America’s Banker Threatens its “Nuclear Option”

What a week in the world’s markets. Volatility has definitely returned, and with a vengeance. U.S. subprime mortgage losses have rippled through global markets causing everything from bankruptcies, equity losses, European Central Bank (ECB) and Federal Reserve intervention through injecting reserves into the markets, credit spreads to widen, calls for the Fed to reduce interest rates, fears of a possible recession, private-equity deals to be repriced, delayed or abandoned, up to a significant rally in yields of U.S. Treasuries as investors seek their safety.

In what was perhaps one of the more potentially fearful stories to hit during the week, and one which may have been drowned out in all the week’s mayhem, China (America’s Banker) has threatened the U.S. with its self-described “Nuclear Option” of selling its holdings in U.S. Treasuries.

To understand the potential impact of this, let’s look at the landscape. China (still a Communist nation at last look) is America’s largest holder of an estimated $407B of U.S. Treasuries – qualifying it as America’s Lead Banker. China owns an estimated $900B of all U.S. bond types, including U.S. Agency bonds, corporates, MBS, etc. 44% of the U.S. national debt is held by foreign investors. Recently, China announced it will establish a government agency to boost returns on its investments and that it may invest in other securities, both to diversify its holdings and to boost returns.

China has the funds to make a significant impact in global markets. Armed with $1.33T of foreign-exchange reserves, Chinese officials said this week that China had the power to set off a dollar collapse if it chose to do so. That’s not a good thing to hear from your Banker. This response came after a number of recent political reprisals from Washington, namely from a July 26 approval of legislation by the U.S. Senate Finance Committee to place higher duties on Chinese imports to compensate for what lawmakers say is an undervalued currency, the Chinese Yuan. Since July 2005, when the Chinese Yuan was allowed to switch to a “managed float” position, the Yuan has risen 9.4% vs the U.S. Dollar. U.S. legislators deem this to be too little, saying the Yuan is undervalued and calling for it to float freely with market forces. Certainly this managed float mechanism hasn’t failed to halt the rise of China’s trade surplus with the U.S., which reached $26.9B in June, so in a sense, Washington has a valid point. Further, certain Washington Senators this week threatened trade sanctions against China unless the Yuan rises faster. China responded by saying that using it reserves “as a bargaining chip isn’t something that can’t be considered in response to some silly U.S. senators”.

While this exchange is currently in the posturing and rhetoric stage, it’s never a good thing to argue with your banker, particularly given how much we owe them and the potential negative consequences if China were to sell its U.S. Treasury holdings which would include a significant backup in bond yields and a fall (dare we say a possible collapse) in the value of the U.S. dollar. It’s doubtful this sort of exchange will lead to China’s use of its “nuclear option” but this should serve America with further evidence of the vulnerability of its Economic Security and should push us to ways of defusing these types of threats by reducing our budget and trade deficits, among other things that would promote our economic security.