China's stash of US Treasuries is going... going .... gone?

[G2Rad]

Article by C. Hugh contributed quite a bit to disabusing me from my "mountains of China bond holding delusion".

It would be interesting to hear comments on the subject from the house.

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quote:



China's "Nuclear Financial Option" Downgraded to "Financial Firecracker"

China's "nuclear option"--selling its vast stash of U.S. Treasuries to wreak havoc on the U.S. economy and interest rates--has been downgraded by the flood of U.S. investors who have exited stocks in favor of Treasury bonds.
Pundits on both sides of the Pacific have been chewing on China's "nuclear financial option" for years. Here's the "story" in a nutshell:

1. The U.S. government has run a massive deficit since 2001.

2. Enamoured of real estate and stocks, U.S. investors shunned low-yield U.S. Treasury bonds (T-Bills).

3. As China's trade surpluses with the U.S. surged, generating billions in dollars that China needed to park in a safe, liquid market. U.S. Treasuries offered just such a market.

4. Following the lead of its mercantilist exporter neighbor Japan, which had long recycled its trade surpluses into Treasuries, China soaked up U.S. Treasuries for another reason: to keep interest rates low in one of its biggest markets (the U.S.).

5. If demand for Treasuries slumped, interest rates would rise, rippling through the U.S. economy, pinching credit-dependent U.S. consumers who would then buy fewer goods imported from China.

6. China buying massive quantities of U.S. Treasuries was thus a "ewin-win" situation for both the credit-dependent U.S. and trade-surplus China.

7. This dynamic led to China's hoard of Treasuries swelling to a staggering $1.2 trillion.

8. As the U.S. dollar declined in value against gold and other currencies, China's leadership understandably became nervous about being so exposed to significant declines in the purchasing power of their $1.2 trillion stash of Treasuries.

9. In response, China has trimmed its purchases and moved its portfolio into shorter-term U.S. bonds which are less exposed to the risk of future inflation.

10. The sheer size of the Chinese portfolio launched the "nuclear option" speculation: could China sink the U.S. economy via the financial "weapon" of selling its vast holdings of Treasuries?

11. Were China (or any owner) to dump $500+ billion of Treasuries on the market in one fell swoop, the supply would exceed demand, and the likely result would be a sudden, steep rise in yields (interest rates) as the Treasury would have to raise rates to attract more capital.

12. This sudden leap up in interest rates would devastate the U.S. economy on multiple levels: real estate would tank as mortgage rates jumped, stock would become less attractive when compared to high-yielding bonds, and the holders of existing low-yield bonds would suffer massive losses in the market value of their bonds. U.S. consumers would also face higher costs of borrowing.

13. The linchpin of the "nuclear option" is the belief that China has "decoupled" from the U.S. econmomy and thus can risk the collapse of its exports to the U.S. as American consumers are too crimped by higher rates to buy more Chinese goods. As I showed yesterday, faith in "decoupling" is misplaced and unsupported by financial facts.

14. The other part of the "nuclear option" story is that China could express its displeasure over various political and trade issues merely by threatening to pursue the "nuclear option."

But a funny thing happened to the "nuclear option" story": American investors have absorbed almost $4 trillion in U.S. Treasuries, making domestic owners the largest holders of Treasuries. China's holdings, as vast as they are, are now a modest percentage of domestic owners--as little as 25%.

This domestic move out of equities and into Treasuries is a seachange with broad consequences. Hundreds of billions of dollars has been pulled out of U.S. equities and dumped into low-yield Treasuries. For context, recall that domestic U.S. assets (real estate, bonds, equities, and other marketable capital) is around $52 trillion.

So owning $4 trillion in Treasuries--more than all non-U.S. owners combined, including China, Japan and the Gulf Oil states--does not require that great a percentage of U.S. capital. Even if U.S. owners absorbed another $4 trillion, that would make Treasuries less than 20% of total capital.

