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China Making Good on Dollar Run Threat?

Posted by Stephen on June 8, 2011

By Bill Wilson – Eyebrows were raised on June 3 when it was reported that China is divesting itself of shorter-term U.S. treasuries. According to U.S. Treasury data, China’s holdings of short-term bills have dropped from $210 billion in May 2009 to $5.6 billion in March 2011, a 97 percent decrease.

Pundits have assured us the Chinese wouldn’t do this. Don’t worry about a run on the dollar, the conventional wisdom advised, it’s not in China’s interests to divest itself of U.S. treasuries. The Chinese would be risking the devaluation of their own $3.04 trillion worth of dollar-denominated holdings.

In other words, not so fast.

After all, last year, the Treasury revised its June 2010 data on foreign holders of U.S. Treasury securities, with a huge upward revision of China’s overall holdings by $269 billion. Apparently, Chinese investors were buying a large number of bonds through the UK and Canada. So, maybe that’s what happened here?

Maybe not. According to Treasury’s data on the UK and Canada, there has been a net decrease over the past five months of short-term bills. That means, then, that China’s divestiture in these types of shorter-maturity treasuries is indeed happening.

But, it may just be replacing them with longer-term treasuries. Once again this year, overall British and Canadian holdings of treasuries have risen dramatically by $288.1 billion since last June, when the last revision occurred. This indicates that, again, China is raising its stake in long-term treasuries — and buying them through British and Canadian markets to boot, making it harder to track its purchases.

Curiously, this comes at a time when China has advocated repeatedly of divesting itself of dollar-denominated assets, calling for the lowering of its foreign exchange holdings from $3.04 trillion to about $1 trillion.

Zhou Xiaochuan, the head of the People’s Bank of China, Tang Shuangning, chairman of China Everbright Group, and Xia Bin, another Chinese central banker, have all advocated an approach that would dramatically reduce China’s dollar holdings.

Overall, China has openly advocated replacing the dollar as the world’s reserve currency, with Zhou specifically calling for it to be replaced by the International Monetary Fund’s Special Drawing Rights (SDRs). Zhou wrote, “SDR has the features and potential to act as a super-sovereign reserve currency.”

In addition, China’s credit rating agency, Dagong, has once again downgraded the U.S.’s credit rating, this time to A+, citing the Federal Reserve’s QE2 program to purchase $600 billion of U.S. treasuries. Dagong wrote that the Fed’s “move entirely encroaches on the interests of the creditors, indicating the decline of the U.S. government’s intention of debt repayment.”

So, clearly China is worried about the strength of the dollar and questions the Fed’s decision to print money to pay the debt, and is actively seeking alternatives to the current system.

Therefore, there is a clear contradiction between what China is saying, and what it is doing. On one hand China is talking up the risks of a U.S. default on the $14.3 trillion national debt and the need to divest itself of foreign exchange holdings, and on the other is raising its levels of longer-term U.S. debt holdings. At the same time, it is moving surreptitiously in the markets to make it harder to discern what its posture actually is.

How to make sense of this?

There appears to be three possibilities: 1) internal factions in China are fighting over the future of Chinese monetary policy, sometimes publicly; 2) China is making an economic decision to put out misinformation on their long-term posture on treasuries perhaps to drive down prices and get a bargain on the markets; or 3) China is positioning itself and preparing a massive dump of U.S. treasuries on the market after ratcheting up its positions.

Considering that we are in the midst of a treasuries bubble, with prices historically high, and the fact that the risks of holding U.S. debt are ever-increasing — with S&P downgrading its outlook on U.S. debt to negative and Moody’s threatening to do so if a deficit reduction plan is not implemented by Congress and the White House — the last possibility is the only one that makes sense.

After all, why knowingly increase one’s stake in an asset that everyone knows is going to go down? Markets cannot make sense of the move, because it is irrational — from an economic point of view of maximizing return on investment.

Strategically, it makes perfect sense. China means what it says. It wants to unseat the dollar as the world’s reserve currency, and if it costs them a couple trillion dollars to do that, then that’s the price.

Bill Wilson is the President of Americans for Limited Government. You can follow Bill on Twitter at @BillWilsonALG.

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