Lots of Treasuries, little leverage

In recent years, China’s relationship with the U.S. has resembled nothing so much as a hostage situation. Beijing’s enormous holdings of Treasuries gave it immense leverage over Washington, which lived in perpetual fear of China choosing to not finance any new debt or sell off its current holdings.

That worst-case scenario is closer than ever to becoming a reality - or so say the Republicans who are vying for their party’s presidential nomination. But one important point has escaped Donald Trump and company: If the dynamic between China and the U.S. is still a hostage scenario, the roles have been reversed.

Beijing has been trimming its holdings of Treasuries in recent months in order to prop up the yuan. Over the past year, its overall foreign exchange reserves have fallen by about $315 billion to $3.7 trillion. But the scale of these sales has been relatively modest. And there are at least three reasons that a more massive Chinese selloff of Treasuries is exceedingly unlikely.

The first reason is China’s rickety economy. It has always been true that if Beijing dumped hundreds of billions of dollars of Treasuries, U.S. yields would skyrocket and devastate the key market to which China ships its goods. In 2004, former U.S. Treasury Secretary Lawrence Summers warned about relying on this dynamic to ensure stability for the long term: “It surely cannot be prudent for us as a country to rely on a kind of balance of financial terror to hold back reserve sales that would threaten our stability.” But as Summers also pointed out, the arrangement “is a reason a prudent person would avoid immediate concern.”

That’s especially true in the current economic environment, as Chinese growth sputters and traders begin to short Shanghai stocks. China needs every growth engine it can muster. And that means enticing U.S. consumers to spend by ensuring their government enjoys low interest rates.

The second reason China will hesitate to sell off Treasuries is Japan. Beijing knows that if it ends its unique relationship with the U.S., Tokyo would gladly step in to take its place. With about $1.2 trillion of Treasuries, Japan is already only marginally behind China in the dollar-leverage department. And two of Prime Minister Shinzo Abe’s signature policies are especially relevant in this context: keeping the yen weak and Barack Obama happy.

If Abe’s economic revival program has experienced any measure of success, it’s because of the yen’s 30 percent drop since late 2012. That’s why Abe will want to make sure the yen doesn’t rise on a trade-weighted basis against the recently devalued yuan. If that means offsetting Chinese dollar sales, then so be it.

And for all Abe’s strongman bluster in Asia, he’s been as compliant a Japanese partner as Washington has encountered in decades. Abe has consistently done President Obama’s bidding, whether that has involved facilitating the relocation of U.S. military bases, passing a draconian state secrets bill or making an end-run around the country’s pacifist constitution. In the wake of a major Chinese selloff, Abe is sure to oblige any request from Washington that Tokyo do something to save the U.S. bond market.

The third reason that China won’t sell Treasuries is there’s nothing else it can buy. It turns out the Pentagon was right in 2012 when it concluded “China has few attractive options for investing the bulk of its large foreign exchange holdings out of U.S. Treasury securities.” Where else could China strategically stash a few trillion dollars? Euro zone debt, in a desperate hope that Greece won’t crash anew? Japanese government bonds? Swiss francs? Australian property? Mineral-rich African nations? None of these are very attractive options. (It’s conceivable that President Xi Jinping might have momentarily been tempted to use China’s currency hoard to prop up Shanghai shares, but the country’s unsuccessful stock market interventions of the last several weeks have given him little reason to think that would turn out well.)

During the last U.S. presidential election, an editorial in a Chinese state-run newspaper declared that if Washington insisted on flouting Chinese interests (by selling arms to Taiwan, for example), Beijing should “use its financial weapon to teach the U.S. a lesson.” Three years later, America owes even more to China than the $1.16 trillion it owed then. But the increase in debt holdings hasn’t translated to an increase in leverage; quite the opposite. The U.S. has become for Beijing what Trump was for the New York bankers he borrowed money from during the 1980s - too big to fail.

*The author is a Bloomberg View columnist based in Tokyo and writes on economics, markets and politics throughout the Asia-Pacific region.

by William Pesek