As American pundits and polls dismiss the idea that China would dump its massive holdings of US Treasury debt as retaliation against US tariffs, a contrarian view is emerging in Beijing that the government may use the securities as a “weapon of last resort”.
China’s US$1.12 trillion holdings account for just 5 per cent of total US national debt, which may mean any material damage on the US economy stemming from a bond sales would be limited. In addition, even if it did cause market volatility, China’s remaining holdings would also be hurt, which the Chinese may view as a move that is too risky, US sceptics have said.
“While we think China will continue to sell Treasuries, as it has for most of the last year, we do not think that the pace at which they sell will increase as a direct response measure for tariffs. Rather, we believe that the pace at which they sell Treasuries will continue to track the pace at which they see capital inflows,” said Matthew Hornbach, an analyst at Morgan Stanley.
However, with Beijing vowing to fight “to the end” and the US preparing to place a 25 per cent tariff on a further US$300 billion of Chinese imports, China may have “no choice but to sell” its US Treasury holdings, according to some analysts and reports widely distributed on China’s social media .
Flowers bloom on a tree bloom near the US Treasury Department building in Washington, DC. Photo: Agence France-Presse
This would devalue US bonds, causing yields to rise, potentially sharply. If China converted the dollar proceeds from its sale back into yuan, it would strengthen the Chinese currency against the US dollar, potentially significantly.
However, one line of thinking is that because the trade war could remove the US as a viable market for Chinese exports, a strengthening yuan against the dollar – which would make Chinese goods more expensive for American buyers – may be seen as an acceptable outcome by Chinese policymakers.
“This will only happen when China has no other option. It is a weapon of last resort,” said David Chin, the founder of Basis Point Consulting.
“If China is not exporting to the US any more, then they do not need to have a weak yuan and strong dollar to encourage Americans to buy.”
However, China would have to sell strategically to maximise profits while triggering enough panic in the global financial markets, Chin said.
China is making a profit on its US$1.1 trillion treasury holdings. It bought them at an average of 3.3 per cent yield over the past decade compared to the current yield of 2.4 per cent on 10-year treasury bonds. That leaves room for it to sell US$700 billion of its US$1.1 trillion holding before pushing yields to its break even point of 3.3 per cent.
The US$700 billion figure is based on Russia’s sale of around US$81 billion of US Treasuries between March and May last year, which pushed yields from the 2.80 per cent to 2.90 per cent.
Chinese media has already laid out a plan for how Beijing could offload its Treasury holdings.
Initially, China may want to avoid market attention by quietly and occasionally offloading US Treasuries, local media reported. Once the market became accustomed to such trades, China could rapidly ramp up sales to create panic and a quick correction in the market, the reports said.
Because of the massive size of the US Treasuries market, buyers and sellers have the power to cause investment changes to snowball so as to influence market sentiment and trigger investor fear that could spill into the broader capital markets, traders said.
“Massive amounts of continuous selling of US debt will raise suspicion among professional traders that there is a major seller in the market, which could be China,” said Jasper Lo, chief investment strategies at Eddid Securities and Futures.
“That could quickly spillover worries of the value of US dollar treasuries and assets, and cause global financial market turmoil.”
The dollar’s weighting among global central banks’ reserves has gradually declined. The latest data from the International Monetary Fund (IMF) showed that in the global central banks’ foreign exchange reserves at the end of last year, the dollar ratio had dropped from 72 per cent in 2000 to 61.7 per cent by the last quarter of 2018, the third consecutive quarterly decline and the lowest level since 2013.
Talks between the US and China have broken down, leading to an escalation in the trade war. Some are speculating that China may sell some of its US Treasuries as a means of retaliating for higher US tariffs. Photo: Bloomberg
Non-US central banks are increasingly reluctant to hold US bonds in large amounts because of the relatively low returns. The low yields are a result of risk aversion among investors, sparked by mounting concerns over a global recession and the Federal Reserve’s dovish monetary policy.
Overall, March was a bad month for US assets, with overseas investors selling a net US$12.5 billion in US Treasury bonds and US$24 billion in US stocks. The biggest seller of US Treasury bonds was Canada, which sold US$12.5 billion worth of securities, the biggest drop in its holdings since July 2011.
Similarly, China’s US Treasury holdings in March decreased by US$10.4 billion to US$1.1205 trillion, its lowest since May 2017, according to data from the US Treasury. The decline contrasted sharply with the increase in its foreign exchange reserves to US$3.1 trillion in the same month, the highest since August last year.
China remained, however. the largest US foreign creditor, ahead of Japan which added US$5.7 billion in March, bringing its holdings to US$1.0781 trillion, a five-month high.
Like many other countries, the composition of China’s reserves remain a closely-held secret, but it is thought that about two thirds of its US$3.1 trillion in foreign exchange reserves are held in dollar-denominated assets, much of that in US Treasuries.
The Federal Reserve building is seen in Washington, DC. Photo: Agence France-Presse
By increasing the share of gold and Special Drawing Rights – the IMF’s composite currency – in its foreign exchange reserves, Chinese media said Beijing was shoring up support to ensure the stability of the yuan.
If China does resort to dumping US Treasuries, it could incite unknown US counter measures, which could heighten market volatility. China’s play could also draw the wrath of other large bond holders, such as Japan and the European Union.
“It’s a very convoluted situation because there are parties involved like the EU, with their holdings. So this is a big geopolitical move that is a significant situation but only when there is no hope for reconciliation,” Chin said.
For now, the notion of escalating the trade war with monetary weapons is seen as just talk, particularly on the US side – from Wall Street pundits to regulators.
“They could certainly sell them if they want to. But since global markets are global markets, I’m not sure there’d be much of an effect,” St Louis Federal Reserve Bank president James Bullard, a member of the US central bank’s policymaking Federal Open Market Committee said at a conference in Hong Kong on Wednesday.
He noted that the slide in China’s foreign reserves, which could been partially due to sales of US Treasuries, by nearly US$1 trillion between mid-2014 and early-2017 had been a “non-event in global markets”.
“I don’t think it as much of a threat as it’s made out to be,” he said.