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International Relations

Fears of China reducing US debt jolt markets amid trade friction

Reports of Beijing shunning Treasury bonds have echos of Japan in '97

China currently holds the world's largest foreign exchange reserves, about 40% of which are in U.S. government notes.   © Reuters

TOKYO -- The U.S. bond market on Wednesday showed how sensitive it was to the risk of China reducing its U.S. Treasury purchases as trade friction between the two countries lingers.

The yield on the benchmark 10-year U.S. Treasury note shot to a 10-month high of 2.59% in London, before retreating later in the day and ending roughly unchanged in New York. Yields rise when bonds are sold.

The selling was sparked by reports that China may halt or slow down its purchases of U.S. Treasury holdings. China has the world's largest foreign exchange reserves -- holding $3.1 trillion, about 40% of which is in U.S. government notes, according to Brad Setser, senior fellow at the Council on Foreign Relations.

On Thursday, China's State Administration of Foreign Exchange released a statement denying the reports, stating they could quote the wrong source of information or be fake news. 

In recent years Beijing has held its foreign reserves at roughly the same level and has not been actively increasing purchases of U.S. debt. The worry, therefore, centers on whether it is shifting away from U.S. assets.

"It is China. It cannot be said they will never sell U.S. Treasurys," said Keiko Onogi, a bond strategist at Daiwa Securities. "But even if they do, they would do it in a way that won't disrupt the market."

The reports come as an improvement in bilateral economic ties largely failed to materialize following Donald Trump's visit to Beijing in November. 

Despite the seemingly amicable relationship formed by Donald Trump and Xi Jinping, trade friction lingers between the U.S. and China.   © Reuters

On the face of it, the U.S. president and his Chinese counterpart Xi Jinping seemed to have formed a close personal rapport. Later the same month, however, the U.S. launched an investigation into aluminum and steel imports to protect U.S. national security interests. Any punitive measures could hurt Chinese exports to the U.S. at a time when Xi is trying to steer the country through structural reform.

"Beijing could hint at reducing its U.S. Treasury holdings to signal that they won't let Washington dictate the terms of bilateral discussion," said Toru Nishihama, an economist at Dai-ichi Life Research Institute. Reducing Treasury holdings can be a tool to remind Washington that there are two superpowers in the world, he said.

Japan example

It is not the first time that the market has been gripped by fears of China dumping U.S. debt. The use of Treasury notes as a financial weapon is sometimes referred to as the "nuclear option" in financial markets.

There was similar speculation around 2009, when the U.S. issued a record amount of debt to finance economic stimulus measures. China's then-Premier Wen Jiabao expressed concerns about the country's fiscal health.

Back in 1997, Japan's then-Prime Minister Ryutaro Hashimoto sparked a sell-off by saying he had been tempted to dump U.S. Treasurys. In a speech at Columbia University, he urged Washington to work harder to stabilize the dollar, warning that Japan "had the option of reducing Treasurys and increasing gold" within its portfolio.

Unlikely scenario

Almost all experts, including Onogi and Nishihama, see the chances of China using the nuclear option as remote, given the rebound effect that would hit its own economy.

A large sale of U.S. Treasury bonds would precipitate a plunge in U.S. bond prices, causing the value of China's existing reserves to drop as well.

It would also spark increases in worldwide interest rates and threaten global growth, potentially hurting China's exports.

"President Xi Jinping has plenty of more targeted tools to pressure the United States and retaliate against trade measures," said analysts at Eurasia Group. "These include informal regulatory actions to deny market access to U.S. firms and exports. These are tools Beijing has used extensively," they added.

Using slowed Treasury purchases as a mechanism to warn the Trump administration against an aggressive trade stance was "highly unlikely," they concluded.

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