Don't Panic over China's US Treasuries Sales

The news that China sold US$34 billion worth of US treasury securities in December has mostly been greeted with suggestions that China is warning the US of its vulnerability to the ending of China's bond purchases. It has become part of the "China rules the world" mythology and is taken seriously by many Americans.

The latter is perhaps not surprising given that no less than Treasury Secretary Timothy Geithner saw it necessary to thank China for buying so much US debt. Many commentators linked the sales to deterioration in US-China relations generally linked to Taiwan arms sales, President Obama's meeting with the Dalai Lama and disagreements over addressing the Iran nuclear issue.

However, this thinking both grossly exaggerates the degree of leverage that China has through its treasury holdings, and invents a political driver behind what was most probably a technical adjustment, not a fundamental change in China's reserves policy. It may even have proved singularly ill-timed if China sold the dollar proceeds of its treasury sales because the US currency has bounced significantly, particularly against the euro, since then.

The December net sales were just 4 percent of its holdings of treasuries, a significant but not dramatic amount. Anyway it followed a sharp build-up of China's dollar holdings, particularly of short term treasury paper in the aftermath of the credit crisis. China may well have decided it was now safe to replace treasuries with higher yielding paper. Perhaps too China's official sales have been partly matched by unofficial purchases made through offshore centers – the UK is the third largest (after China and Japan) foreign holder of treasuries but its official ownership is small and most of the beneficial owners are from elsewhere. At December 2009 UK holdings were up $130 billion over a year and those of Hong Kong, likely a proxy for some Chinese official money, up $75 billion.

Treasuries are anyway only part of China's holdings of US debt. Debts of US government agencies such as Fannie Mae are another $400 billion or so. Of China's total US$2.4 trillion dollar holdings, probably at least 60 percent, or US$1.5 trillion, is in US official debt of one sort or another.

China cannot dump enough treasuries and dollars to make major inroads either into its holdings of them or sufficient to cause a major problem for the US. Firstly, any overt signals from China that it intends to sell its holdings for political purposes would cause the market to dry up and prices and the dollar to drop sharply. China would be hurt on both counts and a fall in treasuries prices would immediately have an impact on other dollar debt. The Federal Reserve would then intervene to prop up the bond market to prevent damage to the US economy from a sharp rise in yields and the Japanese and European central banks would likely buy dollars to prevent a sudden escalation of their currencies. China would achieve nothing except infuriate not only the US but its other major trading partners.

Recent sales of treasuries have coincided with near-record issue by the US, but China's apparent buying absence does not seem to have had much discernible impact. Yields have crept up but more in response to a stronger economy and fears of a return of inflation than anything else. China may be a "bond vigilante" as indicated by China Banking Regulatory Commission head Liu Mingkang worrying publicly about ultra-low US rates stimulating inflation. But that is a broader concern and one already embedded in the marketplace.

A more immediate challenge may face China's management of both of its reserves and currency. A return to a policy of very gradual appreciation of the Yuan might just be enough to satisfy the US but would likely result in further inflows into the Yuan, complicating China's efforts to stem credit growth. On the other hand a sharp one-off appreciation – say 15 percent -- would have beneficial impact in cooling the economy and easing trade tensions. But it would likely be followed by a sudden exodus of cash parked in the yuan in hope of an exchange gain. China's reserves would contract suddenly and force it to sell short term assets such treasuries. That would probably not cause any problems for the US as much of the money exiting Yuan would end up in treasuries and probably most remain in dollars.

The fundamental problem for China remains, as it has long been, its combination of fixed exchange rate to the dollar at an artificially low level with exchange controls which preclude use of the yuan as an international currency. The first has resulted in China accumulating reserves, mostly in dollars, far in excess of its needs. The second has meant that the only large economy alternatives to the dollar are the euro, now under pressure because of Greek and other debt problems, and the yen.

Over time the US dollar role will decline as countries diversify their assets into smaller currencies and emerging countries. China will probably be the major contributor to that process but it can only be accomplished very gradually and no country will want China to own its debt if Beijing is seen to threaten to disrupt its debt market for political purposes.

Meanwhile China will learn the hard way that it is less worrying to owe a trillion dollars than to be a creditor expecting to collect that.