Fiscal Imprudence
As the New Year began, reports emerged that Chinese officials were considering reducing or even halting their purchases of US treasury securities. As China is the largest holder of US government debt (their holdings accounting for about 10% of total US debt outstanding), the news rattled financial markets.
Here's some background to these reports. China's foreign exchange reserves, the largest in the world at $3.1 trillion in January 2018, are invested in various financial assets including gold and government securities, the latter of which have typically been comprised principally of US treasuries. Such US holdings stood at some $1.2 trillion at the end of 2017, or nearly 40% of China's total foreign exchange reserves. Given this heavy weighting, it is perhaps not surprising that the Chinese government would begin considering a more diversified investment strategy for its reserves. And another factor may be at play - the Trump administration's mercantilist tendencies have produced world trade tensions, particularly between the US and China, and Chinese officials may be using their foreign exchange clout as something of a geopolitical football.
So, just as China ponders reducing its financing role in the operation of America's central government, the American government continues along its normal course, spending far more than it collects. Annual budget deficits have averaged 2.8% of GDP between 1967 and 2016, and hit 3.5% in 2017. Data (from the Federal Reserve Board of St. Louis) indicate that US public sector debt, accumulated over years from such deficits, has increased dramatically, especially through the past two decades, from some 50% of GDP in 2000, to 60% in 2010, to nearly 104% by the end of 2017. Given this extraordinary jump in debt - to a level that now exceeds America's GDP - one might reasonably expect Republican Congressional leaders, and the Republican White House, to begin focusing on fiscal prudence, especially as the growth of the US economy - and indeed that of most other major world economies - now appears sustainable and perhaps even accelerating. (Indeed, the Federal Reserve Board is now shifting monetary policy to a less accommodative stance.)
Instead, with apparently no regard to outstanding debt, this is what's happened. First, at the end of 2017, the Republican government passed a massive set of personal and corporate tax reductions, hailing the package as their signature move in the first year of the Trump Administration. While one can easily argue that America's corporate tax structure needed adjustment to be more internationally competitive, and that such a move will spark earnings, employment growth and hence tax receipts, a $1.5 trillion tax-cut package can hardly be viewed as a sure way to, on balance, reduce debt, nor as even necessary to boost an already-growing economy with an unemployment rate of 4.1%, nor as an appropriate policy given ever-higher mandatory projected spending on entitlement programs. Then, late last week, a new, $320 billion bipartisan spending deal was passed by the Congress, increasing spending caps and extending overall spending authorization, thus ending, for now, the latest round of government shut-downs. This extra spending will simply exacerbate deficits and debt. And, just at date of writing, The Trump White House announced their 2018 Budget, a visionary, non-binding document - as all White House Budgets are - that apparently includes a "road map" for offsetting growth in spending "in a responsible manner". Yet even this Republican Budget remains hugely unbalanced, in part because it proposes $200 billion in federal investment as seed money for a $1.5 trillion package of infrastructure projects.
From all the above, it would seem clear that America's budgetary process has been, and remains, very far from its basic purpose - to impose financial order. It is much closer - especially under an erratic Administration - to causing chaos. Is it any wonder, then, that, as the debt market digests the certain prospect of substantially more T-bond supply from the Treasury Department, the very long bull market in US Treasuries has finally turned bearish? And, thus, can it be at all surprising that the Chinese are considering modifying their foreign-exchange investment strategy?