China Using Holdings of U.S. Treasury Bonds as Cudgel to Bludgeon United States


Contrary to our prediction, shares of the Commonwealth Bank fell yesterday. A $2 billion profit was not enough to please everyone. But mostly it was the bank’s $1.20 dividend that appeared to disappoint the crowd, even though it was a six percent increase.

Outside Australia, all eyes are on Greece. According to Bloomberg, Germany and France want the Greek government to make concrete budget cuts before organising a bailout. Of course it’s not just the Greeks that have a lot to lose if a deal isn’t found. A lot of bondholders (banks) will lose too.

But the biggest loser of all is Europe’s common currency itself. Monetary union in Europe was always an experiment. It got rid of all the old colourful paper currencies in Europe and replaced them with impressive looking new paper notes. It also made the euro a reserve currency to rival the dollar.

It now looks, though, like Europe’s experiment with paper money may go up flames even faster than the U.S. dollar, which is an impressive achievement. Twelve economies, one interest rate policy, high government deficits as a matter of course….it’s a mess. It makes high-yielding commodity currencies like the Aussie dollar and the Canadian loony look downright sexy.

One perverse irony of the Euros woes is that it might be good for the U.S. dollar. Still, the bond markets are telling us that the world is fed up (or over-fed) with U.S. debts. Dow Jones newswires reports that an auction of $25 billion in 10-year U.S. notes “did not go particularly well.” It doesn’t bode “particularly well” for an auction of $16 billion in thirty year bonds set for later this week.

Even though the 10-year auction was over-subscribed, this kind of action suggests higher yields (borrowing costs) ahead. That’s an ominous sign if you have or plan to have large structural deficits. It’s also a bad sign given that the Fed hasn’t even begun its “exit strategy” from the bond markets. It’s still supporting prices and suppressing yields.

If the mere indication that it’s going to exit the market lessens demand for Treasuries, what will it’s actual exit do? Come to think of it, what will happen when the Fed stops buying and the Chinese start selling? We reckon the Fed will have to a quick about face. More on that in second.

Further to yesterday’s point about debt as a very bad habit, check out the chart below. It shows the large spike in gross and net interest paid to Australia’s overseas creditors. By today’s standards, paying out $30 billion in interest to your creditors (half of whom are in the U.S. and the U.K)seems like a fairly small price to pay for such an extravagant increase in house prices across the nation.

Interest Liability on Foreign Debt

Source: Australia’s Foreign Debt – data and trends

Just one small point, though. According the date, 37% of Australia’s debt is denominated in Aussie dollars and 39% of it matures in 90 days or less. This makes the debt sensitive to exchange rates and extremely interest rate sensitive too. A spike in rates and/or a fall in the Aussie dollar makes paying back and servicing the debt much more expensive.

Perhaps this is one reason CBA is keeping more of its cash.

In any event, the net interest on the debt doesn’t look back-breaking at these levels. But if the debt continues to accumulate or interest rates rise, it does start to get heavier. And at bottom is a simple financial point: interest paid on your borrowings doesn’t increase your capital. It’s just money sucked into a giant black hole.

You had better hope the capital goods or investments you made with your money compensate you for the cost of servicing your debts. In Australia’s case, that means the country needs higher and higher house prices. By the way, the ABS reported yesterday that housing finance approvals fell by 5.5%. The question is begged: when housing finance slows down, will housing prices follow?

Yesterday we claimed that borrowing your way to national prosperity is a sure-fire way to servitude and political instability. Today, we aim to prove it. To do so, we cite this article from Reuters. It suggests that China is using or should use its large holdings of U.S. Treasury bonds as a cudgel with which to bludgeon the United States its strategic adversary/ indispensable economic partner.

Figures in the People’s Liberation Army want the financiers to sell U.S. bonds as a way of punishing Washington for selling arms to Taiwan. Mind you this might not seem like such a good idea if the bond selling triggers a run on the dollar and swift devaluation in China’s forex reserves. But maybe China’s arsenal of U.S. bonds is a like a pile of bullets – they’re no good unless you fire them.

Of course what we’re suggesting is that China accumulated U.S. debt as both a by-product and a weapon. The huge stock of U.S. government securities was by product of China’s trade strategy. That strategy was to keep its currency low and gain global manufacturing market share through low labour and production costs. The result was a blizzard of U.S. dollar trade surpluses that were reinvested into U.S. bonds.

You could say it’s China that’s paid for the wars in Afghanistan and Iraq.

But why is this bundle of bonds now a weapon? We think China’s export-driven growth strategy is on its last legs. Labour unions in Europe and America given today’s political climate and high unemployment – will have the ear of politicians. And they will be saying something like this, “Make the Chinese pay!”

