[Salon] What if China and Japan dump their US Treasuries?

[Chas Freeman <cwfresidence@gmail.com>]

https://asiatimes.com/2022/05/what-if-china-and-japan-dump-their-us-treasuries/

What if China and Japan dump their US Treasuries?

America’s top Asian bankers hold a combined $2.4 trillion in US Treasury debt and both have good cause to sell

by Andrew Salmon May 5, 2022

TOKYO – The Japanese yen’s sharp decline may be producing an unexpected loser: the US Treasury Department.

One of the most intriguing mysteries of the last three months is this: Why is Japan, the biggest foreign holder of US Treasury securities, placing so many “sell” orders? In three months, Japanese institutional managers have dumped a cool $60 billion of US paper.

Granted, that is a drop in the proverbial bucket considering Tokyo holds a $1.3 trillion stack of Washington’s IOUs. But the magnitude of the selling is getting increasingly hard to ignore.

The most plausible explanation is the yen’s 13% drop so far this year. That fall complicates the economics of loading up on US debt at a moment when US inflation is at 40-year highs. That’s despite the negligible 0.22% return investors receive on 10-year Japanese government bonds.

The real concern, though, is that Prime Minister Fumio Kishida’s team might throttle back on US dollar purchases. That concern also applies to Chinese President Xi Jinping’s government, which holds the second-biggest stash of US debt.

Still, it is hard blame Tokyo and Beijing given how poorly the Federal Reserve and US lawmakers are playing their financial hands.

Chairman Jerome Powell’s Fed remains oddly laid back amid the worst inflation since 1982. Even before Russia’s Ukraine invasion ballooned oil prices, supply chain chaos related to Covid-19 was already pushing producer and consumer costs into the stratosphere. That left the Fed behind the inflation curve – and with a self-inflicted credibility deficit.

This neglect is colliding with legislative sparring in Washington – that’s dimming the odds Congress can address supply-side-driven inflation – or inflation caused by ultra-loose fiscal policy. Making matters worse, this dysfunction comes as Washington’s debt tops $30 trillion, further imperiling the dollar’s status as the globe’s reserve currency.

US Federal Reserve chairman Jerome Powell. Photo: AFP / Al Drago

On Wednesday (May 4), the Powell-led Fed picked up the tightening pace, adding a 50 basis point rise to a 25 basis point move in March. That was the Fed’s biggest hike since 2000, and Powell is telegraphing the growing odds of similar actions for June and July.

He, however, doused speculation the Fed might start moving in even bigger increments. “A 75-basis-point hike is not something that the committee is actively considering,” Powell said, cheering stock traders everywhere.

In its official statement, the Fed highlighted risks from tightening labor markets. These strains are getting “to an unhealthy level” that could further fuel inflation, the Fed warned. The plan, the Fed says, is to curb such risks without triggering mass layoffs.

Yet the real inflation surges are beyond the Fed’s control.

“The Fed can’t fix supply-side challenges with higher interest rates,” says Jim Baird, chief investment officer at Plante Moran Financial Advisors. The US hiking rates, Baird adds, can’t “re-open Chinese factories, increase grain shipments from Ukraine, reposition container ships to where they are needed or hire truckers to move goods.’’

Risks, headwinds and wild cards

These pressures, of course, are in the orbit of elected officials in Washington.

Congress could be acting to revitalize supply chains and taking steps to raise America’s economic game. US President Joe Biden could scrap Donald Trump-era tariffs on China that raise prices on US households.

Meanwhile, Powell and US Treasury Secretary Janet Yellen must redouble efforts to ensure America’s top bankers are on board. Taming inflation will indeed require more Fed tightening. Investors agree Powell and Yellen need to be in lockstep to maintain trust in the globe’s biggest economy.

If that trust evaporates, waters will be roiled – and then some.

Tokyo, for example, could soon decide that being America’s top banker is a risk too far for Asia’s No. 2 economy. China is Washington’s second most important financier with $1.1 trillion of Treasury securities. If Beijing got wind Tokyo was selling US debt, Xi’s team might follow suit.

Here, Xi-Biden relations are an obvious wildcard. Since taking office in January 2021, Biden hasn’t ended predecessor Trump’s trade war against Chinese goods. Instead, Biden’s administration ratcheted up the pressure on mainland companies listed on US exchanges.

Just this week, investors learned the US Securities and Exchange Commission (SEC) is investigating Didi Global’s June 2021 initial public offering (IPO). In its annual report, released on Monday, the Chinese ride-hailing giant admitted the SEC “made inquiries in relation to the offering.”

