Of Docks and Dollars

I shot this lad collecting parking fees in the Lao capital of Vientiane. Note his vest, which says JIAOTONG, apparently Chinese. Most consumer goods in Laos come from China, as do many of the merchants.

Tom Holland in the SCMP blistered those feeling the forex fears from China after military leaders blustered earlier this month. News this week says that China has slipped to number 2 holder of US debt after dumping a bit in December. Holland, in a piece entitled Fat-headed generals wrong to see forex reserves as a weapon, argues:

Given that China's US$2.4 trillion pot of foreign reserves is by far the world's largest (see first chart), and that it is held mostly in US-dollar-denominated assets, Luo's threat sounds devastating.

Coupled with the news late on Tuesday that Beijing's direct holdings of US Treasury debt fell by US$43.5 billion over the last two months of 2009 (see second chart), his bellicose words added fuel to the fires of a dozen internet conspiracy theories.

Believe the theorists and you would have little doubt that a fatally weakened US economy now lies at the mercy of a small band of unhinged Beijing warmongers just itching for an opportunity to destroy the value of the US dollar and bankrupt the US government by abruptly selling down their holdings of Treasury bonds.

Certainly the US military establishment takes the prospect seriously. In late 2008, Colonel Jeffrey Haymond, vice-commander of the space development test wing at Kirtland Air Force Base in New Mexico, published an article in the journal of the US Air Force's research institute entitled "The economics of a Chinese currency attack".

In Haymond's scenario, Washington dispatches two aircraft carrier battle fleets to the region following a Taiwanese independence vote. Suddenly, global financial markets go haywire, with massive selling of US Treasury notes. Long-term interest rates jump by a full percentage point in a single day and the US dollar falls 5 per cent.

It becomes obvious that China is dumping its foreign exchange reserves. US stocks fall 30 per cent while the US dollar drops 20 per cent against the euro. Slammed by the volatility, banks and investment funds begin to fail and the US economy is brought to its knees. A Chinese currency attack on the US, Haymond concludes, would be "a viable tool of economic statecraft". Luo and his comrades in the PLA clearly think so, too. The trouble is that they, the internet conspiracy theorists and Haymond are all wrong. The whole idea that Beijing could use its foreign exchange reserves as an weapon against the US is nonsense. It simply wouldn't work.

To see why, just imagine what would happen if China really did try and dump its holdings of US Treasury bonds. Once word got around the market that Beijing was on the offer, every financial institution in the world would run for cover. Bids would vanish and all liquidity would evaporate. With no buyers in sight, Beijing would not be able to sell its debt.

Trying to sell the US currency in the foreign exchange market wouldn't work either. The only buyers likely to emerge would be the central banks of Europe and Japan, who could sell their own currencies in unlimited quantities in order to stabilise their exchange rates against the US dollar. As a result, the most visible consequence of the Chinese action would be that the yuan's exchange rate against other major currencies would soar, crippling China's export sector.

And contrary to common expectations, a Chinese attempt to dump Treasury bonds wouldn't ruin the US government's finances. Yields would rise initially (although Federal Reserve purchases would soon push them down again). However, it would rapidly become apparent that Washington is not reliant on Beijing to fund its budget gap. Over recent months, Chinese purchases of Treasury debt as a proportion of the federal deficit have shrunk almost to zero without precipitating a crisis.

Note how unrealistic the whole scenario above is (for starters, why on earth would Washington defend Taiwan if it voted to declare independence, when it has clearly indicated Taipei would be on its own if that occurred?). Holland could have added much more -- a rising Yuan against the dollar would dramatically spike China's imports, while a falling dollar would give fresh impetus to the ailing US export machine (and other exporting nations, like hated Taipei and distant Europe). Too, once those US securities were dumped, they would cease to be leverage over the US. That would give Washington a lot more room to manuever. Is that really what Beijing wants? To give up secure leverage for an uncertain future? Not to mention all that lovely interest from the US treasury.....

Observations on Holland:

1. China has already stopped purchasing US treasuries in significant amounts.
2. The amount sold in December was a tiny fraction of all Chinese holdings, around 2%. No earthquake there.
   
3. While Beijing's chorus in the US blamed Taiwan, or the US military, or anything but Beijing for deciding to dump a few US treasuries -- in a permanent state of victimhood, poor Beijing is always the passive recipient of someone else's actions -- the sell-off dropped China below Japan, so that it is no longer the leading holder of US treasuries. Looks to me like the whole thing was a PR exercise -- Beijing decided to sell just enough bonds to become #2, and take some of the focus off its holdings of US debt. This may be because a stealth sell-off is in the works, or perhaps just because it didn't like everyone watching its financial arrangements.Whatever the case, congrats to the PR boys in Beijing who once again got the Usual Suspects out there flacking for it.
   

The media is really confusing me. Are tensions rising or falling between Beijing and Washington? Should I go with the BBC's Nimitz docks in Hong Kong despite China tensions or with the AP's U.S. Warship In Hong Kong In Sign Of Easing Tension? China hasn't really taken any of the actions it threatened to, as several reports have noted -- which also suggests that the whole We're Tough! exercise was aimed at its domestic front.

Interesting times, indeed.
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