Hawks in Washington like to warn about China's military buildup. They should be encouraged by Beijing's emerging financial drawdown.
China trimmed its mammoth dollar holdings by $13.6 billion in October from the previous month, putting its hoard at a 20-month low. This appears to reflect an economic decision to reduce its stash of Treasuries, which at $1.25 trillion remains the largest in the world. As China works to expand the yuan’s use worldwide, it's moving toward a market-determined exchange rate. That means buying fewer dollars. Whatever the reason, though, the decline means that U.S. ally Japan -- the second-largest holder of Treasuries at $1.22 trillion -- will soon surpass China again, as it did very briefly in 2013.
Since 2008, when China took over the No. 1 spot, U.S. officials have fretted about Beijing’s leverage over the American economy. In 2009, then-Secretary of State Hillary Clinton frankly asked former Australian Prime Minister Kevin Rudd, “How do you deal toughly with your banker?” On her first trip to China as a cabinet member in February that year, Clinton dropped human-rights issues in favor of prodding China to buy more debt. “We are truly going to rise or fall together,” Clinton said. “By continuing to support American Treasury instruments, the Chinese are recognizing” that interconnection.
The bizarre spectacle of America's top diplomat jingling the beggar's cup in front of a rising rival enraged conservatives -- and rightfully so. The dangers of over-dependence on China are obvious. Chinese leaders have occasionally suggested using Treasuries to pressure Washington on policies they dislike. In August 2011, the state-run People’s Daily ran an editorial arguing “now is the time for China to use its ‘financial weapon’ to teach the U.S. a lesson” regarding its support for Taiwan.
Influential economists like Brad Setser, a Treasury Department staffer, have long argued China's bond holdings pose a national security threat. While dumping its holdings would cost China dearly, a selloff could hurt Washington more. As central banks and investors around the world piled on, yields would surge, credit-rating companies would pounce and the U.S. could be pushed into recession -- or worse.
Japan's dollar holdings have been rising to drive down the yen, a cornerstone of Abenomics. Given the trouble Prime Minister Shinzo Abe is having defeating deflation and prodding companies to boost wages, the yen is sure to go much lower still. Many see the currency reaching 150 to the dollar, compared to today's 118, which would mean huge dollar purchases in 2015. That would easily return Tokyo to a familiar position as the biggest Treasuries holder, which it was for decades before 2008.
Of course, no matter who holds the No. 1 slot, America’s huge bond exports will always leave it vulnerable. Bond traders remember all too well Japan’s own threats to exploit its dollar holdings. I was in the New York audience in June 1997 when then-Japanese Prime Minister Ryutaro Hashimoto admitted that “several times in the past, we have been tempted to sell large lots of U.S. Treasuries.” One such temptation came amid contentious auto-industry negotiations.
Still, the bond hoarder you know is arguably better than the one you don’t. If Japan were America's banker, it would remove a major risk factor in markets. The country is a solid U.S. ally, with a free economy and a government subject to democratic checks and balances. As China's military ambitions rise, territorial disputes come to the fore and North Korea's nuclear ambitions grow, Tokyo will have little reason to alienate Washington.
Obama can't force Japan's demand for Treasuries, of course. But perhaps the U.S. can offer trade concessions as part of Trans-Pacific Partnership talks as an incentive. The U.S. could also give Japan exclusive and direct access to buying debt through the Treasury. In 2012, the U.S. let China bypass Wall Street in the first-ever direct buying scheme for a foreign power. Why not shift the perk to Tokyo, as long as Japan agrees to ramp up bond buying substantially?
Likewise, Japan's stimulus efforts will mean even more debt issuance. Washington could agree to become a sizable buyer of Japanese government bonds (just as Japan is running out of people, it will have fewer willing bond buyers). Tighter financial linkages would encourage each side not to undermine the other.
It’s always possible China will remain a big buyer of Treasuries. But the size and duration of China’s recent drawdown suggests this “is more of a structural trend that’s developing,” Stanley Sun of Nomura Securities tells Bloomberg News. Washington would be wise to encourage the shift to a friendlier banker.
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