Shortly after the $4 billion IPO, Chinese regulators launched a cybersecurity probe, which saw the removal of Didi’s apps from mainland stores. The SEC’s investigation is, at best, a new wrinkle in Didi’s journey from tech role model to a cautionary tale and, at worst, an omen of more probes to come that rattle world markets.

The SEC, Reuters reports, is expanding its list of US-listed Chinese entities that face delisting over audit transparency. Another 80 companies are reportedly being added, including household names JD.Com and Pinduoduo.

The Russia-Ukraine conflict is its own wildcard. Until now, Xi’s government has walked a fine line between not condemning Russia’s invasion while also not appearing to aid and abet Vladimir Putin’s aggression. This careful balance could shift at any moment, putting top Chinese banks at risk of global sanctions.

Some worry about the precedent set by the US, Japan and European Union barring Moscow’s access to hundreds of billions of foreign currency reserves. By deploying what Columbia University economist Adam Tooze calls “the nuclear option,” Biden and his allies are “really ripping up the playbook” in ways that could alter long-term dynamics in currency markets.

Greenback’s mad strength

Yet the potential fallout from America’s two top bankers calling their loans may ensure it won’t happen. There’s a mutually-assured-destruction dynamic that tends to limit selling options in Tokyo, Beijing and elsewhere.

It’s often thought that their combined $2.4 trillion of Treasury debt holdings give Japan and China great leverage over Washington. On the surface, that’s true.

But considering how the financial carnage sure to ensue would boomerang back Asia’s way, slamming exports, Japan’s and China’s seat upon sacks of trillions of dollars is as much a trap as a bargaining chip.

In Japan’s case, though, the divergence between a Fed hiking rates and a Bank of Japan going the other way could make dollar purchases increasingly prohibitive. The cost of hedging alone may deter Japan from buying dollars. The price of protecting against moves in the dollar exchange rate has risen a whopping 80% since early 2020.

The dollar, though, continues to climb – soon even to 20-year highs versus the euro. In April, the main dollar index rose 5%, its best showing since January 2015.

“We expect the USD to stay strong versus the EUR, as a hawkish Fed stance and geopolitical concerns will support the USD,” writes UBS Global Wealth Management wrote in a research note.

A weaker yuan would be welcome right about now in Washington. Photo: AFP / Chen jialiang / Imaginechina

The dollar is also surging against the Chinese yuan – up neatly 4% year to date. This partly reflects the fact the Fed is tightening, while the People’s Bank of China opens the liquidity spigot even wider. It reflects, too, concerns that Xi’s “zero-Covid” lockdowns are damaging prospects for 5.5% economic growth.

It’s not in China’s interest, though, to let the yuan weaken too drastically. It would increase the risks of importing inflation and make it harder for struggling property developers to make payments on dollar-denominated loans.

What’s more, yuan internationalization is arguably Xi’s top financial success since 2012. A sharply lower yuan might cost the currency much of the hard-won creditability it’s accrued in recent years.

What could possibly go wrong?

A sharply weaker dollar in such a fragile environment could upend the entire global financial system. Any signs of unraveling in the linchpin asset of international finance would unnerve markets everywhere.

The strains can already be seen in Japan.

Shunichi Suzuki, Japan’s finance minister, recently admitted that the costs of yen weakness outweigh the benefits as surging raw-material costs increase the odds of imported inflation. That, says economist Maxime Darmet at Fitch Ratings, suggests the Bank of Japan might be coming under pressure “to slightly reduce policy accommodation” of recent years.

The PBOC has even greater latitude to soften the economic impact of slowing growth abroad and Covid lockdowns at home, monetary policy committee member Wang Yiming said late last month. On April 25, for example, the PBOC cut its foreign exchange deposit reserve ratio by 100 basis points to 8.0%, effective on May 15.

“The move should help to address depreciatory pressures on the yuan by making it more attractive for exporters to sell USD,” says economist Carlos Casanova at Swiss private bank Union Bancaire Privée.

The yuan, he adds, “has been under tremendous pressures as of late, including a widening policy differential with the US as well as concerns about the impact of Covid lockdowns on the economy.”

PBOC action may be needed soon, given the downshift signaled by the Caixin Services purchasing managers index for April, which fell to 36.2 from 42 a month earlier. Such data, notes analyst Jeffrey Halley at Oanda, is “likely to be one of several headwinds facing China markets” this week.

Such pressures would intensify if the dollar loses credibility in the months ahead – and Biblical turmoil may be inevitable if Washington’s biggest bankers decide to call in some of the biggest loans in world history.

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