China Losing Faith

The Financial World According to Inya” Column
by Inya Ivkovic, MA

China is losing faith — in America’s ability to sustain its debt, that is. What we have long feared has started happening. In December of last year, foreign demand for U.S. debt, typically sought in the form of U.S. government bonds and Treasuries, has tumbled by the largest margin. Leading the way is China, which, until December, has held the most U.S. debt.

After selling off $34.2 billion worth in U.S. government bonds and Treasuries in December, and a total of $45.0 billion these past five months, China has effectively surrendered the torch to Japan. At this point, I find it difficult to call this anything else but a very dangerous trend for the U.S. The reason behind China’s decision to reduce exposure to U.S. debt is, of course, the growing concern that the U.S. is not going to be able to finance its swelling debt, at least not without some serious devaluing of the greenback.

And who would not be scared? In 2010, the U.S. is staring in the eyes of a monster budget deficit of $1.6 trillion, as tax revenues are spiraling down the toilet amidst unrelenting spending pressures caused by the Great Recession.

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Incidentally, this latest move by China’s central bank happens to coincide with more tensions developing on several fronts between China and the U.S. Actually, we are talking more about China having a beef with the U.S. “Buy American” trade policies, its selling arms to Taiwan, and President Obama’s meeting with Tibetan spiritual leader, the Dalai Lama.

Regardless of the reason, economists have long feared the day that China may pull out of U.S. debt, and potentially take with it other foreign investors. Is China really that powerful? Well, no; at least not on its own. However, selling that much U.S. debt could result in the U.S. having to pay higher interest rates to keep others interested, thus jeopardizing its own very fragile and very young economic recovery.

Do we expect China to liquidate all $755 billion of its U.S. government securities holdings? Probably not, because securities backed by the U.S. government are still valued as the safest and most liquid in the world. Additionally, China’s own economic dynamic is very closely connected to the U.S., the latter being its largest consumer and also the best place to invest China’s huge foreign reserves. So, if China rocks the boat too much by reducing its holdings of U.S. debt, it just might fall out of it itself.

The U.S. is in no position to rock the boat either, considering how highly dependent it is on the willingness of “kind foreigners” to keep on buying its debt, which is probably the only source of financing of the country’s burgeoning debt at interest rates that are relatively low. International trade tariffs, arms deals with Taiwan, and even the Dalai Lama could be too much and force China to remind the U.S. where the fine line is by reducing its holdings of U.S. debt and throwing the U.S. dollar over the cliff.

So far, the boat is rocking, but it still appears seaworthy. The 10-year U.S. bonds are still sporting interest rates that are low. Actually, these rates have drifted lower, as investors stampeded out of European government bonds following the Greece debacle. Additionally, Japan has proven a solid replacement for China as the net buyer of U.S. government securities in December. Japan stepping up to the plate like that was reassuring.

I still find it worrisome that China is restructuring its portfolio after spending most of 2009 getting its hands on as much U.S. debt as possible. On the other hand, it is possible that this shift away from U.S. debt means other investors are able to absorb a bit more risk, such as Japan, Canada, Britain and Australia.

I remain unconvinced and worried at the same time that China is truly losing faith in the U.S. Considering how intertwined and deeply dependent China and U.S. really are, China reducing its exposure to U.S. debt has to be more than mere punishment for the latter stepping out of line with some foreign policy moves. I fear that China is worried that the U.S. may not be able to cleanse its economy either in time or sufficiently to create new, organic growth. And, if the worst-case scenario indeed develops in the U.S., China’s reasoning could be that it at least will not be left holding the largest bag.