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Fixed-Income Insights

Trade and geopolitical tensions have spurred investor concerns that China may unload all or part of its holdings of U.S. Treasuries totaling $1.1 trillion. 

 

In Brief

  • Trade and geopolitical tensions between China and the United States have raised concerns that China may sell all or part of its massive holdings of U.S. Treasury securities in response to developments that Beijing considers unfavorable to it. 
  • A large-scale disposal of Treasuries by China could lead to negative economic and market consequences worldwide, spurred by a spike in U.S. interest rates and a big drop in the U.S. dollar.
  • It seems likely, though, that if the selling process were to lead to financial instability, the U.S. Federal Reserve (Fed) could emerge as a buyer of Treasuries to calm markets. 
  • If China were to sell its $1.1 trillion of Treasuries in retaliation for pressure from Washington to balance its trade surplus, for example, the effect may be the opposite of what Beijing intends. 
  • Why? For China, selling Treasuries—and the U.S. currency it receives as proceeds—could actually lead to the undesirable outcomes of weakening the U.S. dollar and strengthening the yuan (thereby making Chinese exports more expensive). 
  • Meanwhile, China has become less critical to U.S. Treasury financing, as Beijing’s role as a large-scale purchaser of Treasuries has diminished somewhat over the past several years.
  • The key takeaway—Analysis suggests that investor fears over China’s holdings may not be realized, and even if they were, and the Fed took mitigating action, the consequences likely would be less severe than initially believed. 

 

China’s enormous holdings of U.S. Treasury securities often are perceived as leverage that could be used against the United States to extract a better negotiating position on a variety of issues. The perception that the United States is dependent upon China’s financing of its debt implies a spike in U.S. interest rates and potentially a fall in the U.S. dollar were China to suddenly stop its purchases and sell its holdings. But is such a scenario likely to unfold?

A variety of recent developments seem capable of provoking such behavior in China, fueling fears of potential financial instability. Although concerns about the current U.S. administration’s stance toward the “one China” policy vis-à-vis Taiwan, assessing a 45% tariff on imported goods, or characterizing Beijing as a currency manipulator seem to have been put aside, other potential sore spots remain. Adoption of a so-called border-adjustment tax by the United States could be perceived as an across-the-board tariff on Chinese goods, and could provoke some retaliatory response. 

To be sure, trade is not the only flashpoint for the U.S.-China relationship. Disagreements over developments in the South China Sea also could result in some pushback from China, as could the imposition of additional U.S. sanctions on North Korea. But the issue of trade is perhaps most concerning, since China’s holdings of U.S. Treasuries are related to trade and the trade imbalance with China seems a potential target under the White House’s “America First” policy.

Fed Backstop
China’s U.S. Treasury holdings of $1.06 trillion, according to the U.S. Treasury Department, are second only to Japan. Liquidation of the entire portfolio would certainly affect prices of U.S. government securities as well as the broader U.S. fixed-income market. Even though the Securities Industry and Financial Markets Association (SIFMA) reports that daily volume of U.S. Treasury securities traded during the first two months of 2017 averaged more than $540 billion, $1.0 trillion of sales over a short period of time would move markets.

It seems likely, though, that if the selling process led to financial instability, the U.S. Federal Reserve (Fed) could emerge as a buyer of Treasuries to calm markets. Even without the Fed as a backstop buyer, once it became clear that China’s sales had concluded, the market impact could be short-lived, while the negative financial consequences for China could be long-lasting. Given the political and economic considerations, a retaliatory dumping of Treasury securities seems an unlikely path for a global power dependent on trade with the rest of the world to pursue. Such a move also ignores China’s need for foreign reserves and related debt as a collective tool to manage the volatility of its own currency.

If China were to sell the entirety of its holdings of U.S. Treasury securities in retaliation to pressure from Washington to balance its trade surplus, the effect may be the opposite of what it intends. For Beijing, selling Treasuries—and the U.S. currency they receive as proceeds—weakens the U.S. dollar and strengthens the yuan.  Dollar-denominated goods then become more competitive and yuan-denominated goods less competitive, promoting a reduction in trade surplus with the United States—the very trade effect China would strive to avoid.  It appears, then, that China’s leverage is less powerful (although still worth reckoning with) than many investors fear, and from China’s perspective, it may be impractical to utilize.

Reduced Role
It also may be comforting for investors to note that over the past several years, China has become less critical to U.S. Treasury financing. Its absolute holdings have ranged from $1.16 trillion in 2011 to $1.27 trillion at the end of 2013 and to $1.06 trillion by year-end 2016. However, because the level of outstanding Treasury securities has grown, from $8.9 trillion in 2011 to $13.9 trillion at year-end 2016, China’s relative financing importance has gradually declined. In 2011, for example, China held 13.1% of outstanding U.S. government debt; by year-end 2016, it held only 7.6%, according to Treasury and SIFMA statistics.

Even when China held a larger portion of U.S. debt, the risk to U.S. markets may have been less than feared. In 2012, U.S. secretary of defense Leon Panetta conducted a national security-risk assessment of U.S. debt held by China and came to conclusions similar to those outlined above. The assessment found that “attempting to use U.S. Treasury securities as a coercive tool would have limited effect and likely would do more harm to China than to the United States.” 

The collective conclusion of the effects of currency movement, potential Chinese losses, and declining relative importance to U.S. financing do not suggest China’s “leverage” is unimportant in terms of a potential adverse effect on U.S. rates. Instead, analysis suggests that investor fears over China’s holdings may not be realized, and if mitigating action is taken by the Fed, consequences may be less severe than many investors fear. China may have other negotiating tools if trade with the United States becomes an issue, but the ineffectiveness of its “leverage” with U.S. Treasury holdings may allow investors to worry less about the potential interest rate consequences of a large sale of Beijing’s U.S. Treasury portfolio.

 

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