China’s Real Weapon?

The NYTimes ran a story yesterday about the potential dangers that the Chinese Navy’s rapid buildup may pose to the US. But China’s increasing military power may well be less important than another weapon that China has acquired over the past few years: substantial control over the fate of the US economy.

Consider that China’s central bank probably holds a few hundred billion dollars worth of US government securities – more than any other single investor in the world aside from the Bank of Japan. Note that this compares to a total stock of marketable Treasury securities of about $3,000 bn (excluding those held by the Fed and S&L governments), about $1,200 bn of which are held privately in the US and $1,800 of which are held by foreign individuals and institutions.

What would happen if China decided to dump, say, $100 bn of US government bonds on the market all at once? In fact, what would happen if China simply threatened to do so? I have no idea what the precise impact on prices and yields would be (though I would be interested to see the estimates of anyone knowledgeable), but I can confidently say that interest rates would end the day higher than they began it. Probably a lot higher.

Just for the sake of argument, suppose that it turns out that China has enough clout in the bond market to make long-term US interest rates rise by a full percentage point whenever they want. Just because China has such power doesn’t mean that it would ever do so. After all, China also has very powerful weapons in the form of nuclear missiles… but in practice, those weapons are not really useful against the US in any conflict other than total war. Is China’s influence over the US bond market similarly irrelevant, or is it actually a useful weapon?

To answer that question, we need to think about the impact that it would have on both the US and on China. Possible effects on the US:

• The effects on the US’s financial markets would be immediate, though possibly only short-term. The US stock market would tumble. I would find it easy to believe that a one-day rise in long-term rates of 1% could easily trigger a stock market fall of 10%. The dollar would also immediately fall, probably by a lot. If these changes in asset prices persisted for a period of some weeks, we would then expect there to be noticeable effects on the real economy…
• The sharp jump in US government bond yields would feed through to mortgage and consumer rates. Prospective home buyers would immediately have to seriously reevaluate their purchasing plans, and I would expect real estate volume to dry up, very quickly. The real estate bubble would be over.
• The sharp fall in household wealth would probably cause households to curtail spending. This would be exacerbated by any increase in import prices due to the fall in the dollar.
• Business investment spending plans would be put on hold. The tremendous uncertainty created by such a dramatic move in interest rates would cause a lot of businesses to stop in their tracks, if not directly because of the higher interest rates, then because of the doubts about their future course.
• Put these effects together, and I can easily imagine US economic growth coming to an immediate halt. If interest rates did not recover within a few weeks, a US recession seems entirely plausible to me.

What about the effects on China?

• The Chinese CB (the PBOC) would take enormous capital losses on its reserves. Such a rise in interest rates would probably wipe out 5% of the value of their bonds (i.e. losses of $10 or $20 billion) even before exchange rate changes are taken into account. With the possible exchange rate changes, total capital losses could easily total $50-$100 bn. The real significance of capital losses on the PBOC’s balance sheet is the subject of some disagreement, but everyone would agree that it would represent some loss for China.
• If the PBOC actually sold US bonds (rather than simply threatening to do so), it would probably have to buy back some of the sterilization bonds that they had previously issued in order to keep China’s money supply from shrinking. This however, could be seen as a good thing for China’s financial system, not a bad.
• China’s interest rates would rise along with the US’s. However, since so much of China’s credit market seems to be allocated by mechanisms other than price, I would expect the real effects of this to be less disruptive than on the US.
• If the financial market disturbances were long-lived enough to have real effects so that the US economy slowed, China’s exports would also probably slow. This would tend to push the Chinese economy toward a recession of its own.

To me, it seems that the costs to China are significantly smaller than the costs to the US. Furthermore, one could argue that the US government is more sensitive to the political fallout of economic dislocation than the Chinese government, simply due to the nature of democracies and totalitarian regimes.

So is this a useful weapon for China? I think that it probably is. The tremendous financial volatility and sharp falls in asset prices that would follow financial saber-rattling by the Chinese would impose enormous costs on the US, while imposing moderate costs on China. By making this calculus clear to the US government, I think that the Chinese government probably will be able to use its leverage over US financial markets as a real bargaining chip if a serious disagreement arises between China and the US in the future.

Is there any defense against this weapon? There might be a couple. Perhaps the best defense would be to enlist the aid of allies (e.g. the Bank of Japan) to buy up as many bonds as the Chinese sell. And naturally, the Fed would take center stage in the defense of the US, by also buying bonds and rapidly expanding the US’s monetary base to try to mitigate effects on the US’s financial markets. Whether such defenses would be fully effective is anyone’s guess.

One last note: I think that China’s motives for its accumulation of dollar assets are purely economic – the BWII system has provided enough important benefits to the Chinese economy to justify its support thus far. The geopolitical benefits to China that I’ve described are simply a side-effect. Nevertheless, if I were one of China’s leaders, I would feel quite pleased with this addition to my arsenal.

Kash