Should Americans Worry About Foreign-Government Holdings of Dollar-Denominated Assets?

by Don Boudreaux on April 29, 2007

in Trade

Is there real reason for Americans to worry about the Chinese government buying and accumulating lots of dollar-denominated assets?

Probably not.

The U.S. economy is so massive compared to that of any other country that any government seeking to win influence over Uncle Sam by threatening to depress the prices of dollar-denominated assets would have to purchase and stockpile huge amounts of such assets.  To accumulate such huge amounts the foreign government would have to tax its citizens heavily – so heavily, in fact, that sour economic consequences likely would befall that foreign country long before, and to a greater degree than, such consequences befall the United States.  And such massive investments in dollar-denominated assets would make Americans noticeably wealthier and, hence, better able to withstand a sudden, politically induced negative shock to their prosperity.

Moreover, a massive sell off by (say) the Chinese government of dollar-denominated assets would further drain the Chinese government itself of huge amounts of wealth.  As Richard Rahn writes  in today’s Washington Times,

Contrary to some scaremongers, the Chinese won’t suddenly sell all their U.S. government bonds, since those bonds provide much of their bank reserves. If they engaged in massive sales, they would drive down the price of the bonds, thus destroying their own banking system — and they know better than to do that. When the Chinese buy U.S. bonds, U.S. investors can put more of their capital into higher rate of return productive investments in the U.S. because there will be less U.S. government debt they need to finance. Thus, the Chinese holding U.S. government bonds benefits both China and the U.S.

Of course, perhaps the foreign government cares more about non-economic goals (say, influencing U.S. military policy toward Taiwan) than it cares about economic consequences.  If we make this assumption, though, we must also hold open the possibility that the U.S. government cares more about certain vital non-economic goals than it cares about more narrow economic consequences.  If, for example, Americans feel strongly that the U.S. military should help protect Taiwan from an invasion, then a threat from Beijing to dump lots of dollar-denominated assets on the market unless Uncle Sam promises not to protect Taiwan will not obviously work.  What reason is there to suppose that the U.S. government is more apt than other governments to elevate narrow, short-run economic concerns above diplomatic issues, national-defense needs, and other important “non-economic” considerations?

Also keep in mind that the greater are a foreign-government’s holdings of U.S. assets, the greater is the potential leverage of the U.S. government over that foreign government.  Most obviously – and most extremely – the U.S. government can default on some or all of its debt.  Such a default will have serious harmful economic consequences for Uncle Sam (just as suddenly selling off its huge stockpile of U.S. Treasury securities would have serious harmful economic consequences for the Chinese government).  But if we suppose that governments are especially prone to discount economic consequences in favor of the pursuit of non-economic goals, then the leverage which the debtor government gains over the creditor government perhaps looms as large as does the leverage that the creditor has over the debtor.  In the end, it is impossible to determine which of these two governments, if any, has significant leverage over the other.

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{ 16 comments }

David White April 29, 2007 at 2:23 pm

"Is there real reason for Americans to worry about the Chinese government buying and accumulating lots of dollar-denominated assets?"

Probably so.

"Further deterioration in US economic growth from this point onward will cause the US Federal Reserve to consider cutting the US short term interest rate. While many participants in the US financial markets are conditioned to look at this outcome favourably, at this point such a decision would result in a repatriation of foreign capital (and rising longer term interest rates), because the interest rate differential versus other countries will become less favourable. An interest rate cut for a highly indebted country that is highly dependent on foreign capital will result in a completely opposite effect from that intended. The flight of private foreign capital back to China would result in the termination of China’s fixed exchange rate system, as the tremendous increase in their domestic money supply would necessitate it. Once that occurs, the foreign capital outflow would turn into a flood, given that there would be no foreign central bank intervention to offset it. Any benefit to debtors from a lower short term interest rate will be negated by the tremendous offsetting cost of sharply higher longer term interest rates (as US government debt is sold off in the US dollar liquidation). The US Federal Reserve is in a box. The Fed is now powerless to rescue the US economy, because of the threat of foreign capital flight. The emperor has no clothes."

http://www.prudentbear.com/articles/show/2001

Nathan T. Freeman April 29, 2007 at 2:59 pm

If I owe you a thousand dollars, I have a problem. If I owe you a million dollars, YOU have a problem.

quadrupole April 29, 2007 at 7:35 pm

China holds about 4% of all outstanding US government debt. Putting aside the psychological effect on the market of them selling all of it… would dumping 4% of a class of bond *really* kill off the whole market? I somehow doubt it…

Python April 29, 2007 at 9:37 pm

David W.,

Please explain the steps that are taken to create a "repatriation" of Chinese investment – from start to finish. Please be specific. An answer of "they sell their bonds" isn't specific enough. Please explain who they sell the bonds to, the return they expect to get when they sell them, and what they will do with the extra money.

Also please clarify that you are in fact speaking of selling current holdings, not decreasing the level of future bond purchases.

dave smith April 29, 2007 at 9:38 pm

Nathan really said it all.

I think I'll steal it from him next time this comes up at lunch.

Matt C. April 30, 2007 at 9:03 am

I think the mortgage industry is a good example. No matter what the talking heads say, the mortgage company does not want to foreclose on a home, no matter how small or large. They are out money either way. Don's last point is important, the debtor and the creditor are both hurt.

