Why China’s U.S. Treasuries Are a Double-Edged Sword

(Bloomberg) -- It’s the biggest pile of debt in the world -- the $15.9 trillion U.S. Treasuries market. It’s been built with the help of foreign central banks and investors, who have clamored to buy U.S. government bonds through good times and bad. But what happens if their appetite wanes? Both China and Japan -- the biggest foreign owners of Treasuries -- have pared their holdings from the record levels of recent years. Against a backdrop of increased trade tensions with China and bigger U.S. budget deficits, a drop in demand for the bonds could be particularly ill-timed. But such a move would not be without its dangers for China as well.

1. Have foreigners ever owned this much U.S. debt?

No. Nor has the U.S. ever owed so much. Foreign investors hold $6.4 trillion in U.S. government debt, more than twice as much as in 2008. (The share of debt owned by foreigners fell in that time period, to 40% from 56%, primarily because the U.S. Federal Reserve was buying so much itself.) China is the largest foreign holder of Treasuries at the moment, followed by Japan, and between them they account for more than $2 trillion of U.S. securities.

2. What’s the worry for the U.S.?

It relies on bonds to finance government budget deficits. Reduced demand, at a time when Treasury issuance is rising as the budget shortfall grows, could force the U.S. to offer higher interest rates to lure investors. Those higher borrowing costs in turn would squeeze the U.S. budget just as spending on an aging population is projected to dramatically increase. For investors who dump their bond holdings, or even just trim purchases, the risk is that they reduce the value of outstanding Treasuries, harming their portfolios.

3. Has China cooled on Treasuries?

Mainland China holdings peaked in 2013 at more than $1.3 trillion. They fell by a record 15% in 2016 but have since rebounded to $1.13 trillion as of February 2019. But as trade tensions escalate between the Trump administration and China, traders are on the lookout for any sign that America’s largest foreign creditor will turn its back on the Treasury market. When Bloomberg News reported in January 2018 that senior Chinese officials recommended slowing or halting purchases of U.S. securities, bond prices tumbled. On May 13, a tweet purportedly by editor-in-chief of China’s Global Times sent shockwaves through the market. It said “many Chinese scholars are discussing the possibility of dumping US Treasuries.”

4. Why might China cut back its Treasuries purchases?

In general, it’s natural that China doesn’t want to become overly reliant on one particular asset. Now, trade tensions with the U.S. may be another factor. If China simply slowed its purchases, the effects would likely be gradual and modest. A true selloff, by contrast, might induce panic selling by other foreign governments, higher U.S. interest rates, a depreciated dollar and depressed U.S. home prices. Some have even suggested World War II-style bond drives would be needed to inspire Americans to buy more debt.

5. What would be the downside for China?

There are a number of reasons for Beijing to hesitate. For one thing, China has few alternatives to invest its $3.1 trillion in foreign-currency reserves, the world’s largest stash. And China itself would feel great pain if it prompted a selloff. U.S. exporters could see an unintended boost to business because of the cheaper dollar, and consumers might cut back on imported China goods as the exchange-rate shifts are added onto the tariffs U.S. President Donald Trump has imposed.

6. Why does China hold so much U.S. debt?

Since China has a large trade surplus with the U.S., it has excess dollars -- which the government plows into U.S. Treasuries. It also manages its exchange rate in a set band versus the dollar; to do that, it buys and sells both dollars and yuan. Treasuries outrank other securities in allowing China to "both do reserve and exchange rate management in such an effective manner," says Amar Reganti, a fixed-income strategist at GMO’s asset-allocation group, and former deputy director of the Treasury’s Office of Debt Management.

7. What’s the situation with Japan?

With close to $1.1 trillion of Treasuries as of February, Japanese investors had around the same amount in their portfolios as they did at the start of 2017. The previous two years saw the Japanese reduce their pile, which hit a record in 2014. While the global allure of Treasuries changes over time, with swings in the cost of currency-hedging, they remain in high demand.

8. Why are foreign holdings so large anyway? 

The emergence of sub-zero yields in various sovereign markets around the world in recent years -- fueled by unconventional monetary policies from the European Central Bank and the Bank of Japan -- helped spur investor appetite for anything that still has a positive yield, such as U.S. Treasuries. While yields in America were close to historical lows, they still looked relatively attractive to investors who were otherwise faced with the prospect of paying for the privilege of owning debt.

The Reference Shelf

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