China Is Not Going To Sell Their U.S. Securities

China Is Not Going To Sell Their U.S. Securities

February 17, 2010 1 Comment

Whether China will continue to own/buy our bonds or not is a story that shows up in the media every few months. It makes good copy but most of the people who write about it have little direct knowledge of the situation.

Bottom line: China is not going to stop buying U.S. securities but they have become our biggest creditor–too big to ignore what they are thinking.

I have spoken with the Chinese leaders personally about this issue in recent months. They are concerned that the U.S. government is spending too much money, that our budget deficits are too big, that our debt is growing too fast, and especially that the Fed has printed so much money in the last year we will have significant inflation in the future. A Chinese Vice Premier, asked me privately if these dangers were real (yes they are) and what China can do to protect itself (not much.) I have also spoken with the head of China’s central bank, the head of their social security fund, and the head of their sovereign wealth fund. All are of the same view.

China has had a more or less fixed exchange rate against the dollar since 1995 (except for the 2 years following July, 2005, when they caved to U.S. political pressure and tried to gradually increase the value of the yuan, inviting speculators to bring floods of hot money into China). They keep the rate fixed for one reason–they believe their economy, and therefore their political system, will be more stable with a fixed rate than with a floating rate. Chinese history is riddled with peasant revolts taking place during times of sudden inflation. A fixed exchange rate is essentially the same as tying the Chinese price level to the U.S. price level, in effect delegating their monetary policy and inflation control to the Fed.

Chinese leaders were greatly impressed by two recent crises.
1) Japan’s deflation and recession/depression, starting in 1989 and lasting over a decade, following the major appreciation of the yen against the dollar. During Japan’s lost decade, the price of land in Tokyo fell by more than 90%. This is one reason Chinese leaders do not want to appreciate they yuan, as Obama’s team is pressing them to do. They do not want to be Japan deflation II.
2) the Asian financial crisis of 1997, when Thailand, Korea, Indonesia, Malaysia and other Asian economies were wiped out when speculators attacked their currencies. (China escaped the crisis because their currency was both fixed to the dollar and not freely convertible in the markets.) China’s leaders do not want to participate in the next currency crisis either.

China has accumulated more than $2.4 trillion in foreign reserves (foreign securities) as of 12/31/09, shown in the chart below. (More than double Japan’s $1,1 trillion in reserves.)Their precise allocation is a secret but my information suggests they now hold about 70% of the reserves ($1.7 trillion) in dollar denominated securities. (The rest, about $700 billion, is mainly held in Euros.)

China foreign exchange reserves

Just under half of that ($755 billion) of their dollar holding is U.S. Treasury securities, as you can see in the chart below. the rest (about $900 billion) is held in dollar denominated securities that are NOT Treasury securities, for example, government agency securities (like FNMA), corporate securities (like GE commercial paper or U,S, stocks) or private equity. They divide their dollar holdings among dollar assets based on returns, just like a pension investor. Chinese holdings of Treasury securities have increased sharply over the last 2 years, reflecting their increased worries over the credit risk of other U.S. securities.

China’s $755 billion holding of U.S. Treasury securities is about 10% of the roughly $8 trillion of Treasury securities held by the public today. Big, but not gorilla big.

China has 2 worries about U.S. economic policy.
1) Huge US spending and borrowing will push U.S. interest rates up, which is the same thing as saying push the prices of U.S. securities down. They don’t want to lose money on their $1.7T of dollars.)
2) Rising U.S. inflation would push China’s price level up too, which could lead to economic and political stability there with, perhaps, the government losing power. They REALLY don’t want that to happen.

Although they are worried about U.S. policy, they really do not have the option of selling their holding of U.S. securities. The obvious reason is they would be driving down the price of the dollar securities they own. More importantly, if they were to sell their dollar securities, they would drive down the value of the dollar against the yuan, wrecking the fixed exchange rate they have worked so hard to preserve, and inviting possible economic and political instability.

Over several years, of course, Chinese authorities cold reduce their dollar holdings to, say, 50% of their total reserves by buying Euros. As you can read int he news, however, they are not going to do that right now because the potential default of Greece had made the Euro even riskier than U.S. securities.

Long-term it is imperative that we get our spending, deficits, debt, inflation and interest rate risks under control. American companies need Chinese factories and Chinese markets as much as China needs U.S. securities. (More than half of the profits of the U.S. companies in the S&P 500 this year will be earned offshore, much of it in greater China.)

Bottom line: Chinese leaders are not going to dump their dollars in a hurry. But we can’t keep doing this forever or they will own the place. We must get U.S. spending, deficits and debt under control. And we must prevent the massive Fed stimulus of the past 2 years from creating a big inflation increase over the next few years.

JR

John Rutledge

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