Tuesday, June 30, 2009

Shifts in China's Asset Portfolio

China will be selling its U.S Treasury bonds and using the $ to purchase up natural resources such as oil in Iraq. What would Hotelling think of this? Fear of inflation would suggest that treasury bonds will be offering a low rate of return and if China believes in "Peak Oil" then the returns to holding inventories of oil and other non-renewables will be high. For details read this NY Times article on China hoarding natural resources .

The real issue here is "induced innovation". Imagine two polar cases. In case #1, China is unable to hoard gas at low prices and recognizes that its growing middle class and upper class want to drive private vehicles that run on gasoline. In this case, China would make a push to increase its fleet's fuel economy. Abstracting from a severe rebound effect, anticipated scarcity of oil would create incentives for China to develop its own "green cars" for home use and potentially world export.

In case #2, if China believes that it can tap into oil endowed places such as Iraq for billions of gallons of gas then the imperative of innovation on the green front fades as the current fossil fuel technology can live on providing driving services to the newly wealthy Chinese.

For those who care about climate change mitigation, case #1 is the better one.

What about Ben Bernanke? Has he calculated how much higher will equilibrium interest rate for U.S T-bills will be if China reduces its purchases by 20%, 40%, 60%? If China does shifts its portfolio and this becomes public knowledge, will this information reduce demand by other smaller buyers as they feel that "China must know something" and this could set off a nasty spiral.