Frequently when the Treasury Department or the Fed reports on foreign holdings of Treasuries, someone publishes a panic piece to the effect that country X is dumping their Treasuries. And from time to time we get articles on China’s doomsday weapon, the threat to dump their Treasuries. If we accept the idea of ‘dumping’ as a sudden massive insertion of some asset into a market, we will show in the post why there are large negative consequences and few positive consequence of trying to dump Treasuries. We will also show why dumping a large Treasury position may not even be possible.
Markets of reasonable size in any asset have the following properties:
- The current price of an asset is the market equilibrium price between the range of prices sellers are willing to sell at and the range of prices for which buyers are willing to pay. One can think of it as the equilibrium point between two forces, the force of selling interest and the force of buying interest.
- If a seller enters the market needing to quickly sell a large position in the asset, the price will be driven down until there are no more buyers or until the position has been sold to the the buyers at the highest offer prices.
- Even if such a seller is willing to sell in small quantities over time, the cumulative selling pressure will depress the equilibrium price to some degree.
- The opposite effects occur when buying assets.
- This ignores commissions and spreads that occur around most market transactions.
In summary, if the market is in equilibrium a buyer coming in will drive the price up and pay a positive differential or premium over the original equilibrium price to acquire his position. A seller coming in will depress the price and pay a negative differential to divest himself of his position. This is discussed more fully in The Dilemma of the Impatient Trader.
On the matter of international trade, a country running a trade surplus will experience the surplus as a net increase in reserves of the currency in which the trade is conducted. The acquired currency from all the individual trade transactions accumulates in the country’s banking system. If it is a currency other than the native currency, it ties up capital and dampens economic growth. The country’s central bank then prints native currency to buy up the foreign currency which ultimately accumulates in the central bank, at the same time causing inflation in the local economy.
The Case of China
China has been running a trade surplus with the rest of the world and the US in particular for over a decade. This has resulted in the accumulation of a massive foreign reserve, especially in US dollars since that is the reserve currency of commerce and its largest trading partner has been the US. Total Reserves excluding Gold for China (TRESEGCNM052N) are shown in the following graph:
Figure 1. China’s total foreign reserves. (Click on image to open in a new window)
To understand where the US contribution to China’s current account surplus came from, simply look at the following graph, Trade Balance: Goods and Services, Balance of Payments Basis (BOPGSTB):
Figure 2. The US balance of trade deficit. (Click on image to open in a new window)
We see that the US has been running a negative trade balance with China (we haven’t found a source for a breakdown showing the amount with China alone) and the world since before 1992.
From this data and the discussion in the Preamble, we understand why China would have a large foreign reserve of US dollars – a mercantilist trade policy.
Why Does China Own Treasuries and How Much Does It Own?
We looked at how much China held in US Treasury securities in Tracking the Ownership of US Debt. In particular, the table MAJOR FOREIGN HOLDERS OF TREASURY SECURITIES shows that as of Dec. 31, 2011, China held $1,151.9 billion in Treasuries. So roughly 1/3 of China’s foreign reserves are in Treasuries. But why not simply hold dollars instead of recycling them back to the US economy by purchasing Treasuries?
The answer is a Treasury returns a nominal amount of interest and a dollar doesn’t. Granted the real rate of return on some maturities is negative. But this is still better than the real return on a dollar which is more negative. The value of a dollar depreciates daily by the amount of inflation in the US.
There is a more subtle reason for converting their dollar reserves into Treasuries. The total US currency in circulation is given as Currency in Circulation (CURRCIR) shown in the graph:
Figure 3. US currency in circulation. (Click on image to open in a new window)
In particular, as of Dec. 31, 2011, the amount was $1,067.3 billion. This is $84.6 billion short of the nominal amount of Treasuries held. There was, and is, not enough currency in circulation to cover the value of China’s trade surplus with the US. But had China not converted trade dollars into Treasuries, US dollar liquidity in the global economic system would have been reduced to the point that commerce including China’s, would have ground to a halt. The only other antidote would have been for the Fed to print more money and place it in circulation by some specialized monetary policy. We suggest that they would have at least had to double the amount and this would have been hugely inflationary, especially for China.
The other aspect of this scenario is as the supply in dollars dried up, their value against other currencies would have risen exponentially. This of course would have prompted the Fed response noted above since with a rising dollar, exports would drop and the US economy would move into recession. This exemplifies the inherent fallacy of linear thinking that such a scenario represents. In practice, the global economy is a complex adaptive system that would counter such imbalances through other channels.
What If China ‘Dumps’ Its Treasury Holdings?
Here’s the deal, it is unlikely ever to want to ‘dump’ Treasuries in the sense of what was discussed in the Preamble:
- China holds Treasuries because it did not want to be holding US dollars.
- China is still running trade surpluses and still accumulating US dollars. It doesn’t need more.
- When China sells a US Treasury, it gets US dollars in return, something it doesn’t need or want at the moment and something it worked to get rid of by converting into Treasuries.
If it wanted to, however, it couldn’t:
- There are not enough dollars in existence to redeem them with.