What they’ll mean is that China will be pressured to give up its main economic weapon – currency manipulation. This has kept Chinese exports cheap all over the world and led to the gutting of American manufacturing jobs. It’s made it pretty tough on exporters in Europe too. As a result of China’s dollar peg, European exporters suffered doubly from a weaker U.S. dollar. American goods were cheaper in Europe. But European goods were not cheaper in China.

So the unions and the politicians will probably not tolerate another leg of the global recession in which China gains more market share by keeping the currency peg and exporting its way to more growth (if growth is to be had). It brings us to the end-game of China’s export-driven development.

It also brings us back to one of the great monetary questions of the day: when will China de-peg? The answer has always been simple: when it is in China’s interests to do. To us, that means China will de-peg when the benefits of increased purchasing power in the currency are more important that dwindling export profits.

In other words, we think China is close to a new phase of growth that’s driven by consumer demand, domestic consumption, and more mature Chinese capital markets open to foreign investment. A de-pegging of the currency would see a much stronger Yuan. This would give Chinese savers a lot of spending power on global markets. They would also be able to buy more Chinese goods, which might lead to higher wages in China too (and more stoking of consumer demand).

This is all a theory, of course. And we could be way wrong. But there will come a day when Chinese customers are worth more to Chinese producers than American customers. De-pegging the currency will bring that day forward. And it could be sooner than you think.

This means that the accumulation of forex reserves was never really meant to protect China from external trade shocks, although they would be handy in that event. It means they were a side effect of a trade strategy whose ultimate objective was to gain as much global manufacturing market share as possible.

Now, you might wonder why China would damage its own interests by “punishing” the United States and selling bonds. But it depends on what China’s interests are. If China’s interests are in fundamentally weakening an economic competitor and strategic adversary, then selling U.S. bonds is in China’s interests.

China’s ultimate interests are in regaining Taiwan. And we’d suggest it try and use its bond leverage to weaken U.S. resolve about defending Taiwan. And selling U.S. bonds or crashing the dollar wouldn’t just weaken U.S. resolve. It would expose the loss of strategic influence that occurs when you are a chronic debtor nation.

Mind you the U.S. still has a lot of aircraft carriers, strategic bombers, and nuclear weapons. It’s not like its bereft of tools of persuasion. But the basis of all those tools has always been a strong economy, a strong industrial base, and sound finances.

The question now is, if the base of military strength has been eroded, how long will the U.S. maintain its military advantage? Can America afford it? And when push comes to shove, will American voters demand that an American President defend Taiwan? Hmmn.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.


  1. China just become the worlds largest exporter and they have continued to grow this sector during the GFC. I dont believe they can switch it off and switch on domestic consumption like Dan suggests in this article.

    The chinese are culturally a savings people – confirmed by the property market. They use property like we use term deposits.

    That said, it seems like domestic consumption is booming when in reality they are just planting their savings in bricks and mortar.

    Now how are they going to get their savings out of that property to buy chinese manufactured products?

  2. I see China’s biggest issue is maintaining stability when the government has to play with the levers both economic and political. Let’s face it they own them all except free will.

    In today’s paper theres an article saying that the govt intends closing small steel works in China. As someone who has been there and bought from these mills and workshops i can tell you that they won’t be happy.

    Most smaller opeations are out in the sticks and without them the local economies will struggle.

    China’s biggest threat is from within as they try beat down the capalist revolution that they themselves started. People in the cities are well educated and at the moment very patriotic. They’ll do it for a while but eventually they’ll have to let the dog of the leash or risk being mauled.

  3. Nice to see the article I quoted yesterday got used as the basis for today’s reckoning :) I thought it was pretty relevant too, and on a fairly mainstream site rather than some crackpot conspiracy theorist one too.

    China’s move is straight out of Sun Tzu’s art of war.

    In fact most of their actions in the last 20 years are a prelude to conflict that’s coming up sooner or later. Lets look at the list:
    1) Establish production capacity. Check (everything’s made in china)
    2) Quietly increase military capability. Check (modernizing armed forces)
    3) Weaken foes supply base. Check (Stranglehold on foreign reserves)
    4) Weaken foes production capacity. Check (manufacturing moved to Asia)
    5) Establish connections with enemies of enemies. Check
    6) Keep enemy distracted with other conflict. Check (see Iran veto’s in security council).
    7) Establish cultural significance. Check (Olympics)

    The list goes on. Nobody should be surprised when China starts to flex its muscle more and more, and the USA is forced to quietly back off a little. They’ll make a lot of noise, but they’ll know what the consequences are if they really push their luck.

    As an added bonus, China gets to be a super power without all the moral responsibility that the USA has given itself to be the worlds police officer. Notice how nobody expected China to rescue the people of Haiti or Bali or wherever else there’s a natural disaster.