There are limits to U.S. debt growth, however, and it is those limits which constitute "the nuclear option." The U.S. could readily absorb the entire Chinese portfolio ($1.2 trillion), but what it cannot absorb is $1.4 trillion in annual deficits, year after year. In other words, if dent is a "nuclear" weapon, the U.S. will have to set the weapon off itself by borrowing more than it can support out of national income.

If the U.S. economy melts down due to over-borrowing, we have nobody to blame but ourselves.

The U.S. government has already borrowed over $3 trillion in the past two years; at that pace, the nation's debt load will quickly balloon to ujnsustainable levels. (Exactly what that level will be depends on the interest rate/yield demanded by future buyers of Treasuries.)

Ironically, perhaps, the key driver behind domestic purchases of Treasuries is the widespread disdain for stocks after two equity meltdowns in less than a single decade.

The net result of this structural change is the Chinese "nuclear option" has been reduced to a firecracker.

China's leverage has slipped along with its percentage of the total Treasury market, and with Americans' disavowal of equities as a rigged, risky market.

Which side of the trade would you rather hold: China's dwindling share of U.S. bonds, or the U.S. share of Chinese exports? Let's put it this way: if China's export market implodes and its trade surplus disappears, the central government will have trouble creating the jobs needed to maintain its power.

If China launches its "nucelar option," the market might be roiled for a short period of time, but their share of the total Treasury markets is simply too small now to be "nuclear."

Perhaps the real "nuclear option" here is the potential for the U.S. to restrict China's imports to the U.S. market. Should China's exports dry up, it will face domestic turmoil on a scale few can imagine.

[Silver Shield]

Don't worry Benjamin Shalom Bernanke can and will buy whatever China sells.
Now if China buys an equivalent amount of gold and silver....

[G2Rad]

Now if China buys an equivalent amount of gold and silver....


which is a repeat of the same old song called "nuclear option"

[G2Rad]

here is more from the same source:


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The "China decoupling" story holds that as China's households grow wealthier then China will no longer need export markets in the E.U. and the U.S. The story is appealing but the facts don't support it.
For years, many have argued vociferously that China's economy will "decouple" from that of the U.S. and the E.U. The theory--more like a quasi-religion in some analysts' minds--is that as China's consumers grow wealthier they will absorb all its vast production, and as a result China will no longer be dependent on exports.

There's just one problem with this theory: it rests entirely on a superficial understanding of the Chinese economy and the limited role of households in its Central-State planned economy.

Many who hold that China will not only decouple from the U.S., but that its hundreds of millions of newly minted middle-class consumers will actually pull the U.S. out of its deflationary slump with their insatiable demand for consumption. Here is a typical mainstream listing of China's growth as a reason the U.S. won't slip into recession. again.

A single statistic completely undermines the "China will decouple from the U.S. because Chinese domestic demand will absorb all its production capacity" story:

The proportion of the China's GDP contributed by the household sector (wages, salaries and consumption) peaked at 56 percent in 1983 and has since dropped to 36 percent—roughly half the size of the consumer economy in the U.S.

That means that China's households are receiving a smaller piece of the pie as China's GDP grows, even the annual average wages of workers in urban areas of China increased from 12,422 yuan ($1,832) in 2002 to 29,229 yuan ($4,311) in 2008.

By comparison, according to the Social Security Administration, the average wage in the US in 2008 was $41,335--almost ten times the average urban wage in China, which is considerably higher than rural wages.

It's not just that wages as a share of GDP are low; the inescapable need to save further reduces consumption. China's households do not all enjoy ample healthcare coverage or retirement benefits. Indeed, only direct employees of the State or local governments have coverage and pensions; those unfortunate enough to have worked for State-owned enterprises which have closed have found they have little to no medical insurance or pension.

That's because State-owned enterprises funded their employees' healthcare and pensions much like U.S. companies. Even though the government owned the business, the Central State did not take on those obligations when they sold or closed thousands of ineffeicient State-owned enterprises; those obligations were either dumped on the buyers (who usually balked) or they simply vanished.

