The U.S. Could Seize China’s Treasury Holdings

There is one story that may be bigger than the elections, the riots and the pandemic, but it will take a few years to play out.

The U.S. will convert China’s $1.4 trillion of Treasury notes to a trust fund for COVID-19 victims and economic damages. In other words, say goodbye to China’s dollar reserves.

China was massively negligent by covering up the release of SARS-CoV-2. The toll in human suffering and economic losses are incalculable. The U.S. could seize Chinese holdings of U.S. Treasury securities and convert them to a trust fund to help make up some of the costs. It’s simple justice for the original crime.

Some say China would consider that an act of war. But guess what? The war started ten years ago. China has been conducting unfair trade policies, intellectual property theft and technology theft for years. Only recently has the U.S., led by Trump, stood up to China.

Critics also argue the U.S. dollar would crash as China would move into the euro, the Japanese yen, gold and other reasonably liquid currencies such as the Australian dollar.

But reserves are not kept in “currencies.” They’re kept in bonds denominated in currencies or in gold. So China does not have stacks of dollar bills in the basement. They own U.S. Treasury notes.

Most Japanese government bonds are already owned by the Bank of Japan. And the market for the Australian dollar is tiny.

On the other hand, the market for U.S. Treasuries is extremely deep and liquid, with primary dealers, repo facilities, futures contracts and other legal infrastructure.

If this development happens as I envision, Treasuries would rally on reduced floating supply. The alternative markets are all too small (gold would also get a lift).

This will not happen overnight. The litigation could easily take years and China could gradually reduce its holdings of U.S. Treasuries in the meantime.

But would that be a serious problem?

Some analysts have maintained that China can dump those Treasuries on world markets and drive up U.S. interest rates. This would also drive up mortgage rates, damage the U.S. housing market and possibly drive the U.S. economy into a recession (Well, we’ve already had that due to the Chinese virus).

Analysts call this China’s “nuclear option” when it comes to fighting a financial war with Trump. There’s only one problem…

The nuclear option was always a dud. If China did sell some of their Treasuries, they would hurt themselves because any increase in interest rates would reduce the market value of what Treasuries they would have had left.

There have always been, and still are, plenty of buyers around if China became a seller. Those Treasuries would be bought up by U.S. banks, or even the Fed itself. If China pursued an extreme version of Treasury dumping, the U.S. President could stop it with a single phone call to the Treasury.

That’s because the U.S. controls the digital ledger that records ownership of all Treasury securities. We could simply freeze the Chinese bond accounts in place and that would be the end of that.

So, you never really had to worry about China dumping U.S. Treasuries. China was stuck with them. It had no nuclear option in the Treasury market.

But China could use a real nuclear option by fighting a currency war.

China could simply massively devalue its currency. It would make Chinese goods cheaper for U.S. buyers by the same amount as the tariff. The net effect on price would be unchanged and Americans could keep buying Chinese goods at the same price in dollars.

The impact of such a massive devaluation would export deflation from China to the U.S. and make it harder for the Fed to meet its inflation target.

Also, the last two times China tried to devalue its currency, August 2015 and December 2015, U.S. stock markets crashed by over 11% in a matter of a few weeks. So, watch the currency. That’s where China could strike back. If they do, U.S. stock markets would be the first victims.

Maybe you think that’s unlikely because it would be such an extreme reaction by China. But you have to put yourself in the shoes of China’s leadership. These aren’t academic issues to China’s leaders. They go to the heart of the government’s very legitimacy.

China’s economy is not just about providing jobs, goods and services. It is about regime survival for a Chinese Communist Party that faces an existential crisis if it fails to deliver. The overriding imperative of the Chinese leadership is to avoid societal unrest.

If China encounters a financial crisis, Xi Jinping could quickly lose what the Chinese call, “The Mandate of Heaven.” That’s a term that describes the intangible goodwill and popular support needed by emperors to rule China for the past 3,000 years.

If The Mandate of Heaven is lost, a ruler can fall quickly.

Up to half of China’s investment is a complete waste. It does produce jobs and utilize inputs like cement, steel, copper and glass. But the finished product, whether a city, train station or sports arena, is often a white elephant that will remain unused.

The Chinese landscape is littered with “ghost cities” that have resulted from China’s wasted investment and flawed development model.

What’s worse is that these white elephants are being financed with debt that can never be repaid. And no allowance has been made for the maintenance that will be needed to keep these white elephants in their usable form if demand does rise in the future, which is doubtful.

Essentially, China is on the horns of a dilemma with no good way out. On the one hand, China has driven growth for the past eight years with excessive credit, wasted infrastructure investment and Ponzi schemes.

The Chinese leadership knows this, but they had to keep the growth machine in high gear to create jobs for millions of migrants coming from the countryside to the city and to maintain jobs for the millions more already in the cities.

The two ways to get rid of debt are deflation (which results in write-offs, bankruptcies and unemployment) or inflation (which results in theft of purchasing power, similar to a tax increase).

Both alternatives are unacceptable to the Communists because they lack the political legitimacy to endure either unemployment or inflation. Either policy would cause social unrest and unleash revolutionary potential.

China’s internal contradictions are catching up with it. China has to confront an insolvent banking system, a real estate bubble and a $1 trillion wealth management product Ponzi scheme that is starting to fall apart.

A much weaker yuan would give China some policy space in terms of using its reserves to paper over some of these problems. A maxi-devaluation of their currency is probably the best way to avoid the social unrest that terrifies China.

If that happens, the effects would not be confined to China. A shock yuan maxi-devaluation would be the shot heard round the world as it was in August and December 2015 (both times, U.S. stocks fell over 10% in a matter of weeks).

China doesn’t have a nuclear option. But it does have one very powerful weapon.

Will it use it? Here’s an even more important question:

Do you own gold to protect your wealth in these uncertain times?

Regards,

Jim Rickards
for The Daily Reckoning