China Pulls the Plug on U.S. Treasuries

George Washington's Blog: "

You've heard that:

Senior Chinese military officers have proposed that their country ... possibly sell some U.S. bonds to punish Washington for its latest round of arms sales to Taiwan.

You know that China is dumping American assets, unless backed by the government.

Now, the U.S. is reporting that:

Foreign demand for U.S. Treasury securities fell by the largest amount on record in December with China reducing its holdings by $34.2 billion.

The December drop in treasury holdings pre-dates the recent spat over Taiwan, and is therefore unrelated. However, it does show that China is starting to give up on our 'too big to fail' nation (and see this).

And bond auctions are now starting to fail.

Total foreign holdings of U.S. treasuries fell by $53 billion. Japan has now passed China as the largest foreign holder of treasuries."

Today FT Alphaville continues:

A good day for China conspiracy theorists, a bad one for holders of US Treasuries, as official US figures confirmed that earlier paranoia about Beijing’s plans to dump Treasuries were proven correct.

From Wednesday’s FT:

Foreign demand for US Treasury securities fell by a record amount in December as China purged some of its holdings of government debt, the US Treasury department said on Tuesday.

China sold $34.2bn in US Treasury securities during the month… leaving Japan as the biggest holder of US government debt with $768.8bn. China overtook Japan as the largest holder in September 2008.

Not only that. The overall monthly sell-off of $53bn worth of Treasuries was the biggest on record. Net purchases of long-term US securities declined to $63.3bn from $126.4bn in November, according to the Treasury figures.

However, foreigners overall increased their purchases of US equities, buying $20.1bn in December after buying $9.7bn the previous month. Japan’s holdings for example rose 1.5 per cent in December to $768.8bn, while China’s dropped 4.3 per cent to $755.4bn.

And also China bought $4.6bn of longer-dated coupon debt.

The overall shift away from short-dated Treasuries, amid growing concerns about the US fiscal deficit but more importantly a move away from the “flight to safety” strategy of the last couple of years, could mean the US will have to pay more to service its debt interest and put further downward pressure on stock prices.

Indeed, as Associated Press notes on Wednesday: economists are split over the significance of the decline. Some doubt that the drop in foreign holdings of short-term Treasuries signifies growing unease about holding US debt, noting that net purchases of longer-term Treasury debt rose in December by $70bn.

But others see the decline as a warning signal, adds AP:

They fear that foreigners, especially the Chinese, have begun to worry about record-high US budget deficits and are looking to diversify their holdings. A sustained drop in foreign demand for dollar-denominated assets could lead to higher US interest rates and falling stock prices [and] could threaten the US recovery. But economists said they see no such evidence yet.

For China, the shedding of US debt marks a reversal that it began signalling last year by suggesting it may reduce some of its holdings – and also signifies a big turnround from earlier in 2009 when senior Chinese officials highlighted their frustrations at having to maintain large holdings of US Treasuries.

Alan Ruskin, a strategist at RBS Securities, told the FT that China’s behaviour showed that it felt “saturated” with Treasury paper and that the December sale signalled a trend.

For the US, such a trend would be very unwelcome, coming as the White House grapples with cutting the US deficit, which is projected to be $1,560bn in 2010, or 10.6 per cent of GDP.

Alan Meltzer, an economics professor at Carnegie Mellon University, said China’s shift should be a wake-up call for Washington, according to AP.

“The Chinese are worried that we have unsustainable debt levels, and we do not have a policy for dealing with it,” Meltzer said.

From Beijing’s perspective, though, it’s a very tricky balancing act. China still has substantial holdings of US Treasuries and a further sign of no-confidence from Bejing could drive down the value of its US securities portfolio.

China’s Treasury holdings peaked at $801.5bn in May, and net sales in November and December were the first consecutive months of reductions since late 2007, reportsBloomberg.

But, as Minyanville’s Howard Simons notes:

The marginal supply of investable funds in the world today is China’s $2.4 trillion stash of foreign reserves. Where they invest those funds, for how long they peg the yuan at its present rate near 6.83 per dollar, and their own internal credit policies are the dog; everyone else right now is the tail, and what a wonderful view that is.

Some economists have warned against reading too much into December’s drop in foreign purchases of short-term Treasury debt, pointing to month to month volatility in the figures, as AP notes. They also argue that Europe’s debt crisis has put pressure on the euro and boosted demand for US Treasuries and the US dollar.

But, as ShortView’s Michael Mackenzie points out on Wednesday, the big question at a time of unease about sovereign debt, is what happens if China continues on this path?

At some point, foreign indigestion of Treasuries means the US will need domestic investors to step up and buy and at the risk of higher rates, he warns, concluding:

While bond traders dismiss Tic data as old news, it is perhaps worth recalling that “a trend is your friend” only when you are on the right side of it.