Reuters reported today that talks in Beijing between American and Chinese representatives had no substantive results, but that each country agreed it needed to set its houses in order:

China will rebalance toward domestic demand-led growth,” U.S. Treasury Secretary Timothy Geithner said, while the United States had already learned the “importance of living within our means as a country and at a household level.”

Cross our apple-pie-loving hearts and hope to die.

Economics overshadowed the high-level dialog, with the U.S. expressing “concerns” (!) about the situation in Xinjiang. Of course, China had its own criticism for the U.S.:

As a major reserve currency-issuing country in the world, the United States should properly balance and properly handle the impact of the dollar supply on the domestic economy and the world economy as a whole,” Vice Premier Wang Qishan said earlier on Tuesday. (Reuters)

In other words, USA, don’t put the country in hock. The United States, of course, has to listen, as China recently surpassed the US$2 trillion mark as the single largest investor in U.S. Treasury bonds.

However, since January this year, China has been reducing its purchases of T-bills. According to The New York Times:

All the key drivers of China’s Treasury purchases are disappearing — there’s a waning appetite for dollars and a waning appetite for Treasuries, and that complicates the outlook for interest rates,” said Ben Simpfendorfer, an economist in the Hong Kong office of the Royal Bank of Scotland.”

Indeed, Brad Setser at a Council on Foreign Relations blog calculates:

In February, China bought Treasuries. $4.64b by my count. It bought $5.61b of bills, while reducing its long-term Treasury holdings by $0.96 billion. But China also reduced its US bank deposits by $17.24 billion. Consequently, by my count, China’s total US holdings fell by $13 billion. Short-term claims fell by $11.3b, and long-term claims fell by $2b.”

So where did the US bank deposits go? Another New York Times articles cites:

China’s goals vary by commodity. Chinese companies have bought iron ore heavily on the spot market in anticipation of higher prices in annual contract talks now nearing completion. The Chinese government has been stockpiling oil and some metals for strategic reasons, and bought huge quantities of aluminum and canola to insulate domestic producers of these goods from falling global prices over the winter”

China also has another concern: its economy’s sagging performance. As recently as last autumn – when the Chinese economy was still on a roll – China’s central government ordered its state-owned banks to fork over as much as 20% their deposits to China’s central bank. The deposits came from all the revenues from its export-driven companies, the Foreign Direct Investment (FDI) flowing into the country to set up new factories and other operations; as well as the speculative flows from overseas Chinese that want to catch the China wave. China’s central bank would then re-invest the money in U.S. Treasuries. With China’s US$600 billion stimulus package, though, China’s central government needs to reduce state-bank requirements so the local banks can make loans to local governments and State-owned Enterprises (SOEs). Recall, the powers that be have committed China to 8% growth in its wealth, or GDP.

In addition to the diversion of funds from buying T-bills to investing domestically, China has the additional challenges of seeing FDI into the country decrease for the last three years running, and of the slowest compounded growth in its trade surplus with America and Europe in years. The Chinese government is trying to be more prudent with its cash surpluses.

Despite a substantial proportion of that money re-inflating the country’s real estate and stock market bubbles, China is unlikely to clamp down on its stimulus program any time soon: call the bubbles “collateral damage”, if you will. The central authority believes it has to prime its economy through a fiscal stimulus effort that may be springing leaks throughout its economy and society (see my post, Thee Doth Protest Too Much ); however, it needs to buy time to “re-balance” its economy from being export-driven to more internal-consumption driven.

The Chinese central government is committed to ensuring the American economy’s success by continuing to buy T-bills to help keep American interest rates low. Higher costs for the American government to pay down its debt will ripple through the economy to make the cost of borrowing for companies and individuals more expensive overall as well as ramp up inflation – a surefire way to stall a restart. Inflation will also devalue all those hundreds of billions of dollars of T-bills the Chinese have invested in.

Besides, as one of the Chinese government’s top monetary economists, Yu Yongding, replied in a New York Times interview – quoting John Maynard Keynes, “…If you owe your bank manager a thousand pounds, you are at his mercy. If you owe him a million pounds, he is at your mercy.”

So, it ain’t over till the Fat Lady re-balances – uh, sings.