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August 29, 2015

China Is Selling U.S. Treasurys and the Impact Could Be Huge

By Valentin SchmidEpoch Times | August 29, 2015

Last Updated: August 28, 2015 7:33 pm

U.S. dollar notes are counted next to stacks of Chinese 100 yuan (RMB) bank notes at a bank in Huaibei, in eastern China's Anhui province, on Sept. 23, 2014. (STR/AFP/Getty Images)

People have said for a long time China could get the United States in trouble by selling vast quantities of its Treasury holdings. Now China is selling Treasurys because it is in trouble itself—with big implications for the United States.

It all started with China’s clever idea to manipulate its currency and use exports to generate economic growth right after its accession to the World Trade Organization in 2001. This policy worked great and generated double digit growth for China until the financial crisis of 2008, but it had several side effects.

Running a huge trade surplus with the United States would have normally lead to an appreciation of the yuan, as importers bid up the currency in order to be able to pay for the flood of the products coming out of China.

This, however, would have made exports less competitive, which is why the People’s Bank of China (PBOC) was printing yuan and selling them at the same time to keep the exchange rate roughly stable. This is how the Chinese central bank ultimately ended up with a stash of foreign exchange reserves, reaching a high of $4 trillion in 2014.

This money was mostly invested in U.S. Treasurys (currently $1.45 trillion, including Belgium as a proxy account) so the United States wasn’t complaining about this part of the deal either.

MORE:It’s (Semi) Official: China Sells Treasurys to Support Currency

The constant buying kept rates low at a time when U.S. national debt ballooned from about $5 trillion in 2002 to $18 trillion in 2015. So during the Fed’s QE program you had two major central banks monetizing U.S. government debt. Now everything is about to reverse.

China is facing huge economic headwinds and a financial crisis which is essentially home-made — but its big dollar position makes the situation worse.

Carry Trade Unwind

Because of the severe mismanagement of its internal investments (overcapacityreal estate bubble, stock market bubble) and some changes in policy, capital flows into China in the form of bond and equity investments as well as the infamous carry tradestarted to reverse in 2014.  

This, together with the Fed tighteningU.S. dollar liquidity led to the dramatic events of this summer, which included a stock market crash of 30 percent and a surprise devaluation of the yuan of 3 percent.

MORE:China’s First Bond Default Suggests a Reform AttemptChina’s Latest Rate Cut Is Not About the Economy or the Stock Market

In order to restore stability and support the currency, China has been accelerating sales of foreign exchange, reducing its total to $3.6 trillion, down $200 billion in 2015. The bulk of these sales have been Treasury securities ($130 billion through Belgium until June 2015) and probably another $100 billion more in the last two weeks of August, according to Societe Generale estimates.  

US Impact

The reverse of the China export trade will have serious consequences for U.S. financial markets, especially if it gets worse, as Deutsche Bank estimates.  

“China has around $2 trillion of ‘non-sticky’ liabilities including speculative carry trades, debt and equity inflows, and deposits by and loans from foreigners that could be a source of outflows,” it says in a note.

First, if more Treasurys get sold than bought, the price will decline and yields will go up. Indeed, as stocks dropped by 6 percent since the end of July and Treasury yields should have gone down as investors move their money to safety, the remained roughly stable around 2.2 percent for the 10-year bond.

MORE:Making Sense of China’s Currency Move

Citibank estimates yields will rise around 1 percent for every $500 billion of Treasurys sold. If China continues at the current pace, that will happen in six weeks. This is assuming China will keep defending the yuan, which would be in its best interest to tod.

Higher rates have a ripple effect through the economy and financial markets because they serve as a benchmark rate for other financial instruments, such as corporate debt and can also influence stock valuation. In the long term it will also influence spending on interest by the U.S. federal government and therefore the budget.

In addition, investing in Treasury bonds despite low yields has been a one way bet for the last decade. Given significant price declines in this market (virtually all other markets have already been clobbered, except for equities) could lead to an outright financial panic. 

So it seems the initial claim that China could get the United States in trouble is essentially correct—if only it wasn’t in so much trouble itself.

http://www.theepochtimes.com/n3/1737965-china-is-selling-u-s-treasurys-and-the-impact-could-be-huge/