China's US bond threat cuts both ways

Business | Karl W Smith 15 May 2019

US business and political leaders have long worried that China's large holdings of US Treasuries might be a strategic vulnerability for America. Those fears were stoked yesterday morning when the editor-in-chief of an English-language organ of the state media, the Global Times, tweeted that Chinese scholars were looking into ways to sell off Treasuries.

Some discussion about such a move wouldn't be surprising. But if Chinese scholars want to be truthful, there is only one thing they can tell their leaders: Dumping US Treasuries would not only wreak havoc with the Chinese economy, it would play right into US President Donald Trump's hands.

A large sale of Treasuries would have two main effects on the US and global markets, both of which the president has been clamoring for.

The first and most obvious effect would be to drive down the price of US government bonds. Price and yield are inversely related. So selling would have the effect of driving up interest rates on US Treasuries.

At first this might seem to go against Trump's oft-stated preference for lower interest rates. And in fact interest rates on Treasuries closely track those set by the Federal Reserve.

But Trump's obsession with interest rates stems from a larger concern - boosting economic growth. He only wants the Fed to lower rates so US banks will put some of their US$1.4 trillion (HK$10.9 trillion)in reserves to work in the economy. A huge sale of US Treasuries by China would have a similar effect: As interest rates on Treasuries began to rise, banks would use some of their reserves to buy more Treasuries. That spending would put more cash into the wider US economy and stimulate growth.

There is a second, somewhat related, effect of a sale of Chinese bonds: It would drive down the value of the US dollar. When China sells US bonds, it receives dollars in exchange. The Chinese could use those dollars to buy other US assets, but the whole point of selling Treasuries is for China to divest from all US assets.

That means the Chinese would need to exchange their dollars for some other currency - euros, pounds or even the yuan. Putting so many dollars on the foreign-exchange market would weaken the value of the dollar. The effect would be to drive up the price of foreign imports for US consumers and drive down the price of US exports.

Trump has already made it clear that he thinks America should be exporting more and importing less, and is willing to accomplish that goal by raising tariffs. A weaker dollar would likewise push Americans to buy fewer foreign goods and encourage foreigners to buy US goods. Administration officials seem to realize this, which is why Treasury Secretary Steven Mnuchin called for a weaker dollar in Davos last year.

At some point, the dollar would get so weak that imports from China would be balanced by increased exports. The trade deficit with China would effectively be eliminated - one of Trump's main goals.

To be clear, this process would be painful for US consumers, just as the tariffs are. In this case, however, the proximate cause of the pain would not be Trump's tariffs but China's selling.

In short, if China decided to sell huge amounts of US Treasuries, it would do far more to accomplish Trump's goals than any tariffs he might impose.

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