Who Will Fund the Record $1.56 Trillion U.S. Deficit?

With the U.S. heading for a record federal deficit this year, many are wondering just how much debt the country can stand. The Treasury Department forecasts a deficit of $1.56 trillion this year, breaking the $1.4 trillion record set just last year.

But will the U.S. be able to sell its massive deficit? In other words, who's willing to buy all those Treasury bonds? In previous years, the answer was easy: China, which has amassed an $889 billion trove of Treasuries, and Japan, which holds a $765 billion stash.

Those countries' investments may not be enough to support the 2010 deficit, however. Recently, China and Japan have reduced their Treasury holdings, and Chinese officials have expressed concerns about the long-term viability of the trillions in new Treasury debt.

China's Appetite Fading

While China's holdings dipped by only $5.8 billion, the country is no longer snapping up hundreds of billions of dollars in T-bills as eagerly as it did a few years ago. To put the $1.56 trillion deficit in context, China and Japan together own a total of $1.65 trillion in U.S. Treasury debt, a figure that's only a whisker away from the debt the U.S. Treasury must issue in fiscal 2010 to fund the federal deficit. That means China and Japan would each have to double their current holdings of $1.6 trillion in one year to cover the shortfall, which they're unlikely to do.

Some observers believe that China will have to keep buying Treasuries because it runs a trade surplus with the U.S. The basic idea is that China has to park those surplus dollars somewhere, and the Treasury market is a safe and liquid place to put them. All that makes sense, but China's total trade surplus with the U.S. was $227 billion in 2009, only 14.5% of the 2010 deficit.

It seems the U.S. will have to turn elsewhere -- such as to oil-exporting nations -- to find buyers. Oil-exporting countries have continued buying U.S. debt, but in modest amounts, increasing their holdings to $218.4 billion in January from $207.4 billion in December 2009. Even if those countries doubled their holdings in 2010, the additional $218 billion would fill only 14% of the 2010 U.S. deficit.

Overall, foreign holdings of Treasury securities rose by $17 billion to $3.71 trillion in January. If China and Japan together maintain their holdings at roughly $1.65 trillion, all other foreign owners would have to increase their combined $2 trillion stake by 78% to absorb the $1.56 trillion in new debt. That's highly improbable considering that foreigners bought a total of only $390 billion Treasuries in all of 2009.

Can U.S. Savers Fund the U.S. Deficit? No.

The recent surge in the U.S. savings rate has led to a deluge of speculation that Americans could fund their own government's skyrocketing deficits, but the facts simply don't support that idea.

The U.S. Bureau of Economic Analysis calculated a rate of 4.3% for 2009 and total personal income in 2009 was about $12 trillion. That brings total U.S. savings to $470 billion for the year, far below the needed $1.56 trillion in Treasury debt. It's a sobering fact that even if every dollar of U.S. savings were invested in U.S. T-Bills, the nation's savings would only cover 30% of the deficit.

And Americans just aren't buying many T-Bills, even though they have poured a record $369 billion into bond mutual funds since March 2009. Even if all of that money had gone to purchase Treasury debt, it would only have covered 24% of it. As it is, bond mutual funds purchase local government municipal bonds and corporate bonds, as well as Treasury bonds, and -- as historian Niall Ferguson noted in a recent Newsweek article titled "Empire at Risk" -- American investors were net sellers of Treasuries in the second quarter of 2009.

Bond mutual funds bought $142 billion Treasuries and pension funds and insurance companies together purchased a mere $22 billion, according to Ferguson. So who did buy Treasuries issued that quarter? Mostly the Federal Reserve.

Situation May Not Be Sustainable

The situation is starkly different from 2007, when China was buying about 75% of all the Treasury bonds issued. Last year, the Federal Reserve was forced to step in as "the buyer of last resort."

And on top of selling the $1.6 trillion to fund this year's deficit, the Treasury must also sell new bonds to replace those that are set to mature.

All together, analysts at Morgan Stanley foresee a demand shortfall of $598 billion by June 2010, which would represent roughly one-third of the expected year's deficit. It's unclear how that deficit in deficit funding will be filled.

Will buyers who have shown reluctance to sink vast amounts of cash into T-Bills suddenly start soaking up trillions more in new Treasury debt at today's low yields? Or will the major purchaser be last year's "buyer of last resort," the Federal Reserve?

If that's the case, perhaps the more salient question would be: Is this backdoor system of funding the deficit through the Fed really sustainable over the long-term?