What China Legitimately Fears


by Mario Rizzo


The U.S. Treasury, the State Department, and Larry Summers are all keen to convince the Chinese government that all they have to fear is fear itself when it comes to their investments in Treasury securities. After all, the U.S. will honor its obligations.


Frankly, I am amazed at the U.S. response. Yes, I realize that there is little else they could say. The default risk of holding U.S. securities is indeed quite low. But you don’t have to be very smart to realize that this is not the relevant risk.


As the U.S. (and other Western governments) floods the world with its bills and bonds as far as the eye can see, interest rates will surely rise. There will be at least three reasons: (1) the supply of bonds outstanding will continue to expand and sooner or later a higher rate of interest will have to be paid to get it all sold; (2) when there is economic recovery interest rates will rise generally; (3) as inflation picks up – which it will, given the huge increase in base money that the Fed will fear to withdraw from the system – the purchasing power premium in interest rates will grow. The dollars paid out as interest will be increasingly worth less.


Holders of bonds will thus experience capital losses as bond prices fall.


It is true that the Chinese export industries would benefit from economic recovery. However, that recovery in real terms will depend, in part, on the effectiveness of stimulus (and, of course, on the natural recuperative powers of the economy). If real recovery is weak and inflation accelerates in the medium-term, the Chinese will be hurt overall. Then what will Economics-Team Obama say? I guess they will say, “We didn’t default.”



4 thoughts on “What China Legitimately Fears

  1. I’m not sure exactly how this would work, but suppose they start dumping the bonds. Interest rates would tend to rise. Now, if there is a time lag, and bankers here expect the Fed to try lowering rates in response — again, if there’s a time lag — might not banks convert some of their excess reserves to bonds (anticipating that the lowering of rates would bring about capital gains on bonds)? So, in this way, some selling surges by the Chinese would encourage banks, in response, to convert reserves to bonds rather than offering loans to the non-bank public? Another possible problem from the perspective of the Fed’s mission?

  2. Holders of government bonds experience capital losses only if they sell before the bonds mature. A more serious risk for Chinese investors in Uncle Sam’s piano paper
    is currency depreciation due to inflation, in this case of the dollar vs. the yuan.
    They might want to keep some of their stash in gold as a hedge.

  3. “Holders of government bonds experience capital losses only if they sell before the bonds mature.”

    Yes, but those aren’t the relevant ‘losses’ — they experience opportunity cost losses as soon as the rates rise, which are the losses that really count.

  4. It depends on the expected holding period. I once bought a stock and had a small loss after two weeks; six years later I sold it and made eight times my investment. I had no intention of selling after two weeks.
    The loss that matters is a permanent loss of capital that comes from selling an investment at a capital loss.
    Warren Buffett has pointed this out many times, including in his annual letter to shareholders of Berkshire Hathwaway. He is generally unconcerned about buying a stock that falls in value immediately afterward. The exception would be a losing stock that he later concluded he shouldn’t have bought in the first place.
    Strictly speaking of course a lower quoted price on an existing investment is an opportunity cost loss, but long term investors measure this against expected gains.
    I doubt the Chinese government is trying to time the U.S. bond market; they no doubt want to hold Uncle Sam’s paper for longer than the average holding period of a day trader.

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