- Whatever reason might be behind a decision to dump would become visible to investors worldwide. There would be no market for the securities if the reason were a rational divestiture. (see Other Actors below)
- Any speculators willing to take the other side of the trade would be offering pennies on the dollar. The Chinese would suffer a massive capital loss on the reserves they sold. (See: The Dilemma of the Impatient Trader).
- Even if their reasons were benign, the size of their position could exhaust willing buyers leading to a condition of ‘no bid’.
The Treasury position the Chinese have built up was constructed over many years. To unwind this position will take an equally long period of time to minimize the loss of capital due to the negative differential mentioned in the Preamble.
The Wisdom of Diversification
No prudent investor builds an outsized position in any asset and the Chinese are certainly prudent. The problem the Chinese have is there are few asset classes that they can diversify into without creating large market distortions. They have enough reserves that they could buy all the gold in the world at current prices. As with the Hunt brothers and silver, any attempt would drive gold prices into the stratosphere.
We have seen a draw-down on their Treasury position beginning in July, 2011. We will have to see if this becomes established as a major trend. So far there have been buyers without causing market distortions. But at the rate they are decreasing their position it will take years.
The key thing to understand in building scenarios around Chinese debt or any other market or asset class is that every change is a change in a complex dynamic global system. Every change has a consequence and often multiple unforeseen consequences. We have shown why the Chinese can’t ‘dump’ their Treasuries and given some suggestions of the consequences that would emerge early in any attempt to do so.
The Federal Reserve Board recently published a paper, Foreign Holdings of U.S. Treasuries and U.S. Treasury Yields, that estimates:
if foreign official inflows into U.S. Treasuries were to decrease in a given month by $100 billion, 5-year Treasury rates would rise by about 40-60 basis points in the short run. But once we allow foreign private investors to react to the yield change induced by the shock to foreign official inflows, the long-run effect is about 20 basis points.
That is ‘dumping’ $100 billion in Treasuries would reduce the price and raise the yield on the 5-year note by half a percent. This would attract new buying that would force the yield down, so long-term, the increase would be about a quarter percent.
Another problem with the thinking of the “dumping Treasuries” crowd is they fail to understand that there are other actors in the global economy. Central bankers pretty much share the same DNA. If the PBoC decided to “dump” Treasuries for some good reason, then the BoJ might very well have decide to dump them also. And the BoE, etc. After all, international finance is like a game of musical chairs, no one wants to be the last player standing.
And if China sells a Treasury, who buys it? Can they in fact even find a buyer? If it became clear that China was divesting itself of Treasuries, not only would they have to pay the premium of an impatient seller (The Dilemma of the Impatient Trader), a buyer would know that the price he pays today will be higher than the market price tomorrow as sales continue. His position will be a losing one in the space of a day (or an hour, depending on how fast the Chinese “dump” their position.
As an example of the lack of thought on this aspect of the issue, consider this comment by Gary North (Reality Check: 20120828) (bolding ours):
The Treasury Department does have to face this scary possibility, namely, that the mainland Chinese central bank is not going to the Treasury any longer. On the contrary, the People’s Bank of China may be selling Treasury debt for dollars in order to buy other currencies.
While the Treasury may have a general concern on how its auctions go – and so far they have gone very well – it need have no concern over what the Chinese sell because if they sell there is another actor called a buyer and the Treasury has no concern who it is.
The point is that in economics, problems cannot be analyzed in terms of a single actor or even a small set of actors. The global economy is an increasingly connected network of players.
So the answer to the question posed in the subject heading of this post is “no one of consequence”.
Zero Hedge reported today: Is China Really Liquidating Treasuries? The article comments on the recent development of China being given direct access to Treasury auctions thereby bypassing Wall Street middlemen. We are not concerned about the why of this decision. We do wish to comment on the article and the decision, however. Our points are:
- Treasury auctions are a venue for buyers only. China cannot sell anything through these auctions and must do so through other venues.
- We track foreign holdings of US debt (Tracking the Ownership of US Debt). The reader has direct access to the debt held by China through this post. We lament the latency of the data. As of the weekly update 10 minutes ago, the latest data we have is for March 31, showing a consecutive monthly increase in holdings.
- The author writes: This raises a much more interesting question — now that the PBOC has effectively been upgraded to primary dealer [PD] status. This does not give the PBOC PD status with the Fed. Should the Fed decide to do so, we would expect a news release to announce the addition and the name to appear on the list of PDs.
- However the Treasury, the Fed and the PBOC wish to conduct their business, we see no need for the accuracy of foreign holdings data to change other than in the direction of more timely reporting.
In his annual address at Jackson Hole on August 31, titled Monetary Policy since the Onset of the Crisis, Bernanke made the following observation:
if the Federal Reserve became too dominant a buyer in certain segments of these markets, trading among private agents could dry up, degrading liquidity and price discovery. As the global financial system depends on deep and liquid markets for U.S. Treasury securities, significant impairment of those markets would be costly, and, in particular, could impede the transmission of monetary policy. For example, market disruptions could lead to higher liquidity premiums on Treasury securities, which would run counter to the policy goal of reducing Treasury yields.
The reverse arguments apply to too dominant a seller. Bernanke is supporting many of the points that we have made.