Thursday, May 27, 2010

China Moves the Market

China’s official foreign exchange reserves total about $2.5 trillion, and continue to rise each month. How China invests these funds has a large impact on the value of financial assets.

On April 4, 2010, total market capitalization of U.S. stock markets stood at $12.3 trillion. For the purpose of this discussion, assume this number more or less reflects total market capitalization in late May. On May 26, 2010, the DJIA and other major market indices fell in the last two hours of the trading day in response to stories that China, concerned about financial problems in Europe, was considering selling some of its portfolio of euro-denominated public debt (or slowing or ceasing its purchases of new euro debt). The DJIA dropped sharply, from 10,170 to 9,974, a decline of 1.93%. Thirty percent of U.S. exports go to Europe. Further decline in the euro vs. the dollar would reduce the dollar value of U.S. repatriated euro earnings.

Taking that fall of nearly 2% as an approximate indicator for the decline in U.S. equity market capitalization, the story that China would reevaluate its purchases of euro debt chopped $237 billion off the equity values on U.S. exchanges. Chinese denials of the story restored this loss in the first hour of trading on March 27.

Fast forward one, three, five, or ten years. Assume China continues to add to its holdings of U.S. federal debt. Long-term projections indicate that the U.S. federal government will borrow a trillion dollars each year over the next decade. Budget planners must suppose that China will buy some, perhaps a significant, part of this new debt. Now imagine what would happen to U.S. equities and interest rates, and its impact on the U.S. economy, should China hint that it might stop buying new debt or, worse still, sell some of its U.S. treasuries.

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