Those who have been following the news know that China's central bank is planning to set up an investment fund to diversify its assets and increase its returns. The reports invariably describe the U.S. treasury bonds, which comprise much of the fund's current holdings, as "safe," but low yielding. Let's play with some arithmetic here. The dollar has fallen by more than a third against the euro since 2002, which means that each dollar purchases one-third less in euro land than it did five years ago. Back in the summer of 2003, the interest rate on the 10-year treasury bond bottomed out at 3.05 percent. Today, it stands at around 4.6 percent. This means that the bonds China held back then have lost approximately one-third of their value. (The price of the bond is inversely proportional to the yield. The actual calculation of the bond price is a bit more complicated, since it does matter when they reach maturity.) If the yield on 10-year treasury bonds rises back to its avearge rate for the decade of the 90s (6.8 percent), then the value of the bonds would drop by another 30 percent. The point here is that if "safe" means that you cannot lose money, then U.S. treasury bonds are not a safe asset for the Chinese central bank. This is important because the central bank's motivation in holding treasury bonds was not to find a safe asset in which to store its wealth. It was to prop up the dollar against the yuan and to keep long-term U.S. interest rates low (that's why they bought long-term bonds) to keep the U.S. economy growing. This in turn sustained the huge growth in China's exports. While this helped to spur China's extraordinary growth over the last decade, it was inevitable that at some point the country would no longer need the U.S. export market to sustain its growth. It seems that this day is now approaching. [Note: Felix Salmon has corrected my arithmetic here. For a very long maturity bond, the price can be treated as inversely proportional to the interest rate. For a 30-year bond, this is close to true. For a ten-year bond, the closeness of the maturity makes a big difference. The 50 percent increase in U.S. interest rates that I note here corresponds to an 11 percent fall in the bond price. I should have bothered to check this one before writing. (I still don't think the Chinese central bank bought 10-year bonds in 2003 yielding 3.05 percent expecting to get a good return.)]
--Dean Baker
