US/China trade tensions are back in the news, with each side reiterating tariff threats. The US has threatened to tax basically all Chinese imports, and China has responded in kind. But from China’s perspective, there is just one problem: It imported just under $130 billion worth of merchandise from America last year, complicating like-for-like retaliation if America taxes all $505 billion in Chinese imports.[i] Hence, China has threatened to add non-tariff measures to its retaliatory arsenal. This could take a number of forms, including using its regulatory clout to torpedo big mergers involving US firms and making it harder to do business there. But some observers think China could choose another option: dumping its US Treasury holdings in an effort to sink the US economy. Trying to ascertain what politicians will do is sheer guesswork, and we won’t try. However, there are some key reasons why dumping Treasurys wouldn’t benefit China. Further, even if China did sell a chunk of its holdings, it likely wouldn’t damage America’s economy as much as some think.
The logic behind China dumping debt to hurt the US is that it would send long-term interest rates soaring, potentially even causing a debt crisis as bond payments mushroom. We will get to why that isn’t likely momentarily. For now, consider the reverse: China suddenly liquidating all its US bond holdings would be tantamount to economic suicide.
The country’s vast Treasury holdings are a function of its exchange rate policy. Officials manage the yuan’s movements against a trade-weighted basket of currencies, keeping fluctuations small and gradual. If China dumped all its Treasurys in one go, the yuan would likely skyrocket as the government converted the proceeds to its home currency. This is problematic for an export-heavy economy. If its currency spikes, one of two things likely happens. Exporters raise prices overseas, potentially driving away customers and sinking sales, or they keep prices steady, swallowing a big loss on currency conversions. Either would be a rather large negative.
Plus, if such a move succeeded in torpedoing the US economy, that would hurt the many Chinese businesses that export to America. The US buys 18.4% of total Chinese exports.[ii] Besides, if China decided to dump all its debt, it is pretty unlikely to do so in one shot. So if we assume rates wiggle higher as China sells, it would be taking losses on the debt it still held—locking them if it continues selling. (Bond yields and prices sit on opposite sides of a see-saw.) All in all, none of this seems to add up to economic stability, which is crucial to the social stability Chinese authorities likely hope to maintain.
But what if China went through with it anyway? It isn’t clear to us this would damage the US economy as much as some expect. China is just one buyer of US Treasurys. There are many others! Japan owns almost as many. European investors collectively own more, 22% of the total international investors hold.[iii] US investors, too, have a large hankering for bonds. Their holdings far outweigh international investors’.
Exhibit 1: China Is Only One of Many Buyers of US Debt
Source: FactSet, as of 10/12/2018. Debt held by the public, Treasury and other government offices, as of 9/30/2018.
If China dumped its holdings, rates might temporarily rise as the market absorbed the supply glut. But other buyers would likely see Treasurys trading at a discount and smell a buying opportunity, pushing bond prices back up and yields back down. Like stocks, bonds trade in an auction marketplace. Many institutional investors and banks would jump at the chance to own a long-term Treasury bond yielding something north of today’s rates.
And what if China sells its holdings gradually? Well, as Exhibit 2 shows, it has done so before, without any identifiable negative effect on the US economy or bond markets. From November 2013 through March 2016, China’s holdings fell -20%. If you add in Belgium and the UK, where many believe China owns additional holdings via its offshore proxies, its total holdings fell -24%. Yet 10-year US Treasury yields also fell during this period. Later, after China began adding Treasurys anew, rates rose. That doesn’t fit with the fear. Meanwhile, the US economy grew just fine, and the Treasury had no trouble finding buyers for US debt.
Exhibit 2: Yields Don’t Move in Lockstep With China’s Holdings
Source: St. Louis Federal Reserve and U.S. Department of the Treasury, as of 10/11/2018. 10-Year Treasury yield, 8/1/2013 - 7/1/2018. Major Foreign Holders of U.S. Treasury Securities, 8/1/2013 - 7/1/2018.
[i] Source: US Census Bureau, as of 10/11/2018. Trade in Goods with China for 2017.
[ii] Source: World Trade Organization as of 10/12/2018. China merchandise trade by destination 2016.
[iii] Source: US Department of the Treasury as of 10/11/2018. Major Foreign Holders of US Treasury Securities July 2018.
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