Gruebel, former head of Credit Suisse
• The U.S. government to boost its equity stake in Citigroup to 36% by converting $25bn preferred shares to common stock
• US GDP dropped 6.2% in Q4 of 2008
• US economy expanded 1.1 percent in 2008, the slowest pace since 2001
• Obama predicts $1,750bn deficit
• General Motors reported a net loss of $30.9bn in 2008
• Japan’s exports fell by 45.7% in the year to January
• U.S. home prices fell 18.5% in Dec-08 from a year earlier based on the S&P/Case Shiller home price index
• Mass protests in Ireland against pension cuts and the government's response to the banking crisis

Recommended Read
An interesting dilemma for both China and the U.S.: http://www.ft.com/cms/s/0/07e696a0-014a-11de-8f6e-000077b07658.html

This article gives a glimpse of the dilemma facing both US and China with regard to their currencies and the management of growing debt on the US side versus the growing surplus on the Chinese side. The essence of this growing dilemma is highlighted in the following quote:

"US Treasuries are the safe haven; it is the only option," said Mr Luo. "Once you start issuing $1-$2 trillion . . . we know the dollar is going to depreciate, so we hate you guys, but there is nothing much we can do."

Chinese investors are now the biggest foreign holders of US Treasuries with nearly $700bn. In total, foreign investors own about $3,000bn or more than half of all US Treasuries publicly available. The fact that the US is still somewhat considered the only true safe haven would explain why the US Dollar still remains relatively strong against all other major currencies. However, it also shows the precarious situation the US may face in the very near future. In order to continue to be able to find buyers for the growing US debt mountain, something has got to give. If the US$ were to depreciate, foreign investors would need to be incentivized with significantly higher yields on US treasuries. At the same time it is not in the interest of the US government to raise interest rates as this may give a further blow to an economy that is already in intensive care. Furthermore, a weaker Dollar means higher relative inflation compared with another currency. As a highly indebted US investor, I would want to carry as much debt as possible if inflation were to ensue in the coming years. Inflation may be the debtors best friend and a creditor's worst nightmare.

How this balancing act will play out is going to be one of the pivotal questions for the future of the global economy. It also becomes increasingly apparent that any solution to the global financial crisis can only include a dialogue and close cooperation of the major economic powers. From a Chinese perspective, one could hypothesize that Chinese investors may slowly divert their investment strategy away from US treasuries but still remain in US$ denominated assets. True tangible assets e.g. real property may be the alternative. This may explain why we have been hearing of "property tours" i.e. Chinese investors touring the US in search of property investments. At some point, this may actually help put a floor on the US housing market. Also quite interesting as to why Chinese investors would favor US investments over investing in their own country; from their perspective, the grass still appears greener on the other side of the fence. Very curious to get some feedback as to why that is still the perception...

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