China vs. the U.S.- Who Will Blink First?

Includes: FXI, FXP-OLD, TBT, TLT
by: Mike Kane
I was flipping through the television late last night and came across a documentary from 2004, called “The Year of the Yao.” It followed Yao Ming during his first year in the NBA, through the eyes of his young American translator. While watching this, it got me thinking about China, and what the future will hold for our two countries.
As Jon Markman, from MSN Money, wonderfully noted in his July 17 piece:
[the U.S. and China are] on an economic path of mutually assured destruction…the world’s largest Ponzi scheme might be coming to an abrupt end.”
The Ponzi scheme he is talking about is not Social Security or Medicare or even Madoff. It is the continual Chinese purchase of U.S. debt over the last decade, which has fueled America’s access to easy credit and theconsumer spending binge. If the Chinese ever decide to stop purchasing our debt, then the whole pyramid scheme will come crashing down. This will make the $64.8 billion Madoff scandal look like chump change.
The Chinese have pegged their currency to the U.S. dollar. If they float their currency, their stock market will plummet, as a fair price is factored in and much of their manufacturing industry vanishes. The government risks a violent overthrow if this happens. Many will ask, "Why don’t the Chinese sell their U.S. debt on the open market?" This is a bad solution, because it will depreciate the value of the dollar. If this happens, any money they get in exchange for their bonds will be worthless. Likewise, if they let the world know that they are dumping U.S. bonds, many will begin shorting the Chinese markets. This domino effect could have a huge impact on the global economy, akin to the 1997 Asian economic crisis.
The U.S. is in an even more precarious position. As of the time of writing this article, we have over $11,675,436,559,627.94 in national debt, with the Chinese holding nearly $800 billion of it. Treasury Secretary Timothy Geithner has asked Congress to raise the debt ceiling, and there is still a strong possibility that the U.S. will enact healthcare legislation and possibly a second stimulus bill that could mean trillions more in debt. If the Chinese don’t buy our debt, who will?
To make up for a shortfall in Treasury sales, the U.S. is left with two options: First, introduce more cash into the money supply, in essence purposefully driving up inflation, or second, do the most dreaded thing in any politician’s vocabulary: raise taxes. Neither of these options is good for the Americans or the Chinese.
The question remains, who will blink first? I have a hunch that it will be the Chinese who play our bluff and start quietly unwinding some of the bonds they hold. For those sophisticated investors looking to play both sides of this faceoff, a very small short position in Chinese A shares, through the Proshares UltraShort FTSE/Xinhua China25 ETF (FXP) might be a good addition to your portfolio (the benchmark Shanghai Composite Index was off over 6.6% last week alone, and a bigger correction might be on the way). A popular recent trade for sophisticated investors betting on a decrease in buyers of U.S. debt has been a shorting of long term U.S. Treasuries, done through a small position in the Proshares UltraShort 20+ Year Treasury ETF (NYSEARCA:TBT).

Disclosure: No Positions