Treasury Bonds: Why China's 'Nuclear Option' Isn't So Scary
China's holdings of U.S. Treasury bonds are so huge that they constitute a financial "weapon of mass destruction." At least, that's how the story goes, which is why the prospect of Beijing dumping all its Treasurys in one fell swoop is called China's "nuclear option."
In this view, the sudden dumping of China's $850 billion in U.S. Treasurys would disrupt the bond market, sending the U.S. economy into a tailspin as the U.S. dollar crashes in value and yields rise.
But a closer look at the data and some recent trends suggest the power of this feared "nuclear option" is overrated.
If we brush aside the hype and political posturing, we find that $850 billion really isn't that big a number: It's about 10% of the total dollar value of outstanding Treasury bonds. Of that $8.6 trillion in outstanding bonds, roughly half are owned by foreign central banks and private investors.
The Fed Can Absorb China's Holdings
China's holdings shrink even further when placed in the context of the U.S. Federal Reserve's bond holdings. For instance, in 2009 the Fed purchased $1 trillion in mortgage-related securities to keep mortgages available and home loan rates low. The Fed currently owns $1.086 trillion in mortgage-backed securities, and $808 billion in U.S. Treasurys.
Could the Fed soak up China's $846 billion stake of U.S. Treasury if China were to dump its entire holdings? It's certainly within the Fed's power to do so. It can purchase whatever assets it chooses. Were China to exercise its "nuclear option," the Fed balance sheet would have to expand from $2.3 trillion to $3.1 trillion to absorb the entirety of China's holdings.
While this is hardly a trivial expansion, note that the Fed's purchase of $1 trillion in mortgage-backed assets didn't disrupt the U.S. or global credit markets. History simply doesn't support the claim that such an expansion of the Fed's balance sheet would trigger financial mayhem.
While China Has Sold, Americans Have Bought
While the size of China's holdings of T-bonds has been in the news for years, another trend has gotten much less coverage: Americans have been buying U.S. Treasurys. If we look at Table L.10 "Assets and Liabilities of the Personal Sector" in the Federal Reserve's Flow of Funds report, we see that the amount of Treasury bonds owned by U.S. households shot up from $112 billion in 2008 to $928 billion in 2010. If nonprofit organizations are included, the total rises to $1.06 trillion.
U.S. companies and pension funds (public and private) also own substantial quantities of U.S. Treasury debt:
Insurance firms, savings banks and credit unions hold $270 billion
private pensions hold $407 billion
Federal, state, and local governnent pensions/retirement funds hold $300 billion
State and local governments hold $512 billion
In addition, commercial banks in the U.S. own $1.6 trillion in Treasury-issued securities.
According to the Investment Company Institute, American households continue to put their cash to work in bond funds, which have attracted $620 billion since the start of 2009 and $87 billion in the third quarter alone.
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Meanwhile, China's holdings have slipped from $940 billion last July to $846 billion in July of 2010 (the last month for which data are available).
All this suggests that the home-grown appetite for U.S. Treasury is robust enough to absorb China's entire stake without major disruption to the bond market. The Fed's power to expand its balance sheet at will gives it the power to buy whatever securities it deems necessary to maintain financial stability.
At less than 10% of the outstanding Treasury debt, China's holdings simply aren't big enough to warrant the frightful "nuclear option" moniker.
