Blog on the Run: Reloaded

Monday, September 6, 2010 1:43 pm

China and U.S. Treasuries: From nuclear option to firecracker


For some time now, American investors’ fear has been that the Chinese owned so many T-bills that if they sold a bunch at once, interest rates (bond yields) would have to climb dramatically for those bills to find buyers, with horrible consequences for U.S. credit markets.

Thing is, as Charles Hugh Smith reports, the U.S. stock market is now so widely (and correctly) perceived as a rigged game that many American investors have gotten out of stocks and into Treasury bonds — so many that the leverage of the Chinese over U.S. finances has been significantly diluted:

But a funny thing happened to the “nuclear option” story: American investors have absorbed almost $4 trillion in U.S. Treasuries, making domestic owners the largest holders of Treasuries. China’s holdings, as vast as they are, are now a modest percentage of domestic owners–as little as 25%.

This domestic move out of equities and into Treasuries is a sea change with broad consequences. Hundreds of billions of dollars has been pulled out of U.S. equities and dumped into low-yield Treasuries. For context, recall that domestic U.S. assets (real estate, bonds, equities, and other marketable capital) is around $52 trillion.

So owning $4 trillion in Treasuries–more than all non-U.S. owners combined, including China, Japan and the Gulf Oil states–does not require that great a percentage of U.S. capital. Even if U.S. owners absorbed another $4 trillion, that would make Treasuries less than 20% of total capital.

There are limits to U.S. debt growth, however, and it is those limits which constitute “the nuclear option.” The U.S. could readily absorb the entire Chinese portfolio ($1.2 trillion), but what it cannot absorb is $1.4 trillion in annual deficits, year after year. In other words, if debt is a “nuclear” weapon, the U.S. will have to set the weapon off itself by borrowing more than it can support out of national income.

If the U.S. economy melts down due to over-borrowing, we have nobody to blame but ourselves.

Of course, the deficit hawks claim that that’s where we’re headed right now. The other side of that argument — and the correct side — is that we need to be running deficits in the short term to get people back to work (more people working and paying income taxes and buying stuff and paying sales taxes, and fewer receiving unemployment checks, also will help reduce the deficit), and we need to be directing that spending toward means of increasing our future productivity so as to generate the wealth needed to bring deficits back under control and pay down debt long-term.

Now, while it’s good that China no longer has the capacity to blow up our economy — which has positive ramifications for everything from our relations with Iran and North Korea to the security of Taiwan — we also don’t want things to veer too far in the other direction:

… if China’s export market implodes and its trade surplus disappears, the central government will have trouble creating the jobs needed to maintain its power.

If China launches its “nuclear option,” the market might be roiled for a short period of time, but their share of the total Treasury markets is simply too small now to be “nuclear.”

Perhaps the real “nuclear option” here is the potential for the U.S. to restrict China’s imports to the U.S. market. Should China’s exports dry up, it will face domestic turmoil on a scale few can imagine.

Tiananmen Square showed us that the Chinese government has the will to deal ruthlessly with domestic turmoil. But that was primarily a political movement. But if tens or hundreds of millions of Chinese rise up because exports have fallen off so badly that they can no longer afford food, Beijing may find itself faced with a situation it cannot shoot its way out of … not solely against internal targets, anyway.

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