Will China Drop U.S. Debt? Unlikely

There has been a lot made out of the prospect that China will drop US Treasuries, and even that the rest of the world will follow suit and take on some form of a new global currency. Let's look at it from a behavioral perspective.

China essentially has two choices:

1. It could continue buying US Treasuries, while running the risk that the debt will continue to fall in value, or
2. Begin selling off its Treasuries and adopt a new preferred form of reserves.

Which decision makes the most financial sense? That would be option 1. If the second option were implemented, it would result in a massive loss of reserves for the Chinese. Their remaining Treasuries would plummet and they would put themselves in a race with other Treasury-holders to dump them the quickest.

Yet if they choose option 1, don't they still have to deal with the dollar slowly losing its value? Of course, but it's not like the Chinese don't have any say in the matter. This is the beauty of viewing this issue from a behavioral perspective. If you were the Chinese and you had decided to hold onto your US debt, yet you didn't like the American devaluing their own debt by printing money and spending excessively, what would you do? You would threaten to dump it.

This is why we're seeing the Chinese and other foreign nations question the legitimacy of American debt and suggest a switch to something else. They know that the US can't run without the Chinese buying Treasuries, so by threatening to sell off American debt, the Chinese are hoping to put a little fear in the back of the mind of the US government.

As a result, the US is more likely to try to maintain the value of the dollar, and by extension the American debt held by the Chinese. It would be highly unlikely that the Chinese would actually follow through on this threat, and if they did it would probably occur a long way down the road.

But for now, at least from the behavioral perspective, it is reasonable to believe that this threat is empty.

Comments

[Dave Wrixon]

I don't think if you have any concept of how much China is being expected to ramp up its contributions to cover US excesses. It would very soon be in for two to three times what it is in for already. There are times when it is sensible to cut you losses and run. It seems that at the moment it is try to prop up US Treasuries in the bond market whilst at the same time using them and other dollar assets to swap for assets that are no so dependant on the dollar. Commodities might be priced in dollars but they do not generally depreciate with the dollar. In otherwords, the rug is being pulled but the statue is being temporarily stabilized by other means.

2009 Jun 18 06:32 AM

[The Geoffster]

This kid could get a job as an Obama Czar.

2009 Jun 18 09:28 AM

[Bondo]

My sense is that while the Chinese et al are not eager to "dump" US Treasuries they are also not eager to load up on more either. So for this and other reasons I am still expecting long US Treasury yields to increase, modestly over the next few months, and dramatically when (if?) the economy starts cranking along again.

2009 Jun 18 10:01 AM

[dybydx]

recent months have seen the PRC buying up alot of oversea assets, in particular commodities and resource companies. they also loaded up on swap agreements and pumped the IMF.

all of this was done in USD. maybe "dumping USD" isnt the right wording, but they are definitely using it, but without buying more US products.

2009 Jun 18 10:29 AM

[Donald Ingram]

You underestimate the Chinese - big mistake. The Chinese do not make "empty threats". The Western mind prepares for the future by planning five years down the road? One year ahead? Okay, maybe twenty years when it comes to what the kids do after college.
The Chinese however have a totally different approach to time that is a bit vexing to the Western way of thinking. They plan in generations. As in what the great-grandchildren will be doing. This is one of the great strengths of China, this patience in all things.
They have made their mind up that the dollar will be replaced and that they will take a leading position on the worlds stage as befits their size of population. This will happen. Maybe not soon. Maybe take some years. Or a generation. Happen it will.

2009 Jun 18 11:11 AM

[bill klym]

Look not to what the Chinese are saying but what they are doing.They are loading up on commodities.Commodities are priced in U.S. dollars.Why exactly would you being loading up on commodities if you believed the currency in which they are priced was going to hold its value?

2009 Jun 18 12:26 PM

[jratl]

From a behavioral perspective, I would make threats as the author suggested hoping the US will maintain the dollar's value to protect the current investment. But I'd be implementing alternative strategies such as buying commodities and precious metals. They have other options to choose besides US debt or some new global currency.

2009 Jun 18 12:27 PM

[Genesis]

Wrong question. All they have to do is not drastically ramp up purchasing of U.S. debt, and the dollar will fall. I do think Drew is highly eligible for a government job though.

2009 Jun 18 12:36 PM

[Drew Arnold]

Haha well thanks! The job market is tough now anyway...

