No wonder the US intervened in the Yen market. Had Japan acted alone, it would have sold US bonds to fund the purchase, adding further strain to treasuries.
Nonetheless, this episode forces us to revisit an evergreen question (Opens in new window) in the politics of global finance: Can Beijing now dump some treasuries as a pressure tactic against Washington?
To answer that, we must first look at the sources of weakness in US bonds. Broadly speaking, there are four interconnected reasons.
First, the return of inflation since the pandemic and the Fed’s inability (Opens in new window) to rein it back to its 2% target for five years is eroding central bank’s credibility (Opens in new window).
Second, the US debt dynamics (Opens in new window) are increasingly unsustainable (Opens in new window).
Third, the new Fed Chair Kevin Warsh is having to maintain (Opens in new window) an awkward balance. He was hired to cut rates by the US president but is in no position to do that. His response is muddled rhetoric (Opens in new window), which is further eroding Fed’s credibility.
Finally, and most structurally, the central dynamics underpinning the dollar as a global reserve currency, has shifted (Opens in new window). Unlike before, now more global capital flows into US equities and corporate debt, as opposed to government debt (bonds). As observed by Dominik Leusder (Opens in new window) and Shahin Vallee (Opens in new window), this shift is undermining the US dollar’s exorbitant privilege (Opens in new window). Hence, bonds now must compete with equity markets for money, which is the crux of the treasury market’s troubles.
Now, how can the Chinese use this against the US? The answer to it lies in the fundamental overhaul of China’s foreign exchange reserve management.
According to Brad Setser, as Beijing stopped (Opens in new window) piling more dollars in its foreign reserves around 2015, it shifted that accumulation to its state-run commercial banks.While China’s publicly disclosed $1.8 trillion forex reserves have stayed almost flat for a decade, the amassing has shifted (Opens in new window) to Chinese banks – which now hold over a trillion in shadow reserves. After all, China’s $1 trillion plus trade surplus (Opens in new window) needs to be parked somewhere, and dollar being the safest financial asset, is the only real choice.
Now here is the catch, given that China is not openly accumulating as many dollar forex reserves, it is also buying fewer (Opens in new window) US treasuries – down (Opens in new window) from $1.2 trillion to around $650 billion over the past decade. As China’s exposure to treasuries goes down, it gives it the ability to operationalise them against the US as a soft weapon. During the next tense episode with the US, the Chinese government can sell a few American bonds as a pressure tactic and hike up the treasury yields. Thus, forcing an extremely indebted country’s borrowing cost, further up. This is likely to spook any American administration.
Americans have long feared (Opens in new window) this – your key adversary also being your leading debtor. Earlier, China was unlikely to dump US Treasuries because doing so would erode the value of its own foreign exchange reserves, which it relied on to manage its currency. Today, however, China holds ample dollars and is less dependent on Treasuries for that purpose.
In this new world, Beijing can pressure Washington by hiking up treasury rates at will, without touching its much larger stock of dollar reserves. China doesn’t have to tank the US bond market, just hike it up a little bit to make Washington concede on a given day. The shift from bonds to cash dollars has given China a subtle source of leverage.