Financial Wargaming: If China Dumps US Treasuries

Boo! Here's a fun feature you may have overlooked. Well, let's just say it's fun contemplating--I offer no guarantees that it will be enjoyable if it comes through. It is said that popular entertainment gains resonance from being not entirely disconnected with reality. In particular, resonating with commonly held anxieties usually works. During the eighties when Ronald Reagan was at the height of his "evil empire" phase, there was a made-for-TV movie concerning a Soviet takeover of the United States, Amerika. More recently, of course, the reds under the bed of the ever-gullible American public have been the Chinese instead of the long-departed Soviets. Hence the entertainment takeover of "Chinese Invasion"-style scenarios. So, for your consideration today, I have nothing less than a call to arms if China takes the "nuclear option" of unloading its Treasuries.

As it turns out, even (bored) journalists enjoy their share of scare stories. This being the IPE Zone, a common favourite is that of China being sufficiently piqued with the United States as to unload its dollar-denominated holdings. It's certainly true that the Chinese are, in the larger scheme of things, far from majority bondholders in America. Yet, the knock-on effects of a vote of no confidence by America's largest creditor would likely cause the others to lose the comforting thought that the Chinese would always lap up the remainder. What then would Uncle Sam do? Having stuffed the Federal Reserve with Treasuries, options are by necessity limited. There's the "Buy American" tack, although that never did help US automakers any. Perhaps the better analogy would be to the government encouraging Americans to buy war bonds...

Most experts say if there were signs of this [Chinese sell-off] happening, the U.S. government would go for a combination of persuading Americans to buy more U.S. debt, the same way they did in World War II, and finding friendly foreign governments to make additional purchases. Banks could be called on to increase their holdings of treasuries, and as a last resort, the Federal Reserve could also be called on to fill the gap, though this could risk turning any dollar weakness into a slump.

"The U.S. government should have and maybe still could call on the people of the U.S. to invest in U.S. debt," said David Walker, a former U.S. comptroller general who heads an advocacy group calling on the government to curb the U.S. budget deficit and borrowings.

And what will trigger China going into a major tiff? Taiwan, which the US is generally believed to be obligated to defend in the event of a PRC attack? Contrary to our excitable Reuters scribes, I doubt the South China Sea would be a tipping point other than in the very unlikely event of American vessels being blocked from entering these sea lanes--in which case Treasuries would be the last of our problems on planet Earth:

It likely would take something like a massive rise in tensions over an issue like Taiwan or oil exploration in disputed areas of the South China Sea, including possible military confrontation between the two nations. Such a confrontation would also make it easier for Washington to appeal to the American public to buy its debt for patriotic reasons.

But Beijing could also justify pulling back sharply from U.S. Treasuries if the dollar were to plunge, perhaps because of Washington's failure to curb its budget deficit and debt. "I worry that we could be at a tipping point," said Eswar Prasad, a Brookings Institution economist and former International Monetary Fund official with responsibility for China. "If the Chinese say 'We're not buying any more Treasuries,' this could act as a trigger around which nervous market sentiment coalesces," he said. "People could start wondering how the U.S. is going to finance its deficit."

Would other Asian countries be able and willing to pick up the slack? Germany has troubles in its own backyard, while Japan has homegrown fiscal woes. Which leaves us with:

Other countries in the region that already buy large amounts of U.S. Treasuries to try to keep the value of their currencies from climbing, such as Thailand and India, or countries with large sovereign wealth funds, such as Singapore, could also be called on to increase their purchases. Then there are the oil producers in the Middle East, such as Saudi Arabia and the United Arab Emirates, which have traditionally been seen as American allies. Together, the region's oil producers hold around $210 billion in Treasuries.

"These countries all have a massive amount of dollars invested in Treasuries already," said Eric Stein, vice president and portfolio manager at Eaton Vance in Boston. "It would be hard for them to commit to incrementally increase their holdings."

As before, the obvious solution for these profligate people is not to spend so !$%damn much (or increase revenue generation very significantly). Then again, US banks could be forced to buy American sovereign issues the way Chinese banks are forced to buy sterilization bonds at present:

Treasury officials already tout the increasing demand for Treasuries from U.S. domestic savers. But Walker, the former comptroller general, sees potential for a more aggressive effort to market Treasuries to Americans that could help shift the government away from dependence on foreign creditors.

In his view, the efforts would have to include an appeal to patriotism and come with a longer-term plan to rein in the budget deficit. "What we need to do is have a plan that's reasoned, reasonable, can reassure our foreign lenders and also demonstrate to the American people that Washington can get something done," Walker said.

Eaton Vance's Stein said U.S. banks could also be pressured, or even forced, to buy more treasuries as part of their capital cushions. "It seems maybe on some level unbelievable that that would happen in the U.S.," Stein said. "But other countries even now, if they can't find anyone to take down their paper, will turn to domestic banks."

What if, indeed.