The point is that the Chinese are not in a position to sell off treasuries to any large extent in the short term, and refusing to buy them at this point would diminish their reserves because other treasury holders would immediately sell theirs off. So what they're doing is using threats of a switch to a new reserve currency as a way to protect their current investment, as jratl said. At the same time, they're clearly diversifying their reserves by stocking up on commodities and other currencies, using that as a giant hedge against their treasury reserves. Once they are diversified enough, sometime in the distant future, they can reduce their buying of US treasuries and even begin to sell them off.


On Jun 18 12:36 PM Genesis wrote:

> Wrong question. All they have to do is not drastically ramp up purchasing
> of U.S. debt, and the dollar will fall. I do think Drew is highly
> eligible for a government job though.

2009 Jun 18 12:51 PM

[Phil Trupp]

The Chinese are intent on keeping their exporters in business. As a result, the mechanics of their finance require them to continue buying U.S. dollars. Nouriel Roubini says the Chinese have yet to internalize the contradictions in their position. He may be correct, but their macro pattern remains intact. Excess demand in the U.S. created the market for Chinese exports, but now demand has softened and the Chinese have jumped into commodities. Meanwhile, the frustration of lower demand has caused China to be less than comfortable tied to continuing volatility in U.S. markets. In the short run, they are focused on keeping their exports high and maintaining a lid on their own currency.

2009 Jun 18 01:18 PM

[ALEXANDER RAINWATER]

If I can recall correctly, United States Secretary of Treasury Timothy Franz Geithner recently went to chine to present a dog and pony show for the benefit of Chinese university students. These astute students thought Secretary Geithner was presenting remarks about a Chinese comic opera. A rousing response of laughter and appreciation of the thoughtful efforts made by our government representative was their immediate greeting.
A long time ago, January 2009, Mr. Geithner made some snide remarks about the financial knowledge of the Chinese government in buying the AAA United States Treasury Bonds. The Chinese Peoples Republic should have honored by being allowed to purchase these debt instruments.
The Chinese like anceint history and some may even recall how the other nations of the world stood in line to buy TARP paper. These debt instruments were loving put together by the latesr Goldman representative in government employ to work so diligently for the benefit of the dwindling number of United States taxpayers.
Remember, buy bonds if you can. If you cannot buy notes or T-bills.
Alexander Rainwater

2009 Jun 18 01:20 PM

[Fred Voetsch]

"Which decision makes the most financial sense?
...
But for now, at least from the behavioral perspective, it is reasonable to believe that this threat is empty."


Look at history and you will find the answer. For a young person like yourself to try to draw a conclusion based on your smarts alone is about as smart as my assuming I know how a woman thinks because I dress up as one on Halloween.

In fact China is already reducing their dependence on America bcause they not only can see the wrtiting on the wall (that America will HAVE to devalue the dollar in some manner) but also because they are smarter to invest their money closer to home or at home in order to build themselves into a true superpower.

2009 Jun 18 01:29 PM

[Carey Rowland]

Thanks for your cogent analysis.

Speaking of behavior, the Chinese are using <i>behavior modification</i> to protect their investments, making precise use of positive and negative reinforcements. Since they've got the world's most vigorous GDP expansion along with the trillions invested in us, it's likely they'll be able to prod us along a path that's favorable to their continued robust development.

Now we're the banana (or should I way <i>walmart</i... republic trying to court favor with Uncle Wen. Donald Ingram's assessment is correct: "... they will take a leading position on the world's stage as befits their size of population. This will happen." Yep, 't'will.

Ironic, isn't it that the world's most potent "communist" nation is calling us capitalists to account for our irresponsible use of $$$$?

There could come a day when they have little use for our $$$$, although your theory and a few comments following it convince me that it won't be <i>too</i> soon.

I'm headed to Shanghai next week. We shall see.

Carey Rowland, author of Glass half-Full

2009 Jun 18 01:40 PM

[James Kar]

Instead of behavioral perspective, may be using the term "game theory" is more appropriate. But I am not sure the Chinese is thinking about the "threat" is a game! Chinese does not like to make empty promise. They like to give warning so the issue can be resolved. If the issue cannot be solved satisfactory, then more drastic action will be taken. Of course, right now there is no other currency can replace the US dollar. This is the reason that the Chinese is heavily buying up natural resources. This is a great way to diversify its dollar holding. In this economic environment, holding natural resources is better than holding US dollars. Especially with potential hyperinflation in the future, this move is a smart move. Of course the Chinese cannot just dump its dollar reserves, but it is buying less and less every month. This also causes the T-bond yields to go up. In the near future, the dollar will stay weak. In longer term, the Chinese will move to diversify its US dollar holding by urging the IMF to use special withdraw rights. If the dollar keeps falling or even at its current level, this will happen - just a matter of time. Remember, Russia is working with China on the same issue.

