China’s surging global influence is like the rising tide: barely noticeable but steady. However, once it reaches fundamental structures, such as US Treasuries, the lynchpin of the financial system, western policy-makers should pay attention.
The western view of the rating of Treasuries has been rather benign. The Big Three rating agencies have awarded Treasuries top grades, with only one reducing this rating by one notch because of concerns that the US was approaching its debt ceiling, the total amount the government is authorised to borrow. However, western and eastern ratings are increasingly at odds. China’s most prominent rating agency, Dagong Global, downgraded Treasuries to BBB+, with a negative outlook, in early 2018.
In its justification, Dagong states that the US administration has difficulty focusing on the management of the economy, federal debt is escalating and recent tax cuts reduce the government’s ability to service its debt. The growing gap between government revenues and the debt means the US government is badly prepared to face the next crisis. It cites weakening repayment ability as one reason for the negative outlook.
It seems as if global financial markets are ignoring warnings that the credit risk of US government liabilities is not being assessed properly. Renegotiation of Treasuries is not a prime concern, but there will be large ramifications for the financial system if their value is reassessed. There will be direct losses for those who hold Treasuries, but they also serve as collateral for myriad other financial transactions. According to the rules of the Securities and Exchange Commission, the US regulator, Treasuries can cover up to 95% of any borrowing.
For the moment, China is a lone voice, but Dagong is determined to take on the complacent Big Three. Global financial markets have not heard enough alternative views, particularly on credit markets.
The largest holders of Treasuries might take a direct hit from the deteriorating credit risk. Out of a total of $6tn, China held close to $1.2tn and Japan $1.1tn at the end of 2017. Hong Kong holds a sizable $200bn. In addition, most countries added to the stock of US Treasury securities in 2017.
Most creditors of the US Treasury agree that the dollar has to be replaced as the world’s dominant reserve currency in the long term. In the short term there are a few options. Given that US interest rates are likely to increase and the country will need to borrow more, returns will inevitably have to rise, perhaps also reflecting the deteriorating credit rating. Holding higher yielding securities offers some relief, but they are still paid in the same depreciating currency.
If US creditors were to look for real value, it is an option to purchase resources anywhere in the world for dollars. China is already doing this. It is buying real assets around the globe, ranging from mines to ports.
Those wanting to dump Treasuries might explore swapping US debt for US equity, where the Committee on Foreign Investment in the United States permits. If more holders of Treasuries go down this road, the committee might become overburdened with approval requests. If the promised US recovery materialises, it might be a better choice to target real returns rather than illusory financial ones.
Herbert Poenisch is a Member of the International Committee of the International Monetary Institute at Renmin University of China, and former Senior Economist at the Bank for International Settlements.