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China's "Nuclear Financial Option" Downgraded to "Financial Firecracker" September 2, 2010 China's "nuclear option"--selling its vast stash of U.S. Treasuries to wreak havoc on the U.S. economy and interest rates--has been downgraded by the flood of U.S. investors who have exited stocks in favor of Treasury bonds. Pundits on both sides of the Pacific have been chewing on China's "nuclear financial option" for years. Here's the "story" in a nutshell: 1. The U.S. government has run a massive deficit since 2001. 2. Enamoured of real estate and stocks, U.S. investors shunned low-yield U.S. Treasury bonds (T-Bills). 3. As China's trade surpluses with the U.S. surged, generating billions in dollars that China needed to park in a safe, liquid market. U.S. Treasuries offered just such a market. 4. Following the lead of its mercantilist exporter neighbor Japan, which had long recycled its trade surpluses into Treasuries, China soaked up U.S. Treasuries for another reason: to keep interest rates low in one of its biggest markets (the U.S.). 5. If demand for Treasuries slumped, interest rates would rise, rippling through the U.S. economy, pinching credit-dependent U.S. consumers who would then buy fewer goods imported from China. 6. China buying massive quantities of U.S. Treasuries was thus a "ewin-win" situation for both the credit-dependent U.S. and trade-surplus China. 7. This dynamic led to China's hoard of Treasuries swelling to a staggering $1.2 trillion. 8. As the U.S. dollar declined in value against gold and other currencies, China's leadership understandably became nervous about being so exposed to significant declines in the purchasing power of their $1.2 trillion stash of Treasuries. 9. In response, China has trimmed its purchases and moved its portfolio into shorter-term U.S. bonds which are less exposed to the risk of future inflation. 10. The sheer size of the Chinese portfolio launched the "nuclear option" speculation: could China sink the U.S. economy via the financial "weapon" of selling its vast holdings of Treasuries? 11. Were China (or any owner) to dump $500+ billion of Treasuries on the market in one fell swoop, the supply would exceed demand, and the likely result would be a sudden, steep rise in yields (interest rates) as the Treasury would have to raise rates to attract more capital. 12. This sudden leap up in interest rates would devastate the U.S. economy on multiple levels: real estate would tank as mortgage rates jumped, stock would become less attractive when compared to high-yielding bonds, and the holders of existing low-yield bonds would suffer massive losses in the market value of their bonds. U.S. consumers would also face higher costs of borrowing. 13. The linchpin of the "nuclear option" is the belief that China has "decoupled" from the U.S. econmomy and thus can risk the collapse of its exports to the U.S. as American consumers are too crimped by higher rates to buy more Chinese goods. As I showed yesterday, faith in "decoupling" is misplaced and unsupported by financial facts. 14. The other part of the "nuclear option" story is that China could express its displeasure over various political and trade issues merely by threatening to pursue the "nuclear option." But a funny thing happened to the "nuclear option" story": American investors have absorbed almost $4 trillion in U.S. Treasuries, making domestic owners the largest holders of Treasuries. China's holdings, as vast as they are, are now a modest percentage of domestic owners--as little as 25%. This domestic move out of equities and into Treasuries is a seachange with broad consequences. Hundreds of billions of dollars has been pulled out of U.S. equities and dumped into low-yield Treasuries. For context, recall that domestic U.S. assets (real estate, bonds, equities, and other marketable capital) is around $52 trillion. So owning $4 trillion in Treasuries--more than all non-U.S. owners combined, including China, Japan and the Gulf Oil states--does not require that great a percentage of U.S. capital. Even if U.S. owners absorbed another $4 trillion, that would make Treasuries less than 20% of total capital. There are limits to U.S. debt growth, however, and it is those limits which constitute "the nuclear option." The U.S. could readily absorb the entire Chinese portfolio ($1.2 trillion), but what it cannot absorb is $1.4 trillion in annual deficits, year after year. In other words, if dent is a "nuclear" weapon, the U.S. will have to set the weapon off itself by borrowing more than it can support out of national income. If the U.S. economy melts down due to over-borrowing, we have nobody to blame but ourselves. The U.S. government has already borrowed over $3 trillion in the past two years; at that pace, the nation's debt load will quickly balloon to ujnsustainable levels. (Exactly what that level will be depends on the interest rate/yield demanded by future buyers of Treasuries.) Ironically, perhaps, the key driver behind domestic purchases of Treasuries is the widespread disdain for stocks after two equity meltdowns in less than a single decade. The net result of this structural change is the Chinese "nuclear option" has been reduced to a firecracker. China's leverage has slipped along with its percentage of the total Treasury market, and with Americans' disavowal of equities as a rigged, risky market. Which side of the trade would you rather hold: China's dwindling share of U.S. bonds, or the U.S. share of Chinese exports? Let's put it this way: if China's export market implodes and its trade surplus disappears, the central government will have trouble creating the jobs needed to maintain its power. If China launches its "nucelar option," the market might be roiled for a short period of time, but their share of the total Treasury markets is simply too small now to be "nuclear." Perhaps the real "nuclear option" here is the potential for the U.S. to restrict China's imports to the U.S. market. Should China's exports dry up, it will face domestic turmoil on a scale few can imagine.
This topic was suggested by a U.S. Navy officer currently deployed to a carrier group.
Thank you, J., for an excellent suggestion.