    Unpopular Truth
    February 11, 2010
  4. nice bubble forming in china – “Property prices in 70 cities rose 9.5 percent in January” Bank Lending was 1.4 trillion yuan and PPI again shot up significantly

    The media seems to focus on CPI but that is not as important to China whose entire economy is based on manufacturing. The PPI figure is more important. Some companies like Lenovo has claimed they will have to start raising prices significantly to cover input costs. Another company raised prices 10%…. The problems of excess capacity, credit and stimulus are starting to appear

    In that sense appreciating the yuan will reduce input prices and ease inflation/costs for producers. But this will lead to a fall in exports along with a subsequent increase in imports. China’s investment is slowing down as stated by the government in that they will not keep building roads etc… this year like last year. Both these sectors of the economy will then see a fall in unemployment

    Unemployment is not acceptable to the politburo as it leads to social unrest

    So its either leave the peg in place or pour more credit down the throats of the people to boost consumption – simply to reach 8% GDP growth

    So do you protect the producers (PPI) or the people (property bubble)?

  5. Unpupular Truth, notice how the US have practically invaded Haiti (quite a nice grab too… Haiti has oil!), and only days before the earthquake they were conducting a massive training exercise for the (military) command/control/communication response to an environmental disaster in that region. Had _China_ done what the US had done, it might have sparked a regional war.

  6. This discussion will become irrelevant with the appearance of the black swan.Her name is Sarah.

    Alan Edwards
    February 11, 2010
  7. “Her name is Sarah.”
    Send lawyers, guns and money. The ship has hit the fan!

    And a second Black Swan:

    From today’s NY times:

    Those _clever_ Swiss! :)

  8. Maybe China will start selling US Treasury Bonds when they finally accept the reality that the real value of their holding is only a fraction of the face value… Exchanging years of toil with some toilet paper? That day won’t be pretty…

    Sometimes it seems to me that a clash between China and the US is inevitable. Surely the Chinese elites would have already known that they’re on the receiving end of a giant financial con job. When you have nothing to lose you’ll fight… But then again there might be too much vested interests for the Chinese to make a move like this as they have as much to lose as the Americans do.

    Also, I am not sure about this Chinese domestic consumption talk. China is in many ways more capitalist than the West. The disparity between the haves and the have-nots is huge. Have you ever heard of the saying “rich country (government), poor people”? The truth is that the majority of the wealth generated by the export driven economy went to only a small portion of the population. There will be some growth in Chinese domestic consumer consumption, but it will be a lot smaller than what most people predict now.

  9. Firebug – i agree

    I have a few thoughts on the property bubble

    1. to buy a property in china requires a deposit between 30% and 50%
    2. so chinese savings which could be $100,000 plus is being locked up in the most illiquid asset – property
    3. Even Jim Rogers the china perma-bull has said there is a bubble in some cities

    Therefore you could say that China is transferring the nations wealth into a property bubble…

    I’d laugh but i am not sure if that’s funny

  10. Biker Pete – as stated somewhere above – in a world where guns and troops no longer work (eg: Afghanistan), the only way to take over control of Greece is to “save it from itself” as Germany is doing.

  11. (this is, of course, taking the point of view that the EU is can never be assumed to be permanent and so the habit of expanding one’s sphere of influence continues unabated, even for Germany .. interestingly enough)

  12. Dan, I’m sure it was _never, ever_ Germany’s intent to lead Europe… . ;)
    The European Union was always going to have to face the unequal contribution of some of its member states.

    The Swiss, bless them, realised that some (admittedly very beautiful and inspirational) countries would be a very large anchor. The Brits declined because, well… they’re Brits. :)

  13. Faber says china will slow or crash this year but also says that increasing wages is a good idea – that shows that commentators are not taking PPI seriously. Oil, copper, aluminium, iron ore etc…. its all at historically high prices so to raise wages on top of that is not going to help. However if may lead to stagflation's%20Economy%20Will%20Slow%2C%20Hurt%20Commodities&clipSRC=mms://

  14. GB – you’re right on the property thing

    Seems that the elites will end up conning the savings out of average peasants. Definitely not funny…

    A parallel is the IPO of the shares of previously state owned enterprises

  15. Quote from American source that follows: “Optimists are counting on the growing Chinese consumer class to spend the world back to prosperity. But a new study suggests that won’t be so easy.”

    The study looks at three different scenarios.

    Of course, Oz isn’t “the world” and it doesn’t sound totally unreasonable to me to suspect that Oz will continue to get a help along as China works very diligently on “saving” itself.

    They have a $2.4 trillion surplus was the last I read.

    Same author I quote from above, also raises the question (elsewhere – see below) of whether Greek woes etc and China’s lending issues may be related. With him opining that if they are causally related, then things are worse than if they aren’t. His punt at this time is that they are most likely seperate “crises”.