David White April 30, 2007 at 9:56 am

Nathan,

Right you are. And China knows it. That's why it's created huge investment fund — http://www.gata.org/node/4773 — to diversify out of the dollar. China knows better than to dump its bond holdings altogether, of course, as it doesn't want the dollar-based financial system to collapse any more than anybody else does. Thus is the attempt being made to "manage the dollar down" in an orderly fashion, the problem being that when the dollar finally breaks through 80 on the index, it could well fall off a cliff:

http://charts3.barchart.com/chart.asp?sym=$DXY&data=A&jav=adv&vol=Y&evnt=adv&grid=Y&code=BSTK&org=stk&fix=

But the dollar is doomed in any case, and the powers that be know it. Why? Because the dollar isn't really a dollar at all — http://www.csamerican.com/stuff.asp?k=25. For unlike the constitutional dollar, the Federal Reserve Note is a non-asset-based (i.e., irredeemable) credit instrument that becomes currency via the debt that must be taken on to complete the transaction. And that debt is now exploding so rapidly that unless other central banks do the same, their currencies will appreciate to the point that it shuts down their countries' export trades. Thus is global liquidity running in the double digits, and thus is inflation — which, properly speaking, is a monetary phenomenon — running in the double digits as well. (Anyone who believes the government's CPI figures must be living off the land.)

And let's be clear: The government's claims that it wants a strong dollar are blatant lies, as the Fed can only strengthen it by raising interest rates and thus hammering the already reeling housing market. This in turn would hurt the consumption upon which some 70% of GDP depends, and thus would the economy stumble into an inflationary recession (which in fact it already has).

That's why the Fed is now powerless; that's why the emperor has no clothes; and that's why you're right but, more importantly, dead wrong.

skh.pcola April 30, 2007 at 10:53 am

David:

"…such a decision would result in a repatriation of foreign capital (and rising longer term interest rates), because the interest rate differential versus other countries will become less favourable."

Not true, at least in the "big picture." Compare these central bank interest rates and see that we can comfortable cut our rates by 50 basis points and still be competitive:
http://www.dailyfx.com/page/central_bank_interest_rate.html

quadrupole:

".. would dumping 4% of a class of bond *really* kill off the whole market?"

It might not kill the market, but it would definitely shock the supply side. Look at how unrest in Nigeria, with it's 2% share of daily oil production, rippled through the oil futures market. It doesn't take double-digit percentages to ding markets in the short-term.

David White April 30, 2007 at 11:50 am

skh.pcola,

As the GATA link I referenced above says, "[T]he expected appreciation of the yuan is worrying the Chinese government. If the US dollars depreciates against the yuan by 5% this year, which is almost certain, the reserves will 'shrink' by $50 billion against the yuan, equivalent to the amount of capital the Central Huijin Investment Co has injected into Industrial and Commercial Bank of China (ICBC), Bank of China (BOC) and China Construction Bank (CCB)."

So when you factor in that government bonds worldwide are losing propositions vis-a-vis real inflation, diversification out of them and into equities (asset inflation) will put pressure on central banks to raise interest rates. But because the US housing market hasn't bottomed out yet, the Fed won't be able to follow suit and may even cut rates.

Either way, investors will exit the US bond market, forcing the Fed to step in lest the government go into default. So much, then, for "managing the dollar down," as this highly inflationary move will send the dollar into a free-fall. But as this is the only way that the US government can pay its debts and meet its Social Security, Medicare, and other liabilities, that's what it will do — inflate them away.

Expect the inflation to be papered over, however, with the issuance of the amero — http://www.amerocurrency.com — amid the creation of the North American Union. For when China stops vendor-financing its US exports, the US will seek to offset the loss of cheap Chinese labor via the effective naturalization of the Mexican workforce (locking up Canada's vast natural resources in the process).

Gustavo April 30, 2007 at 12:00 pm

Although our government (from Argentina, the country of the happy economic plans) doesn't have enough US' assets to be a significant threat, it is taxing us to buy more and more reserves. Despite how crazy it is for a government to tax people in such a way or for the citizens to tolerate it, it is actualy happening.

Ray G April 30, 2007 at 9:17 pm

"Should Americans Worry About Foreign-Government Holdings of Dollar-Denominated Assets?"

No.

Sam Grove May 2, 2007 at 2:36 pm

"Is there real reason for Americans to worry about the Chinese government buying and accumulating lots of dollar-denominated assets?"

I certainly don't.

Maybe I should worry about my government's spending.

Sorry, I just don't worry about such things.

Sudha Shenoy May 2, 2007 at 9:04 pm

1. It's worth taking a look at the numbers. As of 28 Feb 2007, Chinese govt holdings came to: 4.8% of all Federal debt. That is, somewhat over 95% of all Federal debt is _not_ held by the Chinese govt.

2. All _foreign govt_ holdings of Federal debt came to somewhat over 24% of the total. That is, just under 76% of Federal debt is held in the US.

David White May 3, 2007 at 9:27 am

At the end of the day, it's not about who holds the debt but the debt itself — i.e., how long the US government can get away with issuing non-asset-based (work-free) credit to fund the welfare-warfare colossus it has become.

But of course only fools "worry about such things."

jason July 19, 2008 at 8:22 am

I guess you guys have heard about Gordon Brown breaking his golden rule on not borrowing more than 40% of budget, this is very dangerous for brits as we dont have a real reserve currency like the dollar, although it is a semi- one, we cannot run the printing presses like america can as all assets are priced in dollars not pounds
so the us has an advantage and can potentially inflate its debt away, i think brown is copying bernanke just like blair followed bush and the uk will fare a lot worse than the us who the world needs to their goods.

jason July 19, 2008 at 8:57 am

buy gold! the "ultimate fiduciary par exellance"

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