With the US-China trade war escalating, several people have asked me if I believe China will unload its vast holdings of US Treasury securities to punish America for the stiff tariffs President Trump has placed on many Chinese goods we buy. This dangerous possibility is being referred to as China’s “nuclear option.”
China is the largest foreign holder of US Treasury debt at $1.13 trillion (apprx. 5%) of our total national debt of over $22 trillion. Japan comes in at #2 with $1.07 trillion. Brazil is far, far behind at #3 with about $308 billion.
But here is the more important number: China owns around 23% of US Treasuries held by all foreign governments. That’s big!
The question is, what would happen if China stopped buying US Treasuries, or worse, they decided to unload all of the current $1.13 trillion? Many worry this could lead to a new financial crisis in the US. That’s what we’ll explore today.
At least for the moment, the financial markets aren’t especially worried that China would take such a seemingly drastic step, in large part because the move might not have much upside for China except to create headlines – a bargaining chip, if you will.
Yet, the fact is China has already been pulling back its presence in the US bond market. Its holdings of Treasuries have fallen nearly 4% over the past 12 months, even as total foreign government ownership has increased by 2.6% over the same period.
It remains to be seen if this reduction is simply a short-term anomaly or if it’s the start of a major trend. Even if it is the latter, there is no indication that China intends to exercise the nuclear option and liquidate all of its vast Treasury holdings.
China’s leaders are well aware that exercising the nuclear option is not in their best interest, and some believe it could actually benefit the US in some ways – assuming the reduction happens gradually.
For one, a large Chinese reduction of Treasuries would likely weaken the dollar and make US exporters and multinationals more competitive globally. For another, Treasury yields would rise and thus cause bond prices to fall, lowering the value of China’s US bond portfolio, perhaps significantly.
And then there’s the question of where China would put its money – all that cash would have to go somewhere – and US bonds are among the highest-yielding in the world when weighed against their relatively low risk. Given that, it still seems that US Treasuries are the optimal place for China to hold much of its cash.
Because the US imports far more from China than the other way around, China needs additional leverage to fight the tariff battle with the US. While China might prefer not to liquidate much of its Treasury portfolio, it may consider doing so if President Trump gets the authority to enact 25% tariffs on all Chinese imports, which totaled $539.5 billion in 2018.
On Tuesday of this week, Chinese President Xi Jinping ramped up his rhetoric yet again on the trade war with the US. His remarks were interpreted to mean that China is not going to cave to US trade demands anytime soon.
The South China Morning Post newspaper reported this week that “Beijing is in no rush” to resume trade talks with the US. If so, the trade negotiations between the world’s two largest countries have hit a roadblock.
As I wrote on Tuesday, I worry that this much-expected trade deal could fall apart. I hope I’m wrong.
In summary, I believe the odds are very low that China will pursue the “nuclear option” and fire-sale/dump its massive US Treasury holdings of $1.13 trillion. Doing so would almost certainly drive up interest rates and drive down the value of their Treasury holdings, not to mention the risk (however low) of another financial crisis.
Whether or not China’s leaders have decided to gradually reduce their holdings of US Treasuries remains to be seen. But even if they have, that should not be a big problem for the US.
As noted above, China liquidated 4% of its Treasury holdings in the last 12 months, and our bond market held up just fine. China sold off another large chunk of US Treasuries from mid-2014 to late-2016, and 10-year Treasury yields actually fell during this period. No problem.
The US Treasury market is the largest market in the world, by far. As long as China reduces its Treasury holding gradually – even if it liquidates all of them – it should not be a problem.
Finally, keep in mind that we don’t know if China has decided to reduce its Treasury holdings to zero over time. In my view, that would be a bone-headed decision. The Chinese are not dumb. So for now, ignore the alarmists’ warnings about China exercising the nuclear option.
The Fed would start buying those bonds in the case of a fast liquidation by China.