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"We are what we repeatedly do." (Aristotle)
"Success: To laugh often and much; to win the respect of intelligent people and
the affection of children; to earn the appreciation of honest critics and endure
the betrayal of false friends; to appreciate beauty, to find the best in others;
to leave the world a bit better, whether by a healthy child, a garden patch, or
a redeemed social condition; to know even one life has breathed easier because
you have lived. This is to have succeeded."
"It is not the critic who counts; not the man who points out how the strong man stumbles,
or where the doer of deeds could have done them better. The credit belongs to the man
who is actually in the arena, whose face is marred by dust and sweat and blood, who strives
valiantly; who errs and comes short again and again; because there is not effort without
error and shortcomings; but who does actually strive to do the deed; who knows the great
enthusiasm, the great devotion, who spends himself in a worthy cause, who at the best
knows in the end the triumph of high achievement and who at the worst, if he fails, at
least he fails while daring greatly. So that his place shall never be with those cold
and timid souls who know neither victory nor defeat."
"To endure is greater than to dare; to tire out hostile fortune; to be daunted by
no difficulty; to keep heart when all have lost it -- who can say this is not
greatness? (William Makepeace Thackeray, recommended by U.Doran)
"Daydreams of a fair world which would treat him according to his real worth are
the refuge of all those plagued by a lack of self-knowledge." (Ludwig von Mises)
"The way of the Tao is reversal." (Lao Tzu)
"May a fair road always be open to you." (CHS, April 2, 2006)
"A healthy homecooked family meal and a home garden are revolutionary acts."
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"If you like eating, begin liking dirt."
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be restricted by chronic diseases." (CHS, May 9, 2009)
"Greed is a wonderful motivator but fear works much faster." (Riley T., Sept. 2008)
"Democracy can be likened to two wolves and one lamb voting on what to have for lunch."
(unknown source, submitted by Tim B.)
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"Just look at us. Everything is backwards; everything is upside down. Doctors
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destroy freedom, the major media destroy information and religions destroy spirituality."
Michael Ellner (submitted by Gene M.)
"The things we admire in men, kindness and generosity, openness, honesty,
understanding and feeling are the concomitants of failure in our system. And those
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"Do you know what amazes me more than anything else? The impotence of force
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"During times of universal deceit, telling the truth becomes a revolutionary act."
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"O Lord our Father, our young patriots, idols of our hearts, go forth to battle -- be
Thou near them! With them -- in spirit -- we also go forth from the sweet peace of
our beloved firesides to smite the foe. O Lord our God, help us to tear their soldiers
to bloody shreds with our shells; help us to cover their smiling fields with the
pale forms of their patriot dead; help us to drown the thunder of the guns with the
shrieks of their wounded, writhing in pain; help us to lay waste their humble homes
with a hurricane of fire; help us to wring the hearts of their unoffending widows
with unavailing grief; help us to turn them out roofless with little children to
wander unfriended the wastes of their desolated land in rags and hunger and thirst,
sports of the sun flames of summer and the icy winds of winter, broken in spirit,
worn with travail, imploring Thee for the refuge of the grave and denied it -- for
our sakes who adore Thee, Lord, blast their hopes, blight their lives, protract
their bitter pilgrimage,
make heavy their steps, water their way with their tears, stain the white snow
with the blood of their wounded feet! We ask it, in the spirit of love, of Him
Who is the Source of Love, and Who is the ever-faithful refuge and friend of all
that are sore beset and seek His aid with humble and contrite hearts.
Amen." (Mark Twain, via Dublin Mick)
"But we are told that we need not fear; because those in power, being our
representatives, will not abuse the powers we put in their hands. I am not well
versed in history, but I will submit to your recollection, whether liberty has been
destroyed most often by the licentiousness of the people, or by the tyranny of rulers.
I imagine, sir, you will find the balance on the side of tyranny. Happy will you
be if you miss the fate of those nations, who, omitting to resist their oppressors,
or negligently suffering their liberty to be wrested from them, have groaned under
intolerable despotism! Most of the human race are now in this deplorable condition;
and those nations who have gone in search of grandeur, power, and splendor, have
also fallen a sacrifice, and been the victims of their own folly. While they acquired
those visionary blessings, they lost their freedom."(Patrick Henry)
"Of all the enemies to public liberty war is, perhaps, the most to be dreaded, because it comprises and develops the germ of every other. War is the parent of armies; from these proceed debts and taxes; and armies, and debts, and taxes are the known instruments for bringing the many under the domination of the few. In war, too, the discretionary power of the Executive is extended; its influence in dealing out offices, honors, and emoluments is multiplied; and all the means of seducing the minds, are added to those of subduing the force, of the people…. [There is also an] inequality of fortunes, and the opportunities of fraud, growing out of a state of war, and … degeneracy of manners and of morals…. No nation could preserve its freedom in the midst of continual warfare."
(James Madison)
"When sacrifice, trade-offs and accountability are anathema, then so too is liberty."
(July 17, 2010, CHS)
"Whenever you find yourself on the side of the majority, it is time to pause and
reflect."
(Mark Twain)
"You assist an evil system most effectively by obeying its orders and decrees. An evil system never
deserves such allegiance. Allegiance to it means partaking of the evil. A good person will resist an evil
system with his or her whole soul. (Mahatma Gandhi, via Ken R.)
"Madison Avenue is a very powerful aggression against private consciousness.
A demand that you yield your private consciousness to public manipulation."
(Marshall McLuhan)
"When the going gets weird, the weird turn pro." (Hunter S. Thompson)
"It's not where you take thigngs from, it's where you take them to." (Jean-Luc Godard)
"The man who has a garden and a library has everything." (Cicero, via Lee Bentley)
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