It started with China's investment in US Treasury...

I am not an economist. I did most of my works in business strategy. But I got interested in the issue of RMB exchange rate, and started reading blogs of some economists and writers. A recent discussion posted by Michael Mandl (see 1 and 2) of Businessweek and Brad Sester raised an interesting issue. I see it a little differently and here I am trying to present my view from a "business" perspective.

One of the issues under discussion is on the implications of the increasing foreign ownership of US treasury. Some view this as "selling away your country", some believe there is nothing to worry because it is not a "zero sum game". Dr. Sester believes one should compare external debt to external credit (and assets), plus perhaps export values (minus import). He is therefore concerned that US may have to sell off the country when the debts are due. Dr. Mandl believes that, to answer Dr. Sester's question, the meaningful parameter one should look at is the net worth of a nation. I am not an economist. So I simplify the problem by imagining US as a corporation (US Inc), and look at the cashflow of this corporation. My result is in agreement with Dr. Mandl's, with some caveats.

The Financial Model

  1. Let's use the usual financial parameters and tools for a business corporation to describe US as a country, including its government, corporations and residents. We can find analogy for all the usual financial parameter for a country, including Net Worth(NAV), Cashflow, NPV, etc. In particular, one can view the Treasury bonds as corporate bonds, and selling of subsidiary/asset of a company as selling of corporations (e.g. Unocal) or other assets (e.g. Rockefeller Center), foreign assets (gas fields in Asia owned by Unocal) can be considered as minority investment in companies controlled by other "Inc", etc.
  2. Selling and buying assets in "fair market value" is business activities among corporations. It should also be considered as normal commerical activities among these "Inc"s, as are trading of physical goods, services, or equity stocks.
  3. When one tries to address Mr. Sester's concern of "selling off the country", one wants to consider if there is a scenario that the company has to sell its assets in a "fire-sales". In normal circumstances one would not, unless the "Inc" is under severe financial pressure due to major disruption in the market (e.g. financial melt-down, natural disaster). Therefore, one should look at the cashflow of the Inc, i.e., whether the Inc can afford to pay off the interest and principal of these external debts. The answer is obviously "yes" in the case of US Inc, because the debt is denominated in US$. US government can always issue domestic bond to pay off its foreign debt (or even print more paper money :) ). Mr Sester's concern will be valid if the bonds are denominated in Euro or RMB.
  4. To look more closely into the issue of the ability to deal with the debts in future , what really matters is the future "cashflow". i.e. The amount of inflow (domestic earning, earning from foreign investments (external credit/asset), revenue from export) - outflow (payment of interest, principal, and for import). If one generates more cash inflow than the payment, one should not worry about Dr Sester's concern.
  5. Example: let's assume my net asset is $100. I owe $15 debt. I own $20 credit/asset under other people's management (is equity a reasonable analogy?). So my gross at home under my own name is $95. My net is $(95+20-15=100).
    Is this good or bad? I would say it depends on the return for each piece.
    If my $95 is yielding 3% a year, and $20 4% a year, $15 debt i pay 2.5% a year. I would definitely issue more 2.5% bond and buy more asset that yields 4% if i could, provided I can find these deals. Because I am now sure I have the cash to pay my interest in the future. However, if the yield % (interest rate and investment return) are reversed, borrowing more is not a good deal for me.
  6. In an efficient market traded by "rational" managers one should be striking for the maximum return. (I have ignored the volatility in future for simplicity) each person/Inc will try his/its best. Therefore, for these Inc's only the combined long term return should matter (domestic and external asset asset yields - debt interests + trade balance, where trade includes revenue for intangible goods such as services).
  7. Now the question should be: is US trying its best (collectively, govt and enterprises) to secure the best long term return? By borrowing money cheaply via bond issuing and use the cash raised to finance investment for better return?
  8. Dr Mandl used DCF (discounted cashflow) to demonstrate that the total wealth of US is still increasing. So one should not worry about foreign debt, as long as the increase in domestic wealth surpass the increase in foreign debt. If my total net worth increase, it does not matter if my debt increse, because my gross asset would have increased more. I agree with his conclusion in principle. However, I believe the DCF calculation at such a macro-level may be problematic. There are a few ways to prove his point that it is not a zero sum game. One can use book value (i.e. valuing assets such as housing price based on the most recent transaction), market value (e.g. market capitalization of stock and market price of asset, incorporating current value and anticipated future cashflow by the market) or NPV (Net Present Value, using DCF, Mandl's method). Calculating NPV involves a number of assumptions. The result usually attracts debate and controversy. (how many reports from Wall Street analysts do you believe?) Since the market price is equally likely to go up or down, there is no reason to adjust it up or down. I see the current market value as the most reliable measure of value
  9. To justify the claim that the debt help to increase wealth, one probably could compare the ROCE (return on capital employed = GDP / Total Asset Investment) and the bond interest rate
  10. Dr Brad DeLong believes external debt vs future export still matters. I agree, but I want to add that US domestic value (including land and home) also matters, mainly because these debts are denominated in US$.
  11. Dr Sester's claim that one should look at external debt vs external assets. I think there is a value to look at this ratio, especially if neither conutry has control on the exchange rate (even through regulating internal interest rate), or when there is a short term squeeze such that you cannot convert your domestic earning to fill the difference in cashflow. In fact, the more appropriate measure is external interest due to external debt vs return generated by external asset. Even in this case one should include surplus in domestic calue creation (not to mention that all these external debts are denominated in US$ for US).
Other discussions
  • What about China? China has been taking FDI in large sums all these years, and the FDI generates return for the investor and also for China (employment, corporate expenses, to a much lesser extent, tax, etc). They are "selling" themselves in a way. This is what the Chinese leaders maybe thinking: as long as the future return can be justified for the land and the tax/etc concession I have given away, I am willing to owe more debt. China had virtually no external asset when they began 25 years ago. I believe they even took some loans back then. Now they have external assets in terms of US treasury, to a large extent due to the help of these FDIs. China's ability to attract FDI has been well praised internationally
  • What China should really worry is a sudden depreciation of US$, in that case all its investment in US Treasury Notes will become worthless. Therefore, it is another reason to revaluation RMB before it is too late
  • A question: do you call Australia selling its nation when it exports its irn ore? Or Saudi selling its nation when it exports oil?

1 comment:

Sun Bin said...

Krugman tried to show that US has used the money it earned (and borrowed) to invest into some shadow asset (housing) or consumable (military), which does not contribute to any long term value.