The Global Savings Glut in Reverse

The global savings glut theory where balance of payment surplus countries accumulate dollar reserves/t-securities is understood to have some of the following effects:

1.  This accumulation reduces the term premium by putting downward pressure on LT US t-sec yields.

2.  It suppresses the FX rate of the countries accumulating reserves.  In other words, it keeps the dollar FX rate higher than if the accumulation had not taken place.  This dollar overvaluation reduces US nominal income growth.  

3.  Excessive and persistent balance of payments surpluses must correspond with other countries running deficits.  This comes in the form of either an increase in private (ex. MBS pre-GFC) and/or public sector (ex. fiscal deficits leading to treasury issuance) leverage in deficit countries as well as trade deficits.    

4.  These persistent surpluses could be the cause of the disinflationary trends we have seen in developed markets as they stifle global aggregate demand.  This also seems to correspond with overcapacity or excessive aggregate supply.  

5.  The above factors lead to the Fed having to target lower short term policy rates as well as unconventional monetary policy.  

Now if this is a correct interpretation of the theory, then shouldn't PBOC dollar/t-sec selling produce some of the opposite effects? 

• an increase in the term premium that coincides with a rise in both LT and ST treasury yields
• a dollar depreciation with reverse effects on NGDP
• a rise in developed market inflation rates especially in the US
• a pick up in global and US aggregate demand
• the narrowing of US trade deficits which safely accommodates US fiscal and private sector deleveraging
• all of which enables the Fed to safely target a higher ST policy rate without risking a US slowdown

If the PBOC were to target lower rates by managing the Chinese domestic monetary base, I'd suspect that this narrowing in interest rate differentials relative to US rates would induce continued capital flight.  If the PBOC were to not sell off dollar assets to manage the FX rate then wouldn't this scenario actually be the one that produces continued dollar appreciation/yuan depreciation? 

If so, then this strikes me as the disinflation or even deflationary scenario which would continue to suppress the US term premium while reducing global aggregate demand.  If this lead to a US slowdown/recession, it would likely mean widening fiscal deficits (automatic countercyclical stabilizers kicking in) funded by issuing treasury securities that may eventually be bought the by Fed.  Thus, either the PBOC supplies US Treasuries or the US treasury may be forced to eventually.  

Another point to consider is whether a depreciating Yuan would put upward pressure on the Euro FX rate.  If so this threatens to counter the region's expanding current account/trade surpluses (particularly Germany's) and weak recovery.  In a recent post, Bernanke made mention of how the Eurozone replaced China's previous excessive current account/trade surpluses.  Therefore, a weakening yuan may either force the ECB to engage in more aggressive monetary policy or otherwise risk a politically destabilizing slowdown in EZ economic activity.  

Problematically, the Chinese government bond market may be too immature/small to allow the PBOC to offset dollar sales by buying enough yuan government bonds to ensure that the monetary base stops contracting (and eventually expands).  In an economy that is burdened by private sector debts, monetary tightening would be inappropriate.  If the developed world is any indication, this private sector debt growth deceleration could lead to a private sector deleveraging cycle that risks causing the problems we have witnessed in the US after the private sector credit bubble and GFC.  Under a dollar peg regime, the PBOC was essentially forced into adopting the Fed's monetary stance which was just as inappropriate during the Chinese private sector credit boom as it is now during a potential bust.  

On the fiscal side, in order to facilitate domestic private sector deleveraging that otherwise may threaten NGDP growth, I can't help but wonder whether the Chinese government will eventually follow in the footsteps of the US and Japan (1990s) by running large fiscal deficits funded by issuing Chinese government debt.  This would open the door for the PBOC to conduct monetary policy via OMO/repo/QE using these government securities.  

A Chinese fiscal expansion could also play a pivotal role in rebalancing the economy toward domestic consumption by channeling financial assets to the Chinese household sector via either direct transfers/tax cuts/social spending and/or by instituting a much stronger social safety net.  Without this occurring, I find it hard pressed that China will be able to rebalance it's economy since it seems evident that right now the Chinese household sector is not in a financial position to support a consumer economy that can soak up the economy and global system's excess capacity. 

These policies may threaten China's position as a capitalist safe haven where entrenched interests in China may attempt to stifle a rebalancing that threatens the status quo.  Therefore, it may not be possible to engage in such an aggressive policy stance that favors the household sector (wage earning labor).  Moreover, doing so very well could disrupt a global supply chain that has grown dependent on cheap labor from this region of the world since this would mean accelerating labor costs relative to those in developed economies.  With that said, a large currency depreciation under these circumstances is no panacea either if this eventually means unemployment reaching levels that would result in an acceleration in nominal wage growth.  A depreciation would also cause a decline in the dollar value of Chinese assets held by the domestically wealthy as well as foreigners that have invested heavily in the development of illiquid assets within the country.   

*What’s China’s Biggest Problem?

This debate between David Beckworth and Patrick Chovanec delves into the PBOC's reserve management and monetary policy.  Given my above thoughts, I don't necessarily think their positions are nearly as mutually exclusive as they present them to be.