US block on Russia’s foreign-exchange reserves could cause China, Saudi Arabia and others to dump their US debt holdings
TOKYO — Japan and China tend to agree on very little when it comes to economic strategy, geopolitics or managing Western idiosyncrasies. Yet Joe Biden is bringing Tokyo and Beijing together on one issue: their combined US$2.4 trillion of US Treasury debt holdings that are now suddenly in doubt.
At issue is the US president’s move to freeze a sizable portion of Russia’s foreign-exchange reserves as punishment for Vladimir Putin’s Ukraine invasion. In Biden’s words: Washington is “preventing Russia’s central bank from defending the Russian ruble making Putin’s $630 billion war fund worthless.”
By some calculations, more than half of that stash is now beyond Putin’s reach.
What worries officials in Tokyo is that the action could make its $1.3 trillion of US government debt worth a whole lot less. In recent conversations with senior Bank of Japan officials, the decision to separate Putin from billions of state wealth is likely to cause China, Saudi Arabia and other regimes in Biden’s crosshairs to reduce their holdings.
“Then, if state wealth managers are thinking relationally, wouldn’t it behoove Great Britain, Ireland, Luxembourg, Switzerland, South Korea and Taiwan to front-run that selling?” notes one senior BOJ staffer. “Selling just leads to more selling. This will become Asia’s big paranoia for the rest of 2022.”
Officials insist Japan would resist the urge to dump dollars – at least for now. But the safety of Tokyo’s mountain of US Treasuries is complicating the year ahead for BOJ Governor Haruhiko Kuroda and Prime Minister Fumio Kishida.
For Japan, the immediate worry is a surge in US bond yields that slams global markets and business confidence. Already, the potential fallout from Putin’s attack on Ukraine is upending all that Asian governments thought they knew about 2022. The implications for already surging inflation and stressed supply chains have equity markets on edge.
Bourses in Shanghai and Shenzhen are a particular focus of global investors. The benchmark CSI 300 index has fallen 27% from a peak 12 months ago, drawing comparisons to the stock meltdown of 2018.
That year, the composite index lost more than 25% in a selloff amid slowing mainland growth and a deepening US trade war. The rout of the last 12 months is being driven by slumping property markets and worries President Xi Jinping’s “zero Covid” policy will dampen growth.
Ukraine-related risks abound, too. The People’s Bank of China (PBOC) worries its recent easing moves will collide with surging commodity prices, particularly oil and gas. Reports that China is mulling buying or boosting stakes in Russian commodities and energy companies might enrage officials in Washington.
This week, the New York Times quoted US Commerce Secretary Gina Raimondo as warning Washington could take “devastating” action against Chinese companies helping Russia evade sanctions. The specter of an intensified Sino-US conflict could drive the CSI Index further into the red.
On Thursday, Chinese stocks listed on US exchanges saw the worst selloff since the 2008 financial crisis. The Nasdaq Golden Dragon China Index dropped 10% as American depositary receipts of Alibaba Group, Baidu Inc, Nio Inc and XPeng Inc plunged.
At the same time, Russia would need China’s help in turning its $24 billion in International Monetary Fund reserves into cash. Those assets can only be exchanged for five currencies the IMF deems “freely usable.” And the US, European Union, UK, and Japan aren’t going to help Putin. If Xi does, he faces sanctions on China, too.
Looming in the background, though, are concerns about the stability of US Treasuries. BOJ officials say that not since Biden’s predecessor Donald Trump mused about defaulting has Tokyo needed to keep tabs on political maneuvering in the context of protecting state assets.
In 2016, while still a candidate for the presidency, Trump told CNBC: “I would borrow, knowing that if the economy crashed, you could make a deal. And if the economy was good, it was good. So then, therefore, you can’t lose.”
During his time in office, Trump’s inner circle mulled canceling portions of debt the US owed Beijing. Trump considered a dollar-to-yuan devaluation of the kind Argentina or Vietnam might suddenly announce.
Moody’s Analytics economist Mark Zandi speaks for many when he says “it’s complete craziness to even contemplate the idea of not paying our debt on time.” Zandi says “it would be financial Armageddon.”
Yet Xi’s government isn’t the first to fret about the safety of its massive US debt holdings. In 2009, for example, then-premier Wen Jiabao made a remarkably rare public plea to US officials to be better stewards of the vast Chinese state wealth sitting in Treasuries.
“We have made a huge amount of loans to the United States,” Wen said. “Of course, we are concerned about the safety of our assets. To be honest, I am a little bit worried.” He urged Washington “to honor its words, stay a credible nation and ensure the safety of Chinese assets.”
Two years later, S&P Global Ratings made Wen seem downright clairvoyant when it yanked away Washington’s AAA status. Now, a decade later, Wen’s successor, Li Keqiang, has even bigger worries on his hands.
US government debt has topped the $30 trillion mark, roughly twice the size of China’s annual gross domestic product (GDP). Political polarization in Washington also puts America’s credit rating in jeopardy.
The 2011 downgrade was the result of Republicans playing politics over raising the US debt ceiling, a periodic adjustment that ensures the government pays its bills. If Republicans win a majority in the US House of Representatives in November elections, that combined $2.4 trillion of Japanese and Chinese state wealth could be in harm’s way.
Republicans, warns Eurasia Group CEO Ian Bremmer, are almost certain to retaliate for the Democrats impeaching Trump twice. “Biden’s impeachment will lead the GOP agenda and public trust in American political institutions will take an even larger hit,” Bremmer warns.
S&P economist Beth Ann Bovino worries failure to raise the debt limit could be “more catastrophic to the economy than the 2008 failure of Lehman Brothers” and would squander most of the economic gains in the years since that dark period.
Such an outcome, Bovino says, would force the US government to shut down, erasing $6.5 billion of economic output per week. It also would unleash a “butterfly effect” that shakes the global economy.
One clear winner amid the uncertainty is China’s currency. Its appeal as a safe haven in recent weeks has not gone unnoticed in FX trading circles. The fact the PBOC is beating the US Federal Reserve, the European Central Bank and the BOJ to market with a digital currency only increases the yuan’s appeal as a diversifier.
Biden freezing Chinese reserves may be a win for Bitcoin, argues Lewis McLellan at the Digital Monetary Institute. “This development will no doubt be keenly noted by central bank reserve managers,” he says.
“Foreign securities and currency, held overseas, are supposed to provide an immediate boost to a currency in times of stress. Accordingly, reserves are selected for their stability and liquidity,” McLellan says.
Admittedly, he adds, “those are qualities not typically associated with Bitcoin. It’s notoriously volatile and trying to move large amounts of it typically causes major price drops. But it has some very important qualities.”
One is that it’s “non-custodial.” A central bank, McLellan says, can set up its own “cold wallet,” which is a device that stores cryptocurrency offline and free from the threat from sanctions. Another: It’s digital.
“As Russia is learning,” McLellan says, “gold in your own vault is a difficult asset for a foreign power to freeze, but it is also very difficult to liquidate. Bitcoin can be sent to addresses all over the world in a few minutes.”
In the meantime, the world will be obsessed with shifts in Chinese foreign-exchange reserves, the globe’s largest. In January, they fell $7.8 billion to $3.214 trillion.
Neighboring Tokyo, which has 1.3 trillion reasons of its own to worry, will be watching for signs that US-Russia tensions could pull the rug out from under the dollar. “Let’s just say lots of vacation plans are being canceled by BOJ people,” quips one central bank staffer.