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China’s “Nuclear Option” For Its U.S. Debt Holdings?

Monday April 9th, 2018   •   Posted by Craig Eyermann at 6:11am PDT   •  

35902018 - falling bombs falling dollar on a white background A trade war between the U.S. and China has ramped up in recent weeks, with both nations proposing new tariffs on the goods that each imports from the other in a series of tit-for-tat announcements.

The Reuters news service however has been exploring a scenario where China’s role as a major creditor to the U.S. government could be used as a weapon against the United States as part of its retaliation strategy.

Overall, as of the end of the U.S. government’s 2017 fiscal year on September 30, 2017, China held at least 6.8% of the U.S. government’s $20.2 trillion total public debt outstanding, and a slightly larger share (9.4%) of the $14.7 trillion “publicly-held” portion of the national debt, which is the part of the government’s debt that isn’t owed to another federal government entity like Social Security or the pension funds that it operates for the benefit of the U.S. government’s military and civilian employees.

Last week, Reuters‘ Trevor Hunnicutt and Kate Duguid described how China might use its holdings of U.S. government-issued debt against the U.S. as the “nuclear option” in the trade dispute between the two countries:

China held around $1.17 trillion of Treasuries as of the end of January, making it the largest of America’s foreign creditors and the No. 2 overall owner of U.S. government bonds after the Federal Reserve. Any move by China to chop its Treasury portfolio could inflict significant harm on U.S. finances and global investors, driving bond yields higher and making it more costly to finance the federal government….

Asked by a reporter on Wednesday if China would reduce its U.S. Treasury holdings in retaliation, Vice Finance Minister Zhu Guangyao reiterated China’s long-standing policy regarding its foreign exchange reserves, saying it is a responsible investor and that it will safeguard their value.

China’s foreign exchange reserves, the world’s largest, stood at about $3.13 trillion at the end of February, with roughly a third of it held in Treasuries.

“If they wanted to pull the nuclear switch, if they committed to dumping Treasuries, it would have an immediate and temporary impact on money markets in the United States,” said Jeff Klingelhofer, a portfolio manager who oversees more than $6 billion at Thornburg Investment Management Inc.

Hunnicutt and Duguid go on to report that Klingelhofer and other analysts believe that China taking such an action would be a low-probability event, one that would be at “cross-purposes” to the nation’s interest in safeguarding the value of its foreign exchange reserves.

Moreover, at least one analyst speculated that such a move would be very counterproductive, where the action could backfire against China:

Brad Setser, senior fellow for international economics at the Council on Foreign Relations in New York, said China can sell Treasuries and buy lower-yielding European or Japanese debt.

But the effect would likely be to strengthen the yuan against the dollar, weakening the relative desirability of its exports, analysts said. The sale could also tank the value of the Treasuries China retains, with nothing to show for the aggression.

To borrow a phrase from J. Paul Getty: “If you owe the bank $100 that’s your problem. If you owe the bank $100 million, that’s the bank’s problem.”

Since we’re talking about $1.17 trillion owed by the U.S. government to China however, it is probably safe to err on the side of that amount of debt being a really big problem for everybody.

More insight: Over at Credit Writedowns, Edward Harrison explains why China would have a very difficult time in using its U.S. Treasury holdings as leverage in a trade war with the U.S.

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April 2018