China, Mortgages, Gluts, and More…

“Over the past decade, China and the United States have developed a deep symbiotic, and dangerous, relationship. China discovered that an economy built on cheap exports would allow it to grow faster than it ever had….American consumers snapped up these cheap exports – shoes toys…and the like – and China soon found itself owning a huge pile of American dollars. Governments don’t like to hold too much cash, because it pays no return, so the Chinese bought many, many Treasury bonds with their dollars. This additional demand for Treasuries was one big reason (though not the only reason) that interest rates fell so low in recent years. Thanks to those low interest rates, Americans were able to go on a shopping spree and buy some things, like houses, they couldn’t really afford. China kept lending and exporting, and we kept borrowing and consuming. It all worked very nicely, until it didn’t.”

-David Leonhardt, Economics writer for the New York Times

The Great Recession is the gravest recession since the Great Depression. It has led to countless home foreclosures in the United States (U.S), created massive Wall Street firms to go bankrupt, and created financial catastrophes in other countries outside of the U.S. The Great Recession was in part started by the collapse of the housing bubble which had been growing at a rapid rate from 2002 to 2008. While there were many macro-economic failures that helped lead to the current crisis, China played a big role in it’s financing of U.S. debt through its savings and investment in U.S. Securities and Agency and non-Agency bonds.

Yuan / Dollar

China began investing in U.S. securities and agency bonds for two reasons. First, the East Asian Financial Crisis plays a big role. Holding so many securities and bonds is a cushion in case something like the 1997 episode happens again. Second, the Chinese use a pegged undervalued exchange rate to help their growth policy of export led growth. When foreign entities export to the US they are paid in dollars. Having so many dollars allows them to in part control how many dollars are on the market and since they wanted to keep their exchange rate low relative to the United States that meant that people wanted China’s goods over the U.S. That meant other countries such as the United States wanted to import more of China’s cheap goods (cheap due to their pegged exchange rate) etc.  Because of their low valued exchange rate, the Chinese accumulate so many dollars they must do something with them rather than let them just sit. The Chinese took all these dollars and used them to buy Fannie Mae and Freddie Mac bonds and securities as well as private MBS which recycles dollars, which Americans use to buy consumer products, back into the U.S economy in the form of debt. China lends us money and then with that lent money we can go and buy more of their cheap consumer products.

The cycle of the Chinese buying U.S. securities and bonds worked for awhile, but when the U.S. housing bubble began to burst, the Chinese supposedly had 10% of their GDP invested in securities guaranteed by Fannie Mae and Freddie Mac. Fannie and Freddie were considered a good investment by the Chinese government because their mortgage backed securities were explicitly backed by the U.S. government.  China had invested $376 billion in long-term agency securities most of which were likely to be debt issued by Fannie Mae and Freddie Mac. The South China Morning Post (September 25 2008) estimated that Chinese Banks held $9.8 billion in U.S. sub-prime loans at the end of 2007 and $25 billion in Fannie Mae and Freddie Mac as of June 30, 2008. This mass amount of buying mortgage backed securities makes it so the interest rates decrease in the mortgage market.

Ben Bernanke

While the Chinese over investment in the mortgage market led to decreased interest rates in the mortgage market, Alan Greenspan and Ben Bernanke both have their theories about how China contributed to the housing crisis and the overall Great Recession. Bernanke believes that a savings glut (combination of diverse forces has created a significant increase in the global supply of saving) was the cause of the financial housing crisis which helped lead to the Great Recession.  While there was an increase in the external U.S. deficit, there was a decline in U.S. savings. In China, the Middle East, and Russia there was a significant increase in savings due to oil revenues piling high. However, as savings was increasing, consumption was falling behind, especially in China. While China had savings increasing as well as investment, savings was increasing more than investment and in the long term savings must equal investment.  Interest rates often reflect this as they adjust to make savings and investment equate. However, savings kept increasing and investment fell behind in China. The Chinese then put their money in U.S. Treasury and agency bonds rather than investing it in say buildings, roads, social expenditures etc. This caused interest rates in the United States to decrease in the long term. Hence, all of the buying up of agency as well as non-agency bonds by China in the mortgage market helped to keep the interest rates abnormally low in the mortgage market.

Alan Greenspan

Alan Greenspan, the former chair of the Federal Reserve has a similar yet different view on the subject. He believes that there was a decline in long-term interest rates in the 1990’s due to the shift toward export-led markets (such as China). Growth in China as an emerging market led to an excess of global savings relative to intended capital investment.  Increase in savings propelled global long-term interest rates to become progressively lower. Real estate capitalization rates declined and converged across the world (not just in the U.S.).  This led to a global increase in housing prices and hence the global housing bubble.

All of these are just current ideas on what happened to create a recession as grave as the Great Recession. Economics is hard to study especially when it is occurring and being analyzed right now. Whether it is the Chinese savings glut, export led markets, or abnormally low interest rates in the housing market that led to the extremely high housing prices, China played a role. In a globalized economy, one countries actions can have an effect on many other countries. China may not be the sole cause of the great Recession but they defiantly contributed.

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