While China's leadership is planning to offer basic healthcare for the 300 million citizens not covered by current healthcare insurance, many Chinese families must save cash to pay for household medical costs. The planned coverage won't pay for treatment of chronic diseases.

Indeed, there are two ways to enter a typical big-city Chinese hospital; either waltz in and pay cash, or go to the end of the line for those without cash. the days of the Central-State-supplied "barefoot doctors" providing rudimentary healthcare for all citizens are as long gone as the Ming Dynasty.

As a result, Chinese households are prodigious savers: China boasts a savings rate of 38%, fully ten times that of the U.S. But Chinese savers have few choices on where to invest their money: they can either leave it in a savings account which draws 2.25%, less than the inflation rate of 3.1%, or invest in real estate or domestic stocks.

The money pouring into property has created an unprecedented asset bubble in housing, which rose 12.4% year-on-year in May, according to China's National Bureau of Statistics.

Half of the flats in Shanghai and Beijing are empty.

Although owning vacant flats is widely viewed as a form of savings in China, as Americans have learned to their sorrow, speculative real estate is inherently risky: it can drop in value, decimating the owner's equity.

Such a decline in Chinese real estate would cut deeply into household capital, further reducing the desire and ability to consume more goods and services--Chinese or Western.

Economist Michael Pettis, who lives and works in China, has explained how the Chinese banking authorities have in essence pushed the costs of cleaning up bad loans onto the Chinese households by reducing interest paid to less than inflation.

By limiting the number of investment options, authorities funnel much of the household savings into banks via savings accounts. By paying interest that is less than inflation, then the authorities are handing banks billions of yuan of "free money" which they can re-invest or loan out at much higher interest rates, earning high profit margins on the households' massive savings.

Thus there is a connection between low consumption and high savings rates: since Chinese households earn a negative return on their savings, they are forced to save even more to compensate. As Pettis recently explained: "Chinese consumption dropped from a very-low 45% of GDP ten years ago to an astonishing 36% last year just as—no coincidence-- Chinese households were forced to clean up the last banking crisis."

In other words, China's financial authorities have as a matter of policy suppressed consumption by providing a weak social safety net and by channeling household savings into banks that pay a negative rate of interest on that capital.

Whether intended or not, this policy encourages households hoping to earn a return equal to inflation to speculate in real estate. As analyst Andy Xie recently noted, channeling China's household capital into real estate development is hurting the country's long-term prospects by diverting the capital from other more productive uses. Ultimately, Xie says, this decreases capital efficiency and thus lowers domestic consumption.

Those proclaiming the coming decoupling and rise of the Chinese consumer neatly glide over the fact that investment, including foreign direct investment (FDI), accounts for 44% of China's economy, a higher level than Japan or South Korea ever reached in their modernization drives. This is an economy that is exquisitely dependent on massive inflows of capital to sustain its growth; the entire household sector is a mere 80% of direct investment.

Even more startling to those who believe China has too much cash laying around, much of this investment is borrowed. China's mostly state-controlled banking system made loans last year that were worth one-third of economic output, and this year they are on track to hit 20% of GDP—a total of roughly $2.5 trillion in new credit over two years.

This means that the central state banks made loans that cumulatively totaled more than 55% of the total household income of the entire nation. In other words, the breakneck pace of growth in China is heavily dependent on debt-fueled investments. Should the return on investment drop due to weak demand for Chinese exports or real estate development, then that weakness will further weigh upon Chinese households' income.

Unsurprisingly, much of this debt is in danger of default: Chinese Banks Face Default Risk on 23% of $1.1 Trillion Loans (Mish).

Take a small share of China's GDP, a dependence on risky real estate speculation for higher yields than those offered by savings accounts and an economy heavily dependent on unprecedented levels of direct investment, and you get the picture not of a robust consumer which can absorb all of China's mighty production, but instead an economy very dependent on debt, investment and exports, and a vulnerable household with many reasons to save and few to spend.