China’s Asset Sale Could Weaken Dollar

Even before moving into the White House, the Obama administration promised that it would usher in a new era of openness and understanding that would solve the often-times turbulent relationship between the US and China. To underscore this new-found optimism, Hillary Clinton made China one of her first foreign visits as the newly-minted Secretary of State.

Things got off on the right foot with Clinton highlighting China’s growing influence in the global economy. The Secretary of State made it clear that the new administration understood the value of a strong and functional relationship with the emerging super power:

“Some believe that China on the rise is, by definition, an adversary,” she said. “To the contrary, we believe that the United States and China can benefit from and contribute to each other’s successes.”

A rather odd compliment perhaps, but it is accurate in that the US and China are highly dependant upon each other. As the world’s largest exporter, China relies on the massive might of the American consumer to buy its goods and the US remains its number one market by far. Without America’s seemingly insatiable appetite for consumer goods, China could not hope to continue its transition to a modern economy, while America relies on China to help cover deficits that have climbed to $1.5 trillion or so each year.

Recent estimates place China’s total foreign currency reserves at nearly $1.5 trillion with about half of it in US-denominated securities. This definitely gives China the balance of power in this relationship and for the first time, it appears that China could be prepared to use its leverage to make a point.

Last fall, the US announced that it was selling $6.4 billion in arms to Taiwan. The problem is, China considers Taiwan a “break-away” province and has never relented on it’s territorial claims over the region. As such, it has vehemently opposed the sale of American arms in the past, but this time, Beijing is threatening to hit back where it hurts – America’s economy.

In what can only be seen as a warning shot over the bow, it has been reported that Chinese authorities have instructed its currency reserve managers to begin divesting reserves of US-denominated funds. Treasury bills and US agency debt will be retained, but asset-backed mortgages and other non-guaranteed securities are to be eliminated from currency reserves.

Risk Aversion or Retribution

If the divestment of much of its US investments is truly intended to “punish” the US for supplying what it considers an enemy force with shiny new Black Hawk helicopters and Patriot missile interceptors, it would mark a watershed moment in Sino-US relations. Sure, there have been quarrels in the past, and the US has even sold weapons to Taiwan before, but other than a bit of sabre-rattling, nothing further developed.

On the other hand, this could simply be an attempt by China to reduce the risk level of its currency reserves; which is not unreasonable given that the Federal Reserve is expected to begin winding down its quantitative easing program. This will almost certainly result in an increase in US interest rates as the Fed tries to remove liquidity from the economy, and will likely lead to a widening of spreads for mortgage-backed securities. This could trigger significant losses in the unsecured securities portion of China’s reserves.

If risk aversion is indeed the catalyst for the sell-off, this may actually be more frightening than an act of retribution. After all, if the world’s richest investor suddenly turns bearish on you, this could be a sign that you are in trouble.

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