2009 Jun 18 02:46 PM

[Dave Wrixon]

They are not making threats. They are offering the US an opportunity to Save Face.


On Jun 18 11:11 AM Donald Ingram wrote:

> You underestimate the Chinese - big mistake. The Chinese do not make
> "empty threats". The Western mind prepares for the future by planning
> five years down the road? One year ahead? Okay, maybe twenty years
> when it comes to what the kids do after college.
> The Chinese however have a totally different approach to time that
> is a bit vexing to the Western way of thinking. They plan in generations.
> As in what the great-grandchildren will be doing. This is one of
> the great strengths of China, this patience in all things.
> They have made their mind up that the dollar will be replaced and
> that they will take a leading position on the worlds stage as befits
> their size of population. This will happen. Maybe not soon. Maybe
> take some years. Or a generation. Happen it will.

2009 Jun 18 04:28 PM

[perceptions_now]

Agreed!

The real question is not whether China & others will continue with what they have done in the past.

The new question is, will they or can they, find Trillions more in good money, to throw after what has already gone?

And, given the current downturn, I suggest that is not possible, even if they wanted to.


On Jun 18 06:32 AM Dave Wrixon wrote:

> I don't think if you have any concept of how much China is being
> expected to ramp up its contributions to cover US excesses. It would
> very soon be in for two to three times what it is in for already.
> There are times when it is sensible to cut you losses and run. It
> seems that at the moment it is try to prop up US Treasuries in the
> bond market whilst at the same time using them and other dollar assets
> to swap for assets that are no so dependant on the dollar. Commodities
> might be priced in dollars but they do not generally depreciate with
> the dollar. In otherwords, the rug is being pulled but the statue
> is being temporarily stabilized by other means.

2009 Jun 18 07:53 PM

[strutzma]

I agree with Wrixon, Option 1.5 is actually that they slow their purchases of Treasuries (note also that they're buying short term Treasuries lately, rather than longer dated paper) and increase their purchases of raw commodities with their existing dollars/Treasuries. This way they can talk tough to keep their own purchasing power while dumping their reserves for commodities or controlling stakes in their producers.

2009 Jun 18 08:10 PM

[LCACM]

It is strange that now the Chinese government is threatening to dump US Treasuries with the excuse that the US budget deficit is so high. If one looks at the root of the current meltdown it is the overproduction and dumping of goods by the Chinese, aided by the Free Trade policies of the US government and the WTO. The only reason the Chinese purchase US Treasuriies is to funnel cheap credit into the US economy so that US consumers can keep purchasing Chinese goods with Chinese credit. If China were to stop buying US debt and instead use their Trade surplus for their own onfra development, it would bring the both the US government and the US consumer /taxpayer/voter to their senses. This would be a win/win for all.

2009 Jun 18 09:18 PM

[Mark Anthony]

You get it totally wrong. Here is China's really smart strategy in dealing with its huge US dollar reserves:

seekingalpha.com/artic...

The strategy is obviously working so well that most people are still fooled so far.

2009 Jun 19 12:00 AM

[gzhao7081]

Ridiculus,

Simply because USA government to the world is the analog of AIG to the insurance industry..

Deeply in debt and too big to fail...

Then the rest of the world should support the bad behavior by lending a hand to USA, indefinitely?

This is beyond ridiculous.

Two solutsions,
1) United states downsize their lifestyle to the level sustainable.
2) United states ramps up their productivity to support their life style.

With option 2 clear out of the mid-term sight of view (as an example, auto industry in USA is no longer competitive to the rest of the world), option one is the only choice.

To force the bad child of US government( and consumers) to correct their consumptuous behavior, the world (including CHINA) should gradually cut the 'cheap money' supply. It's like heroin, they more you spend, the more you want to spend.

Somebody (and the rest of the world) should spank the ASS of USA for wasteful spending and give it some color to see see.

Reduce the US treasury is the first and necessary step.

2009 Jun 19 09:12 AM