China a major buyer of US treasuries is reported to be losing its interest in buying more US debts. For the US economy which has exhausted all options and now looking at deficit spending as the last hope this could spell more trouble. First a brief background.
President Elect Obama announced that the US deficit could reach $1 trillion for years to come. He has said that he will be passing multi-billion dollar fiscal stimulus packages to stop the free fall of the US economy. Fiscal policy is now the only available lever to pull given that the only other major lever, Monetary policy has been exhausted. The Fed had already reduced the target interest rate to 0-0.25%, there is no further room for the monetary policy. Even now the lax monetary policy did not stop the fall and is proving to be impotent. The only hope is fiscal stimulus.
But with any fiscal spending the first question to ask is, “How is the Government going to fund the spending?”. In other words, what gives? The only revenue source to the Government is the Tax collection. When the Government spendings exactly match the tax revenues collected we will have a balanced budget. Otherwise we get surpluses or deficits.
The Government does deficit spending by issuing debts, in the form of US treasuries. Any individual, institution or Sovereign funds from around the world can buy these. Until now a biggest buyer of US debt has been China. But with its slowing economy and its posed $1 trillion fiscal stimulus it is losing interest in buying US debt.
What does this mean?
The US Government has to find other buyers from locally or from EU. It may have to spice up the bonds issue by increasing the rate it offers on these bonds, but this means the interest rate for all US credits will go up. For an economy struggling under credit crisis, this will further staunch credit available to businesses and individuals and the effects may negate the positive effect from Government spending.
The net is, without a buyer for US debts at current rates, getting out of the economic crisis through deficit spending is not going to work.