Foreign Demand for US Treasuries Falls by Record Amount

Foreign demand for US Treasury securities fell by a record $53 billion in December.

China led the way, selling $34.2 billion in Treasury securities during the month. And it was the second consecutive month that China reduced its holdings.

The drop was significant since the old record was a $44 billion decline, set in April 2009.

China is saturated with US debt and signaled last year that it would begin reducing some of its holdings, which had doubled since 2007.

The size of China's holdings was so great that, as of September 2008, it had surpassed Japan to become the number one holder of US government debt. With $769 billion in holdings, Japan has now regained the top spot, while China dropped from $790 billion to $755 billion in Treasury holdings.

At the height of the financial crisis in 2008, many investors sought the perceived safety of US Treasuries. But the growing size of US deficits and the national debt may have changed that perception.

China is the biggest US trade partner and the sale of its goods here has helped to finance US deficits. So this selloff is politically sensitive. The US may now have to pay higher interest to compel foreigners to continue buying its debt. And the US can no longer rely on China, so it will have to look elsewhere for buyers.

Japan may not be the most reliable candidate since its debt is now 200% of GDP.

This sea change comes at a difficult time for the US; it now projects a $1.6 trillion budget deficit for FY 2010, which is 11% of GDP.

The trouble in European debt markets — due to the problems in Portugal, Italy, Ireland, Greece and Spain — has recently increased demand for US Treasuries, which could remain attractive as long as the crisis persists.

However, one questions remains: will the Chinese continue the selloff, or will they simply stop buying additional Treasuries?

Though it may just be posturing, two leaders in China's military have publicly called for their government to economically retaliate against the US for selling arms to Taiwan.

However, dumping its Treasuries would do as much damage to the Chinese economy as to the United States because it would further devalue the dollar. That would hurt China's ability to export to the US, and the Chinese economy is totally dependent on exports.

If the Chinese are willing to absorb a serious blow in order to punish the US, they hold an enormous amount of power and leverage. Further dumping of their Treasury holdings may amount to cutting off their nose to spite their face, but trying to understand or predict Chinese behavior may be futile.

The problem for the US is that it doesn't just need to sell Treasuries to finance its deficit spending; it needs to sell them to pay off the holders of maturing Treasuries. In other words, it needs to borrow from Peter to pay Paul.

In the absence of enough buyers, the Federal Reserve will simply conjure money out of thin air to pay the Treasury for its bonds. Such action increases the monetary supply and devalues all existing dollars.

That's the price all of us have to pay as China and others dump our bonds, and / or refuse to buy more of them.