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    Will China Wreck the US Treasuries Market and the US Dollar?

    © AFP 2018 / FRED DUFOUR
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    Ivan Danilov
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    Beijing may be considering dumping its US bond portfolio in reply to Trump’s trade threats, but can it really hurt the US Treasury market and crash the US dollar.

    An unconfirmed news report from Bloomberg regarding an impeding halt of further Chinese purchases of US Treasury bonds rattled the global markets, showing just how fragile the global financial system really is. It also reignited an old debate about America’s vulnerability to Beijing’s hostile actions, given the huge size of the Chinese portfolio of American bonds that can be used as a financial weapon against the US Treasury market and by implication, the US dollar. The short-lived panic in the foreign exchange market and the US Treasury bonds market ended after the Chinese State Administration of Foreign Exchange (SAFE) issued a strongly-worded statement, claiming that the Bloomberg report was “fake news.”

    However, American officials and some financial experts went into full damage control mode in order to reassure investors that China has no way of hurting the American financial system and the price of US Treasuries. Some experts believe that the leaked report was actually a warning shot fired to make Donald Trump less willing to engage in a full-fledged trade war on China. Who can be trusted on this issue? The mainstream media and the US officials, who say that everything is fine, or the financial markets that panicked when the Bloomberg report hit the wires?

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    The mainstream view on the risks, associated with the Chinese bond portfolio, is that no matter what China does with its US Treasuries holdings, the US market and the US dollar will be fine, mainly because there are other buyers for American bonds and the bond market can be propped up by the Federal Reserve. When asked to comment on the news about China’s alleged intention to change its foreign reserves policy, Treasury Under Secretary for International Affairs David Malpass stressed the unparalleled liquidity and robustness of the US Treasury market.

    “The U.S. Treasury market is a deep, robust market within the world and so we are confident that our economy, with the economy strengthening, that it will remain a deep, robust market,” Malpass said to a group of reporters in Brussels. 

    Alan Ruskin, head of G10 foreign exchange strategy at Deutsche Bank, echoed Makpass’ comments, noting in commentary quoted by CNBC, that “there are some good arguments why China's bark will prove a lot worse than its bite.” 

    There are several reasons for such dismissive comments. A popular opinion is that there are no viable alternatives to holding US Treasury bonds for a big reserve manager like the Chinese State Administration of Foreign Exchange (SAFE). This opinion boils down to the argument that while American Treasuries may be unattractive, they’re still better than the next best alternatives. Another popular opinion is that by selling Treasuries China will shoot itself in the foot, because a fire-sale of its 1 trillion dollar portfolio can’t be completed without incurring massive losses due to the fact that, somewhat ironically, flooding the market with bonds will depress the price, meaning selling at a loss. It is assumed that the Chinese reserve managers are rational and will not act on the threats to sell their American holdings.

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    There are several problems with this line of reasoning. Some experts, like Mark Cabana, head of US short rate strategy at Bank of America Merrill Lynch, believe that China has some viable alternatives to the US Treasuries. “We're of the view if you're a reserve manager, Treasuries aren't terribly attractive. If you're China, you don't have too many options, but this could certainly mean they could diversify into euros more or in U.S. dollar terms, hold more in cash,” Cabana told CNBC. Moreover, the reasons behind the possible rejig of the Chinese reserves may be political and not economical, therefore nullifying the argument that China won’t give up on Treasuries because it will result in losses. It is obvious that in Sino-American relations political necessity sometimes trumps all other considerations, so crashing the US Treasury market in order to make a political point may be considered a viable strategy at some point.

    Despite the fact that the Chinese State Administration of Foreign Exchange slammed the Bloomberg report as “fake news,” most commentators believe that the initial leaks were some sort of “financial saber rattling” meant to remind Donald Trump that China is the largest foreign holder of US Treasury bonds and is basically the bank that bankrolls a significant part of the US budget deficit.

    This reminder comes at a time when the White House should feel particularly vulnerable, because the Trump Administration tax reform plan requires the budget deficit by $1 trillion over the next decade. The increased deficit will have to be financed by additional issuance of Treasury bonds. If China starts selling its bonds, then the US Treasury will have to offer higher yields in order to attract investors, therefore increasing the US debt servicing costs. However, the biggest danger is that the Chinese actions will reduce the value of outstanding Treasuries, harming portfolios of all other investors, who may decide to sell their Treasuries, triggering a chain reaction.

    Even if the Federal Reserve steps in to save the day, the US Treasuries’ image of the “safest investment on Earth” will be severely damaged. Besides that, Beijing’s decision to dump its American bonds will be viewed by the market as a vote of no-confidence in Donald Trump’s economic policies and that may prompt other sovereign holders of US debt to reconsider their portfolio allocations. The damage in this case will be asymmetrical because China will lose less than the US.

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    Although Beijing will be unable to unilaterally crash the US Treasury market or the US dollar, the threat to sell its portfolio of US bonds has serious implication for the long-term stability of the US economy and financial system. It is possible that such a threat will be enough to prevent a trade war between the US and China, despite the fact that some US officials from the Trump Administration and maybe even Trump himself want to start a trade war. If cooler heads in Washington and Beijing prevail, the US Treasuries will remain a relatively safe investment, at least until the next crisis in Sino-American relations.

    The views and opinions expressed by Ivan Danilov are those of the author and do not necessarily reflect those of Sputnik.       

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