  16. There is another factor in this.

    If Dan is right, and I’d bet he probably is, then the US will reach a point where it will have the choice of shifting into declining power mode or taking one last shot at regaining the top dog position.

    It HAS all that firepower and, before it loses its logistics ability to support it, there will be a moment of use it or lose everything.

    If there is a rational human being in charge at the time, we may negotiate the process.

    But if there are warmongers like the last lot of Republicans in the WH, or total nut cases like Sarah and her teabagger/ dominionists, we are going to be toast.

  17. Biker and Dan, if you could ever get your hands on a book “The Germans” by Gordon A. Craig it is well worth the read. Very readable, none too fat but comprehensive on history. It is especially strong on Adenauer who sits among the few political lions of the 20th century who did not do more damage with their shortcomings than good with their strengths. Adenauer’s legacy is one where Germany seeks to cooperate rather than dominate in Europe. The Euro was a big mistake but became attractive due to the Bundesbank’s success. The little guys wanted the ride but not the discipline, the poms (their inflationist banksters) at least knew they they would get blown away trying to keep time with German styled discipline getting in the way of asset inflating ticket clipping. So I agree with Biker.

  18. a trillion here, a trillion there….. what ever happened to the 60 trillion $ derivative “death star”…. any updates would be appreciated.

    and the US troop heroes holdng exercises just before the Haiti ‘quake? a bit like the exercises before and during the 911 attacks… and still unable to ground the maverick planes for 40 mins… hard not be a conspiracy theorist. If only it were honest and fair economic competition that ruled the day.

  19. The US is compelled to devalue $US so as escape its massive debts. The devaluation is blocked by the yuan peg, and would be a very bad look for the US and for Obama. Solution: provoke and insult China on every sensitive point until they sell of US Treasuries precipitating a collapse of the $US. Obama then gets to blame China, deflecting international and domestic outrage.

  20. David Hannaford
    Bernanke just talked about raising rates so they must want a stronger dollar – for now anyway

    Prices in China, especially producer prices, are increasing. PPI is increasing rapidly, Lenovo is raising prices and Boasteel just raised its steel prices. So inflation is increasing in China faster than in the US. Therefore, when a US importer buys Chinese exports he will get a reduced quantity. E.g. The US importer was able to buy 6 pens for 6 yuan no he only gets 5 pens for 6 yuan.

    That will have a similar effect as raising the value of the yuan. It could also mean that China will devalue the yaun to the US dollar instead of appreciating it (if they have the balls to do it)

    Wouldn’t that make life interesting!!!

  21. This is interesting, it may be that chinese workers no longer want to work in terrible conditions in the factories. I guess human nature is kicking in and people have tasted a better life or seen others living a better life and want it for themselves

    That should lead to raised wages and better working conditions for workers further increasing costs

    Oil up, copper up, wages up, inflation up…. Cant see the chinese raising the value of the yuan on top of that

  22. The ol’ Chinese Internal Demand myth.

    They wheeled it out at the start of the crisis and said that China had de-coupled from the rest of the world and that things would be just fine because China had a large and growing middle class blah , blah , blah.

    Given the moderate impact so far one might think it’s true. It’s not, the Chinese demand is artificially supported by govt stimulus and dodgy stats.

    Another dip in the US , which will happen when the market stops flatlining (5 months now)and goes dramatically south. The impact on China and therefore Australia, will be almost immediate.

    As someone who works at the pointy end of the mining industry i can tell you that, although things are picking up now, 2009 saw almost no new mining activities in WA.

    My tip, the dow around 6000 points by August.

  23. “Another dip in the US…5 months now. My tip, the dow around 6000 points by August.”

    Now this is the kind of specific, well-informed advice on which readers can bank. F Phil has laid it out for you. China will fold… the DOW will fall 40% and Australia will be sucked down the plughole. And all this just six months away. You read it here first, people! ;)

    I presume Keen’s 40% property crash follows “almost immediate”ly, F Phil? :)

  24. Quite possibly Pete, although I don’t expect the fall in property to be uniform across the country, but 40% is not out of the question in the worst affected areas.

    Thanks for the compliment, i am specific and well informed and not afraid to call ’em as I see’s ’em.

    I’d be interested in your 12 month prognosis.

  25. My prognosis isn’t original, I’m afraid: “The more things change, the more they stay the same.”

    Not sure I believe the forecast of an 8% rise in property this year, in today’s ‘Australian’; or BHP’s Marius Kloppers’ two-decade of sustained growth in China; and Keen’s ‘prophecy’ of riots in Athen’s streets is a little too obvious to be termed anything but self-evident…. but when an authority at the ‘pointy-end’ discloses specific, well-informed, inside information, well, I have to pay attention, particularly with a five-to-six month use-by-date… .

    Probably _always_ a mistake to drink and then blog… . :)

  26. Very wise.


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